Signals #33 – A world of hashes (III)

NFTs are a pretty crazy asset class. See the image below? That’s the image of the NFT that someone paid $1.3 million for. And I just used that image without having to pay royalty or taxes of any kind. So that begs the question, what did that $1.3 million pay for?

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On the surface, this seems like one of those things that rich people do. Like buying snow on eBay or a 14-foot shark, NFTs (Non-Fungible Tokens) seem like a way for people to just pointlessly flaunt their wealth. And there are a lot of people looking to get in on the trend of selling these fancy jpegs. But beneath all of this hype and bluster, there’s something distinctly real. 

Let’s start by taking a step back from NFTs and onto something a little different, Pokemon. I spent a solid chunk of my life on Pokemon Emerald on the DS Lite. But let’s go back even further. Let’s go to 1989 when Satoshi Tajiri and Ken Sugimori co-founded Game Freak. At the time, Pokemon was still just an idea in their heads and they bumbled along with moderately successful titles like Mendel Palace and Pulseman. Then in 1996, with the previous successes, the pair became confident enough to develop Pokemon Red and Blue. The rest is history. 

But what if, instead of the moderate successes, the games flopped and Game Freak was strapped for cash and needed startup capital to begin developing their beloved Pokemon franchise? Although there’s everything from traditional bank loans to an entire VC industry today, at the time, there were few fundraising options out there for a studio like Game Freak.

Now, what if Game Freak was able to make Pokemon NFTs? Imagine owning the original Pikachu NFT. The NFT wouldn’t have any jurisdiction over other players capturing Pikachus nor stop Ash’s starter in Pokemon shows be Pikachu. But it would have a very real collectible value. In that sense, an NFT is no different than say a collectible beanie or luxury Hermes bag. These are all replicable things (though in the NFT’s case, a bit easier than the others) but their value comes from accreditation. It might be silly to buy an online picture of something, but it’s not so silly when you’re the verified owner of the verified rare picture. 

In fact, NFT owners actually have a very real incentive to have as many people copy, steal, and distribute their NFT images as possible. Universal usage increases the recognition of the NFT and with only one such NFT in distribution, higher demand, same supply, equals higher price. 

But for NFTs to obtain real value, they need people to believe in them. What that means is that NFTs need people to recognize that proof of ownership matters. 

To explain that, let’s take the example of a Ferrari. Ferrari builds absolutely amazing cars but their cars, in most cases, aren’t the best. In fact, many Ferraris are slower and less nimble than cheaper equivalents built by McLaren and Porsche. However, the belief behind Ferrari is so strong that simply having that logo bestows a feeling of value. Not every fast supercar is a Ferrari but a Ferrari is definitely a fast supercar. The same concept applies to NFTs. People need to believe that owning a Cryptopunk or Ether-rock has real value. And when people believe that there is real value, then with no tangible foundation, there is no wrong price for an NFT. 

Before we move forward, let’s also take one step back and ask ourselves – 

What is an NFT?

Let’s start by examining the first part of the term. Non-fungible. 

Per The Verge, “non-fungible” more or less means that it’s unique and can’t be replaced with something else. 

Let’s take some non-money and non-art examples. Plants are non-fungible. Take any two Orchids in the world and it’s easy enough to spot that they are not the exact same. They might have the same number of flowers or leaves, but there’s always a slight difference between them. On the other hand, graphics cards are fungible. My brand new GTX 1060 is the same as your brand new GTX 1060. To give a harder example, clothes are fungible. Two different Gideon Size M T-shirts are going to be identical and interchangeable. 

Let’s also take things one step further. Taxi rides are fungible. Whether it’s Uber, Lyft, or another ride-hailing app, the experience is always nearly identical. They transport you from one location to another, often in silence with the driver looking to receive a 5-star review. That’s why there’s very little user loyalty. When products are so distinctly fungible, there’s no reason not to choose the one with a lower cost. 

On the other hand, content is non-fungible. You get a far different subset of content on r/mechanicalkeyboards on Reddit compared to the Facebook Mechanical Keyboards USA group or the #mechanicalkeyboard posts on Twitter. (As a side note, click on those links at your own risk. Mechanical keyboard addiction is real and I still have a dozen of keyboards in my closet collecting dust). As a result, it would be very hard to build a new Twitter or Reddit from the ground up today. I love this quote by Max Glassman, “it’s all about switching costs… It would be difficult to find our favorite leaders’ thoughts in 140 characters elsewhere.”

