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What Gives NFTs Their Value?

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Non-Fungible Tokens (NFT)
Savl
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On June 10th, 2021, a digital image of a punk alien, called Punk #7523, was sold for $11.75 million. This is one of the earliest and rarest NFTs, created on Ethereum blockchain, where a single pixel was sold for over $20,000. The sale of Punk #7523 is not an isolated event, as an NFT of a rock was sold for almost $4 million. So, there is a growing interest in NFTs. However, newcomers to crypto may wonder how NFTs hold their value.

What is an NFT?

An NFT is a digital record, similar to a receipt, that proves ownership of something, either physical or digital. It's commonly used for collectible items, like the pixelated drawing of a Punk Alien.

The NFT contains a record of when the item was created, or "minted" in NFT terminology, and how much was paid for it. Additionally, it includes information on previous sales, as NFTs can be exchanged or traded on NFT marketplaces.

You might be wondering, what's the difference between the Punk Alien and any other digital image that can be traced to a server location somewhere on the internet?

What sets NFTs apart is the way they are created and the unique qualities they possess. Minting an NFT involves creating a new record on a decentralized blockchain, such as Ethereum for Crypto Punks, although NFTs can be minted on other blockchains as well.

One of the key features of decentralized blockchains is that the data they contain is immutable, meaning it cannot be changed. No one can alter the information associated with an NFT, as it represents a unique and unchangeable record.

Of course, someone could simply duplicate an image and mint it as a new NFT, but NFTs are non-fungible tokens, designed to prevent duplication and exchange for an identical item. They represent ownership of a unique item recorded on a blockchain, for which there is no interchangeable equivalent.

On Ethereum and other blockchains, there is a programming standard called ERC-721 that sets out parameters to ensure a record is non-fungible.

An NFT represents where an item exists, like a URL for digital art or the location of a physical asset. It's like a receipt or certificate of authenticity for physical collectibles.

Scarcity & Intrinsic Value

Though this might sound interesting from the perspective of technical innovation, on its own, it doesn’t explain why a tiny pixelated image of an alien is worth almost $12million. To understand that you have to understand the two elements that give collectible items value - scarcity and intrinsic value.

If something is scarce, it has a limited supply. Most famous pieces of art, for example, are one-offs, but being scarce doesn’t, on its own, make something valuable. I could do a one-off doodle on a notepad, put it in a frame and auction it, I’m pretty sure no one would be willing to pay anything for it, because it has no intrinsic value.

Intrinsic value is hard to define as it is subjective appreciation of something’s value, but boils down to being unique, irreplaceable and significant or sacred. My doodle might be unique, but it is easily replaceable and certainly has no special significance, because I have no standing as an artist and haven’t generated any other fame.

Scarcity of an NFT does not only derive from the way it is minted, but also from the composition of the image itself. Punk #7523 is one of a limited collection of 10,000 algorithmically generated images, each of which is unique. Though the collection shares certain common traits, there is relative scarcity within it. This is one of nine aliens in the collection, but it is the only one wearing a mask.

NFTs aren’t irreplaceable, in the sense that an identical version could be created, which would be impossible to detect, but their value doesn’t necessarily derive from the technical skill of the artist.

Like the Mona Lisa, which represents an important juncture in the history of art, Crypto Punks are the first of the NFT genre. They represent the unique aesthetic of the crypto movement, which is itself an important milestone in modern society.

The significance of Punk #7523 cannot be engineered or replicated, which gives it intrinsic value. However, how is its value of $11.75 million determined?

 

The Power of Hype

There is no equation for calculating the value of a piece of art, such as the Mona Lisa, since intrinsic value is subjective. Artists and artistic movements can fall in and out of fashion, and the reasons for this are complex and generally reflect changes in society.

Interest in NFTs is tied to the interest in speculative cryptocurrency. The future value or adoption of cryptocurrency is uncertain and must be understood in a macroeconomic context.

Investors have sought alternative ways to generate a yield on their money since interest rates have remained near zero for over a decade. The financial crisis has disillusioned the younger generation with the existing financial system and made them eager for a new approach.

These factors have transformed interest in concepts like NFTs into a speculative bubble. However, the value of Punk #7523 has already been demonstrated by someone paying $11.75 million to own it.

However, the future value of Crypto Punks is uncertain, as is the value of the many NFTs based on them. The argument about intrinsic value doesn't hold for all of them.

The hype surrounding NFTs may be inflating their value as they become more commonplace. However, early examples are now becoming a form of digital conspicuous consumption, which is known in economic terms as the Veblen effect.

A Veblen good is one for which demand increases as price increases. This seems to contradict the normal rules of supply and demand, but it explains how branded goods, which look identical to cheaper versions, command such high prices.

However, collectible art is not the sole use case for NFTs. Even within that genre, there is a great deal of innovation.

Innovation & The Future of NFT

NFTs are tradable on exchanges such as Opensea. If you're considering buying your first NFT, the decision of which one to buy can be overwhelming, given the large number of options available. The NFT market is becoming saturated as artists attempt to carve out their own niches.

Most NFT creators are opportunists who make little effort to create something of intrinsic value. They mistakenly believe that simply creating an NFT is enough to give it value.

There is also plenty of anecdotal evidence of price manipulation of NFTs, as well as their use in money laundering and as part of complex tax mitigation schemes.

This does not mean that it is all downhill for NFTs created today. As long as meaningful innovation continues, there is potential for growth. The signs indicate that innovation is just getting started.

In December 2021, NFT artist Pak sold an NFT collection called The Merge for $91.8 million. This sale was groundbreaking because buyers did not receive an Ethereum token. Instead, they paid to own "mass" tokens that will be combined to create a dynamic NFT collectible after the token sale. The collection was named The Merge because of this unique concept.

This unique concept is a special moment in NFT history, and its astronomical valuation is justified by the 28,984 buyers who followed the rules of scarcity and intrinsic value. It benefits from the current hype around crypto.

In addition to collectible art, NFTs are playing a major role in the development of Metaverse-type games that operate on a play-to-earn model. This could potentially disrupt the entire gaming economy, and it's worth considering why Facebook recently rebranded to Meta.

NFTs have the potential to disrupt other common records of ownership, such as property or shares, which are both enormous markets. Anyone who has ever purchased a house can attest to the need for innovation in the face of archaic processes.

NFTs can expand digital business models by creating secondary markets for on-demand and subscription services. As long as ownership or rights can be defined in a Smart Contract, they can be traded as NFTs. Currently, most of this data is owned by third parties, but individual ownership could lead to even more possibilities.

Regarding NFTs as collectible art, there is no guarantee that interest will be maintained. Punk #7523 will always be a 24x24 pixelated image, and what will change are attitudes toward the context of its creation.

If decentralization and crypto fail to establish a meaningful place in society, the perceived value of NFTs will likely decline. However, if these ideas revolutionize the way in which all value is exchanged and stored, future generations may consider a Punk Alien to be as important as the Mona Lisa.

Remember: Savl does not offer legal or financial advice. This blog piece should be used to help you form and shape opinions but cannot replace individual financial due diligence.

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Thank you for reading this piece and if you have any questions, feel free to reach out via Telegram @savl_support or join the conversation on Twitter @Savl_official.

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