Why the NFT market will crash
In March 2021, auction house Christie’s sold a JPEG file created by artist Beeple for $69.3 million, a record for a digital work. Ownership of the “original” JPEG – titled “Everydays: The First 5000 Days” – was secured as a non-fungible token, or NFT.
The sale made headlines and NFTs have since gone hot. Investors poured $27 billion into the market in 2021and Meta, the renowned parent company of Facebook, now would have plans to allow users to create and sell NFTs. There is only one problem: the NFT market will eventually collapse, for a multitude of reasons.
In essence, a NFT is an exchangeable code attached to metadata, such as an image. A secure computer network records the sale on a digital ledger (a blockchain), giving the buyer proof of both authenticity and ownership.
NFTs are typically paid for with the Ethereum cryptocurrency and, perhaps more importantly, stored using the Ethereum blockchain. By combining the desire to own art with modern technology, NFTs are the perfect asset for the newly wealthy members of Silicon Valley and their train of cronies in finance, entertainment and the broader investment community. Retail.
But, like other markets driven by exuberance, impulse buying and hype, the fast-moving and speculative NFT market could burn many investors. The current frenzy invites comparisons with Dutch Tulip Mania from 1634 to 1637, when some bulbs fetched extremely high prices before the exuberance wore off and the bubble collapsed.
The NFT market will likely suffer the same fate – but not, as some might think, because of environmental concerns. Admittedly, NFTs consume considerable amounts of power, as cryptocurrencies like Ethereum and Bitcoin are “mined” using computer networks with a large carbon footprint – one that grows with each transaction. But when it comes to understanding what will drive the NFT market down, climate impact is a red herring. The real problem is that the current NFT boom is built on a foundation of sand.
Start with the infinite supply problem. NFTs offer ownership of a digital asset, but not the right to prevent others from using its digital copies. Part of the reason wealthy investors are willing to pay tens of millions of dollars (or more) for traditional physical works of art by Rembrandt, van Gogh or Monet is that the number of masterpieces is finished ; the artists are long dead and cannot produce new works. NFT copies, on the other hand, could become a commodity.
Plus, as with anything digital, there’s no difference in appearance between an original JPEG that sold for $69.3 million and a copy downloaded for free online. In theory, the supply of legally usable copies of NFTs is endless, potentially crushing demand and causing prices to crash.
Because the blockchain is unable to store the actual underlying digital asset, someone buying an NFT is buying a link digital artwork, not the work itself. Although buyers get the copyright on the link, the transaction costs of monitoring endless online sites for viewing NFTs, identifying improper use, and pursuing and prosecuting counterfeits make it almost impossible to apply copyright or deter misuse. This severely limits the monetization of the asset.
Another risk is that NFTs are made and sold with nascent technologies – blockchains and cryptocurrencies. There are currently several competitors standards regarding how to generate, save, distribute and certify NFTs, including ERC-721, ERC-998, ERC-1155, stream and non-stream standards, and Tezos FA2. The resulting uncertainty as to how ownership certification will be secured in perpetuity puts the value of assets and even their ownership at risk.
In fact, the value of NFTs may evaporate if the next wave of more advanced technologies that replace crypto or blockchain are incompatible with secure NFT ownership. Companies that deal with NFTs today may not be around tomorrow, blurring ownership claims.
The price volatility of the cryptocurrencies that underpin the NFT market is also a central issue. NFT prices tend to move in tandem with cryptocurrency prices. When crypto tanked in 2018, the nascent market for NFT.
The psychology of buying luxury goods will also likely exert downward pressure on NFT prices. Most luxury goods are said Veblen Goods, with limited utility beyond allowing owners to publicize their wealth. For this reason, they often generate big profits for sellers.
NFTs allow buyers to spread their wealth primarily through the high price they paid, but only if they receive positive feedback from their peers. If such spending doesn’t resonate with that audience, the investor might as well burn some cash to light a cigarette.
Because owning an NFT does not preclude others from viewing the same assets and reporting ownership, these tokens hardly serve as effective indicators of unique purchasing power. And many NFT buyers remain anonymous anyway, as the blockchain ensures that knowledge regarding ownership is limited.
Finally, changing macroeconomic conditions could negatively affect the prices of alternative assets such as NFTs and traditional artworks. Over the past two decades, the number of billionaires in the world has has more than quintupled, and the disposable income ready to be invested in alternative asset classes has thus exploded. The COVID-19 pandemic has so far reinforced this trend. Much of the vast economic stimulus injected by central banks has gone into financial markets, further boosting the net worth of the super-rich.
But investor attention can be fleeting. After the global financial crisis of 2008, sales of art and other luxury goods decreases by almost 40%. As central banks begin to tighten monetary policy in an effort to curb inflation, new and untested asset classes are likely to be more severely punished than more reliable ones. And the extremely volatile NFT market, based on digital currencies with nothing to sustain them, is hardly a safe haven.
Ultimately, NFT prices will suffer a significant and permanent decline. They remain high for now and may continue to rise for some time, but the crash will come. Investors who think they can time the market are welcome, but their optimism will likely prove misplaced.
Patrick Reinmoeller is a professor of strategy and innovation at the Institute for Management Development. Karl Schmedders is a professor of finance at the Institute for Management Development. Copyright: Project union2022, published here with permission.
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