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NFTs are hot now but the market will eventually collapse

NFTs are hot now but the market will eventually collapse

By Patrick Reinmoeller and Karl Schmedders *

Lausanne – In March 2021, the auction house Christie’s sold a JPEG file created by the artist Beeple for $69.3 million, a record for a digital artwork. The ownership of the “original” JPEG – entitled “Everydays: The First 5000 Days” – was secured as a non-fungible token, or NFT.

The sale made headlines, and NFTs have since become red-hot. Investors poured $27 billion into the market in 2021, and Meta, Facebook’s renamed parent company, now reportedly plans to allow users to create and sell NFTs. There’s just one problem: the NFT market will eventually collapse, for any of a host of reasons.

In essence, an NFT is a tradeable code attached to metadata, such as an image. A secure network of computers 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 newly wealthy members of the Silicon Valley set and their train of acolytes in finance, entertainment, and the broader retail-investor community.

But, like other markets driven by exuberance, impulse purchases, and hype, the fast-moving and speculative NFT market could burn many investors. The current frenzy invites comparisons with the Dutch tulip mania from 1634 until 1637, when some bulbs fetched extremely high prices before the exuberance dissipated and the bubble collapsed.

The NFT market will likely suffer a similar fate – but not, as some might think, because of environmental concerns. To be sure, NFTs consume considerable amounts of energy, because cryptocurrencies like Ethereum and Bitcoin are “mined” using networks of computers with a large carbon footprint – one that grows with every transaction. But when it comes to understanding what will bring down the NFT market, 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 problem of infinite supply. NFTs offer ownership of a digital asset, but not the right to prevent others from using its digital copies. Part of the reason why wealthy investors are prepared to pay tens of millions of dollars (or more) for traditional physical artworks by the likes of Rembrandt, van Gogh, or Monet is that the number of masterpieces is finite; the artists are long dead and cannot produce new artworks. NFT copies, on the other hand, could become a commodity.

Moreover, as with all things digital, there is no difference in appearance between an original JPEG file sold for $69.3 million, and a copy downloaded for free online. In theory, the supply of legally usable copies of NFTs is infinite, potentially overwhelming demand for them and causing prices to collapse.

Because the blockchain is unable to store the actual underlying digital asset, someone buying an NFT is buying a link to the digital artwork, not the artwork itself. Although buyers gain copyright to the link, the transaction costs related to monitoring the infinite online venues for displaying NFTs, identifying illegitimate use, and pursuing and prosecuting infringement make it nearly impossible to enforce the copyright or deter misuse. This strongly limits monetization of the asset.

Another risk is that NFTs are being made and sold with infant technologies – blockchains and cryptocurrencies. There currently are multiple competing standards regarding how to generate, safeguard, distribute, and certify NFTs, including ERC-721, ERC-998, ERC-1155, flow and non-flow standards, and Tezos’s FA2. The resulting uncertainty as to how ownership certification will be guaranteed in perpetuity endangers the value of the assets and even their ownership.

In fact, the value of NFTs may evaporate if the next wave of more advanced technologies that supersedes crypto or blockchain is incompatible with secure NFT ownership. Firms that deal in NFTs today may not be around tomorrow, muddying ownership claims.

The price volatility of the cryptocurrencies underpinning the NFT market is a central issue as well. NFT prices tend to move in tandem with cryptocurrency prices. When crypto tanked in 2018, so did the nascent market for NFTs.

The psychology of buying luxury goods also will likely put downward pressure on NFT prices. Most luxury products are so-called Veblen goods, with limited utility beyond enabling owners to advertise their wealth. For that reason, they often generate large profits for sellers.

NFTs enable buyers to broadcast their wealth mostly through the high price they paid, but only if they receive a positive reaction from their peers. If such expenditure does not resonate with this audience, the investor might as well burn cash to light a cigarette.

Because owning an NFT does not prevent others from displaying the same assets and signalling ownership, these tokens hardly serve as effective indicators of unique spending power. And many NFT buyers remain anonymous anyway, because 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. In the past two decades, the number of billionaires worldwide has increased more than fivefold, and available income ready to be invested in alternative asset classes has ballooned as a result. The COVID-19 pandemic has so far reinforced this trend. Much of the vast economic stimulus injected by central banks went into financial markets, further boosting the net worth of the super-rich.

But investor attention can be fleeting. After the 2008 global financial crisis, sales of art and other luxury products declined by almost 40%. With central banks now starting to tighten monetary policy in an effort to rein in inflation, new and untested asset classes are likely to be punished harder than more reliable ones. And the hugely volatile NFT market, based on digital currencies with nothing to back them up, is hardly a safe haven.

Ultimately, NFT prices will suffer a large, permanent decline. They remain high for now and may continue to increase for some time, but the crash will come. Investors who think they can time the market are welcome to try, but their optimism will likely prove misplaced.

* Patrick Reinmoeller is Professor of Strategy and Innovation at the Institute for Management Development. Karl Schmedders is Professor of Finance at the Institute for Management Development.

Copyright: Project Syndicate, 2022.


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