Non-fungible tokens (NFTs) have exploded in popularity since the development of the blockchain. While NFTs are mostly created for art, sports collectibles, virtual real estate, or other in-game assets, they are unique, indivisible tokens registered on the Ethereum blockchain that give them unique fingerprints that cannot be replicated or altered. Powered by smart contracts that tie them to an owner at all times, the blocks on a chain are visible to the public and enable NFT creators to retain their intellectual property rights and royalties. They’ve changed the game for the digital content realm and power a new economy, one in which people with extra money to spend want to participate.
Eight-figure price tags and celebrity endorsements have driven the general public toward NFTs and pushed NFTs toward the mainstream. In 2021, the global NFT market value topped an estimated $15.70 billion and is expected to reach $122.43 billion by 2028. Yet, some savvy businesspeople aren’t convinced. Bill Gates, for instance, recently described the rise of NFTs as being based on the “Greater Fool Theory.” He doesn’t think buying NFTs of bored monkeys or yesterday’s tweets will last because they won’t help the world. Gates describes himself as an old-school investor who won’t invest in cryptocurrencies since they aren’t a protected asset class. While his concerns have some merit, NFTs do boast many willing buyers and sellers, with many playing for high stakes.
Chain of Fools
The market has experienced two significant bubbles over the past 20 years—the real estate crash in the 2000s and the tech-stock bubble in the late 1990s. A market bubble forms when a series of assets increase in price dramatically beyond their fundamental value. Tulip bulbs, anyone? Investments are allocated to purchase these overpriced assets, contravening what, in hindsight, seem to be prudent strategies. No one really knows how a market bubble forms or what causes prices to continue to rise until the bubble bursts., One popular theory that describes this phenomenon is known as the Greater Fool Theory.
According to economists, the Ethereum blockchain takes hold when people can find buyers to whom to sell overinflated assets. These people buy the stock, commodity, or collectible without regard to its intrinsic value because accumulating value is not their objective. Profit is. And they can always find a bigger fool than they are who will pay more than they did. The bubble bursts when the “greatest fool” buys the item and is left holding the bag. This investing ignores all valuations, earnings reports, and any other market data. As long as there is a greater fool in the market, there is no need for prudence, so speculators can safely ignore the asset’s fundamentals.
As applied to the NFT marketplace, cryptocurrency markets significantly dipped in the spring and summer of 2022, thanks in part due to the TerraUSD crash, but will NFTs suffer the same fate? Perhaps not. Many stakeholders, Bill Gates notwithstanding, view NFTs as valuable investments because they verify the authenticity of the asset they represent, unlike an oil painting or a baseball card. With the rising popularity of digital images, the technology available makes it easy to copy a Caravaggio or counterfeit a Campanella. There’s nothing to authenticate whether you own an Old Master or a master forgery.
Smart contracts, on the other hand, allow NFT creators to identify their works and NFT owners to verify that their NFTs are indeed “original” pieces of digital art or collectibles. NFTs become digital versions of these collectibles, whether the underlying asset takes the form of wine, baseball card, film clip, event ticket, or something else. NFTs have ushered in a whole new marketplace for digital creations.
The technology behind NFTs—the tokens registered on the blockchain—authorizes them to protect all parties to any transaction. The seller knows the asset’s market value, and the buyer understands he or she is buying a legitimate, unique object. For example, many NFTs have other items tied to them as part of the purchase, such as a concert ticket or a weapon that can be used in a video game. When a concert goer buys an NFT-based ticket on OpenSea, they will know it will gain them admittance to their show—peace of mind that does not come when buying from Craig’s List or a scalper. Likewise, gamers can purchase an NFT gaming asset such as a magic spell or character skin on the game platform from a trusted third-party site. When they decide to stop playing, they can then sell the NFT gaming asset to someone else or swap it for a different one for another game. So, NFTs have an authenticity with their place on the blockchain that other “collectibles” lack, which can arguably remove the “fool” from the Greater Fool Theory.
What a Fool Believes
Despite warnings about “fool” purchases, NFTs are an emerging asset class that will pique the interest of more investors in the future. While they aren’t considered securities by the Securities and Exchange Commission (SEC) because they don’t meet the “Howey test” guidelines, NFTs straddle the line between categorization as a product and a security.
Currently, the SEC doesn’t view NFTs as a security because they concluded NFTs fail the third prong of the Howey test—a reasonable expectation of profits derived from the efforts of others. But this designation may change in the future. NFT creators who consider their assets as products rather than investments but then market them based on their capital gains potential could be courting regulatory trouble. NFT creators can write conditions into their smart contracts stipulating that they receive a portion of the sale price each time it’s sold, generating passive income for artists. Within the smart contract, however, there is no expectation that the NFT will make money for the buyer. If the NFT value increases, that is due to the marketplace and not due to any expectation of profit upon its sale like security does. The SEC has greater concerns over fractional NFTs that allow many investors to own a piece of the NFT. Lawsuits, such as a class action against Dapper Labs and an SEC case against a former OpenSea employee for wire fraud and money laundering, have arisen over this very issue.
Although NFTs are not considered securities because they are not divisible or “fungible.” Fractional NFTs, however, blur the line, with some in the SEC viewing them as tantamount to shares in a company. Over time, the SEC has changed its legal purview to regulate other digital assets, and NFTs may be next. NFTs do hold significant value for many owners and creators despite the misgivings of old-school investors and their claim of the Greater Fool Theory that props up their value. While NFTs are more akin to a signed soccer jersey or an original oil painting, they do have intrinsic value that isn’t attributed to the Greater Fool Theory. The SEC has certainly taken notice.
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