GM

NFT royalties are once again the main topic of conversation floating around our Twitter timelines.

Sudoswap kicked the hornets nest a few months back by having neither platform nor collection fees. In response, X2Y2 announced its “Flexible Royalty” approach, where secondary fees are now opt-in (link to their retrospective tweet). Things calmed down for a month or so, until MagicEden recently announced its move to optional royalties in light of competing Solana and Ethereum marketplaces already having them be optional.

This has lead to a range of interesting questions, such as whether a collection incentivised to keep building without secondary fees, and sparked some interesting internal conversations at @goodmindsnft. One of our project’s central tenets is that of experimentation. When important conversations around how NFT projects operate, we want to be at the forefront, developing and testing hypotheses and providing valuable insights to other collections.

State of the market

As it stands, marketplaces respect a collection’s advertised secondary fees, meaning it’s actually an opt-in relationship. There is nothing on the contract level that enforces these fees and it’s only when NFTs are being sold via a marketplace’s contract that these fees are introduced. We’ll skate over the technicals for now, but if you’re interested in the challenges of enforcing secondary fees, let me know! I’ll be happy to write a follow up Field Note.

In light of recent marketplace announcements, many of us are asking questions around: should an NFT collection request secondary fees on sales? Should marketplaces respect these requests? Should consumers be taking a side and voting with their wallets?

This Field Note is going to steer clear of all-encompassing conclusions. The answer to all the above questions is most likely: it depends. It depends on what asset an NFT collection represents, what their project plans are, among many other things. We’ll focus on higher supply PFP collections with largely fungible floors, looking at the result of secondary fees vs a possible alternative.

Drawbacks of a flat secondary fee

While many see secondary fees as a non-negotiable right afforded to collections, I’d argue that the the secondary fee status quo hasn’t been rigorously examined. Let’s question the status quo, and see if flat fees on all secondary sales truly are the best system.

Incentive alignment

All NFT collections (hopefully) aim to create something that people actually desire to own. It’s hard to measure desirability, so let’s assume the best measure is the collections floor price. Note: floor price doesn’t equal holder happiness or quality, simply mass desirability as expressed by consumers’ wish to purchase the tokens. For the purpose of this Field Note, let’s assume that a collection’s value is related to the continued effort and competence of its founders, which I personally believe is actually the case, over a long enough time frame.

One of the main questions surrounding secondary fees is: without fees, is a collection actually incentivised to continue “building” and “providing value” to its holders? While a valid question, I think the opposite also needs to be asked: with secondary fees, is a collection incentivised to bring value to its holders?

Floor price

Secondary fees as an incentive don’t perfectly align with price appreciation. A collection’s floor price could 10x without a single token ever being sold, and therefore without any fees being generated. More realistically though, floor price appreciation comes with an amount of volume, but there are collections of a similar floor price with vastly different total volumes.

Some collections attempt to capture the value of the appreciation of their tokens’ price. The main mechanism we’ve seen to date is the release of a follow on collection. This creates a range of complexities around brand dilution, launch mechanics, additional art, and much more. More importantly though, it’s an admission that secondary fees are not an adequate way to align founders with their token price increasing.

Secondary fees being the primary incentive for a collection post-launch means that a collection is incentivised to drive volume, not token price appreciation.

Volume

Secondary fees are a product of a collection’s volume, so volume is a collection’s true incentive in a secondary fee world. The issue is that volume = churn, and is counter-intuitive to building a base of long-term holders. I believe the attention economy and preference of hype over delivery is directly tied to this incentive misalignment.

A collection could land a huge brand partnership, tweet about it at launch, write an article about how it ties into their roadmap, continue building, and see a meaningful amount of volume and price appreciation as a result. Another collection could spend months posting cryptic tweets, focusing more on marketing and hype, drive huge amounts of volume with little-to-no long term price appreciation, and be much better off financially than the former.

Let’s look at Azuki. They recently made a super cool announcement around Physical Bound Tokens (PBTs). Still, their highest volume day, and therefore highest secondary fee day, came on the back of the Zagabond controversy, which brought absolutely zero value to token holders.

Secondary fees as the primary incentive is telling collections to create as much hype, drama, and churn as possible, not to deliver value to their holders.

Alternatives to marketplace secondary fees

Up until now we’ve been referring to marketplace fees, which are essentially buyers paying a fee to the token creator for no other reason than they’re the token creator. Note: sometimes, and oftentimes, this is reason enough (h/t @beeple). This isn’t the only way to capture value from volume though, and an idea that came up regularly in our conversations was leaning into the notion of liquidity provision.

A central part of the 0 fee discussion focuses on what rights an NFT collection has post launch, which is a highly complex and nuanced discussion. If your fees come as result of you providing TOKEN/ETH liquidity though, you can avoid that entire discussion, provide consumers with a tangible benefit (liquidity), and still earn fees.

Here’s what that would look like at its core: the collection puts a meaningful amount of its tokens and the equivalent ETH value into a liquidity pool, charging a fee on any swaps on that pool.

A liquidity pool won’t capture all of the collection’s volume. It will always capture some volume though due to arbitrage opportunities as well as the benefit a collector will find in being able to buy any one of hundreds of tokens instantly. Marketplace aggregators like Gem even aggregate over liquidity pools. Below you can see that the current floor Good Minds are actually coming from Sudoswap

Liquidity pools create a dynamic where a collection is offering something in return for a buyer paying fees, but still doesn’t solve the problem of secondary fees as an incentive being misaligned with providing holder value. Capturing a portion of secondary fees isn’t the only value of liquidity provision though.

