Non-Fungible Tokens (NFTs): A Beginner's Guide​

There is certainly no doubt that NFTs have transformed the entire narrative of art in a digital economy, the scope of finance as it transforms the way we look at ownership and valuation of digital assets, and so much more. They have revolutionized the monetization of art and in a way also democratized expression. It is no secret that throughout history only a select few have enjoyed privileges of mass attention and inflated valuations of their works. With NFTs, however, small artists from across the globe have been able to channelize their imaginations into creating collectibles for enthusiasts who often look beyond the closely guarded circles to find their boast-worthy pieces of digital art, online avatars, etc. Anyone equipped with internet and perhaps a personal computer, the urge to do well, an uninhibited imagination (and well, some money to afford some cushion cryptocurrency) in any part of the world now has access to collectors in other parts of the world. And this genius of the internet that NFTs have embodies spill over to other aspects as well- there have been instances of millions raised in charity through online auctions of celebrity signed t-shirts, the rise of NFT-gaming and virtual ownership of even land in games like The Sandbox. Plus, with demand and supply expanding in volume each day, investing and trading in NFTs has come to be seen as a very viable possibility.

That said, the rise of NFTs has not been devoid of its fair share of skeptics. There has been concern over the unchecked popularity of this concept that has led many to wonder if NFT investment is an economic bubble in brew. Common concerns relate to the uncertainty regarding price movement of NFTs as valuations are based simply on people’s expectations of their performance, not pegged to any material backing, which leaves this concept exposed to volatility risk. Plus, for people in the area just for investment purposes, there is the overarching risk of over speculation leading to massive swings in the asset prices, thus making NFTs a less than optimum choice of financial product for people with limited appetite for risk.

The second major downside is the risk of illiquidity surrounding NFTs. Liquidity of any asset is defined as how readily can the asset be exchanged for cash. All assets, from stocks to bonds and precious metal, can be offloaded and converted into hard cash that can ultimately buy them goods and services in exchange. The debate surrounding legalization of cryptocurrencies by central banks of several countries, including India, puts NFTs is a tough spot. So even though cryptocurrency is well accepted as the form of payment for many transactions online, there is always the risk of complete crackdown on this form of currency and its usage that looms large over traders. However, it is not all bad since it is this very risk of illiquidity that also prevents panic selloffs among NFT traders, like in the case of equity.

The third and much more under-discussed risk associated with NFTs is that of adverse selection. Anything off the internet can be minted into an NFT- which implies not just the broadening of the scope of creativity but also the existence of a lot of “lemons” (reference- Economist George Akerlof’s award winning theory on moral hazard and adverse selection in the paper, The Market for “Lemons”). Without the presence of any further regulatory authority in place, which is the very characteristic of decentralized finance in which NFTs operate, this problem is exacerbated even more as it is only the collector’s eye for detail that is his safeguard against low quality/rip-off assets.