How NFTs Create Value – Open a company in Russia

Summary.

How much could a cluster of pixels possibly be worth? More pointedly, why is it worth anything at all? The explosion of NFTs and their accompanying marketplaces have left many baffled, incredulous, and deeply skeptical. But while NFTs may be fetching eye-popping, eyebrow-raising valuations, there is a logic to how — and when — they create value. By creating a system of verifiable digital ownership NFTs fundamentally changed the market for digital assets, creating the possibility for new types of transactions. Amidst a flood of new ventures, however, it can be hard to tell which are creating value and which are just riding the hype. The companies that have been most successful on this new frontier have a few things in common: They make meaningful use of the NFT technology itself, leverage a community of users, generate confidence that they can continue executing on the project to maintain ongoing community engagement, offer accessible “on-ramps” for new users, and are able to weather crypto market swings.

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In March 2021, a work of art called Everydays: The First 5000 Days sold for $69 million at Christie’s Auction House. It’s not out of the ordinary to see eight-figure art sales, but this one received a lot of attention because the piece was sold as a non-fungible token (NFT) – an electronic record corresponding to an image that lives entirely in the digital world.

Put differently: Someone paid almost $70 million for a picture on the internet.

Since then, NFTs have started to permeate pop culture in various ways. They’ve been spoofed by Saturday Night Live and embraced by high-profile celebrities like rapper Snoop Dogg and NBA superstar Stephen Curry. There are now hundreds of millions of dollars of NFT sales each week through public marketplaces like Foundation, OpenSea, and Nifty Gateway, as well as custom-built applications like NBA Top Shot and VeVe.

Yet at the same time many people wonder how tokens on the internet could be worth money at all — especially when many of them just represent “ownership” of an online image or animation that you could, in principle, download a copy of for free.

It’s easy to see why NFTs inspire both excitement and deep skepticism: They’re a completely novel asset class, and we don’t see new asset classes appear that often. But what drives the value of an asset that’s really just a digital token people can pass around? To appreciate NFTs properly, we first have to think through what they actually are and the types of market opportunities they enable. And once we unlock that, we can understand how to build businesses around them.

NFTs as a Tool for Market Design

NFTs have fundamentally changed the market for digital assets. Historically there was no way to separate the “owner” of a digital artwork from someone who just saved a copy to their desktop. Markets can’t operate without clear property rights: Before someone can buy a good, it has to be clear who has the right to sell it, and once someone does buy, you need to be able to transfer ownership from the seller to the buyer. NFTs solve this problem by giving parties something they can agree represents ownership. In doing so, they make it possible to build markets around new types of transactions — buying and selling products that could never be sold before, or enabling transactions to happen in innovative ways that are more efficient and valuable.

As the name “non-fungible token” suggests, each NFT is a unique, one-of-a-kind digital item. They’re stored on public-facing digital ledgers called blockchains, which means it’s possible to prove who owns a given NFT at any moment in time and trace the history of prior ownership. Moreover, it’s easy to transfer NFTs from one person to another — just as a bank might move money across accounts — and it’s very hard to counterfeit them. Because NFT ownership is easy to certify and transfer, we can use them to create markets in a variety of different goods.

But NFTs don’t just provide a kind of digital “deed.” Because blockchains are programmable, it’s possible to endow NFTs with features that enable them to expand their purpose over time, or even to provide direct utility to their holders. In other words, NFTs can do things — or let their owners do things — in both digital spaces and the physical world.

In this sense, NFTs can function like membership cards or tickets, providing access to events, exclusive merchandise, and special discounts — as well as serving as digital keys to online spaces where holders can engage with each other. Moreover, because the blockchain is public, it’s even possible to send additional products directly to anyone who owns a given token. All of this gives NFT holders value over and above simple ownership — and provides creators with a vector to build a highly engaged community around their brands.

It’s not uncommon to see creators organize in-person meetups for their NFT holders, as many did at the recent NFT NYC conference. In other cases, having a specific NFT in your online wallet might be necessary in order to gain access to an online game, chat room, or merchandise store. And creator teams sometimes grant additional tokens to their NFT holders in ways that expand the product ecosystem: owners of a particular goat NFT, for example, were recently able to claim a free baby goat NFT that gives benefits beyond the original token; holders of a particular bear NFT, meanwhile, just received honey.

