In a previous piece I developed a framework to determine what NFTs derived their value from. The most salient component to their value turns out to be their marketability and resale potential rather than their intrinsic artistic value.
While I find the technology innovative and quite promising, I don’t believe the combined value of all currently existing NFTs can hold up, and caution the reader against buying anything at current valuations.
The two main drivers of my scepticism are:
A lack of scarcity
The spectre of wash trading
Illusory scarcity
Let’s talk about Bitcoin for a minute.
As an investment, Bitcoin has done pretty well and is not unlikely to hold its value.
Yet, as a would-be currency, Bitcoin derives its value exclusively from the expectation that other people will be willing to accept it against a similar or bigger amount of goods in the future.
Other than the fact that Bitcoin simply works as a transaction protocol, what has convinced most buyers is its scarcity. Bitcoin supply is fixed, there will never be more than 21 million bitcoins.
Enter the hypothetical owner of this little guy:
Well… Like NFTs! My Pudgy Penguins are scarce, there will never be more than 8888! Right?
…
…right?
Technically speaking that is absolutely correct. But there is a potentially infinite number of penguin collections that may hit the NFT market at any time1. Worse yet, it needn’t even be penguins! Any new NFT project arising takes away potential market share from the existing projects.
Wait up, wait up… My Pudgy Penguins were the first tokenized penguins, they enable PoP (Proof of Penguin), most importantly they cost 3ETH a piece, they have nothing in common with PartyPenguins!
Again, you’re right. Early and successful NFTs will likely retain a first-mover advantage. Some will manage to have sufficiently unique attributes to maintain their value. But most will not, and their value will erode with their ability to retain community members and attract newly interested buyers, as those will be faced with an infinitely expanding investable universe.
The issue is that it may not be easy, or indeed possible, to identify in advance the unique attributes that will ensure long-lasting resilience and allure.
But Bitcoin has the same problem! There’s Dogecoin, there’s Litecoin, there’s all sorts of clones taking away market share! Yet it holds its value and you’re confident it may hold it still!
This is beyond the scope of this piece but a fair point nonetheless. Bitcoin has several things going for it, but most notably:
Its “immaculate conception”. Its creator being entirely anonymous, presumed dead or missing, and its supply being as fairly distributed as possible are simply impossible to replicate,
As a monetary good, its network effect is paramount. If you mean to use a digital currency, you will likely use the one that is most universally accepted. While technically assailable (see Ethereum), any newcomer would take years to even begin to compete on that front.
The appreciation of art however does not require the building of a whole infrastructure as was built for Bitcoin, and each new creator will pull demand from other existing ones.
Lower barriers to entry
The physical art world has a way of self-imposing scarcity. It sadly takes more than raw talent to be able to live from your art or sell art at all. You’re likely to need credentials and a healthy dose of schmoozing to even get on the map of local collectors and gallerists.
Physical art also carries with it a natural floor price. An artist could not sell a $1 painting because the proceeds would not cover their costs. Inversely, legions of hobbyists have been creating digital art (of varying quality) forever and will be more than happy to inundate the NFT marketplace with low-cost submissions2.
Just like a higher minimum wage leads to higher compensations across the board, a lower floor price for digital art than for physical art should translate into comparatively lower prices.
The spectre of wash trading
The other elephant in the room is wash trading. Wash trading is the practice of pretending to buy an asset that you are yourself selling. Of course in that case you ultimately remain the owner of both your monies and your asset. Nothing really changes, so what’s the point?
Wash trading has always been rampant in crypto. Among the “traditional” crypto-economy it is a practice mostly used by exchanges to try and appeal to more customers and investors by artificially inflating their numbers. It is shady and dishonest but as long as assets maintain a modicum of organic demand, it should not overly affect prices themselves3, but only volumes. I wrote at length about the issue in the past, publishing one of the first attempts at quantifying the extent of the practice.
Were wash trading to happen within the NFT space, it would wield unchecked price-setting powers. Because NFTs are unique pieces they cannot be sold through orderbooks. Thus any NFT owner can fake a sale of their piece at whichever price they want (provided they have the money, or are willing to collude with deep-pocketed co-conspirators).
Why would they ever go through the trouble, you may wonder. The first reason should be apparent to most. If a piece appears to convincingly appreciate in value over consecutive sales, an actual buyer may turn up and pay the full price that was, unbeknownst to him, arbitrarily set up by the initial owner.
More elaborately, they may wish to have their other similar pieces fetch higher prices. While unique, many NFTs are organized in large collections and their price is in a large part derived from the price of other items in a collection, making them somewhat fungible after all.
Since most collections initially trade cheaply, they’re conceivably easy to corner4 and later have their price artificially propped up.
Launder your money and manufacture tax losses
Likewise, if you’re a drug baron, or you conveniently forgot to pay taxes as a professional crypto trader for the last 5 years, you’re in luck! Pretend you just sold an NFT for $5 million, a once in a lifetime lucky trade, and all your sins will be properly laundered.
Conversely, NFT wash trades offer a unique opportunity to engineer tax write-offs to those who hold properly disclosed cryptocurrencies. Simply anonymously buy or create an NFT, and buy it in the open at an exorbitant cost with one of your disclosed addresses. Later pretend to sell it at a loss to an anonymous address of yours and voilà, you have a tax-loss.
