Speculating on NFT speculation
Unless you have been living under an EtherRock, you probably heard about the explosion in popularity of NFTs (I know, that’s a corny joke, but I couldn’t resist). According to DappRadar, NFT sales volumes surpassed $2.5 billion in the first half of 2021. One of the original NFT collections, CryptoPunks recently hit $1 billion in trading volume over its lifespan. Earlier this year, digital artist Beeple sold a piece of art for $69.3m making it the most expensive NFT ever purchased. Then two weeks ago, the owners of the original doge meme NFT, which had been previously purchased for $4 million in June, sold partial ownership of the NFT and thereby increasing its value to $225 million. So, what is going on here?
One of the core breakthroughs of blockchain technology is digital scarcity. Prior to blockchains, if I sent a picture to someone over the internet, what I really was doing was sending a copy of that picture and thus the file now existed in two places. If that person forwards that same picture to five other people, there were now seven identical copies of that file in existence. However, with blockchain technology, Satoshi solved this “Double Spend” problem and thus, for the first time ever, created scarcity in a world of zero marginal costs.
In the physical world, there is only one Mona Lisa and it is incredibly valuable. Sure, people can take photographs of it, and you can see the image online by doing a Google search, but would anyone deny that the original, one-of-a-kind painting is far more valuable? We now have this same capability in the digital world with NFTs. Anyone can create a digital file that is one of a kind (or limited edition) and transfer ownership of that digital file to someone else.
In the art and entertainment industry, what NFTs are really doing is inverting the ownership model of digital media. Today, creators upload their files to platforms such as YouTube, Spotify, Instagram, TikTok, etc.. and when they do so, they give away ownership of those files to these respective platforms because the terms of service of these platforms allow these corporations to own and monetize whatever is uploaded as they see fit. NFTs are allowing creators to retain ownership of their work, bypass these middlemen and sell directly to their fan bases, thus capturing far more value themselves. Furthermore, because these tokens are programable, artists can track any future sale of a piece of work and be paid a commission every time their work is resold. They can also be programmed to include additional perks for the buyer such as early access to a piece of work or claims on future royalties. We have only begun to scratch the surface of how artists will be able to engage with their fans in new and creative ways.
NFTs are already having an impact in numerous industries such as art, music, gaming, sports, and collectibles. Each of these could be a post unto itself. However, what I want to focus on in this post is how NFTs, and specifically NFT avatars, have also become a status symbol.
Projects such CryptoPunks, EtherRocks, Bored Ape Yacht Club, Art Blocks, Pudgy Penguins, and more are simple jpeg images that range from thousands to millions of dollars per NFT. At a high level, these projects are built very similarly. The collection contains a limited number of images with overarching characteristics that unify them (they are all cartoon apes for example). However, each individual piece within a collection has distinguishing traits (ie: eye color, fur color, clothes, items carried, etc.) and no two pieces are the same. Furthermore, certain traits have been purposefully engineered to be common throughout the collection while other traits are much rarer making those pieces with rare traits much more sought after. Here are a couple of the most successful NFTs in this category:
- CryptoPunks — Released by Larva Labs in June 2017, CryptoPunks is one of the original NFT projects and set the precedent for every other project following in its footsteps. The 10,000 unique pixelated avatars were initially free to claim by anyone with an Ethereum wallet. Today, CryptoPunks have crossed into mainstream culture and headline auctions at major art houses like Christie’s and Sotheby’s. Even the lowest-priced Punk currently goes for nearly $70,000 while the rarest ones are priced well into the millions of dollars.
- EtherRock — Created in 2017, EtherRock is also one of the oldest NFT projects. Currently, the cheapest rock, Rock ID 96, is listed for 678.88 ETH (roughly $2.2 million), while the owner of Rock 0 is asking for 10,000 ETH (roughly $35 million). Apart from the rank and small variations in color, all the rocks are identical reproductions of the same royalty-free, clip art image. According to the creator, “These virtual rocks serve no purpose beyond being able to be bought and sold, and giving you a strong sense of pride in being an owner of 1 of the only 100 rocks in the game :)”
- Bored Ape Yacht Club (BAYC) — Arguably the most popular of the most recent NFT projects, the Bored Ape Yacht Club launched in May 2021 with a flat cost of 0.08 ETH (around $270 at time of launch) per ape. The BAYC team fostered a dedicated community around the project with an extremely active Discord and special benefits for holders. Similar to CryptoPunks, Sotheby’s auctioned off BAYC NFTs for $24 million. Today, the cheapest Bored Ape goes for roughly $20,000 while the highest priced goes for over $300,000.
On the surface, buying jpeg images for hundreds of thousands or millions of dollars may seem irrational. However, writing off the NFT market as insanity would be completely dismissing the importance of social signaling. Displaying material possessions (and these NFTs are nothing more than digital material possessions) to signal wealth and status in society is nothing new or uncommon.
