NFTs, short for Non Fungible Tokens, took the Crypto world by storm in 2021. Many of you might have a lot of questions about them. Given the kind of valuations and trading profits that have been reported by this segment of the Crypto space, this is not surprising at all.
Also, with the restrained acknowledgment of Crypto by the Indian Government, it is understandable that you, as investors, would be looking for numerous ways to capitalize on this opportunity. This compelled me to write an introduction to NFTs for you.
Below I preemptively answer some of the questions you may have followed by some guidance on how best to approach this space.
If you are a novice to NFTs, this article is for you. If you know a lot about NFTs, I still encourage you to read through and maybe learn something new or benefit from my tips & advice.
Here goes then!
Introduction to NFTs: The Basics
What is an NFT?
An NFT is a digital asset that carries a unique embedded signature. This signature makes NFTs verifiable for authenticity and trail of ownership.
This is because a record of that signature & subsequent transactions are stored on a blockchain.
What is the Non-Fungible in NFTs?
Tokenization, in the Crypto world, refers to applications having an economic ecosystem being built around them. Every project or application has its token which is mostly limited in supply, has in app-utility, is exchangeable for other cryptocurrencies & completely homogenous.
To understand homogeneity, consider the example of $NAKA, the token of the Nakamoto Games ecosystem. Each $NAKA is the same as any other $NAKA. Just like a US $ 100 or INR 100 bill is like any other US $ 100 or INR 100 bill.
An NFT, on the other hand, does not have this homogeneity. Each NFT is unique which makes it rare. The exchange of one NFT for another NFT would not result in an equal exchange of value.
The reason is that no NFT is the same as another.
What are examples of NFTs?
The popularity of NFTs has lately been in the form of digital art. This takes the form of graphical imagery & avatars for profile pictures. Crypto Punks is an excellent example. However, this has to be the most basic application of NFTs.
As of late, with the growth of blockchain-based gaming & the metaverse, in-game assets have also been structured as NFTs. These NFTs are in the form of special characters or other in-game assets which can be developed further.
They have utility for in-game activity & can also be traded in the ecosystem’s marketplace. See the example of DERACE NFT horses later in this article.
What are the future applications of NFTs?
Going forward, theoretically, NFTs present solutions to several real-life problems. These include:
- NFTs could digitize records of land ownership. These could be traded with the blockchain providing verifiable authentication of ownership under a community-driven self-regulating system. At present this process is centralized in the form of a land record officer. This centralization of power renders the whole system prone to the lack of conscience of one individual.
- Digitization of Educational & Medical records could again be undertaken through NFTs. An NFT could provide a verifiable record of educational achievement & health status. This result is a reduction in fraud.
To learn more, see this thread by Croissant. Eth for some cool applications of NFTs that may be at your disposal soon.
What is the process of creating NFTs?
NFT creation, also called minting, is a simple process as follows:
- A digital asset is uploaded on a minting platform;
- The user pays the gas fee to mint the digital signature on the asset;
- The asset is stamped with proof of authentication via a smart contract. This is verifiable on the blockchain as a transaction.
The aforesaid process is a generic one. Minting of NFTs for assets with a utility to their respective ecosystems would require additional detailed programming.
What are the best platforms for NFTs?
Other blockchains have also launched their own NFT service with the most prominent being Binance. Metaverse marketplaces also offer platforms for trading NFTs.
A complete guide to getting started on OpenSea is available here for creators, buyers, and sellers.
Introduction to NFTs: Valuation
There are two aspects to NFT valuation – Intrinsic & Non-Intrinsic.
Intrinsic Valuation of NFTs
The current gas fee burned to mint NFTs in the past is called intrinsic value. It may also be called a replacement value. This will be different for each blockchain.
So for example, NFTs on the Ethereum blockchain have a higher gas fee as compared to those on Solana. This is a function of current price & network congestion. We provide an introduction to this method of valuing NFTs below through an example.
Intrinsic Valuation Example
Consider a mint at 1 $SOL when Solana’s price is US$100. Thus, at the mint, we can say that the NFT is valued at US$100. After the mint, the price of $SOL increased by 50% to US$150 thus giving us a new price of US$150 to mint the same NFT again.
We now add the complexity of network congestion to the example above. Let’s say network congestion increases on the Solana blockchain. Resultantly, the mint increases from 1 $SOL to 1.5 $SOL thus giving us a new price of US$150 to mint the same NFT again.
Adding the two effects, we can conclude that the increase in the price of Sol & network congestion would imply a replacement value of US$225 for our original mint at US$100. We can break this down into price effect ($150 instead of $100 per $SOL) and network effect (1.5 $SOL instead of 1 $SOL).
Non-Intrinsic Valuation of NFTs
Non Intrinsic value is tricky. Similar to traditional costs of production, Intrinsic value can be measured by direct inputs. Non Intrinsic is difficult as there are no observable inputs to factor in as this is the value that buyers & sellers ascribe to an asset. Perceptions, desirability & ultimately demand & supply influence this. We provide an introduction to this method of valuing NFTs below through an example.
Non Intrinsic Valuation Example
Consider the original digital artwork for the Google logo. We can surmise that :
- This is a single digital file which speaks of its limited supply/rarity;
- There are billions of copies of this artwork in existence that are worthless. Therefore, authentication through a digital signature would make the original file worth something. This is perception;
- There is a ton of money chasing collectible items which shows desirability & demand;
- All factors combined, the going rate on this artwork could be, theoretically, any number.
What is the Utility Principle for NFT Valuation?
