Written By Thomas J. Brock, CFA®, CPA
Edited By Savannah Hanson
Published: January 14, 2022
Understanding the investment world can be difficult, especially when you consider the myriad of asset classes, fund structures and tax-advantaged vehicles available in the marketplace. Factor in previously unfathomable situations, like a global pandemic and negative interest rates, and the complexity is magnified exponentially.
It doesn’t stop there. Increasingly pervasive technologies, such as mobile payment applications, peer-to-peer lending platforms, robo-advisors and blockchain-based databases are revolutionizing the way we conduct business, manage financial transactions and invest.
Blockchain-based databases are the subject of this article. Specifically, I’m focusing on non-fungible tokens. At this stage, you’re probably scratching your head. What in the world is a non-fungible token?
Fungible vs. Non-Fungible Assets
Let’s start with the word fungible. A fungible asset is one that is easy to exchange for something else of the same type and value. For example, a U.S. dollar bill is fungible. You can trade one for another, and you’ll receive exactly the same value. You can do the same with a cryptocurrency, such as Bitcoin. One Bitcoin is worth exactly the same amount as another.
Conversely, a non-fungible asset is one-of-a-kind. It is unique, irreplaceable and non-interchangeable. Examples include diamonds and original works of art. Each of these assets has unique qualities that cannot be authentically replicated. For instance, every diamond has a distinct cut, color, size and grade. Like the fingerprint of a human being, no two diamonds are exactly the same.
Now, you may argue that no asset is truly fungible. After all, a handful of dollar bills are bound to have some discernible physical differences — maybe tattered corners, ink stains or different series dates. This is true, and it highlights the importance of focusing on the use value of an asset, not its technical characteristics, when categorizing it as fungible or non-fungible.
What Are Non-Fungible Tokens?
This brings us to the subject of this article, non-fungible tokens (NFTs). NFTs are digital representations of assets created and stored with blockchain technology. Each NFT has a unique identification code that distinguishes it from other NFTs and prevents replication. Each NFT is also extensible, which means it can be combined with another NFT to form a third, completely unique NFT.
DID YOU KNOW? Today, most NFTs are part of the Ethereum blockchain, which supports the cryptocurrency named Ethereum. The NFTs are differentiated from the cryptocurrency because their identification codes reflect additional information, including metadata that describes the digitized asset.
NFTs can be created for anything that is convertible into a digital format. Much of the momentum in the space involves the storage and sale of digital art and sports memorabilia, but any static image, video clip, sound or text can be digitized and, potentially, monetized. In fact, Jack Dorsey, the founder of Twitter, recently digitized his first ever tweet. A token of Dorsey’s simple message, “just setting up my twttr,” sold for nearly $3 million.
While the tweet example may sound trivial, NFTs have serious business implications. They have been used to streamline complex private equity and real estate transactions, and they are transforming the way buyers and sellers interact across pockets of the art market. Below, we delve a little deeper into these ideas and explore the pros and cons of NFTs.
Pros of Non-Fungible Tokens
NFTs Foster Marketplace Efficiency
The most obvious benefit of NFTs is their potential to make markets more efficient. The conversion of a physical asset into a digital one can streamline processes, eliminate intermediaries, enhance supply chains and bolster security.
A prime example is unfolding across pockets of the art world. Thanks to NFTs, artists are increasingly able to connect directly with their audiences, eliminating the need for costly agents and cumbersome transactions. Moreover, the digitization of artwork is enhancing the authentication process, further streamlining transactions and reducing costs.
But NFTs have applications beyond marketplaces. Eventually, they could evolve as an effective way to manage and control sensitive data and records for individuals and organizations.
Consider our use of physical passports which need to be produced at every entry and exit point. By converting them into distinct NFTs, we could greatly streamline the process of managing travel and identifying individuals. The savings, in terms of time and money, could be significant.
