Currently, the price of NFTs is still high and will likely continue to increase for some time, but a bubble burst and a price crash will always come. As central banks will tighten monetary policy to keep inflation in check, new market-tested asset classes are likely to be hit harder than more reliable ones.
LAUSANNE — In March 2021, Christie’s set a record for digital artwork by selling a JPEG file created by artist Beeple for $69.3 million. The ownership of this JPEG “original” titled “Everydays.The First 5000 Days” is secured as an NFT.
The sale made headlines and quickly exploded the NFT market. Investors poured $27 billion into the market in 2021, and Facebook’s rebranded parent company Meta is now reportedly planning to allow users to create and sell NFTs.
There’s just one problem: the NFT market will eventually collapse for a number of reasons.
Essentially, NFTs are tradable codes attached to metadata, such as images. A secure computer network records sales on a digital ledger (blockchain), providing buyers with proof of authenticity and ownership.
NFTs are usually paid in Ethereum ETH 0.03% (cryptocurrency) and, more importantly – stored on the Ethereum blockchain. By combining the desire to own art with modern technology, NFTs are the perfect asset for Silicon Valley upstarts and their communities in finance, entertainment and the wider retail investor community.
But like other markets driven by exuberance, impulse buying, and hype, the fast-moving and speculative NFT market could drain the blood of many investors. The current mania draws parallels to the Dutch tulip mania of 1634-37, when some bulbs fetched extremely high prices before the boom dissipated and the bubble collapsed.
The NFT market could suffer a similar fate — but not because of environmental concerns, as some might think. To be sure, NFTs consume a lot of energy because cryptocurrencies like Ethereum and Bitcoin BTC -0.39% are “mined” through computer networks and have a large carbon footprint – increasing with each transaction. But when it comes to understanding what would crash the NFT market, climate impact is one. The real problem is that the current NFT boom is built on sand.
Start with the question of unlimited supply. NFTs provide ownership of digital assets, but do not have the right to prevent others from using their digital copies. Why wealthy investors are prepared to pay tens of millions of dollars (or more) for traditional physical art from the likes of Rembrandt, Van Gogh or Monet partly because the number of masterpieces is limited; the artist is long dead and cannot be produced new artwork. On the other hand, NFT replicas could become a commodity.
Also, like all digital things, there’s no difference in appearance between the original JPEG file sold for $69.3 million and the free-to-download copy online. In theory, the supply of legally available NFT copies is infinite, potentially pulling down demand for them, causing prices to collapse.
Since the blockchain cannot store the actual underlying digital asset, people buying NFTs are buying a link to the digital artwork, not the artwork itself. While buyers get the copyright for the link, the transaction costs associated with monitoring the limitless online venues that showcase NFTs, identifying illegal uses, and pursuing and prosecuting infringements make it nearly impossible to enforce copyrights or deter abuse. This greatly limits the monetization of the asset.
Another risk is that NFTs are being made and sold using nascent technologies — blockchain and cryptocurrencies. There are multiple competing standards on how to generate, secure, distribute, and authenticate NFTs, including ERC-721, ERC-998, ERC-1155, liquid and illiquid standards, and Tezos XTZ -0.03%’ FA2. The resulting uncertainty about how to permanently guarantee ownership certification jeopardizes the value of the asset, and even the ownership of the asset.
In fact, if the next wave of more advanced technologies that replace cryptocurrencies or blockchains is incompatible with secure NFT ownership, the value of NFTs could be evaporated. Companies trading NFTs today may not exist tomorrow, obscuring ownership claims.
The price volatility of the cryptocurrencies underpinning the NFT market is also a central issue. NFT prices tend to move in tandem with cryptocurrency prices. When cryptocurrencies fell in 2018, so did the nascent NFT market.
The psychology of buying luxury goods may also put downward pressure on NFT prices. Most luxuries are so-called Veblen goods that have limited utility beyond allowing owners to advertise their wealth. For this reason, they tend to generate huge profits for sellers.
NFTs enable buyers to flaunt their wealth primarily through the high prices they pay, and they expect a positive response from their peers. If such a big payout doesn’t resonate with this audience, investors might as well burn through cash to light a cigarette.
Because owning an NFT does not prevent others from showing the same asset and signaling ownership, these tokens are difficult to use as a valid indicator of unique spending power. Also, many NFT buyers are anonymous anyway because the blockchain ensures that knowledge about ownership is limited.
Lastly, changing macroeconomic conditions could negatively impact the prices of alternative assets such as NFTs and traditional art. The number of billionaires worldwide has more than quadrupled over the past two decades, and the available income ready to invest in alternative asset classes has ballooned as a result. The COVID-19 pandemic has reinforced this trend so far. Much of the economic stimulus injected by central banks has entered financial markets, further boosting the net worth of the ultra-rich.
But investor attention can be fleeting. After the 2008 global financial crisis, sales of art and other luxury goods fell by nearly 40%. With central banks now starting to tighten monetary policy in an effort to rein in inflation, new and market-tested asset classes could be hit harder than more reliable ones.
Eventually, the price of NFTs will suffer a massive, permanent drop. They still look high for now and may continue to rise for a while, but a crash will come.
Investors who think they can time the market are welcome, but their optimism is likely to be proven wrong.
