What is the Deal with NFTs?

"Right-click, save" this post

If you have not been living in a cave over the past year, you have likely heard about non-fungible tokens, or NFTs. As a technical matter, NFT refers to a single, digital token on a blockchain. If that sounds confusing, perhaps a little more detail is in order.

If you are reading this, then you are probably familiar with Bitcoin. The Bitcoin blockchain is a digital ledger of transactions stored on a decentralized network of computers. The transactions on this Bitcoin blockchain consist of exchanges of a digital asset called a bitcoin. The supply of these bitcoins is determined by an algorithm and will eventually peak at a supply of 21 million. There is nothing special about an individual bitcoin. If I have one bitcoin and you have another bitcoin, they are worth the same amount. They are fungible.

The same thing could be said of a U.S. dollar. If I am holding a dollar and you are holding a dollar, each dollar has the same value. If I want to make a purchase, I can provide dollars to the seller. I do not have to provide the seller with a particular dollar. All dollars are the same. All dollars are fungible.

The Ethereum blockchain is also a distributed digital ledger of transactions. Unlike the Bitcoin blockchain, many digital assets are traded, and all of these transactions are recorded on the Ethereum blockchain. Ethereum allows people to build decentralized applications on the blockchain. Anyone can create their own, unique digital token on the blockchain with their own governance structure over the supply of those tokens. And, in fact, many applications have been created on the Ethereum blockchain that allow people to exchange one token for another.

Of the tokens that exist on the Ethereum blockchain, there are two predominant types. One is a fungible token. These tokens are no different than things like dollars or bitcoins or ether (the cryptocurrency used to pay transaction fees on the Ethereum blockchain) in the sense that they are fungible. I don’t need a specific dollar bill or bitcoin or ether to make a transaction. Every unit spends the same.

The second type of token is a non-fungible token, or NFT. Each of these tokens is unique. In addition, since these tokens exist on the blockchain, the owner of the token is identifiable to everyone on the network. There is no need for a third party to guarantee, validate, or authenticate an NFT. Anyone can access the digital ledger and see who minted the NFT, any details attached to its creation, and every transfer of ownership. (Although I am mentioning NFTs on Ethereum, NFTs do exist on other blockchains, like Solana. This isn’t an important detail for my purposes.)

All of this seems very technical. In addition, there is a lot of talk among those interested in cryptocurrency about the potential of NFTs as a disrupting form of technology.

Yet, despite all of this discussion of the details and the potential, NFTs are most notably associated with ownership of JPEG files of pixelated faces and bored primates that trade for tens or even hundreds of thousands of dollars — well, technically, ether of equivalent dollar values.

What in the world is going on here? And what does this have to do with price theory?

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An important aspect of the UCLA brand of price theory is the emphasis on property rights. Armen Alchian supposedly once said something to the effect of “tell me the rules and I’ll tell you how people will behave.” We can think of property rights as one aspect of the rules. Alchian, in particular, emphasizes three aspects of property rights. The first is excludability. To what extent does the holder of the property rights have the ability to exclude others from the property? The second aspect is alienability. Does the property owner have the right to exchange that property with others? Are there restrictions on exchange? And finally, to what extent does a property owner bear the risk and earn the rewards associated with the property?

This emphasis on property rights can help us to understand what is going on in markets. Each of these aspects of property rights influences the incentives of the property owner and can be used to explain or predict the owner’s behavior. Furthermore, once one starts thinking about property rights, it is hard to think of any type of exchange as anything other than an exchange of a bundle of property rights.

With this as a background, I can address the JPEG NFTs. Perhaps in a future post, I can address NFTs more generally.

Thus far, the most visible use case for NFTs has been the buying and selling of digital artwork. Someone creates some form of digital artwork, sells it to someone else, and mints an NFT that signifies ownership of that piece of art. What has made this especially interesting is that people share this art online and on social media. Others mockingly retort that they can simply “right-click, save” the file and they will own the art as well. This mocking retort seems to reflect the general attitude of the public toward NFTs.

However, let’s think of this from a property rights perspective. Consider art, in general. When someone purchases a work of art, it might provide multiple forms of value to them. They might enjoy looking at the art, displaying the art in their home for their guests to look at, or even just the prestige of being someone who owns art created by a particular artist. In addition, the person might view the art as an investment. Perhaps the art will be worth more in the future.