A new method of valuing NFTs has emerged called the utility principle. This model builds on the Intrinsic value concept and adds observable and perceived utility of the NFT to its going price. We provide an introduction to this method of valuing NFTs below through an example.
Utility Principle Valuation of NFTs Example
Consider the example of the DERACE NFT horse. DERACE has built a play to earn horse racing gaming metaverse where players have to buy a racehorse in the form of an NFT to compete. There are different breeds available, in limited supply, and each has unique in-game abilities that can be honed further through breeding. The better the racehorse, the more chances of the owner winning a greater share of the prize pool.
This example shows us that NFTs can have a utility that can be priced. In this case, the NFT is a gaming asset that allows the owner to earn revenue by competing in a play-to-earn game. The present value of all future revenue today would represent an intrinsic value of holding the asset.
Limitations of the Utility Principle Model to Valuation of NFTs
The model is not perfect & subject to a lot of assumptions. For the case of our racehorses, the following assumptions need to be made:
- The probability that the owner deploys the horse to a set number of races. This requires a probability table;
- The probability that a set number of participants compete in these races thus setting the prize pool. This requires a probability table;
- The present value factor is unknown due to the lack of a benchmark within Crypto.
The lack of a mathematical valuation model thus precludes our ability to fairly compute an NFT’s utility as a measure of intrinsic value. This implies that utility, while intrinsic, as of today, is somewhat arbitrary.
Introduction to NFTs: Demystifying Returns
How much Money Can You Make By Creating Your Own NFTs art?
Gotham Magazine did this list of the top 20 selling NFT artists in April 2021 and the value surpassed US$ 1,387 Million amongst them. Similarly, this list from NFT Now on the 15 most expensive NFT sales returns an aggregate value of US$ 264 Million.
These are astronomical numbers but misleading. First of all, these are pieces of art & therefore bound to have crazy valuations. The desirability that buyers attach to art is the main driver. Secondly, one has to appreciate that these lists suffer from survivorship bias. Not every artist succeeds.
How much can You earn by investing in NFTs – Art or otherwise?
Given the lack of verification of claims made by influencers on social media, it is not easy to gauge reality from fantasy. Hence such trading success disclosures should be taken with a pinch of salt.
This post from Jean Galea summarises some of the tough personal experiences one has to go through in finding winners in a perception-driven market where intrinsic values are ignored and a herd mentality exists. Your NFT trading is likely going to be a long haul and pay dividends over time based on some of the acute factors we have discussed above in terms of valuation.
No model exists yet for NFTs that have in-app or in-game utility for play to earn games and metaverses. This is only because the space is too young for such empirical evidence to exist. For example, this purchase of Decantraland plots was worth US$2.43 Million & lacks any rhyme or reason except for a possible future growth opportunity that is yet to manifest. Whether this was a good investment or not, only time will tell.
Introduction to NFTs: Guidance
I believe I speak for the majority here that not everyone has US$69 million lying around to spend on a Beeple. For most of us, with capital constraints & risk management to consider, investing in NFTs has to be a well-thought-out strategy. Here are my top 5.
Become an NFT Creator
Creators are the largest beneficiaries of NFTs. This is by no means an easy exercise as a certain skill level is necessary. However, you can experiment & with the right attitude & luck, something may click. Consider the example of 12-year-old Benyamin Ahmed who made US$ 400,000 in 2 months selling his Weird Whales NFT collection on OpenSea.
Invest in NFTs at the Mint
This is not breakthrough advice and is synonymous with investing early. Why it makes sense for NFTs is due to the large presence of non Intrinsic factors in valuation. Investing close to the mint means that what you pay is at or near Intrinsic value. Anything above is a bonus.
Look for NFTs with Utility
It is satisfying to own a US $1000 avatar but when you can, look for a utility to your NFT investing. Most play-to-earn gaming platforms have NFTs that allow you to earn income on top of any capital gain you may come to expect. The DERACE racehorses are an excellent example. Digital land in the NAKAVERSE by Nakamoto Games is another. The utility adds to Intrinsic value and that is what smart investors should aim for.
Look for NFTs with New Usecases
Trading avatars may seem like a readily available opportunity but there are more profitable new use-cases coming all the time. The Ethereum Naming Service (ENS) or its Solana counterpart are examples where investors could buy the right to certain web naming customs.
Similar to web domain names in the 1990s and early 2000s, these Crypto web names may flip at a higher price as adoption grows. An excellent guide is this Twitter thread by Pastry. ETH on some of the hottest new projects in the space.
Make NFT Introduction to your Business Idea
There is no shortage of personal or incubator capital available, especially now with the space having some sense of formal recognition & regulation. This should encourage you to explore collaborative efforts to digitize aspects of your world. Some examples are:
- Exporting local art by bridging the street to the digital sphere. You could create a whole new business distribution channel for struggling artists through such a collaborative effort;
- Promote underground music by providing a distribution channel in the shape of NFTs for their revenue generation;
- Launch fantasy games based on local sports where players are represented by NFT cards. This is a successful model employed by Sorare;
- Offer advisory to sports franchises to adopt tokenization of fan engagement and offer NFTs as part of the process. Chilliz & their Socios app are the frontrunners in this space.
Introduction to NFTs – Concluding Notes
NFTs present an economic opportunity that goes beyond the mere trading of cryptocurrencies for a profit. For every pocket, there is room in this space to create, earn &/or collaborate.
The Indian Government’s recognition of the Crypto space has made this possible. It is now down to each one of you to seize this opportunity.
I have tried in this article to present an introduction to NFTs which should serve as a beginner’s guide. Your effort to keep learning & taking action is what will help you succeed.