Burst or Growth: Ongoing Transformations of Overpriced JPEGs

April 15th, 2022

From tokenizing art to generating in-game assets, NFTs were once at the forefront of onboarding users to the web3 economy. In 2021, NFTs ballooned to a $41 billion industry with more than 3.3 million newly created wallet addresses trading over $17 billion in volume.

However, the market has taken a major hit since then. According to NonFungible, the average sale price of an NFT has dropped by almost 70% since January 2022. In the same period, primary sales have declined by almost 90%, plummeting from 26,000 to 3,200 per day. The market capitalization has also shrunk to a little more than $10 billion. The weakened demand has caused many to fear that an imminent collapse could turn their digital assets into worthless jpegs.

Significant decrease in sales volume and demand over the year (source: NonFungible.co

Are NFTs a bubble? If so, what would be the next stage for these overpriced jpegs?

What are NFTs, and why are they important?

NFTs (Non-Fungible Tokens) are unique cryptographic tokens that exist on the blockchain. They often represent real-world objects like art, music, or in-game items in the form of digital assets. In a broader sense, NFTs introduced the concept of ownership to the digital economy where there have been historically only digital services (i.e., registering on Twitter is like renting a space from a centralized server). Ownership creates scarcity, and scarcity creates value.

Apart from revitalizing the art market, NFTs have the potential to transform a variety of industries. In real estate, NFTs are used in transferring land deeds and providing proof of ownership; in education, NFTs began to be seen as a replacement for diplomas to record educational achievements; in the ticketing industry, non-fungible tickets can prevent frauds and are significantly cheaper than traditional ticketing solutions.

Furthermore, NFTs have also proven to be a major game-changer for the gig economy. There are approximately 60 million independent workers in the United States contributing $1.5 trillion to the national GDP. According to a recent survey conducted by Fiverr, about 64% of these gig workers have profited from NFT-related services, including art creation, coding, and community management. For many of these freelancers, NFT projects are gradually turning from side hustles to lucrative careers due to the profitability of these endeavors.

Is this all just a bubble: the value prop of NFTs

In 2021, the market grew 200 times compared to the previous year. Gold-diggers flocked in, but only held their NFTs on average 48 hours before selling for profits, compared to 156 days in 2020. However, with the rapid expansion came an even faster contraction during the market downturn. In the past few months, macro factors like the Ukrainian crisis and inflation injected instability into the financial market. Consequently, the NFT market shrunk by almost 90% in primary sales and 70% in average sales prices. As captured by the greater fool theory, people started trading NFTs at extravagant prices in hopes of offloading the burden (a.k.a flipping NFTs) to “greater fools” at higher prices.

This is in many ways reminiscent of the Dutch Tulip mania. At the peak of the Dutch Golden Age, recently introduced tulips became the symbol of fashion and social status and gained enormous speculative values. Contract prices for the bulbs sometimes reached more than 10 times the annual revenue of a skilled artisan, deviating significantly from the actual value of the tulip. The tulip market eventually collapsed when tulip traders could no longer find buyers willing to pay such an exorbitant price – as the expectation fell, the liquidity problem arose, the supply of greater fools dried up, and the bubble burst.

Most of NFTs are traded for less than the minting cost or dead (source: nansen)

Much like tulips, the intrinsic value of NFTs is highly subjective. Their monetary value reflects the confidence, or perhaps conviction, that their holders have over their long-term growth potential. Consequently, when a community loses faith in a project, the value of that project loses all of its foundations. The NFT industry is hence extremely susceptible to market sentiments The last owners, “the greatest fools,” will provide exit liquidity for everyone coming before and bear the loss from the burst of the bubble.

