NFTs: Why People Pay Millions for a JPEG
Back in early 2018, I came across this cryptocurrency project called CryptoKiddies. Back then, I wasn’t at all into cryptocurrencies. But I remember coming across this and just thinking how stupid it sounded. Why would I pay for a picture of a cat?
Obviously, I didn’t understand them or the technology they were built on. Nor did I realize that I should have bought some since they’re now worth thousands today.
I somehow hate cats even more now.
With the sudden jump in popularity, NFTs have hit the mainstream news. But most news companies don’t really understand what NFTs are or why they have value. The general public has started to come to their own judgemental conclusions, based on odd information curated by unknowledgeable news sources. Sounds about right for crypto.
What’s an NFT?
Before we can dive into why you’d buy an NFT, we need to understand what it is and how it works. If you already know what an NFT is, you may want to kinda skim this part. If you’re still trying to put together what an NFT is, read on.
NFT stands for Non-Fungible Token.
Fungible is an economic term that means a unit is interchangeable. A one-dollar bill is worth one dollar. Another one-dollar bill that’s slightly more worn is still worth the same one dollar. They’re interchangeable.
Non-fungible, therefore, means that they’re not interchangeable. Not all Picasso paintings are worth the same amount. And a copy of the painting is definitely not worth the same amount as the original. These are non-fungible. Picasso's paintings aren’t interchangeable with each other.
Finally, the token part. Tokens are the term used for cryptocurrencies built within the Ethereum blockchain. Put simply, programmers can build on top of the Ethereum blockchain ecosystem instead of starting from scratch. Ethereum has all of the hard stuff done already.
This means that an artist could write a program that gives someone (or multiple people) ownership over an image they made. Because it’s in a blockchain, it is set in stone. Everyone agrees, by the power of logic, on who owns that image. In practice, artists don’t usually write the program themselves. Instead, they use a website like Rarible that does that work for them.
I Heard that NFT’s Take A Lot of Energy
NFT’s are built on Ethereum. And Ethereum miners use a lot of energy.
This all comes down to the way that validation works. When I want to run a program to the Ethereum blockchain, I have to pay a gas fee. Then, a miner sees my request and does that work to put my program into the blockchain in exchange for getting paid that fee. The process for miners to change the blockchain requires them to do “work” (which is just solving a very hard math problem). The whole process is called Proof-of-Work.
Proof-of-work uses lots of energy because there are lots of miners racing to solve the math problem. The problem is that everyone who didn’t win the race just wasted that energy. The solution: Proof-of-Stake. Proof-of-stake has miners take turns instead of racing, meaning way less energy is used.
Because Ethereum is older, it was built on proof-of-work. Ethereum 2.0 is coming to switch the system to a proof-of-stake system but the rebuild won’t be coming for a while. It’s anyone’s guess when it’ll actually arrive.
There are also Ethereum competitors like Polkadot and Cardano that are being developed as well. A decade from now, I expect that there will be a variety of blockchains used, each one with its specialties and downsides. But until then, we’re mostly stuck with Ethereum.
However, miners have started shifting more to renewable energy over the years. In 2018, only 28% of miners used renewable energy. But in 2020, reports found that 76% used renewable energy. And that number is continuously growing. If you want to learn more about energy consumption, I recommend reading this article.
All that being said, yes it uses a lot of power. But it’s a short-term problem and overblown by the media. Do your own research before making conclusions.
Is Bitcoin fungible?
In the market, one Bitcoin isn’t worth more than another Bitcoin. This would point towards Bitcoin being fungible. Every Bitcoin is worth the same amount.
However, from a technical standpoint, Bitcoin is not fungible. Because all transactions are public, you can trace the history of a Bitcoin. A freshly mined Bitcoin could technically be worth more than a Bitcoin used for purchasing illegal drugs. Since each Bitcoin is uniquely identifiable and can be tracked, its previous use could theoretically taint its value.
If you’re confused, just stick with the answer that it is fungible and just forget you read the last paragraph.
Why Would Someone Buy That?
Back to NFTs, why would someone actually buy that? It's not like I need to own it in order to see the picture…
The best way to understand why NFTs have value is to compare them to art or trading cards. A Picasso painting doesn’t do much, yet it’s worth a fortune. Same with trading cards. I don’t need a trading card to see a picture of Babe Ruth, yet for some reason people buy them. You could argue that the value behind NFTs isn’t so much specific to just NFTs but the art and collectibles industries as a whole.
This is the obvious answer for why an NFT has value. People have a weird psychological satisfaction towards “owning” something. Collectors can grow their collection of NFTs just like they might grow their collection of anything else. It's just that the thing they’re collecting is digital.
