NFTs are easy to understand if you examine their core utility. Unfortunately, there are thousands of NFT promoters spending millions of dollars to make sure you never look at that.
This episode is a departure from our standard format, but it’s an important topic. I want to explain what NFTs actually are and how you can best make money with them — if you really want to.
Our Japanese founders will be back next episode.
So let’s get right to it.
This is it, gentlemen. This Queen of Hearts is the winning card. Watch it closely.
Follow her with your eye as she moves. Here she is, and now here, now here, and now—where?
The Queen of Hearts. My hand is quicker than your eye.
If you find the lady, you win, and I pay; if not, I win and take your money.
Who will go me twenty dollars?
Yes, this is in fact, Disrupting Japan. Straight talk from Japan’s most successful entrepreneurs, but today we are going to be talking about Three-Card Monte, or more specifically what Three-Card Monte teaches us about NFTs, or non-fungible tokens.
You all know three-card-monte. Even if you don’t know it by that name. The dealer places three cards on the table, flips over one to reveal the queen. He flips the queen back over and begins shuffling the three cards around the table. He does this quickly, but not too quickly. You can just follow his movements. You confidently point to your card, and the dealer flips over a seven.
You lose your money!
Of course, you never really had a chance. The dealer slipped the queen up his sleeve when he started the shuffle. All that patter and shuffling is just there to distract you. The three cards you see on the table are all decoys. The important card had already been taken off the table.
And you see, just like in three-card-monte, the key to understanding NFTs is looking at what’s missing. In this podcast we are going to grab the dealer by the wrist, dispose of the distracting patter and decoy cards, and take a hard look at exactly what’s been taken off the table.
And to be clear, I have absolutely no opinion as to whether you should invest in NFTs or if you personally will make money from them. Today we’ll just be talking about what they are; their reason for existence. In startup terms, we’ll be defining NFT’s true value proposition.
However, by the end of this episode it will make perfect sense to you why a jpg of a robot with a green mustache is worth $2 million, while the same robot with a red mustache is only worth $50. In fact, you’ll understand why NFTs could not possibly work any other way.
And before we dive in, I want to let you know that although I spent a lot of time checking my facts and making sure what I am about to explain to you is accurate. I am most emphatically not a lawyer or a financial advisor. I am a founder, podcaster, author, hacker, picker, grinner, lover, sinner, and if you are even thinking of taking legal or financial advice from me, you are being an idiot.
OK, with that out of the way, let’s flip over these decoy cards.
Misdirection & the NFT Decoy Cards
Card #1: NFTs Prove Ownership
NFTs are usually described as something like “digital certificate of ownership” or “a digital receipt” or “virtual goods with the blockchain providing proof of provenance and authenticity.” NFT promoters love to claim that they are a “permanent, distributed, publicly-auditable, tamper-proof record” of ownership.
But no. They are not any of that. That’s misdirection, that’s one of the decoy cards.
NFTs absolutely provide a “permanent, distributed, publicly-auditable, tamper-proof record” that you gave your money to a crypto promoter, but purchasing an NFT gives you absolutely no copyrights, usage rights, or ownership rights to the artwork. It’s not a receipt because you haven’t actually bought anything but the receipt itself.
The terms of service a some NFT marketplaces hint at such rights, and some NFTs are sold with legal-sounding jargon that promises them. However, the whole idea that copyrights and usage rights can be transferred anonymously between wallets not tied to any specific legal entities is … well, let’s just say it’s untested legal ground. Particularly when there is no way to know if an anonymous NFT creator owned the artwork in question and when there is no recourse if they are lying.
You’ll find that most promoters quickly toss aside the ownership card when you challenge them. They then fall back to the second decoy card.
Card #2: NFTs Provide Bragging Rights
“Well, they say, NFT buyers are not really interested in the legal minutiae of copyright law. To buyers NFTs are more about bragging rights. NFTs provide a “permanent, distributed, publicly-auditable, tamper-proof record” that they have bragging rights to a specific piece of art.”
OK, let’s flip over this decoy card as well.
Unlike copyrights, bragging rights don’t seem to have any basis in law, so I can’t address that specifically. However, it’s important to realize that the artwork in question is not on the blockchain. It’s just a URL. So, once again, you find yourself with a “permanent, distributed, publicly-auditable, tamper-proof record” that you gave a crypto promoter your money, but you only get a URL in return.
