NFTs - Is winter approaching?
NFTs are all the craze in the crypto world. And among NFTs the most buzz today is for LootProject which is just white text on black background. Yes you read that right - white text on black background.
Lootproject launched about a week back on Aug 27. It has generated $152M in trading volume at the time of this writing (Sept 3). That averages to a trading volume of approximately $19M per day. And this from a project that is less than a week old. This project created just 8000 bags - each bag had some white text on a black background. If you were a lucky one to get one of the 8000 bags minted that day you could have made a decent sum. The most expensive bag at this time was sold yesterday for $946,000 USD. Let that sink in. Not bad for a week’s work if you happened to mint this bag by being in the right place at the right time.
This is not a one off. A staggering $3B USD in NFT sales has been made just on one of the platforms that supports NFT namely OpenSea. A NFT based game Axie Infinity has generated nearly $1Billion in revenue over the last month. The game requires people to spend money to buy digital pets called Axies as NFTs inside the game and breed, battle and trade them. Visa recently joined the bandwagon by purchasing a NFT for $150k. The image corresponding to the NFT owned by Visa is shown below.
There are several people that have bought into the concept of NFTs being a golden ticket. At the same time there is a lot of skepticism about NFTs. For a quick look into such opinions check here and here.
So before you go out and buy a NFT for yourself, let me give you a quick overview of NFTs - what are they? Why are they called that? This is followed by a brief history of NFTs. And I conclude by pointing out the various issues with NFTs currently.
What is an NFT?
So what is an NFT? Well NFT stands for Non Fungible Technology.
Okay but really what problem does it solve?
NFT addresses the problem of ownership of digital media - digital media such as the audio or video or image files that reside on any computer. Humans understand the concept of ownership of physical media. In the past we have not been able to assign ownership of digital media since it is very easy to copy digital files.
The blockchain technology that started with Bitcoin in 2009 solves this problem and allows us to assign ownership of digital media. Consider a recording of my zoom session with my friend. I can claim ownership of this video file. Yes, my friend can view it, copy it and maybe send it around but I own it. Similar to say the Mona Lisa painting. I can take pictures of the painting and send it around but I cannot claim ownership of the painting.
How is the ownership of the digital media assigned? To do this, each digital object is associated with a token. And the token is associated with the owner on the blockchain and this mapping is stored on the blockchain - so the mapping is protected from unauthorized modifications using cryptographic tools. Anytime the ownership changes, the mapping from the token to the owner as tracked on the blockchain also changes. And to change the ownership, the previous owner will have to use the right keys.
In addition to allowing for ownership of digital media, NFTs also allow you to establish provenance. This is another way to say that you can easily determine all the owners of the digital media since the time it was created since information about all the owners is stored in the blockchain. As a result, some digital files might have a higher value since some famous person owned it in the past. This is similar to what you would expect in the real world with physical objects.
Why call it NFT?
Each digital asset is supposed to be unique and hence the tokens corresponding to two different digital assets are also unique and cannot be interchanged. This is unlike the case of other assets like dollars or Bitcoin. Any $100 bill is similar to any other $100 bill. Or any Bitcoin can be swapped with any other Bitcoin.
But any token representing a digital asset cannot be swapped for a different token representing a different digital asset since each is unique. Hence we call these tokens as non-fungible since a given token cannot be exchanged with another token. As a fun fact note that humans are also non-fungible since you cannot swap one human for another. You can though swap one robot for another as long as both are the same model.
I am sure you can see that NFT represents a digital collectible just like the stamps or the baseball cards that we used to collect while growing up. If a particular stamp was very rare then it could command a lot of value. On the other hand, stamps that were numerous and more of which could be produced would be worth very little for the collectors. This could also lead to perverse incentives for the entities that create stamps or baseball cards or other collectibles. By having few stamps or baseball cards the price rises and this increase in price can result in the entity creating more of these limited stamps. This ultimately can result in a crash.
Having explained the concept of NFT, I next provide a brief overview of the history and current state of NFTs.
NFT - before 2021
The first NFT was reportedly created in May 2014 in order to give another revenue stream for the artists. And then nothing much happened on this front for a few years.
Then in late 2017, this concept took off with the popularity of Cryptokitties. This was a game centered around breedable creatures called Cryptokitties. But then, this came to a screeching halt because of issues with scalability of the platform (Ethereum), high fees associated with creating and transferring NFTs and also due to the crypto winter that followed. CryptoPunks was another project that opened in June 2017 with 10,000 unique CryptoPunks each being represented by a token on the Ethereum blockchain.
The market then warmed up again in 2020 to the concept of NFTs with NBA Topshots being open to the public in October 2020. NBA Topshots can be considered to be one of the most successful application of NFTs. The site provides typically a 10-15 second video clips of official basketball games. You can pay to claim ownership of this video clip. I can download the video clip to view or pass around but I am not allowed to claim ownership of this clip.
This site abstracts away the crypto underpinnings to make it easy for the users. So much so that they allow the users to purchase the NFTs using credit cards unlike other sites where the users have to use cryptocurrency to purchase NFTs.
So what can you do as the owner of this video clip? See this interesting article on this topic with more details. Obviously since you own the video clip you have the right to sell the “ownership claim” to others in the future. But then the the NBA specifies various other things that you cannot do with this clip. For example you cannot use the image to create merchandise. You cannot associate the image with anything the NBA considers offensive. You cannot modify the video clip. So the ownership in this case is conditional although it need not be so in case of any general NFT.