Up until now, collecting digital things hasn’t been that viable because who cares. I can collect an image by right-clicking and saving it just as easily as you can. With blockchains, however, a new dimension of ownership can be formed because everyone agrees that you own that unique NFT. There’s no disputing it, it’s written in stone (or more accurately, a highly duplicated leger).
To be clear, however, you own that token. You do not own the copyright to that image. The artist could make more NFTs from that same image in the future, but they wouldn’t be the same as the original ones. Your special, identifiable, token proves you own the original token.
Another legitimate reason NFTs have value is just so they can support the artists who created them. Instead of working with a commissioner, an artist can make whatever they want to make and sell it to the world. Whatever the world decides it is worth is what it's worth. That might be $0 or could be $69 million.
Artists can also set up systems with NFTs that get them royalty whenever the NFT is resold to someone else. This creates a whole new dimension of artists supporting themselves as they can continue profiting off of an NFT in the future.
The last big reason why NFTs have value is because of investing. Many people are jumping into the NFT game hoping that the NFT they buy will be worth significantly more in the future. While some NFTs will go up in value, others might never sell for anything. As a result, it can be a much riskier investing method (more on that later).
Giving NFTs Functionality
Collectability, supporting artists, and investing all give NFTs value. But something an NFT can do that a painting can’t do is have functionality. NFTs have a wide range of use cases besides just being a collector's item.
The first huge implication for NFTs is in video games. Imagine you got a very powerful pickax in a video game. You could turn around and sell that pickax to someone else on the public market. The value of that NFT is the functionality it has in the video game.
Interestingly, other video games could theoretically also support that NFT. This brings a whole new level to the video game world as the items you work hard to get have value and functionality across many facets. Decentraland and Enjin are only two of the projects already creating these systems.
From eCommerce to Real Estate
Another implication for NFTs can be real items. Someone recently listed a real house in St. Louis as an NFT. As absurd as that sounds, the idea of buying and selling real items as NFTs is not worth glancing over.
NFTs would enable you to easily trade real items with the ease of trading a cryptocurrency. Instead of just buying an iPhone, I could buy an iPhone token from one store and redeem it at a completely unrelated store that honors that token. While I’m not a huge advocate of switching our grocery stores to NFT systems, I think the concepts are still fascinating.
Stock markets use systems called ETFs (exchange-traded funds) to let traders diversify their portfolios across many companies with ease. An ETF is basically a pool of stocks and traders can purchase a portion of that pool. As the average of those stocks goes up or down, the ETF fluctuates to meet it.
This ETF concept has been now implemented with the idea of owning a fraction of valuable NFTs. A company called Metapurse has launched the B.20 fund, a cryptocurrency token that can be traded like any other. However, it is backed by a collection of NFTs. The idea is that anyone can start to own these super valuable NFTs without need the millions to buy the NFTs themselves.
There are many other industries that NFTs can help flip upsidedown. For example, the music industry is a mess. Artists make a tiny fraction of their music compared to what a platform like Spotify makes from the artist’s labor. NFTs have the potential to change that and put the power back in the artists’ hands.
Investing in Collectables
From an investing standpoint, NFTs may sound very enticing. However, there are some things you should keep in mind before diving in.
When I want to sell a share of Apple stock, there’s a whole bunch of buyers at that exact moment who are looking to buy a share. This means the Apple stock has high liquidity since there are lots of sellers and buyers.
With collectibles like NFTs, liquidity is very different. There aren’t hundreds of one NFT being sold and bought instantly all the time. You just put it up for auction and see what it goes for.
When you’re choosing to buy something, try to stick with NFTs that is the first of something. That could mean the first NFT from that artist, the first NFT of that kind, or some other “first”. The first element gives that NFT notability and more value over subsequent related NFTs.
Thoughts on “The Bubble”
All of this brings up the question: is this just a bubble? Here are my thoughts.
I expect that the average NFT auction price will start to go down soon. However, that doesn’t necessarily mean that the NFTs are a bubble. As I previously mentioned, a big factor in an NFT’s value is being first at something. As the NFT market starts to mature, we’re going to be seeing much fewer firsts. The firsts could still retain (and hopefully grow) in value.
Tracking the value of NFTs is not easy since there’s no liquidity. Nobody knows how much an NFT is worth until it goes back up for auction. Any other method of valuing is just guessing.
Overall, I believe that NFTs are here to stay. They’re a huge deal to helping artists and have lots of different industries they can start to chip into. As the technology these NFTs are running on matures, I expect we’ll start seeing NFTs popping up in mainstream video games, music, and more.
Consider following me on Twitter for more crypto stuff: @henrygruett
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information may be accurate. Consult a financial professional before making any major financial decisions. All investments are a risk.