2021 seems to have been the birth year of the NFT (or “non-fungible token”). Although NFTs have been in existence since 2012, it is only this year that they have finally been both brought to the and accepted by the masses. The transaction volume that we are talking about here is huge and growing.
The NFT market is constantly evolving. Market commentary ranges from saying that NFTs are the wave of the future, all the way to saying that NFTs are inherently valueless and are a passing fad.
The goal of this article is to educate the reader on what NFTs are and why they matter. Further, I will go on to explain our own analysis of the market at Legacy Group and aim to direct attention to the areas of the NFT market that have the most value to individual investors.
First off, what is a non-fungible token?
Per The Verge, “Non-fungible” essentially means that the asset is unique and it can’t be replaced with something else. For example, a bitcoin or a US dollar note is fungible – trade one for another, and you’ll have exactly the same thing.
A one-of-a-kind painting, however, is non-fungible. If you traded it for a different painting, you’d have something completely different. For instance there is only one original Mona Lisa. There are many replicas, but the original has enhanced value because it is original and collectors value the asset at a higher price as a result of this inherent scarcity in the market. Verifying authenticity in the art world is a vital portion of the investment aspect of the industry and requires credible experts to engage in the authentication process. Nowadays, with blockchain technology, the authentication process is done nearly automatically with an aim to make true verification of uniqueness a value proposition that can be brought to the masses in a commoditized fashion. NFTs represent these non-fungible assets in digital form.
The range of the types of NFTs transacting on the market today is vast, with the most common being art. In March of this year, a digital artwork sold for nearly $70 million at Christie’s. This was the first ever sale by a major auction house of a piece of art that does not exist in physical form.
How do NFT transactions work?
Most NFTs today are sold on the dominant marketplace, Opensea. Other potential NFT assets include music, trading cards/collectibles and video game items that have a “utility” functionality within their given video game ecosystem. Specifically related to utility NFTs for instance, modern-day gamers can purchase characters, costumes and gameplay accessories as NFTs that will provide the buyer with a unique use or value within the given video game. These are often transferable and monetizable. These “utility” NFTs are growing quickly in value and popularity given the exponential growth in the video game market in recent years, which is set to reach $256.97 billion by 2025 and will have more than 2.9 billion players worldwide by the end of 2021.
Most NFTs today are built as part of the Ethereum blockchain. Ethereum is a cryptocurrency, like bitcoin, but the blockchain technology itself supports the creation, recordkeeping and transaction parameters of most NFTs. When transacting for the purchase of NFTs, the common payment mechanism is, of course, Ethereum, or “ETH” as the simplified trade ticker. When people purchase or sell NFTs in today’s market they use almost exclusively cryptocurrencies to do so.
Modern day NFT marketplaces resemble that of simplified stock exchanges where certain NFTs have stated bid values, while others proceed in an auction type format where the highest bidder will win over a stated auction period. These marketplaces act as both primary and secondary exchanges for the NFT assets. There are numerous buyers on today’s marketplaces who make a business of trying to identify arbitrage by buying low on the NFT primary market and flipping their position for a higher price in the near-term in a secondary market transaction.
How big is the current NFT market?
Prior to 2021, the NFT market was a blip on the radar in terms of capital investment amounts. In the chart below, you can see the monthly trading volumes of the largest NFT marketplace today, Opensea, and all data is provided in open source format via Dune Analytics.
You will note that in August of this year the marketplace transacted over $3.4 billion in that month alone, which is over 10x what the marketplace did the month before. Transacted purely in ETH, the NFT market is ultra efficient and no formal banks are required to engage in the transactions.
Many readers may ask: well, if certain NFTs are going for $70 million, all this trading volume may just be for a few high ticket items and could just be a one-time occurrence, right? In terms of the number of NFTs being sold, Opensea, actually, hasn’t traded less than 1.4 million individual, unique NFTs since August of 2021. Every month, millions of NFTs are created, sold and exchanged to the tune of billions of USD in value.
You must also note that Opensea is not the entire realm of the NFT market, they are just one major player. There are numerous other platforms competing for their portion of the pie, and undoubtedly there will be more in the future as the market continues to expand and sophisticate.
How does the NFT marketplace compare to public stock exchanges?
Now to be clear, NFTs are a completely different asset class than a stock or a bond. There is no underlying company, management team, business model, etc. embedded in any of these unique NFT assets. But, given the fact that they are being traded at such huge volumes and at such premium pricing, they are an asset class nonetheless and are traded in both primary and secondary markets similar to a stock on an exchange.
If you were to take the trading volumes of Opensea by itself, not including any of their market competitors, today’s monthly trading volumes in the $2.5 – $3.5 billion range mirror that of some of the smaller and mid-level stock exchanges that exist in today’s global economy. It is important for the reader to remember that the developed world does not have a monopoly on stock markets, although they do hold the vast majority of the tradable, public value that exists globally. Many emerging and developing markets have their own stock markets, largely for domestic companies that do not operate outside of their home country that require domestic funding options. There are a number of these stock exchanges that exist globally and they greatly assist in the capital formation of growing businesses in these developing worlds.