This description is really about property rights. The person who owns the art can get value from excluding others from seeing it. The owner gets to determine where it is displayed and who gets to look at it. The owner also gets value from the fact that art is alienable. When the owner purchases the art, he or she knows that the art can be sold to someone else in the future. That possible future sale comes with risk and possible reward. If the artist becomes more popular over time, it is the owner of the artwork that gains from this popularity. However, if the artist turns out to be unsuccessful or the style of art goes out of fashion, the owner of the artwork bears the risk of those losses. The owner might also get value from owning the property rights in and of itself. Being the known holder of property rights might have value in the form of prestige.

Thus, the value that one gets from art is the enjoyment of the art itself, the prospect of future income, and the prestige of being the owner of the artwork. It might be possible to unbundle those characteristics, however, this is not without loss of value to the owner. An owner could, for example, allow a museum to display the artwork with a sign indicating that it is on loan from the owner’s collection. The owner gets prestige but doesn’t get any daily enjoyment from the art because it is displayed elsewhere. In contrast, displaying the artwork in one’s home allows the owner to see and enjoy the artwork daily, but yields no prestige if no one knows who owns it.

With digital artwork, it might not be possible to determine whether something is original. Furthermore, since people can simply save the digital JPEG artwork without permission, it might not be possible to exclude people from observing and enjoying the artwork. However, that doesn’t mean that ownership of this type of artwork has no value.

Consider the role of NFTs. If any form of artwork is associated with an NFT, the NFT represents something like a property title. On the one hand, with ownership recorded as an NFT on the blockchain, anyone with access to the blockchain can observe who owns the artwork. If this is a physical piece of art, someone might need to authenticate the art for a sale, but everyone knows who the rightful owner is. In addition, anyone who has the authentic piece of art, but lacks the private cryptographic keys necessary to transfer the NFT will find it difficult to sell outside of the black market. Thus, the very existence of the record on the blockchain has value.

While the “right-click, save” response is funny in some sense, one could make a similar argument about conventional, physical artwork. For example, pictured below is Claude Monet’s Water Lillies. This painting is currently on display at the Toledo Museum of Art. In fact, I found the digital file of the painting on their website. Any of you could “right-click, save” the picture below, go find the Toledo Museum of Art Twitter account, and tweet at them, “LOL. I just right-click-saved this Monet painting. I own it now, dummies.”

But right-click-saving the above image doesn’t convey ownership of the actual painting. This is widely understood. Many museums sell prints of artwork like this in their gift shops. Buying the print does not convey ownership of the actual painting and the resale value of the print will reflect that. Nonetheless, this ability to sell prints seems to be the primary difference between the physical art world and the digital art world. Since anyone can right-click-save some digital art, it is going to be hard to sell prints. This explanation isn’t as funny as “right-click, save”, but it is nonetheless the same argument. Possession of the artwork is not the same as ownership.

What this discussion reveals is that what people are buying when they purchase NFTs is literally an ownership token, not the JPEG itself. They value this token either because they value the prestige of the publicly-known ownership, the flow of benefits that they get from holding the property rights to that JPEG, or some combination of the two.

Of course, this generates a testable hypothesis. If NFTs are really about the value of ownership and the value that flows from property rights, then the value of NFTs should be related to the characteristics of those property rights. Fortunately, there is a relevant comparison that I can discuss. The two most popular forms of NFT digital art are the CryptoPunks and the Bored Apes Yacht Club (BAYC). While ownership of each of these forms of digital art is recorded as NFTs on the blockchain, the characteristics of the property rights granted to the NFT holder differ. As The Block explains:

"BAYC NFTs have generous IP rights compared to CryptoPunks," Bobby Ong, co-founder of CoinGecko and an NFT expert, told The Block. "Some people are not happy that Larva Labs is not assigning more rights."

Put simply, CyptoPunk NFT owners do not get rights to use their NFTs for any commercial purpose, whereas BAYC NFT owners get IP rights. Bored Ape owners are using these IP rights to build a blockchain-based game in partnership with Animoca Brands.

This distinction is important. As the article notes, the floor price (the lowest price of the collection) for CryptoPunks has been falling whereas the price of the Bored Ape NFTs has been rising. Why? Because NFTs with fewer restrictions on property rights have more value.

This is exactly what a property rights analysis of NFTs would suggest.