Non-fungible tokens, or NFTs, are a hot topic in the cryptocurrency world, and not only for their high-profile role in digital art. Big brands like Nike Inc. (ticker: NKE), Louis Vuitton and Coca-Cola Co. (KO) are dabbling in NFT creations.
The NFT market had a breakout year in 2021, and there’s still heightened interest in this digital asset class. According to data from Chainalysis, collectors in 2022 have sent over $37 billion worth of assets to NFT marketplaces as of May 1, putting them on pace to easily beat the total of $40 billion sent in 2021.
You’ve probably been introduced to the concept of NFTs through pieces of art that fetched big dollars at auctions, but because of the “smart contract” technology they are based on, NFTs’ utility stretches beyond collectible art.
The NFT marketplace is still relatively new and transaction activity has declined in recent weeks, but investors, institutions, companies and celebrities continue to explore this world of digital tokens and smart contracts. For investors who want a piece of the token pie, here’s what else you need to know about NFTs and how to manage them:
- What are NFTs, and how do they work?
- NFTs and art.
- Buying and selling NFTs as investments.
What Are NFTs, and How Do They Work?
NFTs are non-fungible tokens. Fungibility refers to assets of the same kind that can be traded interchangeably. Bitcoins, for example, are fungible, because users can trade one Bitcoin for another and it will be the exact same asset.
Since NFTs are non-fungible, each token is unique and cannot be replicated. Because of this distinct characteristic, NFTs are represented as unique information on a blockchain, ensuring integrity of digital ownership. This record of original ownership cannot be changed, since its existence is time-stamped on the blockchain.
Each NFT represents either a physical or digital asset. Aside from art, this can be anything from intellectual rights to a title of ownership to an asset.
“NFTs are pieces of information on a blockchain that’s represented in an interactive format with visual representation,” says Nick Donaraski, CEO of blockchain technology company ORE System. For ownership rights, if you purchase an NFT early, that asset is limited and only available through you. This scarcity, Donaraski says, is what allows for the value of the NFT to grow over time.
NFTs are powered by smart contracts. Specifically, smart contracts are the function that manages the transferability of NFTs. “If you think of blockchain as a computer network, the smart contract is the computer that runs the website,” Donaraski says.
NFTs and Art
NFTs are particularly well-known in the context of digital art. Artists create NFTs, which can continue to be traded on a marketplace like OpenSea. Building on their proliferation in the art world, NFTs have been expanding into the areas of gaming, retail, real estate, sports and more. As the utility of NFTs expands, their adoption and popularity should follow.
NFTs are unique due to their verified ownership that cannot be replicated or manipulated. When an item is limited, it becomes more valuable. The NFT market is speculative, with people buying up NFTs because there is the belief that they will later be more valuable to someone else. So people are collecting art NFTs because they think they will be valuable in the future.
Buying and Selling NFTs as Investments
The traditional principle of investing, buy low and sell high, also applies for NFTs. Market participants can buy NFTs early and turn around and sell them for a profit if the interest in the token grows. However, “NFTs should be thought of as an investment that could go to zero and is pure speculation,” says Daniel Strachman, managing partner of A&C Advisors.
“There are NFTs that you can buy where you can flip right away and others you can hold,” Strachman says.
NFTs are not like a stock or a bond where you have a quantifiable idea of the intrinsic value of the investment aside from its market value. They have a market value that’s driven purely by what the crypto community is willing to pay for them.
Knowing that NFTs are risk assets, investors need to determine the right level of exposure to them. “You would have a certain amount of money that you would put into your risk capital bucket, and that would be what you are willing to go to zero or 100,” he says. Another way to think about exposure to NFTs, Strachman says, is if investors have exposure to cryptocurrencies, NFTs could be a subset of that exposure.
Strachman says investors can think about NFTs as a commodity-like asset similar to silver, gold and art. “When people buy art as an investment, it’s an illiquid part of their portfolio,” he says. “Some would call that a part of a commodity allocation.” One commodity-like aspect of NFTs, Strachman says, is that they are “completely uncorrelated” to any other market.
Experts say your individual long-term investing goals should determine the type of NFTs you want to look at. “You have to find NFTs that align with what your portfolio growth (strategy) is, just like any other investment,” Donaraski says.
Some NFTs can provide investors with greater growth opportunities, depending on their applications, Donaraski says. NFTs with real-world utility, like real estate contracts, will ultimately hold greater value in the future.
An NFT can be a legitimate investment if investors understand what the NFT is being used for. “Making sure that you have something that has utility is a better bet for the long-term life of what an NFT is,” Donaraski says. “The life span of the use case … is the life span of that utility.”
The most important thing investors can do before entering the NFT market is research. They should approach this task the same way they do research on a stock or bond. Market participants too often follow a craze, Strachman says, which is good for those who sell the assets but bad for those who buy them. To make better decisions, investors should understand what they are getting themselves into.