However, unlike tulips, NFTs are also social and communal, carrying utilities beyond financial gains. Consumers increasingly identify with the NFTs that they own and express their sense of membership by changing their profile photos into their NFTs and participating in community gatherings. The spirit of the project often translates to the unifying force of that community. The pop-culture-themed NFT Azuki, for instance, hosted a real-world Garden Party in Los Angeles on March 30th, bringing thousands of members who were part of this digital community together for a massive celebration. The women-led project Crypto Coven hosted intimate offline gatherings in Shanghai and reading clubs with a focus on female empowerment. Bored Ape Yacht Club (BAYC) represents a community of OG influential whales; Mfers is a spontaneous community echoing the spirit of CryptoPunks, while Doodles is a community-driven initiative with the theme of likable art and childlike wonder.

A “blue chip” NFT is like the key card into an exclusive club, where people meet friends with similar tastes, interests, and sometimes even beliefs. NFT projects are similar to early-stage cultural hubs. Viewed under this lens, NFT investments are like democratized venture investments into cultural startups that are aimed to realize their promised social influence. The upside of this investment is huge and unlikely to be crashed by short-term market volatility. With digital identity becoming increasingly important to post-pandemic consumers, NFTs are expected to become a non-negligible force in the formation of virtual communities.

Azuki's digital community coming together at the Garden Party in Los Angeles

The Next Stage: Ongoing Trends for Tokenized Digital Artworks

Following the analog of NFTs as cultural startups, top NFT collections like BAYC are cultural centers owning huge IPs and popular recognitions, just like Disney in entertainment or Blizzard in gaming. Early in their path of projecting influence on mass cultures, these cultural centers have much space for growth by integrating their IPs with gaming, entertainment, and physical stores.

Some projects have made their initial forays. Three weeks ago, BAYC announced its plan to launch the “Otherside” metaverse with open gaming features as an attempt to extend its influence beyond the Bored Ape holders. In collaboration with BAYC, Los Angeles restaurateur Andy Nguyen planned to open the first BAYC-themed restaurant in Long Beach, California with feature packaging and employee uniforms emblazoned with bored apes’ imagery, an example of how web3 images continue to interact with the physical reality. Similarly, in a recent interview with Hypebeast, Doodles’ founders expressed their goal to bridge web3 and the real world and connect NFT enthusiasts through community initiatives “such as installations, concert merchandise, and more.”

Ultimately, NFT-based communities are redefining users’ digital identities and driving the next evolution of social networks overtaking the centralized web2 communities formed around social media. By penetrating cultural verticals, trending NFTs have the potential to transform from digital collections into IP-based social/cultural ecosystems.

The ongoing penetration of trending NFT images into popular culture

2) The Rise of Centralized NFT Marketplaces: the Engine for Mainstream Adoption

Crypto exchanges have been seeking their entry into the crowded NFT marketplaces for a long time. Launched in June 2021, Binance NFT has onboarded over 1000 creators and supported the creation of over 2.5 million NFTs, building the largest trading platform for in-game assets. In September, FTX announced the launch of FTX NFTs to render NFT trading an additional investment choice for FTX users. One month later, Coinbase also announced its plan to launch an NFT marketplace aimed at enhancing social experiences including easier collection discovery and community building.

The bullish case for exchange-backed NFTs came with concerns about centralization

While every exchange-backed NFT marketplace occupies its market niche, they share the similarities of lower fee structures, lower pricing standards, and fiat cash-out options. Compared to incumbents like OpenSea, these rising institutional players provide an appealing alternative to everyday consumers with limited experience with the web3 ecosystem.

Instead of competing with their decentralized counterparts within the existing market, exchange-backed platforms are likely to expand the market and attract new buyers. On FTX NFTs, for example, artists have limited control over their brands and earn zero loyalties compared to the usual 5-10% loyalty rate on OpenSea. Binance NFT only allowed pre-approved creators to mint their collections. Restraints like this are nightmares for independent artists or artistic collectives familiar with the freedom on OpenSea, but these centralized platforms minimize trading frictions and are hence more friendly to everyday investors.

