WHAT ON EARTH ARE NFTs?

Fifth Era/Blockchain Coinvestors Newsletter

Vol. 3, No. 5, March 2021

What On Earth are NFTs?

This week we thought we would leave the worlds of fintech, digital monies, and blockchain and go instead in a quite different direction.

Not!

While this edition of our newsletter talks about something that will seem like a world away from Wall Street and the City of London, by the end we hope you will agree that the picture above is very much part of the future of fintech, digital monies and blockchain.

Defining Non Fungible Tokens (NFTs)

'A non-fungible token is a special type of cryptographic token which represents something unique; non-fungible tokens are thus not mutually interchangeable. This is in contrast to cryptocurrencies like bitcoin, and many network or utility tokens that are fungible in nature' according to Wikipedia.

A Little History

Once upon a time Matthew had the high score on the Centipede coin operated video game console in the JCR at Christ Church, Oxford. He also held the high score on Robotron for much longer. He was proud and his classmates were envious. It cost a lot of 10 pence pieces to master the machines. But it was worth it for all of the adulation that he enjoyed. Good times.

Later, he played Metal Gear Solid, Spyro the Dragon, Crash Bandicoot, Gran Turismo, and Final Fantasy on his Playstation 1 with his kids but they simply became much too good for him when their fingers mastered the multifunctional controls and he was unable to. Their fingers whirring across the buttons in ways that his brain could not fathom. He still watched them play, but it was nowhere near as much fun. They had the highest scores, prestige and status. He just paid for the CD's and DVD's at Gamestop to keep them happy.

By the time they had moved on to Runescape, he was really intrigued. Not only were they investing '10,000' hours grinding in the games, but they were also mastering the acquisition, trading and monetization of in game virtual goods powered by proprietary in game virtual monies. Since he was investing into video games including virtual worlds and MMORPG's by then, it was something he needed to understand. They were paying huge amounts for items like the 3rd Age Druidic Robe Top depicted in the image above which was the most expensive item ever in Runescape. It sold for 1,970,648,002 coins. That is a HUGE value when you reverse engineer how many hours of gameplay would have been needed to earn that many coins.

Later the value of scarcity really came home when we were with our kids at the Goodman's auction at Pebble Beach and watched as people first bid up a Bugatti Veyron with celebrity provenance into the 7 figures and then paid over the odds for a Tesla Roadster number 0008 which had been George Clooney's. The provenance was nailed down since he had complained frequently in the press about the regularly failing batteries of the car which had left him stranded by the LA freeways more than once. A scarce car, celebrity provenance and a clear paper trail. In retrospect the $95,000 it sold for seems very cheap today.

What is so Valuable About Infinitely Copyable Code?

In contrast to the Bugatti and the Tesla, why on earth would a digital image of a fantasy piece of clothing, in low resolution pixels carry so high a value? It didn't even have much utility within the game as can be seen from its 'Attack', 'Defense' and 'Other' bonuses. These are the power ups that the player received if playing while wearing the Druidic Robe. Not much to write home about compared to other, much more powerful in game items within Runescape. No, this item became enormously valuable because of its scarcity and because the ownership of it carried with it status and prestige beyond imagination - at least within the Runescape community.

As the Christ Church, Oxford experience illustrates, most of us care about our status within our immediate, and closest community. For digitally native, Generation C men and women (learn about them in Newsletter Vol 3., No. 3), that community can be vast because the digitally connected worlds in which they move are accessible to vast numbers of similarly aged and like minded peers. Having the highest score on Robotron might have been visible to a few score members of the House. Owning the 3rd Age Druidic Robe Top was visible to 1.1 million users at Runescape's peak. Now how many of us can hope to impress 1.1 million of our peers in our lifetimes?

Breaking The Value Down

What tools do we have for breaking this value down? When seen through the lens of discounted cash flow there is not much to analyze here. You spend a lot for it, and you might be able to sell it for more. But that is the greater fool theory in action. However, viewed through the lense of behavioral and emotional economics it becomes quite interesting. The item itself has little functional utility. It doesn't earn anything, and doesn't spin off any cash. But it does create enormous perceived value through the prestige and status it brings to its owner. We don't have many tools for measuring that status. Other than saying that beauty is in the eye of the beholder.

So if you were a software engineer what platform would you build to replicate these types of values not within a proprietary in game environment, but so that the whole world can participate in them should they wish to. Well it needs to be a digital platform of course so the access is global. It needs to be able to ensure that the claims being made are true especially about scarcity and provenance - is there really only one and did George Clooney really own it? That index and registry has to be publically viewable, immutable and secure. Then it helps if the digital item itself can be wrapped in some sort of carrier that will include the item's description but perhaps also other benefits and utilities that the engineers might want to bolt on. Instead of the bonus power ups being recorded in the game code, why not attach them to the item code, or even add in something else of value. So that these values travel with the good rather than the good having to be compared to some external registry. Like having to look up Debretts Peerage after you meet someone at the Bodleian library and you are not sure if they really are the Viscount or not. Ha Ha.

Of course, that means the engineers are going to use distributed ledger, or blockchain technology for the task. To create their unique digital goods - which we are now calling Non Fungible Tokens or NFTs.

Beyond this, what are the other drivers of value? Kinjal Shah at Blockchain Capital puts it this way. " Valuing NFTs is subjective. Just like valuing art, for example, an NFT’s value will likely depend on a confluence of factors, including cultural relevance, scarcity, utility, social status, and credibility. Price discovery is in the earliest stages in the NFT market. There are a number of experiments like peer prediction for NFTS (Upshot), bonding curves for price discovery (Foundation), and unique markets for individual NFTs (Zora). Although the market is currently flooded with NFTs, over time a set of standards will likely emerge to better enable efficient pricing and discovery."

Does Anyone Care?

This is the part that is hard for non digital natives to understand. Even though we may not care, hundreds of millions of digital natives do care. And as we have talked about in prior newsletters, they are now entering the years in which they earn a lot, accumulate the beginnings of their wealth, and begin to collect what they care about. Just as we may seek out that unscratched original vinyl, or the first edition copy of our favorite author's novel, they are hoping to own the made scarce moment in which their favorite athlete dunked the ball to win the key game, or the napkin sketch that Lindsey Lohan just put into an NFT - she is the same age after all and they may have loved her ever since Mean Girls.

We need to take this seriously, since the global collectibles market is huge and these digital natives are the future and will decide what represents good value in years to come.

How Do We Invest in this?

The infrastructure to power the global NFT market places is being built right now by companies like Crypto Art House, Gala, Opensea, SuperRare, Tari and so on. This chart also taken from Kinjal of Blockchain Capital provides a framework and some of the key names.

We are investors in many of them through Blockchain Coinvestors.

Conversely, you don't have to invest in the platforms. You can just open an account and start buying specific NFTs. Don't ask us how you will know which ones will become valuable over time. We don't know how to set prices on modern art either.

Thank you for reading.

Alison Davis
Matthew C. Le Merle