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Digital Article / Technology and Analytics

How NFTs Create Value

Understanding this new — and often confusing — asset class.
by Steve Kaczynski and Scott Duke Kominers

Published on [Link] / November 10, 2021 / Reprint H06OR1

Illustration by Vinnie Hager

In March 2021, a work of art called Everydays: The First 5000 Days sold
for $69 million at Christie’s Auction House. It’s not out of the ordinary to
see eight-figure art sales, but this one received a lot of attention because
the piece was sold as a non-fungible token (NFT) – an electronic record
corresponding to an image that lives entirely in the digital world.

Put differently: Someone paid almost $70 million for a picture on the
internet.

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Since then, NFTs have started to permeate pop culture in various ways.
They’ve been spoofed by Saturday Night Live and embraced by high-
profile celebrities like rapper Snoop Dogg and NBA superstar Stephen
Curry. There are now hundreds of millions of dollars of NFT sales each
week through public marketplaces like Foundation, OpenSea, and Nifty
Gateway, as well as custom-built applications like NBA Top Shot and
VeVe.

Yet at the same time many people wonder how tokens on the internet
could be worth money at all — especially when many of them just
represent “ownership” of an online image or animation that you could,
in principle, download a copy of for free.

It’s easy to see why NFTs inspire both excitement and deep skepticism:
They’re a completely novel asset class, and we don’t see new asset
classes appear that often. But what drives the value of an asset that’s
really just a digital token people can pass around? To appreciate NFTs
properly, we first have to think through what they actually are and the
types of market opportunities they enable. And once we unlock that, we
can understand how to build businesses around them.

NFTs as a Tool for Market Design

NFTs have fundamentally changed the market for digital assets.

Historically there was no way to separate the “owner” of a digital
artwork from someone who just saved a copy to their desktop. Markets
can’t operate without clear property rights: Before someone can buy a
good, it has to be clear who has the right to sell it, and once someone
does buy, you need to be able to transfer ownership from the seller to
the buyer. NFTs solve this problem by giving parties something they
can agree represents ownership. In doing so, they make it possible to
build markets around new types of transactions — buying and selling

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products that could never be sold before, or enabling transactions to

happen in innovative ways that are more efficient and valuable.

As the name “non-fungible token” suggests, each NFT is a unique, one-

of-a-kind digital item. They’re stored on public-facing digital ledgers
called blockchains, which means it’s possible to prove who owns a given
NFT at any moment in time and trace the history of prior ownership.
Moreover, it’s easy to transfer NFTs from one person to another — just
as a bank might move money across accounts — and it’s very hard to
counterfeit them. Because NFT ownership is easy to certify and transfer,
we can use them to create markets in a variety of different goods.

But NFTs don’t just provide a kind of digital “deed.” Because

blockchains are programmable, it’s possible to endow NFTs with
features that enable them to expand their purpose over time, or even
to provide direct utility to their holders. In other words, NFTs can do
things — or let their owners do things — in both digital spaces and the
physical world.

In this sense, NFTs can function like membership cards or tickets,

providing access to events, exclusive merchandise, and special
discounts — as well as serving as digital keys to online spaces where
holders can engage with each other. Moreover, because the blockchain
is public, it’s even possible to send additional products directly to
anyone who owns a given token. All of this gives NFT holders value
over and above simple ownership — and provides creators with a vector
to build a highly engaged community around their brands.

It’s not uncommon to see creators organize in-person meetups for their
NFT holders, as many did at the recent NFT NYC conference. In other
cases, having a specific NFT in your online wallet might be necessary
in order to gain access to an online game, chat room, or merchandise

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store. And creator teams sometimes grant additional tokens to their

NFT holders in ways that expand the product ecosystem: owners of a
particular goat NFT, for example, were recently able to claim a free baby
goat NFT that gives benefits beyond the original token; holders of a
particular bear NFT, meanwhile, just received honey.

Thus owning an NFT effectively makes you an investor, a member of a

club, a brand shareholder, and a participant in a loyalty program all at
once. At the same time, NFTs’ programmability supports new business
and profit models — for example, NFTs have enabled a new type of
royalty contract, whereby each time a work is resold, a share of the
transaction goes back to the original creator.

This all means that NFT-based markets can emerge and gain traction
quickly, especially relative to other crypto products. This is both
because the NFTs themselves have standalone value — you might buy
an art NFT simply because you like it — and because NFTs just need
to establish value among a community of potential owners (which can
be relatively small), whereas cryptocurrencies need wide acceptance in
order to become useful as a store of value and/or medium of exchange.

