CHAPTER SIX

NFTs

Market view

NFTs facilitate the creation of scarcity for digital assets that would otherwise be infinitely replicable, as well as represent important archetypes for how ownership and identity should function in the digital economy. They're an easy way to prove ownership over a digital asset such as art, objects in games, or even memberships and loyalty programs that offer special experiences with businesses or creators.

Despite the media attention on near-term fluctuations in trading volume and floor prices, which admittedly have trended lower in 2022 alongside all risk assets, it is important to appreciate the long-term fundamental capabilities of the technology. As the world continues to shift towards the digital realm, NFTs will be a critical component of the infrastructure that allows ownership and identity to function in a frictionless environment. The art/ collectibles segment of NFTs has served as a powerful onboarding mechanism for the broader crypto industry in recent years. But it is the depth and breadth of potential use cases for NFTs that we believe could represent a possible catalyzing force to enable true mass adoption of these technologies going forward.

As the world continues to shift towards the digital realm, NFTs will be a critical component of the infrastructure that allows ownership and identity to function in a frictionless environment.

The first meaningful manifestation (in terms of mainstream adoption) of the value proposition of NFTs largely occurred within the realm of "digital collectibles" or assets that represent 1- of-1 art, generative art, or profile pictures (PFPs). These subcategories of assets inherently led to speculative market dynamics, akin to those observed in markets for traditional art. Importantly, this use case for NFTs significantly lowered the barriers to entry for creators. On OpenSea alone, creators have earned over US$1B in aggregate royalties in 2022 (through November 30). Further, the category of art/ collectibles reinforced the notion of digital property rights and demonstrated the potential advantages of on-chain ownership, including increased transparency and programmability.

Chart 24. NFT secondary sales volume (Ethereum-based marketplaces YTD)

Lower barriers to entry for creators, however, have also meant that these subcategories can quickly become saturated. As mentioned in our report published in April 2022, "Demystifying NFTs," the market dynamics which characterize NFTs differ significantly from the broader crypto market in terms of available liquidity, as well as the concentration of activity in a small subset of collections. Although there are over 100,000 projects in existence, the vast majority of secondary sales volume occurs within collections representing under 5% of the overall universe. Nevertheless, NFT marketplaces are still generating trading volumes ranging between $5-15M per day. Market liquidity remains a concern, but marketplace aggregator functionality- available on Coinbase NFT and now Uniswap, following their acquisition of Genie - have the potential to improve the liquidity dynamics for NFTs.

While certain "blue chip" collections or otherwise "high-quality" NFTs have been able to maintain relevance and even grow market share due to broader consolidation of liquidity, USD values have struggled to keep pace with ETH-based values as the price of ETH has fallen over 66% year to date in 2022. This has been the case for even the most prominent NFT collections with outsized historical sales volume such as CryptoPunks, evidenced by Chart 25. That being said, comparisons to alltime-highs in terms of floor prices may not be all that insightful - the fact that pixelated jpegs are still regularly changing hands for tens and sometimes hundreds of thousands of dollars should not be diminished.

Chart 25. CryptoPunks floor price (ETH vs USD)

Next waves of NFT adoption

We believe NFT adoption is still in its early stages and the recent downtrends could be perceived as part of a healthy correction in the context of a broader trajectory of cyclical adoption. The bigger question today surrounds how subsequent waves of NFT adoption will manifest - to which there are no easy answers. But almost daily, we're seeing new utility and opportunities for brand building, customer engagement, and rewards:

We believe corporations and brands will likely continue to view NFTs as a differentiated form of marketing spend and create projects that act as powerful onboarding mechanisms for non-crypto-native consumers. Indeed, we believe this technology allows businesses to connect in more authentic ways with their audiences. Beyond these use cases, corporations are also beginning to utilize NFT technology to provide digital verification of physical goods. We think creating immutable and auditable chains of ownership for things like luxury watches or sneakers could help demonstrate the utility of NFTs outside of pure speculation.

Another notable endeavor that has been able to maintain its growth trajectory despite the broader market turbulence is the Ethereum Name Service (ENS), which represents an illustrative example of the utility of NFTs outside of art/collectibles. In this vein, it's possible that the next wave of NFT adoption could be driven by forms of utility more directly tied to the core innovation of digital property rights. Themes such as digital identity, digital footprint mapping, soulbound tokens, and the tokenization of real world assets have the ability to strip away the speculative nature of art/collectibles and emphasize the fundamental advantages of non-fungible tokenization.

Chart 26. Monthly ENS domain registrations

We're also watching the development of NFTs in the gaming space. The outstanding question is whether the best crypto-enabled games will be developed by crypto-native firms or by incumbent video game developers who decide to integrate crypto into a game in some manner. Given the relative advantage in terms of funding that top-tier video game studios have access to, it's possible it's the latter scenario. In that case, crypto could be integrated into the backend of the video game, making it not necessarily noticeable to the user.

Enforcing royalties

An area of recent debate within the NFT community is centered around the concept of artist royalties and specifically, the enforceability of said royalties. While the customizability and perpetual nature of royalties for NFT artists are at the core of the value proposition of the web3 creator economy, the reality is that royalties are not embedded at the token level, but instead at the marketplace level. This means that NFT holders can choose to transact peer-to- peer and circumvent both fees and royalties that are implemented by marketplaces.

While peer-to-peer transactions have always existed at the periphery of the NFT market, they came into greater focus in 2022 as more readily accessible tools were created to facilitate the circumvention of centralized marketplaces like OpenSea. Sudoswap and Blur are two such decentralized protocols that - amongst other functionalities such as pooled liquidity for NFT trading - allow users to circumvent fees and royalties. Platforms such as x2y2 and LooksRare also facilitate royalty-free transactions. In recent quarters, these alternative market places have eaten into OpenSea’s market share, which has dropped to nearly 50% in terms of ETH trading volume (as of November 30).

OpenSea has committed to enforcing royalties on the platform and even introduced new functionality (for new collections only) that allows the issuer to disable trades on royalty- free platforms. While this is certainly a step in the right direction, it still doesn’t solve the issue for existing collections and limits the salability of collections that opt to use the new functionality, as they then can only be sold on Opensea. Conversely, FXHASH is a platform - focused on generative art on Tezos - that has taken a firm stance alongside artists/creators and will not allow optional royalties on their platform.

Realistically, for the large swath of the NFT market that is purely profit driven, this avoidance of fees and royalties will likely continue to be an attractive proposition. Therefore, if artists/creators want to benefit from programmable royalties going forward, they'll likely need to emphasize fostering a collector base that genuinely cares about the art itself and is willing to pay royalties. However, the actions taken by OpenSea to su pport artists/creators is important, as much of the rationale for NFT-based art stems from creator royalties. If royalties are increasingly ignored by market participants, we think it could threaten the adoption of the technology more broadly. OpenSea taking this stance alongside artists/creators is meaningful, given the platform still accounts for an outsized portion of NFT trading volume.