Unless you live under a rock you will know about NFTs. However, between crazy prices and projects going from zero to hero and back, it is difficult to assess which ones to pick. In this article we are going to explore what drives value for these NFTs.

Making digital valuable

Traditionally, digital assets have been easily replicable as they’re just pixels on screens. Think about an emoji – no matter who designs it, its value drops to zero as soon as it is shared on the web as anyone could save a local copy indistinguishable from the original. This is the same for images, videos, illustrations, or digital art.

The premise of NFTs is that a ‘blockchain certificate’ is assigned to digital items which guarantee their provenance, ownership and that level of authenticity. Because it is ‘minted’ on the blockchain, it is not centralised by a single party – everyone can view the certificate but no one can alter it. Anyone can screenshot or save a copy of the item to use, but they cannot pass for the official owner unless they own the NFT. Because the item is a digital file, the copy looks exactly the same, but it is still a copy because the certificate is not attached to it. 

This way, your original item remains scarce, because it cannot be definitely replicated. And we often hear that scarcity creates value. But does it really?

What creates digital value?

The answer is that scarcity is necessary, but not sufficient to create value. Economics law dictates limited supply of a commodity leads to increased price, but that’s assuming there’s demand for this commodity at all. Therefore, we can look at value as a mix of various other parameters.

Value = Scarcity + Utility + Reputation + Liquidity 

Utility represents how easily the NFT can be used, and what you can actually do with it. 

Reputation represents value given by the profile — popularity or infamy — of the original creator or source. 

Liquidity represents how easy it is to buy and sell the NFT.

In 2021, dozens of brands and celebrities have minted their own NFT collections with more or less resounding success. NBA Top Shot sold $500M worth of NBA history, Elon Musk was offered $1m for his NFT song (before aborting the transaction), FormulaOne sold digital collectable car components, and Taco Bell’s collection was, erm, less popular. So what drove the value of these purchases?

Looking at the formula above, we can safely say that reputation played a big factor. Had I released the same song as Elon Musk, I wouldn’t have been offered $1m; and if the basketball clips were not officially endorsed by the NBA, they wouldn’t be as valuable. Scarcity also played a role, as these drops are time-limited and run out quickly, so FOMO leads to irrational behaviour and speculation. Then liquidity — the ability to easily buy and sell — created confidence in the market and incentivized transactions. 

The missing element here was Utility. No one bought these NFTs thinking ‘I’ll be able to use them for X’ or ‘these NFTs will make my life easier for X’. 

Reputation and scarcity driven value works well for digital art and collectables, but this is a relatively niche audience. Sure, the digital collectable market generated over $2 billion in transactions in Q1 2021 alone, but only across roughly 100,000 hyper-users according to a report from NonFungible.com. This might well continue to be the case and be a large market in itself, but to truly emerge into the mainstream, I believe that NFTs need to prove their utility beyond pure collectable and speculative value.

The utility layer

The good news is that the utility layer for NFTs is hiding in plain sight, with 2B users ready to engage: gaming, and its evolution into the metaverse.

NFTs are digital items, so what better place to use them than in gaming environments and the decentralised metaverse? Games will create hundreds of use cases for NFTs (digital fashion, art, weapons, collectables – anything!), enabling players to import and actually use it within games, whether it’s a collectable sword to fight an enemy, a piece of art to decorate their virtual house, or digital fashion for their avatar. Being able to make use of the NFT in the context of the game creates actual value for the whole ecosystem. Players get the benefit of owning valuable assets that they can sell to other players. Game publishers can create more assets for their games, and also program the smart contract linked to the NFT to get a small commission on future purchases. In addition to the traditional in-app purchase or advertising revenue model, NFTs create a new in-game economy for developers to monetize their content.

There are many platforms doing this already, from the Sandbox, Decentraland, to Somnium Space (disclosure: I am an investor in all three). In Somnium Space, a virtual world, you can buy your own land or create avatars you can sell. Every item, from land to avatars to digital art pieces, are actually NFTs. This means that the land or avatar you create cannot be replicated and is therefore actually owned by you. You can build on top of that land and make money from it – in Sandbox and Somnium Space, companies are doing so by building virtual houses and experiences. That is actual utility.

The metaverse is becoming the playground for NFTs to find utility. Land, avatars and assets need a structure to be displayed on. If NFTs are the product, the metaverse is the experience, and as it grows, will become its layer of utility.

Disclaimer: A version of this article originally appeared in Forbes and has been edited for gmw3.com.

Source: https://www.gmw3.com/2022/01/nfts-and-the-missing-layer-of-utility/