Thus owning an NFT effectively makes you an investor, a member of a club, a brand shareholder, and a participant in a loyalty program all at once. At the same time, NFTs’ programmability supports new business and profit models — for example, NFTs have enabled a new type of royalty contract, whereby each time a work is resold, a share of the transaction goes back to the original creator.

This all means that NFT-based markets can emerge and gain traction quickly, especially relative to other crypto products. This is both because the NFTs themselves have standalone value — you might buy an art NFT simply because you like it — and because NFTs just need to establish value among a community of potential owners (which can be relatively small), whereas cryptocurrencies need wide acceptance in order to become useful as a store of value and/or medium of exchange.

The Advent of NFT Ecosystems

As marketplaces have sprung up around NFTs, creators have taken advantage of their possibilities in different ways.

The best-known examples are the digital art market, described above, and digital collectables platforms, such as Dapper Labs’s NBA Top Shot, which enables users to collect and exchange NFTs of exciting plays from basketball games — videos called “moments,” which are effectively digital trading cards. Top Shot has been building in gamified challenges and other reasons to own the cards beyond just their pure collectible value, even teasing that moment holders may eventually receive real-world benefits from the NBA.

But what’s emerged more recently is a model of active ecosystem-building around NFT-native properties — leading to novel organizations developed entirely within the NFT space. These products start with an NFT series, but project forward a roadmap under which holders of the NFT gain access to an expanding array of products, activities, and experiences. Revenue from initial and subsequent NFT sales is fed back into the brand, supporting increasingly ambitious projects — which in turn drive up the value of the NFTs themselves.

The Bored Ape Yacht Club, for example, comprises a series of NFT ape images conferring membership in an online community. The project started with a series of private chat rooms and a graffiti board, and has grown to include high-end merchandise, social events, and even an actual yacht party. SupDucks and the Gutter Cat Gang similarly began building communities around NFT image series and associated online spaces; the former has bridged into a boardwalk-themed metaverse game, and the latter has focused on real-world benefits like extravagant in-person events.

People often take on membership in these collectives as part of their personal identity — even using their favorite NFT image as their public profile picture on social media. Each NFT community has different personalities and purposes, and there are so many by now that almost everyone can find a group they can call their own. In this way, NFT ownership provides an immediate shared text that people can use to connect with each other.

And moreover, in many of these communities, ownership also conveys partial or full commercial rights — or even some degree of governance in how the community is run — which means people members can build properties on top of their NFTs that grow the value of the overall brand. Crucially, this creates a channel by which engaged fandom can feed back into the brand itself: “Jenkins the Valet” is a Bored Ape member-created project that has effectively become its own sub-brand. Individual SupDucks members have created art and character identities around their NFTs that have been absorbed into the SupDucks metaverse. And community-created fan projects have built out parts of the Gutter Cat Gang story arc.

All of these benefits make owning the associated NFTs more valuable — and almost paradoxically, this increase in the value of ownership comes in a form that helps separate the value of ownership from the purely financial opportunity of reselling.

Building on this phenomenon, a few well-known brands have recently introduced NFT series that serve to identify, reinforce, and expand their existing communities of brand enthusiasts. The popular streetwear brand The Hundreds, for example, has built an NFT project around their mascot the “Adam Bomb,” and directly rewards their community of NFT holders with improved access to the brand through connection with the founders and early access to new product releases.

Many emerging NFT applications, meanwhile, are seeking to more explicitly blend online NFT ownership with offline use cases. A few restaurants, for example, have started using NFTs for reservations. And the ticketing industry has a major opportunity here: By issuing tickets as NFTs, venues can give a variety of benefits to purchasers, creating more of an incentive to buy, as well as providing the venues an opportunity to collect royalties on secondary sales.

Other companies are exploring how NFTs could be used in establishing and recording people’s identity and reputation online. MIT recently started offering blockchain-based digital diplomas, which are effectively non-transferable NFTs. Meanwhile, both established players like Facebook (now Meta) and new ventures like POAP and koodos are providing ways for individuals to create and share NFTs around activities, affinities, and interests.

