Taking NFT's Seriously Not Literally

In 2016 Peter Thiel made the following observation about the U.S. election:

I think one thing that should be distinguished here is that the media is always taking Trump literally. It never takes him seriously, but it always takes him literally. …

Whatever your politics or feelings about Peter Thiel for that matter, I think it is indisputable that this blind spot led the media and the broader political establishment to discount Trump, and they were caught by surprise by his success in 2016. There is a similar dynamic at work right now with Non-Fungible Tokens, or NFT’s; this article from the Verge is a good example. It is too easy to look at the eye-popping prices, retro 8-bit art quality and pictures of rocks and just throw up your hands and say it’s all madness. Granted, if you take the NFT digital collectibles market as the entire story you are forgiven if you feel like Jon Stewart back in 2014, when he called Bitcoin the Tamagotchi of currency. But then it’s worth remembering that Bitcoin was trading around $320 then: that’s one hell of a Tamagotchi if you bought then and sold today.

Prices get the headlines, but they are never the whole story. Benjamin Graham’s wisdom about the stock market applies to the NFT market too; any argument for NFT’s inherent value cannot lean just on the price:

In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

Security Analysis, Benjamin Graham and David Dodd (1934)

So let’s take a little while and walk through three ways to take them seriously, not literally: the way they can be used to create scarcity for experiences; confronting head-on the question about whether they can ever have value as art works; and finally, the way they can be used to make generic securitization rails, a prospect with radical implications for finance.

NFT’s as Scarcity for Experience

I have a bit of an obsession with Stoner Cats, which I have posted about previously. That incident, when fans briefly overloaded Ethereum causing multiple failed transactions, was what first got me thinking about the broader implications of NFT’s. The creators of the series, which is about a group of house cats who become sentient thanks to some truly powerful medicinal marijuana, were having a hard time getting funded given the drug themes in the show. So they had what is in retrospect a truly brilliant idea: they minted limited edition NFT’s, sold them to raise $8M in funds, and then only allowed owners of those NFT’s to stream the series. As I said at the time, my guess is a lot of entertainment executives had an epiphany when they saw this: streaming, previously something anybody could get access to with a monthly subscription, could be made into an exclusive experience, much like a backstage pass or an invitation-only event, and thus be sold at a premium.

In the previous Geek Out I focused on the technology behind Quentin Tarantino’s recent Pulp Fiction NFT (for which he has been sued), but this is another example of using NFT’s as tickets to an exclusive experience. In the case of the Pulp Fiction NFT, a clever mechanism is used to hide additional content inside the NFT which only the owner is able to unlock. So now you can not only own a piece of cult film history, but you can also experience Easter Egg-like additional content. Whatever you think about paying for an NFT, there is a long history of people paying to have bragging rights — and this vehicle offers it.

NFT’s as Valuable Art

The moment an aging software engineer starts to talk about art, you probably should run away. Just as I do not expect Beeple or Banksy to have opinions about my Python code, I think it’s fair to save them from my opinions about the merits of their artwork. But grappling with the question of whether an NFT has any value at all inevitably takes you down a rabbit hole of philosophical questions about what makes a unique piece of art. For the purposes of this post, I want to focus on just two elements independent of questions of artistic skill or merit: provenance, and the role of society.

Let’s start with provenance, and a definition from the U.K.’s National Gallery:

Provenance refers to the history of the ownership of a painting or other work of art. Information about the ownership of a painting can come from a range of sources, including contemporary descriptions, inventories of collections, inventory numbers on the paintings themselves and auction sale catalogues.

Provenance in other words is about the chain running from the original creator, through every owner to the present one. At its heart it is about linking creator, owners and transaction price history. What is interesting about NFT’s is the mechanism used for verifying provenance is normally a public blockchain, which has three key attributes: its record of provenance is open; immutable; and incontrovertible. That is, anyone can verify it for themselves; nobody can go back and change it; and no one can challenge the truth of a particular transaction between accounts once it has been confirmed. This is very different from what the National Gallery outlines: in the art world establishing authenticity and provenance can be incredibly tricky and part of the gatekeeping of the art world’s institutions is their key role in this process. Provenance is not trivial with NFT either — I cannot challenge that a token was transferred from one Ethereum account to another, but I can challenge an assertion that I own one of the accounts due to the pseudonymous nature of digital wallets — but I think this will change over time with introduction of decentralized identity standards.

Provenance in turn becomes part of the story we tell about a piece of artwork, and now we can start to see how value could be supported by NFT. If I can not only know that a particular NFT avatar was part of a well-known batch created by Bored Ape Yacht Club, but it was also six months ago used as the Twitter profile picture of a well-known celebrity, that NFT is now different. It has a story, a story anyone can verify, no one can erase, and no one can dispute. There are art dealers who would give their left arms for that degree of certainty about the ownership history of a piece in their galleries, because they can sell the story as part of the piece of art. NFT has this built-in. Importantly, this is what distinguishes the infinitely and freely copyable JPEG representation of that NFT from the NFT itself. Just as you may buy a movie ticket and thus pay for fractional usage rights to a purely digital film yet do not own it, the fact that the NFT is purely digital and that you could use it freely is irrelevant to the question of who owns it, and who owned it in the past. Similarly, that I can view the Mona Lisa does not make it my possession.