They Can Be Used to Fractionalize Ownership of Physical Assets
Today, it’s difficult to fractionalize ownership of certain assets, including real estate, artwork and fine jewelry. It is much easier to divide a digitized version of a building among multiple owners than a physical one. The same goes for a prized piece of jewelry or a rare case of wine. Through digitization, the market for certain assets can be greatly expanded, leading to greater liquidity and higher prices. On an individual level, it can enhance the way financial portfolios are constructed, allowing for greater diversification and more precise position sizing.
The Blockchain Technology Behind NFTs Is Very Safe
NFTs are created using blockchain technology, which is a system of recording information in a way that is impossible to hack, alter or delete. Essentially, a blockchain is a digital ledger of transactions that is duplicated and distributed across an entire peer-to-peer network of participants. All NFTs stored on the blockchain have distinct records of authenticity and chain-of-ownership, which, theoretically, prevents them from being subject to mishandling and theft. Once data is added to the chain, it cannot be changed or deleted. This means each NFT’s scarcity and authenticity are preserved, fostering a level of confidence we’re not accustomed to seeing in many markets.
NFTs Can Provide Diversification Benefit to an Investment Portfolio
NFTs are different from traditional investments, such as stocks and bonds. As discussed above, they have distinctive qualities and offer benefits we are only just beginning to comprehend and realize. That said, ownership is not without risk. We’ll touch on the risks in the next section. For now, just know that the NFT risk profile is different from that of other asset classes. As a result, by adding NFTs to an investment portfolio, you could improve its efficiency. Basically, this means achieving a better balance of risk and return.
Cons of Non-Fungible Tokens
NFTs Are Illiquid and Volatile
Given its relatively immature state, the market for NFTs is not very liquid. NFTs are not widely understood and the number of potential buyers and sellers is small. This means NFTs can be very difficult to trade, especially during periods of distress. It also means NFT prices can be highly volatile.
NFTs Do Not Generate Income
Unlike dividend-paying stocks, interest-bearing bonds and rent-generating real estate, NFTs do not offer their owners any income potential. Like antiques and other collectibles, the returns associated with NFT investments are based entirely on price appreciation, which is not something you should count on.
NFTs Can Be Used To Perpetuate Fraud
While the integrity of a blockchain is unquestionable, NFTs can be used to perpetuate fraud. In fact, a number of artists have recently reported discovering their work for sale as NFTs on online marketplaces — without their consent.
This obviously violates the intent of utilizing NFTs to facilitate the sale of art. The value proposition of an NFT is that it authenticates a physical work of art with a unique token, assuring the person who owns the token that they also own the original work of art. A serious problem arises if someone creates an electronic image of the original work, attaches a token to it, and puts it up for sale on a virtual marketplace. Here, there is no link to the original work. The token is linked to a fraudulent reproduction.
NFTs Can Harm the Environment
It takes a significant amount of computing energy to create blockchain records, and there’s a growing debate around the long-term harm the process is causing the environment. By some estimates, at the current rate, the carbon emissions from mining cryptocurrencies and NFTs will exceed those associated with the entire city of London in the coming years. Blockchain enthusiasts argue that an offsetting reduction in pollution is underway as NFTs transform global marketplaces, reducing the need for travel and office space utilization. Polygon solves this by being the least impactful chain.
The Future of NFT Investment
NFTs are an exciting creation, and they’re garnering more and more attention as their use cases multiply. The headline-grabbing price tags attached to some NFTs are fueling the fire. However, prudent investors should tread very lightly when thinking about buying these assets because NFTs are highly illiquid and volatile.
Buying them with the hope of achieving triple- or quadruple-digit price returns is not advisable. The real value of NFTs lies in their potential to transform the way markets function and enhance the way we manage and control sensitive information. Here, the sky is the limit.
Nevertheless, if you want to participate in the blockchain movement and see NFT ownership as your way to do it, go for it. However, please do so responsibly. Don’t put a lot of money into NFTs and always strive to establish low-cost positions. Otherwise, you could find yourself in a painful spot — financially and emotionally.
See the original article here.