Thanks to their enormous number of users, these exchange giants are uniquely positioned to democratize access to and redefine the user experience of NFT trading. In the third quarter’s earnings call, Coinbase emphasized the goal of integrating social media experience into their NFT marketplace, rendering it more similar to Instagram than a traditional marketplace such as eBay. Users will be able to showcase their NFTs on the Coinbase site and follow each other’s profiles for easier collection discovery. To date, about 3.9 million waitlist requests have been submitted for Coinbase NFT, three times more than the 1.1 million users that OpenSea has accumulated over the past several years. Exchange-backed NFT marketplaces thus carry the hope of pushing NFT trading to mainstream adoption.

3) Financialization of NFTs: Race for Liquidity

Illiquidity has plagued the NFT market since the very beginning. Among over 2100 NFT collections recorded by CoinMarketCap, about 49% have less than 100 sales in all time. For some collections like Meebits, over 66% of the collections have not been sold even once. Investors have little incentive to enter the market without sufficient exit liquidity. Financialization is hence the key to onboard the next million users to NFT trading, from which arise the following solutions:

a) Fractionalized NFTs: Ownership Democratized

Fractional NFTs divide one NFT into smaller pieces representing fractional ownership of the same NFT. They are generated using smart contracts to create a fixed number of fungible tokens linked to the original asset. For expensive artworks, this mechanism reduces barriers to entry and allows retail investors to partake in the growth of previously inaccessible collections, thereby creating new channels for market liquidity.

According to DappRadar, fractional NFTs have a market capitalization of over $186 million. Within the market, The Doge NFT accounts for half of the market worth. After the swell of dogecoin, PleasrDAO split the NFT into 17 billion pieces of ERC20 tokens selling at $0.004 for each piece. A more recent example was Azuki’s experiment in decentralized character IP management. The team decomposed Azuki #40, an image of “an honest bean farmer,” into 50,000 “Bobu” tokens that allow token holders to participate in IP governance.

Despite their recent growth, fractionalized NFTs have garnered unwanted regulatory attention. The SEC cited fractional NFTs’ similarities with securities and warned of imposing regulations to demand the same level of disclosure and transparency. Although the legal interrogation has brought short-term setbacks, fractional NFTs are likely to regain momentum with more regulatory clarities for this sector and the crypto industry as a whole.

The increased NFT market liquidity driven by fractionalization

b) NFT-Collateralized Loans: the Intersection of NFT and Financing

Due to the lack of buyers for extremely expensive NFTs, many holders need liquid money without selling their digital assets. NFT-backed loans provide a solution. Protocols like Arcade, NFTfi, and Pawnfi allow owners to collateralize NFT assets for a crypto loan just like collateralizing real estate for a loan from the bank. The difference is that lenders often get a higher interest rate than they would in a traditional loan, and that it is peer-to-peer trading.

Although the NFT collateral market is still nascent, it has gained much traction since the start of this year. On Arcade, they have accumulated over $20 million of “blue chip” NFTs locked up in exchange for loans. On NFTfi, the total amount of transactions has reached over 28000 ETH (or 90 million USD). Earlier last month, an anonymous borrower took out the largest NFT-backed loan of $8 million by collateralizing their collection of 101 Cryptopunks, attracting much interest to this burgeoning collateral market.

However, there are two major constraints to this evolving marketplace. First, due to the volatility of NFT prices, acceptable collaterals are largely limited to the highest valued collections like BAYC or CrypoPunks and restrict the access of everyday retail investors. On NFTfi, for example, the highest-ranked 3 collections occupied over 41% of the total loan volume. To engage a broader audience, the next step for these protocols is to develop algorithms for evaluating more NFTs collections and also implement risk management measures in case of NFT price drops.

Second, NFT-backed loans are mostly paid in crypto and used for on-chain purposes such as investments in DeFi protocols, which creates significant friction if the borrower wants to pay for everyday expenses. As NFT trading becomes more popularized, the feature of NFT-collateralized fiat loans may become essential to bridge the gap between web3 investments and real-world benefits.