What if, prior to installing the shredder, Banksy had taken a high-resolution image of his infamous Girl With Balloon piece, and then minted an NFT? The shredder does its work, and now you have two pieces of art: one, the NFT, is the only way to verifiably get the unshredded original from the artist; the other, the half-shredded physical piece, has recently gone under the hammer at a premium. Which would be worth more? The physical, damaged piece, or the virtual, pristine piece? They were both created by Banksy, but more importantly, they are connected by a single narrative: the story that links the creation of the original, the creation of the NFT, and the shredding of the original. Note this is not entirely hypothetical: earlier this year collectors burned another Banksy piece after creating an NFT of the original. This is the power of provenance to add value to art.

Society’s role, as Prof. Jamiel Sheikh has pointed out in a recent talk on NFT’s in NYC, is in recognizing, legitimizing and if necessary enforcing ownership. At a recent Solana conference in Lisbon, former Coinbase CTO Balaji Srinivasan referred to the legal machinery as Layer 0, or the Ideology Layer, with blockchains like Ethereum at Layer 1 and optimistic rollups, Lightning and other mechanisms to batch transactions for performance reasons comprising Layer 2. This is incredibly important: a distributed ledger transaction without legal underpinnings is effectively meaningless, just moving bits around. The crypto-libertarians are not entirely wrong in thinking that this is in part about power & state violence: if I cannot take you to court to dispute your ownership transfer of an NFT in the real world and if there is no means of compelling you to comply with the court rulings, my ownership claim is at best fragile, at worst worthless. And with this, a word of warning for those excited about NFT’s potential to hold value: there are very few places in the world where any work at all has been done on Layer 0. I am not aware of any legal precedents, but I do wonder if someone hacked a digital asset and stole an NFT if it could even be prosecuted as theft.

NFT’s as Generic Securitization Rails

To me this final way of taking NFT’s seriously is the most revolutionary one, and underappreciated because of all the attention paid to NFT’s linked to digital images. As I wrote previously on LinkedIn — the post that was the origin of this larger one — NFT’s are best thought of as a pointer to another asset, and the underlying asset can be anything, real or virtual. The pointer can refer to anything (though it cannot change post-minting) and the ownership of the pointer can be tracked in the same way as any NFT. You can also associate metadata with that pointer, and you can have one unique pointer or multiple, representing fractional ownership.

From a finance perspective, that is a very big deal, because if you have a standardized, robust and transparent way of tracking ownership and discovering the prices and price history of any referenced asset or fraction thereof, you have essentially made generic securitization rails. Using another programming analogy, assets become polymorphic: the token interface supports standard operations which can be applied to a multitude of specific instances of assets, even ones not yet imagined.

This matters, because it means higher-level building blocks can be composed and operate on all assets in the same way. A portfolio management smart contract rebalancing using a smart order router layered on top of a number of decentralized exchange protocols can operate on the entire universe of assets referenced on the blockchain, including assets in the real world, or virtual assets like intellectual property rights that nevertheless have real world value. Workflows that used to be special cases executed through paper contracts and FAX machines for every single asset class can be done once and only once for everything. This could greatly increase liquidity and reduce transaction costs for a wide range of illiquid and complex-to-trade assets.

This one idea, that NFT’s pointing to assets can be used to apply the tools of finance to any asset, is in my mind the thing that will truly transform the economy. Tools can be built once and only once for working with the entire range of assets known to humanity. Interestingly, this also has the potential to transform the current digital asset market. Financial asset values often boil down to claims on cash flows. We can debate endlessly about whether Bitcoin has fundamental value, but it is far harder to question the value of a digital asset that lets you tap the underlying asset’s cash flows. Digital assets can be subject to classic fundamental analysis tools (e.g., looking at price-to-sales ratios, or discounting future cash flows) as soon as they start pointing to cash-generating assets. And though the markets are primarily voting, not weighing, with NFT-based assets insights about how much to weigh assets can be embedded along with metadata or through graphs of asset references, e.g. CredMark is doing some interesting work on building DeFi risk models to support insurance which could be applied here. You could imagine credible auditors digitally signing assertions about other assets, whether in regard to their security or their financial soundness or assertions about their fundamentals — and this could all be linked to the assets themselves.

Returning to a point from the previous section, this revolution cannot happen without changes at Layer 0, the legal machinery. If moving an NFT from one account to another changes who has claims on, say, the rental income of an apartment building, this must be supported by legal changes recognizing those claims and allowing them to be enforced in court. Furthermore, if ownership of a digital asset produces something that looks like dividends, the whole argument about whether such assets are securities is pretty much closed. Without changes to current security laws, such an asset would almost unquestionably pass the Howey Test, and come under fire from the full weight of 90 years of U.S. securities laws, rules and legal precedent. This could be crippling for developers of tools built on top of them unless there are carve-outs to allow for a reasonable amount of experimentation. Singapore, with their recently-announced Fintech Regulatory Sandbox Plus, seems to be getting this balance better than anyplace in the world.

Conclusion

I have taken some pains to not take sides on whether the “votes” for current NFT prices are reasonable or not. The goal here was more to provide a framework for thinking about ways that different NFT’s could accrue value. The “fair value” of any given NFT may be far out of line with its price at any given time, especially in the short term in a volatile and immature market, but I hope I have convinced you that a blanket statement that they are always inherently worthless is also hard to support. Whether through scarcity of experience, via the power of human stories or through connection to cash-generating assets, there are ways to leverage this innovation to produce real value, and I expect we are only at the very beginning.