For instance, the smallest functioning stock market is that of the Seychelles Securities Exchange (commonly known as the MERJ Exchange). There are only 24 companies listed on the exchange and the domestic market capitalization is only $19 million. Now Seychelles is a small country of only about 100,000 people, but it is a sovereign nation and the stock exchange does function. If you were to compare the MERJ exchange to the current transaction value of Opensea, the reader would notice that Opensea trades more than 130 times the entire market capitalization of all the public companies in Seychelles on a monthly basis, a huge multiple. To give a more apples-to-apples comparison, the current market capitalization of the Cyprus Stock Exchange (CSE) is $2.82 billion. Opensea, by itself, is churning out the entire value of that country’s stock exchange each and every month.
Conclusion and Author’s Final Words:
Although the NFT market is growing rapidly, I would advise the reader to think critically before making any material purchases on the NFT market and adding them as a significant portion of your investment portfolio.
Largely, I would separate the NFT market into two areas from an investment point of view: the first is art and collectibles. This market has existed for the entirety of mankind, and NFT development is just a natural evolution of the market that already exists. Blockchain technology is enhancing the traceability and the transactability of a new, digital asset class that will largely subsidize the current, more physical, art and collectible market that already exists today.
The second asset class is really that of utility, whether that be via the buying of an NFT to have a unique character with unique abilities in a new video game, all the way to buying land assets in a newly created metaverse from an investment perspective. While both asset types are largely subjective in their quantification of value, this second class has a more likely quantifiable value due to the specific nature of the utility being created by the birth of the NFT asset.
I would value the first class of assets the same as you would a piece of art such as a painting or a sculpture, which of course inherently have more data points for pricing discovery but have a similar methodology to valuation. How rare is the asset in the market? What is the scarcity? What does the art make the owner feel? What inherent subjective value does the piece represent? If individual investors have reached a wealth milestone where art takes up a material portion of their investment portfolio, I do think that investing in certain NFT assets may be of interest to you. But as large art investments typically make up large portions of investment portfolios of ultra-high-net-worth-individual portfolios, I think that most accredited investors may only want to dabble if the NFT asset brings some kind of personal happiness rather than rely purely on asset appreciation probability as an investment thesis.
The second class can largely be valued by the utility of the NFT being purchased. The NFT is meant to have a specific use-case and a specific purchase. The same valuation notes from the “art” framework would, of course, be utilized, with the addition of a more quantifiable “what does this NFT do?” component, which should be an additional value component. Many of these NFTs are priced in a more economic fashion as the average gamer is typically not a USD millionaire. I would largely place this asset class in the same as the class above for accredited investors: buy them if you like and appreciate the utility portion of the asset, otherwise it’s just pure speculation – same as in a casino.
In terms of NFTs vs. traditional art and collectibles, nothing has really changed by the asset being digital except for the nature in which the asset is transacted and how the asset can be used. Largely, I would say the valuations at today’s pricing are completely subjective and are primarily gambles being taken by the same audiences that are extremely bullish on cryptocurrencies themselves: that someone else will pay more than you were willing to. Investors today are paying whatever it takes to enter the market and crossing their fingers that their selected NFT asset will experience the same hyper returns that Bitcoin has had over the last decade. Today’s high asset prices don’t make sense unless you really derive personal value, via an “artistic” value or a “utility” value from the piece itself.
Rather than speculate on the value of individual assets, we choose to strategically invest in individual companies that are looking to be leaders in this space, and we urge readers to do the same. But, if you have some extra Ethereum burning a hole in your pocket, it could be a fun gamble to buy a few digital assets that make you smile and wait to see what happens. We just recommend not touching your pension funds as you play in digital Las Vegas.
If given the opportunity, invest in the companies that create NFTs and video game ecosystems over the NFT itself.
We at Legacy Group feel that the NFT and digital art marketplace has a long way to go before reaching any market maturation. Although we see the current NFT assets today as largely overvalued from an asset perspective, we fully appreciate and recognize the value of the technology and talent that is going into the future of this digital market. We believe that the value of these assets will be in the intellectual property that is created as a result of market movements. We expect that companies that create video game metaverses, art firms that create their own portfolio of NFT collections, and management teams that embrace these new digital technologies will grow at a ridiculous pace in coming years. Our own portfolio company, Polygonus, is readily creating unique business models and IP assets in each of these areas. As this technology is literally brand new, the companies that specialize in these markets will largely be newer, emerging companies. Readers should look to focus on investing in early stage companies who are experts in this market and are driving this world forward to get in on the action. In other words, invest in the companies rather than the products.
The amount of capital flowing into this metaverse and NFT world is astounding. It will only grow in the future.
In this article, we have focused the discussion solely around the NFT market. In reality, the NFT market is directly tied to the cryptocurrency market, the video game industry, the artificial intelligence industry, the digital education industry and more. It is almost impossible to look at the NFT market, or any of the markets mentioned above, in a silo fashion without referencing all their relevant counterparts. Within our own portfolio company, Polygonus, we have seen a surge in demand for NFT asset creation and for NFT video game production. Deal sizes range into the millions of US dollars and new players are consistently coming to the market, looking to compete and make investments. The market is incredibly liquid largely due to the boom in cryptocurrency markets during the past several years. Whether readers choose to participate or not, the digital industries of today are going to have a massive impact on everyone’s life over the coming decades. The amount of talent and the amount of capital being thrown at these industries is simply too large to be anything other than game-changing.
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*This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author(s) and not necessarily those of our clients.