Owning a CryptoPunk or a Bored Ape and displaying it as your profile picture on social media allows people to signal to others that they were either early or they are rich (or perhaps both). It signals to the outside world that they are part of a specific community or “in the know”. It’s the same reason people buy Rolex or Patek Philippe watches when a Cassio watch performs the same task for a fraction of the price. It’s the same reason people buy Lamborghinis and Maserati’s when a Toyota Corolla can get you from point A to point B just as easily. It’s the same reason kids who play Fortnite spend money on skins for their characters even though the skin has no impact on in-game abilities. We use a countless number of items in our everyday lives to signal status or display to the world something about who we are. The only difference between doing that in the real-world and the digital world is scale. While physical possessions will only be viewed by a limited number of people, your digital possessions such as your twitter profile picture, may be viewed by millions.
And this isn’t some fringe group in the far-off corners of the internet. NFT avatars are a full-blown cultural phenomenon that mainstream celebrities and athletes are embracing. Earlier this year JayZ purchased a cryptopunk, put it as his profile pic on twitter and sold an NFT of his debut album at auction house Sotheby’s. NBA all-star Steph Curry purchased a Bored Ape and now uses it as his twitter profile picture. NFL all-pro Von Miller did the same. There is a growing list of actors (John Cleese, William Shatner, Mila Kunis, Ashton Kutcher, Jane Fonda), musicians (Snoop Dogg, Kings of Leon, Grimes, Steve Aoki, Eminem), athletes (Tony Hawk, Rob Gronkowski, Tom Brady) and more jumping into the NFT craze. The growth even compelled one of the world’s top talent agencies, UTA, to sign on to represent Larva Labs (creators of CryptoPunks) for film, TV, video games, and publishing projects. Even Visa bought a CryptoPunk for $150,000 saying that NFTs will play an “important role” in the future of retail, social media and entertainment.
While I’m a big believer of what NFTs might possibly enable, I’d like to clarify that I’m not suggesting that all these NFTs should be worth thousands, let alone millions of dollars today. In fact, it would not surprise me at all if very few of these projects retain their value over the long haul. But even if you think many of the assets are overvalued today, it’s still worth considering the question, do NFTs belong in a portfolio and if so, where?
I personally believe that investing in digital assets takes discipline and an understanding that various crypto investments come with different risk profiles. The asset class currently has two blue chip tokens (BTC and ETH) and then the long tail of everything else (which includes NFTs):
- Bitcoin is a liquid store of value. It’s a trillion-dollar asset that has been around for well over a decade now. It’s not going away and is the digital asset that is most likely still going to be here 100 years from now. Thus, it has relatively low risk as compared to other cryptoassets and yet, still has a ton of upside potential given the trajectory of its adoption throughout the world.
- Ethereum is the second largest liquid token, and its value is entirely tied to the decentralized applications running on top of the network. Today, the vast majority of the Defi and NFT markets are built on Ethereum. However, given the recent upgrade and move to Proof of Stake (see Newsletter 11), there is technical complexity and execution risk. Should Ethereum solve these scaling challenges there is no reason to believe it will not continue to be a dominant player within the ecosystem.
- After that, every other coin or token carries far more risk. They are much younger, smaller, and less proven. Newly launched networks are more susceptible to bugs or hacks. Most of these projects will fail but a few will go on to have massive success. Being able to identify which of these tokens are generating real traction and are not just hype is crucial to having success with this group.
- Then there are NFTs, which are not only extremely speculative but highly illiquid. Investing in individual NFTs does have the potential for massive returns if you can get in early and the project rises in popularity. However, it is also extremely easy to get stuck with tokens that won’t sell. I’d consider this group furthest out on the risk spectrum though in time, that may change.
If you are mindful of those differences, you can make good use of them to build a well-diversified crypto portfolio. The goal is to balance the risk vs reward of the assets in a portfolio. In my opinion, a good way to do this is to weight the portfolio towards Bitcoin and Ethereum while allocating a smaller portion of the capital to emerging tokens and possibly NFTs.
That’s exactly how I approach investing in cryptoassets. In addition to BTC and ETH, I do my best to research and review hundreds of these smaller DeFi and Web3 tokens and only select a handful to add to my portfolio. I can analyze data, trends, and usage and I think that gives me an advantage as relatively very few people understand or use on-chain analytics.
However, NFTs are a different beast. With NFTs, there isn’t any “usage” the way DeFi and Web3 platforms have. It’s more about which project has the most cache or best social marketing team. I’ll be the first to admit I do not have a competitive advantage with regards to NFTs. Maybe as the market evolves there will be more data to analyze and methods to properly value NFTs. However, as of today, I have no clue what the next hot NFT will be, which current ones are fads, or which current ones will retain their value for years to come. As a result, I don’t invest in them. But that doesn’t mean others should avoid investing in NFTs if they believe they have some sort of competitive edge in that space.
Although I have yet to buy a punk or an ape, I’m a big fan of the NFT phenomenon. Yes, I personally think most of the pieces are currently ridiculously overpriced and in time only a handful of these NFTs are likely to retain their value. Will buying a Bored Ape for tens or hundreds of thousands of dollars prove to be a good investment in a few years? Honestly, I have no clue. But even if BAYC or Pudgy Penguins is a fad, NFTs are not. Individual projects will come and go, some may even prove to have lasting value, but the enabling technology of digital scarcity will continue to power ever more creative and interesting use cases. NFTs will expand the market size of art and collectables much the same way Uber and Lyft increased the taxi market by orders of magnitude. Regardless of whether you think this current NFT avatar craze is exciting or ridiculous, there is no question that owning digital artifacts to prove wealth or status is here to stay.
