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Why NFTs Are Harder To Value And Trade Than Cryptocurrencies

Written by moushouar


The non-fungible token (NFT) market has been booming since last summer. NFT’s historical sales volume has reached $41 billion, most of that since last August, up from just $74 million at the beginning of 2021. To put this into perspective, the global art market had total sales of $50 billion in 2020. It is not just the size of the NFT market that is interesting, but also its rapid growth—and that should make any investor think twice. Are NFTs worthwhile from an investment perspective?

Separating out the investment aspect from the fun part of NFTs is necessary since everyone is getting in on the NFT action. The National Football League (NFL) gave away Virtual Commemorative Ticket NFTs to attendees of Super Bowl LVI, and AMC Entertainment is giving away free Batman NFTs to select viewers. These types of NFTs show the parts of the NFT market that are merely fads, and fads come and go.

From an investment perspective, NFTs also appear to be a fad, a replacement for meme stocks for hyperactive traders, more like Beanie Babies than a new investment asset. After all, Robinhood Markets, Inc. gamified the trading of stocks and options; NFTs take this one step further with the gamification of the actual investments. This seems a likely conclusion since most NFTs trade off their social media attention, just like meme stocks. For all these reasons and more, the future of NFTs as an alternative investment class does not look good.

Understanding NFTs

NFTs are a special type of cybercurrency token. Each NFT is unique and tied to a specific digital asset. This digital asset can be any digital file, such as a music file, a video, or a picture file, and some also claim it can be a physical asset, such as a tennis shoe.

A blockchain, the software at the core of any cybercurrency, stores an NFT data in its system, and any users on that blockchain can trade them. The blockchain records all transactions that occur on that blockchain in its digital ledger, including NFT trades. The blockchain does not store the actual digital asset, only proof of ownership; Copyright owners or the originators of an NFT can store the digital asset anywhere.

NFTs are best thought of as records of ownership of unique digital assets and, therefore, non-fungible—meaning they cannot be exchanged, one for the other, because they are not exactly the same. What you do with NFTs is exchange them for a cybercurrency. NFTs can be bought and sold like any cryptocurrency. The distinction, however, is that while NFTs are unique and non-fungible, cryptocurrencies such as bitcoins are fungible—you can exchange one bitcoin for another because they are exactly the same. For speculators, this is what makes cryptocurrencies superior to NFTs; with fungibility, you know what you’re getting. Because of their uniqueness, trading NFTs is more difficult than cybercurrencies.

The NFT Trading Process

NFTs are traded in NFT marketplaces, which have structured platforms like eBay’s. Most NFTs are sold via auctions, although some sell at fixed prices. Some marketplaces specialize in a type of NFTs, eg, art, games, sports, while others sell everything. If you wish to create a new NFT (called minting) you can do so through any of the marketplaces. The largest marketplace is OpenSea, which in 2021 had about a 90% market share by dollar trading volume across marketplaces.

There are fees for creating and trading NFTs, from upfront account setup fees and minting fees to sales fees. If you are going to create or trade NFTs, make sure you know a marketplace’s fee structure. To get a sense of fees collected, OpenSea collected about 8% of its sales volume in fees in January. There may also be royalty fees (usually 10-30% of the sales price) that go to the original creator of an NFT every time a transaction in that NFT takes place.

NFT Collections Are Where the Action Is

Speculators must be aware of the market concentration in trading is in just a handful of what are termed NFT collections. A collection is a group of NFTs that are different from each other yet share similarities. The same creators mint an entire collection, purposefully making the NFTs to be alike but different.

The Bored Ape Yacht Club is the most popular NFT collection, with total historical sales of around $2.5 billion and a 12% market share of the total NFT market, even though their creators only launched them in April 2021. The collection includes 10,000 unique jaded apes , each with a different worn style (you can see some here). The most expensive Bored Ape sold for over $3.4 million at a Sotheby’s auction.

Through 2021, the top ten NFT collections had over $15 billion in historical trading value and around a 60% share of the total NFT market. The dominance of a few collections in the market is most likely due to a preference by NFT speculators to trade within collections. It is easier to value an NFT from a collection because there are other NFTs to compare it to. It follows that, of the money a minority of traders make speculating in NFTs, most of it is from trading within collections. Clearly, informed traders know where the money is, but it is hard to believe that the market can absorb as many collections as there are today: 3,264, up from 193 a year ago. At some point, having so many collections defeats their purpose.

Few Make Money Trading NFTs

Left out of most NFT discussions is how to make money trading them. I only know of one study that attempts to understand this, The Chainalysis 2021 NFT Market Report. This analysis of the data shows that only 44% of the trades in NFTs make money, and only a minority of NFT traders make this money.

The researchers separately examined those who buy newly minted NFTs and then sell them, and those who buy the NFTs in the secondary market and then sell them. Most traders who purchase newly minted NFTs and then sell them lose money, only 29% of these trades make money. Of those who do make money, most of those buyers received a discount to the list price on their purchase. Of this minority who make money, over 50% earn more than a 200% return on their investment, whereas 60% of those who lose money on these trades lose over 50%.

Of those traders who purchase their NFTs in the secondary market and then flip them, 65% make money. But it is just 5% of these traders who earned 80% of these profits. The researchers found that these traders tend to be the most sophisticated, trade with the most capital, buy and sell the most expensive NFTs, trade the most often, and hold a larger portfolio of NFTs.

NFT Investing is Hazardous to Your Wealth

The evidence from the previous study is clear: most NFT speculative traders do not earn a positive return. From an investing perspective the results are unfortunate, but not surprising. Another aspect of trading in NFTs is that fraud within the NFT ecosystem is said to be rampant. The potential for “bad actors” to engage in nefarious selling and trading of NFTs (including counterfeit tokens or assets they don’t actually own) was described as a “contagion” by the CEO of one NFT platform. The result is a situation where your NFT purchase could end up being worthless. Combining the difficulty of earning a positive return and the inherent risks, NFT trading is not a good proposition, so stay away. They have all the signs of being an investing fad that will likely pass.

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moushouar

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