So, does wash trading happen?
I have no direct proof it does, and neither has there ever been much forensic work published on the issue. However, it is absolutely unthinkable that it would not happen to some extent.
Ethics in the cryptoverse is a murky thing. On the one hand, it’s not as rotten as many would expect. On each significant sale you’ll see a flurry of commentators opine “that has to be money laundering”, often with the implication that 1/ It’s impossible anybody would pay such a high price for a jpeg 2/ It is proper, drug-overlord-Bond-villain-level money laundering.
This is categorically wrong on both accounts. It fails to account for the fact that many early crypto believers have been made millionaires, decamillionaires and above by the explosive growth of cryptocurrencies. Most of these people however share an absolute loathing of taxes and have been very reticent to sell the largest part of their holdings. In fact, it is my belief that they’d rather never sell than disclose the bulk of their wealth to any state. They thus hold a tremendous amount of digital purchasing power and are more than happy to partake in the latest investment fad and maybe – who knows? – turn a profit.
On the other hand, the discussion about ethics and wash trading is generally conveniently swept under the rug by the crypto community. It’s a space that knows very little accountability and many institutions and individuals alike have thrived despite obviously unethical practices that would have been their demise in the more traditional economy.
For that reason, many of those who may partake in wash trading those valuable artefacts may not even feel like they’re engaging in nefarious activity. The space might not even hold it against them very long if they were ever found guilty. I therefore suspect that the practice is ubiquitous: the only things that could deter it would be the risk of getting caught and personal ethics. Realistically, both are close to nonexistent on pseudonymous blockchains.
The consequence is that unsuspecting newcomers will get fleeced, buying into expensive items that will appear liquid but shall never again find another bidder.
Sea change
Meanwhile, the expectation of savvy market participants is that wash trading exists, but that they nonetheless have some edge when selecting the projects they invest in and/or that wash trading will remain sufficiently inconspicuous as to keep propping prices up while remaining undetected.
Even in their shoes, I’d be wary of buying into these sky-high valuations. Given the ease with which one may abuse tax law or launder money through the use of NFTs, I wouldn’t be surprised to see swift regulatory calls for KYC/AML be put in place. In a market that’s largely anonymous, that could very quickly crack the already thin veneer of liquidity.
Even a carefully researched piece showing hard evidence of price manipulation from a reputable blockchain analysis firm (Chainalysis, CipherTrace…) may prove sufficiently influential to deter most of the newcomers necessary to absorb the inflow of newly minted NFTs.
In fairness, wash trading may carry a cost: Opensea, the largest NFT marketplace, charges a 2.5% fee on all publicly listed sales. However, until a controversial change was announced on September 3, it was possible to carry a private sale through the platform at no cost whatsoever. Perhaps tellingly, there is no way to observe whether a past sale was private or public, since the fees paid are not a public matter, but are directly taken from Opensea accounts rather than paid on-chain.
One has to wonder whether curbing wash trading was part of the reason for Opensea’s policy change and whether that may have been prompted by regulatory pressure.
In any case, it should be revealing to witness if this apparently innocuous change ends up marking “the top” for any projects.
Some optimism
This piece might read like I disapprove or am missing the value proposition of NFTs entirely. I don’t think that’s true5. In fact, I’d be willing to bet that the market share of NFTs over physical art will only grow over the next few years. There will be ever more projects, and they will, in aggregate, sell for more.
But that is strictly orthogonal to the valuation of existing projects, and may in fact work against them.
Even some of the most praised features of NFTs will deceptively work towards making individual pieces cheaper, not more expensive. For example, each NFT carries within it its own provenance, its record of ownership. A buyer doesn’t have to consult with a litany of experts to establish authenticity, pay the exorbitant Sotheby’s fee or check the Art Loss Register before committing to his purchase.
If you figure this makes the NFT more valuable than physical art, what you’re missing is that the cost of the whole process is already embedded in every work of art, and removing it would not make them more precious.
Disintermediation will not make art more expensive, but it should ultimately contribute to give comparatively more purchasing power to buyers, thus enabling more artists to live off their art. Speculation and rent-seeking be damned, this is what should matter to most.
Actually, there is already at least one less successful copycat: https://opensea.io/collection/party-penguins
Provided that blockchains ever scale and gas prices fall back to reasonable levels
Indeed, if wash trades are to be executed in sufficiently well-endowed public orderbooks they will be constrained by the highest actual bid and the lowest actual ask unless their perpetrators are ready to take on market risk
Corner: Acquiring a large part of the supply of an asset in order to manipulate prices. In general, it ends up misfiring. But the nature of the NFT market structure makes it comparatively easy and safe.
Not everyone can be Frances Coppola or David Gerard and write at lengths about things they despise.
Good thinking, Sylvain. The SEC is already targeting the DEX component of the DeFi (Uniswap), and it is just matter of time when NFTs get into their crosshairs. Especially in case of fractionalized NFTs. Dapper Labs is already dealing with private class action which claims that certain NFTs are securities. As for wash trading, I know from my own experience that DEXes are more prone to it than CEXes as the latter are maturing and also want to avoid regulatory trouble. Same wash trading risk likely applies to NFTs, especially given their more illusory scarcity.
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