Volume and floor price increase incentive alignment

The unexplored benefit of liquidity provision is that it’s actually able to capture some of the price appreciation of a token in a more direct way than volume. Below is some truly napkin maths, but helps provide an insight into a collection’s ability to benefit from floor price appreciation.

For the visual learners, I’ve added advanced pictographic representations of all the numbers.

Example

Let’s say we set up a pool of 100 Good Minds and 1.3 ETH, and the floor price rockets from 0.01 to 0.2 ETH. If we have your pool set up with a linear price increase of 0.01 after each sale, by the time we reach 0.2 ETH we will have sold 19 tokens for a total of 2.09 ETH.

Looking at all the NFTs listed across OpenSea, X2Y2, Sudoswap, and NFTX, it would only take ~30 ETH to see this floor price increase. For a project with 5% royalties, in order to make 2.09 ETH you would need 41.8 ETH in volume across fee-paying marketplaces. In reality, this means notably greater than than 41.8 ETH as there will be sales on Sudoswap, NFTX, and X2Y2 (without fees).

With 43 ETH of volume, we could sweep all but 5 of the Good Minds listed on OpenSea and X2Y2. Gem only includes those marketplaces for sweeps as the price of tokens in a pool increases with each token bought.

Let’s look at what it could do across all marketplaces listing Good Minds. There are currently ~400 Good Minds for sale on both NFTX and Sudoswap, so let’s assume we split 43 (round up to give us an integer amount when split) ETH of volume a collection would need in order to match the 2.09 ETH our fictional pool would gain.

14 ETH across OpenSea and X2Y2 brings the floor to 0.886, with only 20 left listed. On Sudoswap, we could sweep all 401 NFTs for 12 ETH. On NFTX, you could buy 245 NFTs, leaving the floor at ~0.35. Overall, we’d have bought over 800 of the 1,000 Good Minds listed, with all but 20 being on Sudoswap.

These figures are purely illustrative, as in reality when the floor price starts increasing, additional holders will likely list their NFTs. On the other hand though, the 41.8 ETH needed in order to collect 2.09 ETH in secondary fees is actually volume on marketplaces that charge fees, so in reality you’d need a meaningfully higher total volume when accounting for NFTX and Sudoswap activity.

In addition, when looking at the projected earnings of our example pool, we only looked at the ETH gained by the pool selling NFTs. This pool would also be collecting fees on all swaps that happen between the 0.01 and 0.2 ETH floor price, bringing the amount collected to over 2.09 ETH.

Optics

The final benefit of the liquidity pool setup is that of the optics of a collection selling its tokens. Let’s say a collection currently holds a meaningful amount of its own tokens and wish to sell them in order to generate revenue and realise some gains as a result of their increased floor price. It would be incredibly difficult to market their decision to list these tokens for sale, and in many cases could shake holder confidence.

Furthermore, the tokens a collection is holding are unproductive when simply held by their wallet, and are unable to be bought by interested buyers. Imagine seeing your absolute grail NFT, one that perfectly captures you as an individual, but seeing it trapped in your collections wallet.

Liquidity pools solve both of these issues. Tokens held by the collection are productive as they’re actively providing liquidity and stabilising floor prices, as well as generating fees for the collection. The collection also doesn’t need to worry about any sort of announcement relating to selling tokens as the floor price increases, as that’s all handled in a transparent and on-chain way by the nature of the bonding curve.

Conclusion

NFT royalties are once again the topic of conversation. Whether a collection should attempt to charge secondary fees depends on the asset being tokenised, but the difficulty in enforcing a collection’s requested fees is becoming more apparent as more marketplaces moving to optional or no fees.

Secondary fees charged by marketplaces has been the status quo up until now, but when we look at what behaviour it incentivises, much is left to be desired. Secondary fees as an incentive are telling a collection to create hype and churn, not necessarily long term holding or floor price appreciation.

There are alternatives that could work for many collections that don’t rely on the whims of a marketplace, and would work just as well in a zero-fee environment. The main one of these alternatives is that of a collection creating a liquidity pool of its own tokens and generating revenue through that.

A liquidity pool generates revenue through fees, as well as by selling tokens on the way up. A quick bit of napkin maths showed us how much revenue Good Minds would generate via liquidity pool sales if our floor price were to instantly shoot up to 0.2 ETH. We then looked at the volume required in order to see the same amount of revenue through marketplace fees, as well as what impact that amount of volume would have on the collection.

Marketplace secondary fees still make sense for many collections, especially if the marketplace is creating a curated collecting experience, such as Sotheby’s in the old world and SuperRare in our brave new Web3 world.

For other collections, and potentially Good Minds, the notion of holding your own tokens and using them in a liquidity pool provides myriad benefits. Incentives are better aligned with that of holders, there’s no room for damaging optics that could come from a collection announcing it selling some of its tokens, all the while the tokens are productive and generating fees.

If this interested you, please give myself and Good Minds, and check out our collection on Gem. I’m undeniably biased, but I think our art is absolutely bussin’.

Cheers,

Tygra