The Advent of NFT Ecosystems

As marketplaces have sprung up around NFTs, creators have taken

advantage of their possibilities in different ways.

The best-known examples are the digital art market, described above,
and digital collectables platforms, such as Dapper Labs’s NBA Top Shot,
which enables users to collect and exchange NFTs of exciting plays
from basketball games — videos called “moments,” which are effectively
digital trading cards. Top Shot has been building in gamified challenges
and other reasons to own the cards beyond just their pure collectible

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value, even teasing that moment holders may eventually receive real-
world benefits from the NBA.

But what’s emerged more recently is a model of active ecosystem-

building around NFT-native properties — leading to novel
organizations developed entirely within the NFT space. These products
start with an NFT series, but project forward a roadmap under which
holders of the NFT gain access to an expanding array of products,
activities, and experiences. Revenue from initial and subsequent NFT
sales is fed back into the brand, supporting increasingly ambitious
projects — which in turn drive up the value of the NFTs themselves.

The Bored Ape Yacht Club, for example, comprises a series of NFT ape
images conferring membership in an online community. The project
started with a series of private chat rooms and a graffiti board, and
has grown to include high-end merchandise, social events, and even an
actual yacht party. SupDucks and the Gutter Cat Gang similarly began
building communities around NFT image series and associated online
spaces; the former has bridged into a boardwalk-themed metaverse
game, and the latter has focused on real-world benefits like extravagant
in-person events.

People often take on membership in these collectives as part of their

personal identity — even using their favorite NFT image as their public
profile picture on social media. Each NFT community has different
personalities and purposes, and there are so many by now that almost
everyone can find a group they can call their own. In this way, NFT
ownership provides an immediate shared text that people can use to
connect with each other.

And moreover, in many of these communities, ownership also conveys

partial or full commercial rights — or even some degree of governance

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in how the community is run — which means people members can

build properties on top of their NFTs that grow the value of the
overall brand. Crucially, this creates a channel by which engaged
fandom can feed back into the brand itself: “Jenkins the Valet” is
a Bored Ape member-created project that has effectively become its
own sub-brand. Individual SupDucks members have created art and
character identities around their NFTs that have been absorbed into the
SupDucks metaverse. And community-created fan projects have built
out parts of the Gutter Cat Gang story arc.

All of these benefits make owning the associated NFTs more valuable —
and almost paradoxically, this increase in the value of ownership comes
in a form that helps separate the value of ownership from the purely
financial opportunity of reselling.

Building on this phenomenon, a few well-known brands have recently

introduced NFT series that serve to identify, reinforce, and expand their
existing communities of brand enthusiasts. The popular streetwear
brand The Hundreds, for example, has built an NFT project around their
mascot the “Adam Bomb,” and directly rewards their community of NFT
holders with improved access to the brand through connection with the
founders and early access to new product releases.

Many emerging NFT applications, meanwhile, are seeking to more

explicitly blend online NFT ownership with offline use cases. A few
restaurants, for example, have started using NFTs for reservations.
And the ticketing industry has a major opportunity here: By issuing
tickets as NFTs, venues can give a variety of benefits to purchasers,
creating more of an incentive to buy, as well as providing the venues an
opportunity to collect royalties on secondary sales.

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Other companies are exploring how NFTs could be used in establishing

and recording people’s identity and reputation online. MIT recently
started offering blockchain-based digital diplomas, which are effectively
non-transferable NFTs. Meanwhile, both established players like
Facebook (now Meta) and new ventures like POAP and koodos are
providing ways for individuals to create and share NFTs around
activities, affinities, and interests.

How These Businesses Can Succeed

Like all other businesses, each NFT project has to respond to a real
market need. But there are unique challenges to building in the NFT
space:

These ventures must make meaningful use of the NFT technology

itself.
It’s not an accident that so many of the early NFT projects are built
around digital rights management, since that’s one of the most direct
applications of the technology. Club membership benefits for NFT
holders fit in naturally as well, since a given NFT holder can certify
their right to have access simply by pointing to the token in their crypto
wallet.

But NFTs make less sense when there isn’t a purpose to digital
ownership, such as for managing physical collectibles, where people
presumably want to receive the objects themselves. (Unless, of course,
they’re too heavy to move, as in the case of a recent NFT for a 2,000-
pound tungsten cube.)