Presumably, that URL resolved to something like a nice picture of a cat wearing sunglasses when you sent them your money, but after they have your money, there are no guarantees. Domain names can be sold or go dark. Someone could take your image down or replace it with another one. You have no control over any of that. You just have to take them at their word that they will maintain this site for you forever, and for free.
But hey, I’m sure it will be fine!
If you can’t trust the solemn promise of a crypto promoter, who can you trust?
Card #3: NFTs Help Artists
OK, let’s flip over the third and final card before we look up the dealer’s sleeve and see what’s there.
“NFTs are a way to ensure that artists and creators get paid for their hard work.”
No they are not. And as a former professional musician, this is the decoy card that annoys me the most.
This line of bull usually starts with the word “Imagine” as in “Imagine if artists could get paid every time their work is resold!” or “Image if you could take a unique digital item from game to game!” or “Imagine if musicians could be guaranteed to receive the royalties they are owed!”
Well, OK, I’m a fairly imaginative person, and I can imagine all kinds of wonderful things. But in reality NFTs are not enabling any of this. There are plenty of existing platforms and systems that do all that right now, and NFTs don’t seem to be improving or replacing any of them.
Honestly, even a casual glance at the NFT market will show you that most NFT art is algorithmically generated nonsense. But as we’ll see when we look up the dealer’s sleeve, algorithmically generated nonsense is much, much better suited to NFTs’ true value proposition than actual art would be.
By the way, I have no intention of getting into a “But, what is art?” debate. If you find NFT art appealing, that’s cool and totally valid. My point is that the vast majority of NFT art is generated by programmers and crypto promoters for the purpose of creating NFTs. Very, very little is generated by struggling artists trying to reach a wider audience.
And that kind of gives the lie to how NFTs are really about helping artists.
Up the Dealer’s Sleeve: Why Fungibility Matters
OK, so what do we have left? We’ve flipped over all three cards, and now there seems to be nothing left on the table.
Remember, the secret to understanding NFTs, just like the secret to understanding three-card monte, is figuring out what’s been taken off the table. So let’s have a look up the dealer’s sleeve and see what’s missing.
Let’s start with the name. We are talking about “non-fungible tokens”, so obviously fungibility has been removed, but what does that mean exactly, and why is that important?
From a marketing perspective, “non-fungible tokens” is a really odd naming choice. They could have gone with “art tokens” or “creator tokens” or “collectors tokens”, but the creators and promoters went with an obscure (and difficult to pronounce) bit of financial jargon. “Non-fungible tokens.” But this makes perfect sense because, as you’ll see, NFTs have nothing to do with art and everything to do with fungibility.
NFT promoters usually explain that “non-fungible” means unique, but like everything else you hear about NFTs, that’s not quite true. Not exactly.
Uniqueness and non-fungibility are related, but differ in one important way, and that difference is the reason NFTs exist.
If something is fungible it means that it is not legally distinct from any other instance of that thing. For example, commodities are not unique and they are fungible. If you buy or sell an ounce of gold or a barrel of WTI crude, the particular ounce of gold or barrel of oil doesn’t matter; only the quantity matters. So commodities are both fungible and non-unique.
Things like banknotes and stock certificates are unique, but they are also fungible. Banknotes and stock certificates have serial numbers that uniquely identify them, but that uniqueness is legally irrelevant.
It’s easy to tell two different $20 bills apart. They have different serial numbers, they might be worn differently. One might have marks on it. But legally none of that matters. Every $20 bill is legally identical to every other $20 bill. The same is true for every share of Apple common stock. You can’t legally demand that a bank return a specific $20 bill or that your broker provide you with a specific share of Apple stock. Financial securities are both unique and fungible.
The same holds true for cryptocurrencies. Tokens are both unique and fungible. If you loan me one Bitcoin, you cannot demand that I repay you with that specific Bitcoin.
Our whole financial system is based on this concept of fungibility. For anything to be considered a financial security, stocks, bonds, bitcoin, it must be fungible.
And here we start to get a glimpse of NFTs’ real value proposition.
