Getting to grips with NFTs

• Investing in digital assets has taken the fintech world by storm in recent years. Digital tokens can be fungible or non-fungible, with cryptocurrencies an example of fungible tokens. Non-fungible tokens (NFTs) represent unique digital assets that have their ownership secured on a blockchain.
• CryptoPunks and the Bored Ape Yacht Club are two NFT collections that are worth over a third of the $16 billion market. Indeed, 90% of the collectibles market value is made up by just 5% of collectible tokens.
• The 20 largest crypto coins and tokens used for NFTs saw an average maximum year-to-date return of 10,000% (in some cases reaching even 50,000%) in 2021. However, the annualised volatility of NFTs was 120%, against “only” 76% for cryptos, and a “measly” 14% seen in equities between January 2021 and this April.
• NFTs have a broad range of potential applications, from perhaps revolutionising the real estate market and cutting conveyancing costs, to underpinning the metaverse. However, security, counter-party, and carbon emissions risks my slow their adoption.
• Collectible NFTs are probably best seen in a similar light to classic cars or art: to be enjoyed, with value a secondary consideration. As far as including the tokens in strategic asset allocation policy goes, the market seems too untested and volatile for that at the moment.  

Hot on the heels of Bitcoin and other cryptocurrencies, non-fungible tokens (NFTs) are the latest racy fad to burst on the scene in the world of digital assets. Nike and several celebrities have joined the bandwagon in the last eighteen months. In one instance, someone paid almost $3 million for an NFT of the first tweet.   

But are NFTs, and digital assets more generally, an asset class really worthy of consideration by investors?

Getting under the bonnet

Blockchains are integral to the NFT market. A blockchain is a decentralised and immutable ledger that records transactions and tracks assets, through peer-to-peer verification. It allows something of value (whether tangible or intangible) to be converted into a digital token.

Digital tokens are designed to be fungible or non-fungible depending on the purpose. Cryptocurrencies are one example of fungible tokens. By contrast, non-fungible tokens are unique digital assets that have their ownership secured on a blockchain. The tokens can be photos, digital artworks, GIFs, and many other types of assets. However, by nature of being secured on a blockchain, NFTs can be traded using cryptocurrencies – with the blockchain holding irrefutable proof of an asset’s ownership.

Potential applications

NFT tokens have a vast array of possible applications. The tokens can embed “smart” contracts – a self-executing predetermined contract between buyer and seller – in their code. This could let token creators programme themselves a royalty each time their works are resold.

NFTs can also be tied to physical assets, and so has applications, among many, for say the real estate market. It could revolutionise property transactions by mitigating trust-related market failures, and even reduce conveyancing costs.

Similarly, some of Silicon Valley’s largest companies are devoting much time and money to the enormous potential of the so-called metaverse. Indeed, NFTs could be used to enable the transactions that would occur in the metaverse.    

Stratospheric risks and returns

CryptoPunks and the Bored Ape Yacht Club are two examples of “blue-chip” NFTs, and equate to over a third of the $16 billion collectible NFTs market. The former was created in 2017 and could be purchased free. At the time of writing, the cheapest Punk available trades at $188,000, with Punk #5822 having been sold in February for $23.7 million.

Meanwhile, Bored Ape initially cost around $190 on release and now sell for $366,000 a token on average. Indeed, 90% of the collectibles market value is made up by just 5% of collectible tokens.

The roller-coaster ride for Bitcoin investors has been hairy enough: Bitcoin saw a fifteenfold increase in its price in 2017, after returning a mindboggling 8,400% between January and November 2013, with sharp price falls in between. However, the ride for NFT investors has been scarier still. 

Our analysis shows that the 20 largest crypto coins and tokens used for NFTs – data on which has been available since January 2021 – saw an average maximum year-to-date return of 10,000% (in some cases reaching even 50,000%) in 2021. However, volatility can be a killer. The annualised volatility of NFTs was 120%, while crypto volatility came in at “only” 76%. By comparison, equities experienced volatility of a “measly” 14% between January 2021 and this April.

Potential risks

NFT investors face considerable risks, risks that may slow implementation and wide adoption of the asset class. Carbon emissions is one, given that most NFT transactions take place on energy-intensive blockchains. For instance, mining for Bitcoins is thought to use around the same amount of energy as Egypt each year. 

Potential security risks and fears that NFTs could aid criminals are among other factors worth considering. For instance, scam releases and cyberattacks have seen some people either losing money or having their digital assets stolen.

In a sense this is similar to the risks facing investors in art, wine, and classic cars. However, by design, there is no central authority to handle transactions in NFTs and to police the system.

For instance, when dealing with cryptocurrencies there is no bank or code of ethics on which to rely and so counterparty risk can be high. There have been many cases of people pricing NFTs for much less than they intended, for them to be snapped up by purchasing bots before they have chance to realise their mistake.

NFTs: investment or enjoyment?

Unlike equities and bonds, alternative assets, such as art and classic cars, provide their owners with physical assets that can be enjoyed, whether this be a Picasso painting or a revved-up ride in a Ferrari. More than that, many owners purchase such an asset for the pleasure it offers, with any gain in their value seen as a bonus.

Collectible NFTs are probably best seen in a similar light to classic cars or art. As far as such tokens forming part of strategic asset allocation policy goes, the market seems too untested and volatile for that at the moment.