NFT - in 2021
Earlier this year, NFTs arrived with a bang when an artwork by Beeple was sold via Christie’s auction for $69 million althougth there have been some questions raised about this sale. The NBA TopShots themselves continued to break sales records. And CryptoPunks also came roaring back. While they were originally given away for free, the entire collection of 10,000 unique CryptoPunks is now worth billions of dollars.
In all these cases, the digital asset was created by the Creator and then assigned a NFT and the NFT was distributed to the collectors. This has been the case until a week back when LootProject was unveiled.
The LootProject takes a bottoms up approach towards NFTs. In this case, the creator created the building blocks which was white text on black background and released these blocks as NFTs to the collectors. The collectors are expected to mix and match various NFTs to result in other digital assets. This is what has caused all the excitement in the NFT world leading to the crazy sales numbers associated with this project. The tweet thread shown below also explains this approach.
NFT - Sales today
Sales from NFTs are off the chart as you see from the chart below. You can see many other projects in addition to the ones I mentioned in the list below. Even the NFT project in the 20th position has done $33M is revenue in just the last 30 days. This is insane.
Issues with NFT
So we see billions of dollars being spent on trading NFTs. Does this mean that NFTs are the golden ticket. Not really. There are several issues associated with NFTs that need to be addressed. But this will take time and the NFT market is exploding. Hence I believe that the NFT market is setting itself up for failure. And we will be faced with a NFT winter even though NFTs can solve some interesting problems.
So what are the reasons for my current pessimism about NFTs?
The main reason is that we do not understand all the intricacies associated with NFTs. And so NFTs are being used indiscriminately. Platforms have made it very easy to create NFTs out of every digital asset. The creators then attempt to find a scapegoat who can purchase the NFT and make the creator rich in a short amount of time by any means possible. Such a situation always ends in disaster.
Since NFTs are collectibles (and hence they are assets), they need to have some aspect of scarcity to maintain their value. Otherwise, the price of each NFT will be a race to the bottom. Some of the famous NFT projects enforce this. For example, CryptoPunks has issued 10,000 NFTs. Loot has issued 8000 NFTs. And yet many others do not do this.
A second reason is because people confuse the physical and digital media. NFTs are about ownership of digital media and not about ownership of physical stuff. For example, look at the tweet below. The author here bought a diamond that she destroyed after creating a NFT for that diamond. And now she expects to sell the NFT in lieu of the diamond. The mistake here is that NFT cannot represent the ownership of physical entity. NFTs can only represent the digital media.
The author was trying this experiment I assume to show that valuables like a diamond or a house have a price that depends not only on the utility of the valuable but also on the fact that this valuable is a store of value. And so her argument is that NFTs should become the store of value due to which the physical valuables have only a utility price associated with them. But this separation between the utility value and the asset value will take decades given human psychology.
A third reason for my pessimism is due to the fact that NFTs these days are built on top of the Ethereum blockchain. (Okay granted the exception being NBA Top Shots which is built on another blockchain called Flow). In my opinion, the Ethereum blockchain is complex and buggy and not ready for primetime yet. I am more hopeful of NFTs that leverage the Bitcoin blockchain using smart contracts on the Bitcoin blockchain (using technology such as Stacks). But I am not aware of any NFTs that leverage the Bitcoin blockchain which is much more robust.
A fourth reason is on account of the separation between the NFT and the digital asset itself. NFT is just a token stored on a blockchain. The actual media is stored in some other location possibly under centralized control since storing the asset on the blockchain has issues. There is no guarantee that this location where the actual digital asset is stored will survive. See the twitter thread below to see that this is not an exception but the norm
It’s the wild wild west in the NFT land. As a result sometimes artists find their works already minted as an NFT and sold by someone not authorized to do so. See twitter thread below for one such instance. This is the fifth reason for my current pessimism.
And then there is no control on the supply of NFTs. The oversupply of NFTs will result in a bad ending in this phase. As stated in this article,
With NFTs, the risk of oversupply is especially acute, because there is no one in charge, and the barriers to issuance are so extraordinarily low — you can literally create a new NFT in a matter of minutes.
Related to the supply we do have questions such as - if I modify the digital asset slightly I can obviously create a new NFT. So is this really a new NFT?
Finally, the current user experience with NFTs is very bad. NBA Top shots is again the exception here since they have abstracted away the use of crypto. In fact they allow you to purchase NFTs using a credit card as mentioned previously. They just focus on the use case for the customers namely the ability to own limited edition digital assets. This is not the case with the other platforms where you can trade NFTs.
So given all these issues, we need to crawl before we walk and walk before we run. And unfortunately this is not happening - we are attempting to run without either crawling or walking. Hence my current pessimism since once these issues become open knowledge the masses will give up NFTs for the next big thing.
NFT - Future
In the long run I am optimistic about the potential of NFTs although I expect a NFT winter in the short run. NFT allows for several powerful use cases such as but not limited to
Ability to associate conditions with the sale of digital media. This allows the creators to get royalty from future sales also as specified in the conditions. This is the typical use case mentioned.
Ability to own stuff in the metaverse (virtual worlds)
Ability to be paid for ideas when they are cited as opposed to just citation as now. Details of this are given in this article.
Ability to create a digital identity that can be used for transactions in the crypto world.
If you are interested in learning more about NFTs I recommend the following three articles in addition to the various articles linked earlier. The first link connects to a page that gives a quick overview of NFTs. The second link connects to a page with lot of NFT articles and the third link provides details of how you could get started with creating, buying and selling NFTs.