Top 10 things you need to know to comprehend NFT concepts and its ecosystem.

by Chia Sheng Yeong

How does one begin to comprehend the NFT ecosystem? In this article, we help you understand the NFT ecosystem by highlighting the top 10 things to know.

Blockchain

Currently most NFTs exist only in one or another blockchain. As of Nov 2021, Ethereum has the most NFT sales volume, followed by Ronin and Wax.

As Ethereum has a market dominance, NFTs on Ethereum can be considered to be most liquid compared to other NFTs on other blockchains, though there are other caveats that affect the liquidity.

Additionally, the Ethereum blockchain has the largest developer base, therefore it offers more NFT tools like crypto wallets, NFT marketplace analysis, blockchain analysis tools, NFT analysis tools etc. Some well known examples are metamask, opensea.io and rarity.tools. Without a large developer base, a blockchain lacks the right applications for the NFT market to grow. Imagine trying to buy and sell NFTs but there is no marketplace for that blockchain.

Sectors

According to nonfungible.com, there are 6 major types of NFT sectors, each with different corresponding market value. They are Games (7%), Utilities (4%), Sports (1%), Metaverses (2%), Art (9%) and Collectibles (76%). The pie chart missed out music NFTs as its own category.

Different types of NFTs have different transactional characteristics. For example, Cryptoslam data shows that Gaming NFTs have the highest number of sales compared with Art and Collectibles.

However, the average price per NFT for Art and Collectibles is much higher than Gaming.

This suggests that although Gaming NFTs are widely traded and presumably more liquid, other categories like Art and Collectibles seem to have more value.

Primary or Secondary Market

Similar to stocks in the public market, NFTs can be purchased from the primary market i.e. directly from the creators or  on the secondary market.

Primary Markets

NFTs that are directly obtained from the creators are considered to be from primary markets. Most times, this is done by minting the NFTs directly from the creator’s website. NFTs obtained from the primary market are usually cheaper compared with the secondary market – though the price is not guaranteed as it depends on market dynamics for the NFT collection.

The famous Bored Ape Yacht Club (BAYC) initially cost around $270 or 0.08 ETH to mint when it was initially released in September 2021. As of writing, the floor price of the one BAYC costs around $210,000 or 52.2 ETH.

Some NFT minting requires whitelisting. To be whitelisted, the prospect might need to follow any number of the steps below:

  1. Connecting your wallet to the website
  2. Join discussion groups like discord
  3. Get verified by bots in discord
  4. Tweet and tag people about the NFTs

The purpose of the whitelisting is to avoid “gas wars” where the NFT participants rush to mint the NFTs when it is released. It also serves to provide a form of filtering to reward active participants or believers of the NFT project. For example, as a reward to the BAYC holders, the BAYC creators gave away NFTs that allowed the BAYC holders to create Mutant Ape Yacht Club (MAYC).

Being first to mint NFTs through whitelisting is significantly more profitable than waiting for the public minting or purchasing it from the secondary market. According to Chainalysis, around 78% of unwhitelisted buyers would net a loss when reselling their NFTs. About 59% of them will have a loss equal or below half their initial investment. On the other hand, 78% of whitelisted buyers will result in a profit with 51% of them netting a profit of two times their initial investment.

However, not all minting from primary markets net profits. In addition to failed minting transactions that can cost the user, according to OpenSea, only 28.5% of NFTs purchased during minting from the primary markets then sold on to the platform results in a profit; whilst buying NFTs on secondary markets then selling them leads to a profit 65.1% of the time.

Therefore, it seems like minting directly from the primary markets is worth it only when the users are whitelisted.

Secondary Market

In the past year, secondary markets like opensea.io have been the poster child for NFTs. At its peak, opensea’s monthly sales volume peaked at 3.4 billion USD with a market share of 95%.

Secondary markets allow traders or investors the use of historical data to make better informed decisions. Having historical data like average price, median price, floor prices, transaction activity, trading volume, trends etc would reduce risk like illiquidity shocks. Due to the low transaction volume of NFTs and the extreme price fluctuations, average price of NFTs are considered a less desirable metric compared with median price and floor prices. The longer an NFT is on the secondary market and the more transaction activity it has, the more useful the historical data.

Narrative

Some of the best NFTs are sold based on narratives. One of the most expensive NFTs ever sold is Beeple’s “Everydays: the First 5000 Days”. It sold for 69 million USD.

The buyer of the NFT was prepared to pay even more as he viewed it as the starting point of a new age in digital art.