Top NFT collections dominating the NFT-backed loan space on NFTfi

c) “ Yield-bearing NFTs”: Staking NFT in DeFi Protocols

To earn yields from NFTs, owners lock their NFTs in a DeFi protocol to facilitate transactions and provide liquidity. In exchange for their staking, they will receive rewards denominated in the platform’s native tokens, which can be sold on secondary markets for profits. Similar to how bonds accrue interests in traditional finance, yield-bearing NFTs provide the opportunity to earn passive income from digital assets and attract risk-averse investors who do not want to deal with market uncertainties.

NFT staking has been used frequently in crypto gaming. For example, Splinterlands developed a staking platform that allowed users to lock their in-game cards or land NFTs as liquidity pool providers. In turn, they would receive a share of the daily Splitershards (SPS) token airdrop based on the amount that they staked. Owning these tokens represents the membership of the Splinterlands DAO and gives users voting rights on certain governance decisions. With the community growing bigger, tokens become more valuable, and early adopters can sell their tokens to realize staking rewards.

Targeting the root of the NFT liquidity problem — non-fungibility, NFTX offers an innovative solution that harnesses fungibility to financialize NFTs. On NFTX, users can pay a small “minting fee” to deposit their NFTs into a collection-specific vault and create fungible ERC20 tokens (vTokens) pegged to a random asset from the vault. Then, they can instantly sell their ERC20 tokens using sushiswap to liquidate their floor-priced NFTs. Later on, anyone can redeem a random asset with one vault-specific vToken or pay an extra “target redeem fee” to claim a designated NFT from the vault. The liquidity providers of this marketplace, the stakers, lock their NFTs in the vault and earn rewards coming from other users’ minting fees and target redeems fees. NFTX has experienced tremendous growth in the past quarter. Its Total Value Locked (TVL) has increased by 70% to $56 million, while the monthly active users have almost doubled.

Rapid growth of NFTX reveals the increasing demand for NFT staking

The biggest advantage of NFT staking lies in its ability to turn volatile and risky NFT investments into low-risk securities. The upside here is huge.

d) NFT Prediction Markets: Building Derivatives on NFTs

Prediction markets are platforms where participants place bets on outcomes of future events. NFT prediction markets are decentralized protocols that allow users to forecast outcomes in the world of NFTs. Users are able to predict the floor prices of NFTs based on their knowledge and monetize their correct predictions.

In October 2021, decentralized derivatives exchange SynFutures launched NFTures, an intuitive platform for traders to long or short specific NFTs, synergizing with its existing crypto futures product. Since then, the platform has attracted over 33,000 all-time traders. Two months ago, OpenDAO also launched SOSMarket which allows $SOS token holders to participate in predicting the future of NFT projects, prices, governance, and even real-world events.

NFT prediction markets are perhaps the most nascent market amongst the four solutions of financialization. Nevertheless, this trend is included as a nod to the rapid growth of the crypto derivatives market.

Conclusion

As a primer for NFT investors, this paper surveys the key value propositions of NFTs and tackles a specific use case of NFTs — tokenized digital artworks — to analyze three major trends that propel the market forward.

First, leading NFT collections have much space for growth by transforming from digital collections to IP-based social ecosystems, thereby driving the formation of virtual communities in the post-pandemic era. Second, exchange-backed NFT marketplaces will make NFT trading more accessible for everyday consumers through low trading fees and easier collection discovery and spur the next wave of NFT adoption.

Lastly, various NFT financialization solutions continue to combat the liquidity problem in the market and accelerate NFTs’ growth into a popular asset class. Within this category, fractionalized NFTs, NFT-collateralized loans, yield-bearing NFTs, and NFT prediction markets are the four major forces injecting liquidity into the system.

The recent market volatility has driven away many speculators, leaving people with strong convictions about the long-term growth potential of NFTs. Fueled by the entry of institutional NFT exchanges, the growing digital communities formed around NFTs will consolidate the social, cultural, and economic utilities of tokenized artworks, and the increasing innovation combining NFTs with DeFi will provide new opportunities for the market.

The NFT hype may slow down for short-term corrections but is unlikely to burst, not with this speed of innovation, this momentum for crypto adoption, and this passion for digital communities.