How These Businesses Can Succeed

Like all other businesses, each NFT project has to respond to a real market need. But there are unique challenges to building in the NFT space:

These ventures must make meaningful use of the NFT technology itself.

It’s not an accident that so many of the early NFT projects are built around digital rights management, since that’s one of the most direct applications of the technology. Club membership benefits for NFT holders fit in naturally as well, since a given NFT holder can certify their right to have access simply by pointing to the token in their crypto wallet.

But NFTs make less sense when there isn’t a purpose to digital ownership, such as for managing physical collectibles, where people presumably want to receive the objects themselves. (Unless, of course, they’re too heavy to move, as in the case of a recent NFT for a 2,000-pound tungsten cube.)

NFTs also have to leverage a community of users.

Like with any new product, early adopters serve as product evangelists and a source of early feedback. But with NFTs, these users also serve an even more essential role: Their decision to embrace the NFTs quite literally imbues those NFTs with their meaning and establishes their initial value.

Without a robust community of users, NFT projects can fail to get off the ground, or can quickly collapse as all the token-holders lose interest. And this means that if an NFT project doesn’t make its value proposition clear enough at the outset, it can fail to recruit a big enough community — or the right community. Lack of engagement can then become a self-fulfilling prophecy, devaluing the NFTs themselves.

To maintain ongoing community engagement, NFT project teams must generate confidence that they can continue executing.

In the world of crypto, where many people engage partially or completely anonymously, crises of confidence in a project can cascade quickly, which means it’s particularly important that the team communicate frequently and transparently about how they intend to evolve the project. (Many NFT teams have frequent “community calls” for this purpose.)

Here NFT projects can also lean on established brands or institutions, as well as explicit promises of real-world utility. For example, a sports team or popular music artist selling tickets through NFTs can use their existing reputation and events infrastructure to convince people that the NFT tickets really do have value. That said, an existing company releasing an NFT without any specific purpose or value can look gimmicky and thus fail to create engagement.

NFT projects need accessible “on-ramps” for new users.

NFTs also face a number of challenges that are general across crypto entrepreneurship. Most crypto technology at the moment is not user friendly to engage with, requiring interfacing with a number of abstruse cryptocurrency exchanges and wallet providers.

NBA Top Shot has benefited tremendously from submerging most of the underlying crypto structure in its NFT market, and enabling users to purchase moments in fiat with credit cards, rather than requiring people to transact in cryptocurrency. Other projects have recruited onboarding directors to help first-time NFT consumers navigate the process of purchasing.

And an NFT project needs to be able to weather crypto market swings.

Additionally, crypto markets are volatile and the surrounding regulatory frameworks are still being sorted out. These market swings can dramatically change the demand for NFTs — which again underscores the importance of building community and other sources of direct value for NFT ownership.

Outlook

As with any novel asset class, the future of NFTs is uncertain. In the long run, the market will need to contend with the transaction and environmental costs currently associated with using crypto technology. We will also need to establish more explicit legal frameworks around NFT ownership, and clarify how NFTs relate to existing forms of ownership rights — especially around intellectual property. At the same time, it’s likely that the most valuable applications of NFTs haven’t even been envisioned yet.

Nevertheless, the community-based NFT projects that have taken off so far give a hint of what may be to come.

NFTs enable new markets by allowing people to create and build upon new forms of ownership. These projects succeed by leveraging a core dynamic of crypto: A token’s worth comes from users’ shared agreement — and this means that the community one builds around NFTs quite literally creates those NFTs’ underlying value. And the more these communities increase engagement and become part of people’s personal identities, the more that value is reinforced.

Newer applications will take greater advantage of online-offline connections, and introduce increasingly complex token designs. But even today, it’s less surprising than you might think that people are making money selling pictures on the internet.

Disclosure: Both Kaczynski and Kominers own NFTs, as well as other crypto assets. Additionally, Kominers provides market design advice to a number of marketplace businesses and crypto projects, including Novi Financial, Inc., the Diem Association, koodos, and Quora.