Cryptopunk #7523 sold for $17.1 million. The buyer said, quote “This CryptoPunk appealed to me because It is part of the Alien collection which is the rarest of the punks and the only alien that has a mask. I thought it  was symbolic of Covid-19 and the popularisation of NFTs,”

Separately, BAYC’s narrative represents people who “ape” into a trade without doing much research then getting rich and bored. This is somewhat reminiscent of the r/wallstreetbets slang of “Apes together strong” 

Regardless of the reasons for the narrative, the common denominator seems to be that the more feverish a community’s belief in a narrative, the higher the potential price of the NFT.

Scarcity

Once you have found the right NFT collection to trade or invest in, the next thing to consider are the attributes. The NFT attributes are determined by a set of codes during the initial minting process. Some attributes are assigned lower probability to occur when minting than others. This makes those attributes more rare.

As all NFTs are unique, some NFTs will have rarer combinations of attributes. Intuitively, the rarer the collection of attributes, the higher its price or the better it is at maintaining its value given the set of NFT collections.

There are a number of NFT calculators that help you calculate the value of an NFT based on their historical price and scarcity. These NFT calculators can be general for all NFTs or NFT specific. NFT specific calculators are especially useful if there are additional utilities for the NFTs like gaming.

However, not all NFTs within the same collection are easily comparable. This is because some projects use generative arts to create complex aesthetics from the collection of attributes. Such NFTs collections may look very different making it difficult to model desirability.

This leads to the problem where scarcity doesn’t guarantee high prices. Some NFTs may not resonate with the narrative of the community of collectors.

Community

Some of the most valuable NFT collections are in part due to a strong community. A community is considered good when there is a meaningful size and activity.

The size matters because this infers that there is a lot of interest in the NFTs. Most NFT communities communicate or coordinate using Discord and Twitter. By joining their Discord groups or following the Twitter accounts, you get to know the size of the community.

In addition, activity in the community is important too. By participating in conversations like Discord chats, checking out the reactions in the announcement channel and comparing it relative to the size of the community, participants can have a good feel on how active the community is. This is important because large NFT communities with very little responses or reactions to announcements in Discord chats could mean that the members are either non-believers to the NFT ideas or that they are bots. An active community is a good indicator of how much the members “vibe” to the NFT narrative.

Other good gauges of activity can be whether the NFT creators have quizzes, community voting etc.

Team

As with all endeavours, a good team is essential for the success of an enterprise. It is no different with NFTs. When Larva Labs, the creators of Cryptopunk, riding upon their initial success launched another NFT collection called Meebits, it sold out within 8 hours for $75 million.

Even so, the NFT industry is still in its infancy, so new creators largely lack credibility and many choose to be pseudonymous. Therefore, this presents a risk for “rug pulls”. One prominent example is the “Evolved Apes” NFT collection. Investors spent millions to participate in the minting of the “Evolved Apes” only to have the anonymous creators run away with their investments. Granted that current top NFTs like BAYC and Cryptopunks started out this way, it is still important to be aware of the risks.

Not all successful NFT creators are anonymous and lack credibility. NBA Top Shots is created by Dapper Labs. The company behind CryptoKitties. Dapper Labs also created the Flow blockchain to circumvent Ethereum gas fees issues.

The creators of Doodles, one of the top NFTs in opensea.io, are from the design background with huge following or used to work for Dapper Labs – a pioneer in NFTs back in 2017 with Cryptokitties.

As the industry develops, the success formulas for team formation and industry collaboration will become more evident. A proven dedicated team is important for the NFT’s success. Because a strong team will continuously create new growth opportunities for the NFT brand. For example, the collaboration between BAYC and Adidas created new opportunities to ride the wave.

Other brands like Pepsi and Playboy also wanted to be part of the NFT trend, but were less successful. Their floor prices and transactions are nowhere as high as other NFTs.

Without constant brand reinforcement, an NFT brand can lose out in mindshare. Not too long after the collaboration between BAYC and Adidas, BAYC floor price “flipped” Cryptopunk, becoming the most expensive NFT.

Utility

So far, most of the considerations we have covered don’t share how useful the NFTs are. In fact, NFTs are not just mere digital images. It can have many functions. Some NFTs allow owners to play games and earn cryptocurrencies. Axie Infinity is an NFT based play to earn game. It is very popular in the Philippines. Some of the top Axie Infinity players earned so much that the Philippines government wants to tax it.

Due to the gaming component, the number of transactions for Gaming NFTs towers over Art and Collectible NFTs.

Other NFTs like VeeFriends give NFT holders access to conferences, events, dinners, groups and even playing games with the creator.

