The NFT conundrum: Smoke and mirrors, or sound investment?

Non-fungible tokens, or NFTs, have taken the planet by storm. People are willing to pay enormous sums for something that’s hard to describe, and easy to copy. This could be just a strange phase in global financial history like Tulipmania in the 17th century. Or, it could be a new phase in the admittedly odd history of objets d’art.

An NFT is a piece of code written on a blockchain and associated with something else. The “something else” is usually digital, and can be described very loosely as a collectible. It could be a photo, music, artwork, even a tweet, or a screenshot of a Facebook page. The “something else” is instantly and perfectly reproducible, because it’s digital.

However, the NFT written on a blockchain cannot be altered, or reproduced. Blockchains are digital ledgers, where entries cannot be altered, once entered and saved. The concept of the blockchain was invented by the (probably pseudonymous) inventor of bitcoin, Satoshi Nakamoto. Blockchains are used to store transaction records for cryptocurrencies. But they can be used for other things.

Blockchains records can be read by anybody. But they can only be written by somebody with specific permissions (usually due to knowing the password to a given account). Transaction data could be an appropriately coded version of “Coin number 12345 being given by Akansha to Bindu”.

But blockchains can record all sorts of information. Some blockchains are designed to allow for “smart” contracts — “Give this coin to Akansha if she has been vaccinated”. Blockchains can be used to record things like bottles of wine from a specific vintage to prevent forgery. Here the entry may go “Bottle #108 of Jan 2021 sold to Narendra for $108”. If Narendra sells it to Amit for $109, that’s recorded, and so on. So if Lal Kishen, who doesn’t feature in the transaction record, tries to sell bottle#108, you know it’s a fake.

Blockchains have been used in China to bypass censorship, in at least one famously tragic case. A student who alleged she was sexually assaulted by somebody important placed her allegations on record in a crypto-currency blockchain and died by suicide.

So, let’s say somebody creates a digital work of art, or music, or something else. Then, they associate an NFT with it — “This picture of ginger cat washing was drawn by Amitabh”. Or, “this was the first tweet by Jack Dorsey who founded Twitter”. Then they sell the NFT. The transaction is also done in cryptocurrency naturally, which means it is also recorded on a blockchain (not necessarily the same one as the NFT).

Such a picture or tweet can be instantly reproduced for free, hundreds of times if desired. The NFT — the associated blockchain entry — is unique. That NFT can be sold, and every time it’s sold, there will be a blockchain entry of transaction. So the provenance of the NFT is always known.

How do you make sense of this market? People are obviously willing to pay very large sums at this instant for the bragging rights of owning blockchain entries. It’s somewhat similar to owning an autographed cricket bat, perhaps. So an NFT is like any other collectible or work of art in that it is worth whatever people are willing to pay.

Will that worth grow in time? Or will this just be a sometime fad, which becomes a footnote at the intersection of arts & culture, and finance? Since transactions are done in cryptocurrency (there are thousands of cryptocurrencies, if not millions), will even the currency used for the transaction remain fungible? Or will that evaporate?

How does one treat NFTs in tax terms? Is it a work of art? It clearly differs from the Mona Lisa. The art itself is perfectly reproducible multiple times, with copies indistinguishable from the original. Is an NFT a financial derivative? There are some resemblances. An option allows you to trade some underlying asset — say, 100 shares of some company. But options are time bound — NFTs are not. The underlyings of options— the shares you could opt to buy — have a clearly agreed valuation whereas the underlying of an NFT is indistinguishable from any digital copy.

Is the entire NFT market a variation of the popular game known as the “Greater Fool”? People buy shares, or tulip bulbs, or gold on the basis that the price will go up. If they appear to be foolish because they’re paying extravagant prices, they’re hoping a greater fool will come along and pay an even higher price. NFTs may fall into this category as well — clearly a lot of people are speculating in this space.

Maybe, NFTs are all about smoke and mirrors and greater fools. Or maybe this market will eventually mature into just another segment of the arts and culture space. Your guess is as good as mine.