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NFTs – Is the World of Finance About to Go Virtual? (Part I)
Non-fungible tokens (NFTs) are digital tokens on a blockchain, unbreakably connected with a specific digital asset, which could represent anything from a piece of digital art to a parcel of virtual land. To some they are an innovative application of blockchain technology for a niche corner of the artworld that helps to solve authentication and ownership issues. To others they open new opportunities in decentralized finance (DeFi) that may revolutionize the very infrastructure of finance itself built on top of the Ethereum blockchain, or other competing blockchains.
Indeed, DeFi may even lead to the democratization of the way finance is conducted without the need to rely on intermediaries such as brokerages, exchanges, banks or even fiat currencies. In such a scenario, a highly interoperable protocol and decentralized apps can be used to replicate existing financial services in a more open and transparent manner.
Whichever side of this divide one might be on, it’s worth taking a closer look at what all the fuss is about. In part one of this series, we’ll conduct a deep dive on NFTs, exploring what they are and their potential role in finance. In part two, we’ll look at some of the risks and issues that need to be considered when evaluating the use of NFTs in wealth management experiences.
What are NFTs and why are they a phenomenon?
NFTs differ from more established crypto assets, such as Bitcoin, owing to their non-fungible nature. A fungible asset can be exchanged for another asset of the same type. This includes commodities, bullion and currencies which can be substituted on a like-for-like basis (i.e., a $20 bill can be swapped for two $10 bills). This also includes cryptocurrencies such as Bitcoin.
Non-fungible assets have similar characteristics but cannot be substituted on a like-for-like basis, such as property, art, precious stones and other collectable items.
NFTs were invented in 2014 by Anil Dash and digital artist Kevin McCoy to solve the problem of how to prove that an item was a digital original. The holder of an NFT can prove ownership even if it does not give specific copyright or exclusive use of that artwork.
NFTs allow buying and selling of digital items while also verifying the ownership and transaction history. Since they are based on smart contracts, specific rights can be defined to allow for certain commercial activities while excluding others.
Physical assets often have certificates of authenticity and ownership that can be passed to a new owner. For digital items the creator can create identical versions of the original digital asset. Each one has a unique crypto token (NFT) assigned to it that contains authenticity data which can be stored on a blockchain as a tamper-proof, immutable transaction.
For many NFTs, the buyer may not even get ownership of an item but receive a version that is digitally signed by the creator, like a digital autograph.
Although the tokenization of digital art has had success, it is not the only area where the idea of issuing a unique token that contains information, proves ownership, and has certain ownership rights has taken hold. Secondary trading of different types of NFTs has seen reasonable volumes on OpenSea and Rarible, two popular NFT marketplaces.
This has caught the attention of some venture capitalists who see this as a way of building a new type of digital economy, where everything bought or sold online can be done through decentralized applications that are owned and operated by users. An early pioneer of this model has been the gaming industry. Players of online games can buy, collect and trade items digitized as NFTs.
Decentraland and other similar 3D virtual world platforms have taken this further whereby users can buy plots of land in the platform as NFTs using the MANA cryptocurrency which in turn uses the Ethereum blockchain. The platform’s first map, Genesis City, was made up of 90,601 parcels of land. In 2021 and early 2022 major brands started to buy up ‘properties’ including: Samsung, Adidas, Atari, PriceWaterhouseCoopers and Miller Lite. Other firms such as Nike see these venues as an opportunity to sell virtual versions of their products and to reduce production costs through market testing in the virtual world before committing to manufacturing a physical version.
This nexus of virtual worlds, the 3D internet (Web3), and blockchain based digital economics, has become known as a Metaverse. Metaverses are being developed by a number of FinTechs and game developers, including Active Worlds, The Palace and Fortnite. Sotheby’s even recently held its first metaverse auction on its own digitally native NFT trading platform called Sotheby’s Metaverse. Facebook has also stated a commitment to developing a metaverse, even renaming the company to Meta Platforms.
Some financial firms are also buying up land in metaverses. Standard Chartered Hong Kong recently acquired land in The Sandbox metaverse’s Mega City district. FinTechs and future leaning banks see the potential of the metaverse as the next phase in the internet’s evolution. For example, Standard Chartered believes that it will bring new possibilities and unique experiences using immersive technologies and allow financial firms to reimagine their relationship with existing and potential clients on a new platform and re-think their approach to enhanced client journeys.
NFTs also allow buyers and sellers to tap into a growing number of DeFi applications. The blockchain architecture creates an immutable and highly interoperable financial system with unprecedented transparency, equal access rights and little need for custodians, central clearing houses or escrow services, as most of these roles can be assumed by smart contracts.
Smart contracts have access to a rich instruction set and are therefore quite flexible. Additionally, they can store NFTs of digital assets and thereby assume the role of a custodian, with entirely customizable criteria for how, when and to whom these assets can be released. This allows for a large variety of novel applications and flourishing ecosystems.
DeFi has unleashed a wave of innovation. On the one hand, developers are using smart contracts and the decentralized settlement layer to create versions of traditional financial instruments that can be instantly agreed to and require no trusted third parties to manage. On the other hand, they are creating entirely new financial instruments that could not be realized without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins and flash loans are just a few of many examples that show the great potential of this ecosystem.
What is the NFT Ecosystem?
Since an NFT is a token built and managed on a blockchain, acquiring, and storing NFTs require payment in Ethereum or other crypto blockchains depending on where they are built. Before purchasing Ethereum on a crypto exchange such as Coinbase Global, an investor needs to obtain a cryptocurrency wallet. A wallet can take different forms, and either be a physical device, program or service which stores public and/or private keys. As well as storage of crypto transactions and assets, wallets also provide the ability of encrypting and signing. Examples of cryptowallet providers include MetaMask, Coinbase, Binance and Zengo.
The recent interest in NFTs has led to the creation of a plethora of NFT marketplaces. Many of these are focused on a particular type of digital asset. OpenSea offers over 700+ items such as art, virtual worlds, trading cards and collectibles.
Other popular marketplaces include: Rarible, whose focus is art, photography, games, the metaverse and music; and SuperRare, which focuses on unique, single edition artworks.
NFTs allow creators to buy and sell their own content directly rather than relying on agents or auction houses that all take fees for their services. Some NFTs can also be set up to create royalties for the creator each time the token is sold.
Another potential avenue for investors to benefit from the market for NFTs is through the creation of funds that invest directly in underlying NFTs, or ETFs which track an index or basket of stocks that are involved in the NFT ecosystem. There is already an established and growing number of crypto funds. In 2021, Wave Financial launched a traditional NFT Fund offering investors exposure to digital art, collectibles and the metaverse. The Fund will allocate its assets in a 70/30 split across collectibles and platforms/protocols. The Fund’s managers have stated that they may use machine learning to formulate pricing and valuation models for NFTs by studying the transaction data off the blockchain. Through these models, the Fund believes it can calculate the value of an item’s rarity over time and the main drivers of value for an NFT.
If you’ve made it this far, it’s safe to assume the world of NFTs and their potential impact on finance is a topic that resonates. And while it’s true NFTs have the potential to shake things up from a wealth and investment perspective, there are some key concerns which must be acknowledged. In part two of this series, we will explore some of the issues and risks associated with NFTs which warrant careful consideration.