There’s lots of talk about NFTs these days, because they use blcokchains, the technology undergirding cryptocurrencies, and there can’t be anything more exciting these days than cryptocurrencies. All this chatter encourages some people to consider investing in NFTs.
Traditionally, assets are what we invest in, and securities are financial assets. Bonds and shares in companies are securites. In the simpllist way, and most basically, securities are claims: a share is a claim to the profits due to owners of a company, a bond is a claim to be repaid, and possibly earn interest on the loaned amount. Investors buy shares and bonds because they expect the claim to be valued at least as much as what they paid to buy those claims. They expect some positive return on investment.
This is how a share works, for example. The company issues shares to raise capital. These shares offer a claim to a share (!) of the profits (or losses which are just negative profits) of the company to the holder. The company has the money, which presumably they will use to guarantee those future profits for the owners/shareholders of the company. If the company does well, it will make more profits, now and in the future, and the share value of the company will increase. This increase in the value of the share will be reflected in a higher price for the share and a positive rate of return on the investment of the shareholder-investor. What I’ve just described is the basic tenet of equity investing, and of course there are many variations including shorts, options, and other derivatives. All, however, can be tied back to some real productive assets owned and used by the company to undertake economic activity and generate profits.
Now, how does a NFT work? First, what is a NFT? It’s a non-fungible token, and the important word there is token. The non-fungible part just means it’s unique and can’t be copied easily. Most definitions you’ll read for NFTs will concentrate on the NF part, ignoring the T bit. But what is a token? It’s an artifact, a convenient manifestation of a claim. For example, you go to the pinball machine and drop in a token to play. It’s not a real coin – those you exchanged for tokens at the arcarde counter – and has no intrinsive value, and cannot be used outside the arcade. The same is true for a NFT. It’s not real money, and it only has value inside the system or institution in which it was created. Back to what an NFT is. A NFT is a code in a blockchain ledger that says you “own” something. The most famous NFT is probably Beeple’s Everydays: The First 5000 Days which is described as a digital piece of art and is a collage of thousands of images created by the artist Mike Winkelmann. The NFT was sold by Christie’s auction house for $69.3 million in 2021. Now, the artwork is a digital file, available to anyone, and easily downloaded and shared. Maybe the original zillion-megapixel file is not public, and maybe it has a digital watermark on it, but the point is that’s not what the NFT is. The NFT is not the piece of digital art. Remember, it’s a token. As a token it’s a claim to something – the right to pull three balls in the pinball machine, or the right to the digital piece of art. Ah, no…that last bit isn’t true. And this is where NFTs become both weird and scary, in my opinion.
NFTs are considered assets – digital assets, financial assets, or maybe some other type of asset, by some people. They are viewd as an investment opportunity. The hope is that you can buy a NFT, and subsequently find someone willing to pay you more than you bought it for, to pocket a nice return on investment. They can be traded, just like shares and bonds, and many other financial assets. They have a price determined by supply and demand. Just as people have bought land on Uranus, investing in a NFT will only have value if the token has value, and the value of the token is determined by the supply and demand for that token. When each token is unique (the supply is fixed at one unit), the price is determined by the demand for that token, which means the price is determined by what some other person is willing to pay to own that token. NFTs might be thought of as derivates in that their value is determined, in part, by the value of the underlying piece of art, or thing, that the NFT as issued on. However, what the relationship to the underlying thing is remains unclear, and might not even exist.
If you’ve ever read about stock options, or even invested in them, they are complicated and scary financial derivatives. Complicated because there are two positions to take on two types of transaction, as well as issue date, purchase date and expiration date to add a time dimension to options. Scary because those complications make decisions harder and options are a zero-sum game.