Recently, Nike acquired RTFKT. RTFKT creates real and virtual sneakers. NFT owners get to redeem the sneakers in real life and plus their virtual characters will also be able to wear them too. This means that the NFTs are not only in 2 dimensional images, but can be used in virtual realities or augmented realities with a digital twin in the real world.

On the other hand, some NFTs like Cyberkongz have yield generation components. Whereby, CyberKongz NFT holders will earn 10 $Bananas tokens everyday. The $Bananas tokens are claimed to have no value and it is only used for NFT personalization functions like changing the NFT name. Nonetheless, at its peak, one $Bananas token is worth $105.

Other than being profile pictures or digital items, NFTs can also manifest in other forms like a virtual land. Sandbox, just like any land, allows NFT owners to create a playground for Sandbox characters to explore. Rent the land out to others or stake it for yield rewards.

NFTs are not for the eyes. They can also be for the ears. Catalog provides artists the ability to create NFT music. This is game changing, because current music monetization platforms like Spotify only reward top artists. To give context, only 7,500 out of 8 million artists make more than $100,000 annually on Spotify. Unique audiovisual NFTs like Beatboxes from Zeblocks consist of 841 uniquely generated rooms where you can fully immerse yourself in virtual reality devices or from your laptop using a web browser.

There are also other utilities from projects like fractional.art and nftfi.com that improve the NFT liquidity through fractionalization or collateralization. A lot of these projects are still in its infancy and will see many more growth opportunities as the industry matures.

Arguably, NFT utilities have yet to mature. Total market cap of NFTs just passed $31.4 billion or around 1.36% of the cryptocurrencies market cap of $2.3 trillion. As the blockchain infrastructure improves and cryptocurrency regulations mature, NFTs will become more useful over time. This will create a growing demand driver for a wide variety of NFTs.

Intellectual Property Rights

Intellectual property rights is slowly becoming a hot topic for NFTs as users find more ways to make them more useful. Other than generating profits from NFT sales or from NFT utilities, the NFT owners might be able to further commercialise their NFTs. NFT owners in theory can sell the royalty rights for use of their NFTs in movies, advertisements, merchandise etc. However, all these depend on the NFT Intellectual Property (IP) rights.

There are two major types of NFT IP rights that are widely used. One is CC0 where the NFT creator will reserve no rights. Thereby, allowing the NFT owners to do whatever they want with the NFTs including assigning rights. On the other hand, the other NFT IP right is called the NFT License. NFT Licence aims to protect the NFT creators while allowing as much flexibility as possible for the NFT owners to enjoy the NFT. For example, NFT Licence only allows limited commercial use of the NFTs. This means the NFT owner can only generate up to $100,000 in revenue each year.

NFT IP rights has caused quite a debate in the NFT industry. There is a Cryptopunk owner who sold his Cryptopunk away because of an IP dispute with the Cryptopunks creators.

So it will be useful to plan ahead. If you plan to commercialise the NFT further, it might be better to purchase NFTs with the right IP rights.

Having said that, there are NFTs with more conventional digital property rights that don’t give owners much choice like veve.me. Veve.me is an NFT platform that sells NFTs based on popular characters like Marvel and DC. Its parent company Ecomi has the digital collectable licence that allows them to create those NFTs, However, because it is restrictive, owners can’t do much with the NFTs. And because the NFTs are tied to commercial licences between companies. In the future, there could be issues when the licences expire or that similar digital collectable licences are also issued to competing platforms.

Separately, not all NFT creators respect IP rights. A DC comics artist plans to shut down his online DeviantArt gallery account after 14 years, because his artwork is being stolen and sold as NFTs. As NFTs become widely accepted, IP theft will become more common.

Being aware of IP rights not only improves the upside of NFT owners, this awareness also helps protect NFT owners from IP violation.

Investment Structure

At the time of writing, the lowest floor price of one NFT from the top 10 collection starts at $11,000 with the highest floor price at $609,000.

Given such high prices, not all investors have the capacity or capability to invest in NFTs alone. Depending on your NFT thesis, fund size and risk tolerances, you might have to consider your investment structure.

There are generally three ways to invest into the NFT Ecosystem:

  1. Individual
  2. Private Group
  3. Institutional

Going Solo

Investing as an individual offers the most freedom to adapt to market changes. At the same time, there is also no accountability and control measures toward holding NFTs. This method is most suitable for individuals with the means.

Going Together

Investing as a group of private investors allows for the deployment of larger funds. However, managing digital assets as an individual is very different from managing it in a group setting. NFTs are normally purchased using cryptocurrencies and are stored in a wallet. The question is, how does a group of individuals custody the cryptocurrencies and assets in a manner that safeguards the interests of everyone? This is especially a problem when all buying and selling transactions on the blockchain are immutable. Any mistake can be as good as a write off.