Now let’s move on to the other part of the term. Token. 

The term token is important because NFTs function as cryptographic tokens, like Bitcoin and Ethereum. Where NFTs differ from any regular cryptocurrency is in their non-fungiblility. I’ll trade my Bitcoin for anyone else’s Bitcoin but I wouldn’t trade my NFT for another NFT. NFTs are primarily built on the Ethereum blockchain due to the ERC-721 token standard support. The code is surprisingly simple but versatile. In CryptoKitties, a collection of NFTs, the cats can actually be pregnant and birth new NFTs

But at the end of all this technical stuff is an enormous opportunity for profit, serious amounts of it. 

You can make money with NFTs?

Unsurprisingly, yes. 

Let’s talk about the simplest, making your own NFT. In a way, NFTs are like dropshipping. A cool picture (or dropshipping product) is important but at the core of these products is marketing. An NFT by itself has no demand and is thus worthless. To sell that NFT, you have to convince people that the NFT has some real value. That’s really hard. 

To give an example, I have a Japanese pencil on my desk. I can sell that pencil to my neighbor for 5 dollars or 10 dollars if I push it since it came from Japan. I would have a hard time selling that same pencil for $100. But if I was a popular kpop artist (which unfortunately I am not), then that pencil could go for $100 easily. The neighbor now believes that there’s some collectible value to the pencil. 

Collectible value is an interesting concept. Whether it’s a vintage 1900s classic car or babe ruth baseball, collectibles seem to always rise in value. Collectibles live in their own tiny market. The supply is constant (or negative) while the demand varies. So buying a collectible is a bet that over time, more people will want the item and be willing to pay more for that privilege of ownership. 

For my neighbor, the equation is rather simple. If I was famous, there would be fans that are willing to pay a premium for the pencil. To them, there’s a tangible real fan value. The pencil represents a fragment of memory to them (maybe my songs helped them smile on a bad day), and those are priceless.

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So up until now, I’ve been talking about a Japanese pencil but the same equations still hold when you substitute NFT for pencil. 

There’s an intrinsic value behind any NFT. That value is the time someone went through to produce the NFT. For most NFTs, the intrinsic value is incredibly close to zero but importantly, it’s not zero. 

There is also a collectible value behind any NFT. Let’s look at the top NFT collections like CryptoPunks and Art Blocks. With each of the individual Cryptopunk going for thousands of dollars ($150,000 in Visa’s case), there’s a virtuous cycle going on here. With each rise in valuation, the NFT receives free media coverage. This coverage adds to the collectible value behind the NFT. There’s a distinct difference between owning a random Cryptopunk NFT and the Cryptopunk NFT that Visa bought which the rest of the world talked about for a day. And a rise in price means more coverage/news which in turn raises prices even further.

For a new artist, however, there is no collectible value. There’s no limit on the supply of new artworks produced by the artist and no guarantee of the demand. This is also why famous painters die broke with their paintings skyrocketing in value after death. As a result, for an artist, the most important part when creating a new NFT is drumming up demand for the NFT. Unfortunately, very little demand happens organically (where someone stumbles upon your NFT and immediately wants to buy it). And collectible value stems from others wanting the same thing; as a result, if no one or very few people want the NFT at the start, there is no buildup of collectible value. 

And finally, we come to the true fan value behind any NFT. NFTs have few outside consequences. Unlike a song that you fall in love with or a trinket that sparkles under the sun, NFTs are simply online pictures. However, perhaps the biggest pro in favor of NFTs is that they are malleable. You can link an NFT with a ticket of admission or the exclusive rights to a weekly mastermind or even a yearly birthday present. The possibilities here are endless. This means that creators that currently have dedicated fans can use NFTs as an exponential function, capturing the revenue along the demand curve. 

And as any economist would tell you, when you reduce the deadweight loss, it’s basically free money.

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Ending

Unsurprisingly, NFTs are not as silly as they first seem. There’s a clear utility behind NFTs that can’t simply be waved away or laughed off. Right now, the clearest use case for NFTs comes in helping creators capture revenue from their fans and for investors to speculate on future valuations. But that doesn’t mean that NFTs can’t evolve into something more tangible and expand into new use cases. In fact, this is one area that people would do well not to bet against. When a jpeg can be worth millions, anything is possible. 

Next week, I’ll be resuming the normal release schedule with one regular Signals report and another issue of A world of hashes. If you’ve enjoyed the past few issues, please do drop me a note! I’d love to hear from you guys!