NFTs also have to leverage a community of users.

Like with any new product, early adopters serve as product evangelists
and a source of early feedback. But with NFTs, these users also serve
an even more essential role: Their decision to embrace the NFTs quite

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literally imbues those NFTs with their meaning and establishes their
initial value.

Without a robust community of users, NFT projects can fail to get

off the ground, or can quickly collapse as all the token-holders lose
interest. And this means that if an NFT project doesn’t make its value
proposition clear enough at the outset, it can fail to recruit a big enough
community — or the right community. Lack of engagement can then
become a self-fulfilling prophecy, devaluing the NFTs themselves.

Video Available Online To watch, please visit this article at [Link].

To maintain ongoing community engagement, NFT project teams must

generate confidence that they can continue executing.
In the world of crypto, where many people engage partially or
completely anonymously, crises of confidence in a project can cascade
quickly, which means it’s particularly important that the team
communicate frequently and transparently about how they intend to
evolve the project. (Many NFT teams have frequent “community calls”
for this purpose.)

Here NFT projects can also lean on established brands or institutions,

as well as explicit promises of real-world utility. For example, a sports
team or popular music artist selling tickets through NFTs can use their
existing reputation and events infrastructure to convince people that
the NFT tickets really do have value. That said, an existing company
releasing an NFT without any specific purpose or value can look
gimmicky and thus fail to create engagement.

NFT projects need accessible “on-ramps” for new users.

NFTs also face a number of challenges that are general across crypto
entrepreneurship. Most crypto technology at the moment is not user

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friendly to engage with, requiring interfacing with a number of abstruse

cryptocurrency exchanges and wallet providers.

NBA Top Shot has benefited tremendously from submerging most of

the underlying crypto structure in its NFT market, and enabling users
to purchase moments in fiat with credit cards, rather than requiring
people to transact in cryptocurrency. Other projects have recruited
onboarding directors to help first-time NFT consumers navigate the
process of purchasing.

And an NFT project needs to be able to weather crypto market swings.

Additionally, crypto markets are volatile and the surrounding
regulatory frameworks are still being sorted out. These market swings
can dramatically change the demand for NFTs — which again
underscores the importance of building community and other sources
of direct value for NFT ownership.

Outlook

As with any novel asset class, the future of NFTs is uncertain. In the
long run, the market will need to contend with the transaction and
environmental costs currently associated with using crypto technology.
We will also need to establish more explicit legal frameworks around
NFT ownership, and clarify how NFTs relate to existing forms of
ownership rights — especially around intellectual property. At the same
time, it’s likely that the most valuable applications of NFTs haven’t even
been envisioned yet.

Nevertheless, the community-based NFT projects that have taken off so

far give a hint of what may be to come.

NFTs enable new markets by allowing people to create and build

upon new forms of ownership. These projects succeed by leveraging
a core dynamic of crypto: A token’s worth comes from users’ shared

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agreement — and this means that the community one builds around
NFTs quite literally creates those NFTs’ underlying value. And the more
these communities increase engagement and become part of people’s
personal identities, the more that value is reinforced.

Newer applications will take greater advantage of online-offline

connections, and introduce increasingly complex token designs. But
even today, it’s less surprising than you might think that people are
making money selling pictures on the internet.

Disclosure: Both Kaczynski and Kominers own NFTs, as well as other

crypto assets. Additionally, Kominers provides market design advice to
a number of marketplace businesses and crypto projects, including Novi
Financial, Inc., the Diem Association, koodos, and Quora.

This article was originally published online on November 10, 2021.

Steve Kaczynski is an avid NFT collector who provides NFT

market commentary for the Decentralized Generation Network
([Link]). His professional background is in communications,
with a focus on public relations and marketing at large corporations.

Scott Duke Kominers (@skominers) is a Professor of Business

Administration in the Entrepreneurial Management Unit at Harvard
Business School; a Faculty Affiliate of the Harvard Department of
Economics; and Co-Principal Investigator of the Harvard Crypto,
Fintech and Web3 Lab. He is also an a16z crypto Research Partner,
and advises a number of companies on marketplace and incentive
design. Previously, he was a Junior Fellow at the Harvard Society
of Fellows and the inaugural Saieh Family Fellow in Economics
at the Becker Friedman Institute. His first book is The Everything
Token: How NFTs and Web3 Will Transform the Way We Buy, Sell, and
Create.

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