To prevent such undesirable scenarios, the group of investors can use a multisignature tool like Gnosis Safe. Gnosis Safe is a tool that allows teams to manage their wallets be it buying or selling NFTs using multi signatures. This is but one of the many tools being developed for a group of individuals to coordinate and manage their digital assets.

Additionally, the group also has to decide their investment approaches. Should they develop their own analytics tool or subscribe to existing tools? Subscription to existing tools like nansen.ai might not provide perspectives that you require for your NFT investment thesis; while developing your own will require specific knowledge and skill.

Additionally, private groups utilising traditional investment structures are handicapped compared with new approaches. For example in the traditional finance world, the investors have to form a legal entity like a private limited company within a geographical region for enforcement. This then invariably limits the potential number of like minded investors that might be living outside the geographical region or adheres to legal and financial systems that are not recognized in the legal entity’s jurisdiction.

All these operational considerations require a small team of developers, analysts and project managers to handle the operations.

Going Institutional

For investors with more stringent requirements and don’t want the hassle, investing through recognized institutions can be an option. For instance, Bitwise NFT Fund that recently launched and Osprey Alpha NFT fund that is going to launch in 2022. These funds use index methodology, whereby they invest only in the top NFT collections. The benefit of such funds is that it utilises the traditional investing approach while keeping the complicated technology related considerations in the background. However, this also means that there are a number of requirements like being an accredited investor in the US, minimum investment etc.

Going Native

The alternative is to participate in an increasingly popular investment approach, which is to form a decentralised autonomous organisation (DAO) as an investment entity. A DAO is an entity whereby the participants operate by following a written constitution that is enforced. In this case, the common goal of the DAO is to profit from investing in NFTs, guided by the constitution. In DAOs, decisions are enforced through smart contracts on the blockchain. Governance tokens might be issued according to individual fund contribution sizes. The governance tokens are used to manage treasuries, perform NFT sales and NFT curation etc. Governance token holders may also vote on extraordinary issues not covered in the constitution. PleasrDAO is one such entity. It was created by a group of crypto natives with the express purpose of collecting NFTs with a charitable twist. They recently purchased an NFT from Edward Snowden to fund his foundation. There are other DAOs like Yield Guild Games, which specializes in yield generation in the gaming sector. Yield Guild Games generates yield by investing in gaming NFTs and lending it to players, providing gaming scholarships etc.

Risks

Speculation Risk

NFT markets are illiquid, volatile and filled with inefficiencies compared to many options out there. There are similarities between this NFT boom with the ICOs craze of 2017. Therefore keeping up with current NFT news and staying educated is essential to performing well in the NFT market.

Regulatory Risk

The NFT market is still growing and the governments are slowly catching up with regulations and intellectual property protection. The lack of regulation and oversight might put investors at risk of wash trading or market manipulation like insider trading, pump and dump. Even though transaction fees on some blockchains like Ethereum are high, it still hasn’t prevented such problems from happening. For example, Cryptopunk #9998 was sold for 124,457 ETH or $532 million at the time of the transaction. It is not registered as the highest priced NFT ever sold as many believe that it is a wash trade.

Technology Risk

All NFTs are built on blockchain and blockchains are still an emerging technology. Although blockchains are continuously stress tested and audited, issues like hacks, bugs, flashbot exploits, metadata exploits, direct-to-miner exploits still happen. At the time of writing this article, Opensea.io is suffering from a bug that allows attackers to sell BAYC six figure discounts. In the coming future, protocol development and smart contract standards will be improved on, with more utility being unlocked.

Fraud Risk

As mentioned previously in the Team section, many upcoming NFT creators lack credibility and might keep their identity anonymous. Until further technologies like decentralised KYC or social identity networks are developed, along with new regulations and enforcement becomes the norm, the risk of fraud might be prevalent.

Fat Finger Risk

Fat finger risk is a risk where a user mistype. Because blockchains are immutable, this means the mistake is irreversible. A BAYC owner recently mistyped the amount of ETH and sold the NFT for $3,000 instead of $300,000. As blockchain use becomes more prolific. Expect fat finger incidences to occur more frequently.

Summary

In summary, before investing or trading NFTs, you might want to consider all the points above. This article tries to be as exhaustive as possible, but because the NFT industry is still nascent, future developments will change how we think about the it.

Nonetheless, NFTs are promising. More has yet to come.

Disclaimer: The opinions expressed in this article are unqualified opinions of the author. It is meant for informational purposes only. It is not meant to serve as financial or investment advice. Please consult with your financial advisor.