If you take away fungibility you still have something valuable, but it can’t be a financial security. Without fungibility, you have what’s known as a “collectible”, like art or baseball cards.
Baseball cards have value. They don’t have unique serial numbers or identifiers, but they are definitely not fungible. My 1972 Topps Nolan Ryan card is different from any other 1972 Topps Nolan Ryan card. Faded colors, scratches, tinny creases, and little marks all influence the value of my card. The price of each card must be determined individually.
This distinguishes a collectable from a security like a share of Apple stock, each of which is worth exactly the same regardless of condition or appearance.
OK so what does the fact that NFTs can’t be securities give us? Again, just like in three-card monte it’s not what we get, but what’s been taken away.
We need to look for what’s been taken off the table.
There are a lot of laws and oversight you need to comply with if you want to buy and sell securities. There are strict know-your-customer laws that must be obeyed, auditing and reporting requirements that must be followed, and a raft of anti-money laundering regulations. These are all taken off the table if you are dealing in collectables.
If you are running a crypto exchange, you are dealing in securities and will be regulated like a stock market. If you are running an NFT marketplace, on the other hand, you’re regulated like the local comic book store.
Not fungible? Not a security. Not a security? No SEC regulations or Know-Your-Customer (KYC) requirements.
At least for now.
Two ways to Make Real Money in NFTs
Well, with the securities laws removed, there are two basic ways of reliably making a lot of money with NFTs; the Illicit and the Opportunistic.
The Illicit Method
At its core, money laundering is simply the process of getting money earned from illicit activities into the world financial system. It’s not easy to do. If you show up at the bank with $5M in cash, you also need to have a good explanation of where those funds came from and a paper trail to back up your story. If you don’t the bank simply will not accept your money. Those pesky Know-Your-Customer laws forbid it.
This as been a challenge for the crypto back market. It’s easy to get dirty money into crypto, but getting a significant amount out is hard. Most governments classify crypto as a security, so crypto exchanges must follow the same KYC laws as banks.
NFTs solve this problem nicely.
Let’s say that you have $20 million in dirty money from, I don’t know, drugs, ransomware, or torturing puppies. It doesn’t matter. Let’s just say you are a bad person with a lot of money. Much of that money is probably already in crypto, but if it’s not, getting it into crypto is trivial and you can do it anywhere in the world.
Once that’s done:
- Step 1: Use a bit of clean money to set up an account and buy some NFTs.
- Step 2: Cover your tracks by moving some of your dirty crypto through alt coins, Monero, some off-chain transactions, some through Tornado.cash or another tumbler, and have it eventually wind up in a new wallet that you control.
- Step 3: Sell some NFTs to your new mystery wallet for a huge profit.
- Step 4: Report the sale, pay your capital gains taxes, and deposit your new, squeaky-clean money into the bank.
In the real world, of course, the process would be automated and might involve thousands of wallets and transactions.
You can also run the process in reverse if you want to take a tax loss by moving money into crypto.
NFTs are instruments that act like securities, but are not regulated as securities.
This is their core value proposition, and I have to admit that it is absolute genius.
This is why algorithmic art is perfect for NFTs. You or I, as rational human beings, can look at set of 10,000 pictures of a robot with minor, algorithmically-generated variations and understand that these so-called “collectables” are not actually scarce and that there is no real artistic difference between the robot with the green mustache and the one with the red mustache.
You and I can see that. But the law can’t see that at all!
The red and green mustaches make them clearly and visibly different, and the market values them differently. So legally, NFTs are clearly non-fungible. They are clearly collectables, and it would be exceptionally hard for a financial regulator to argue it any other way.
NFTs don’t exist to support the art. The art exists to support the NFTs. It doesn’t matter what NFTs look like. All that’s required is enough variation in appearance and valuation to demonstrate that they are non-fungible and therefore should not be regulated as securities.
Algorithmic art is perfect.
The Opportunistic Method
Now, before we get into the opportunistic method of making real money with NFTs, I want to state what should be blindingly obvious. Most of the people who are minting and trading NFTs are not laundering money.
However, even if you have no need or desire to launder money, you can still make an astounding amount of money opportunistically and (at least for now) legally using securities that can’t be regulated as securities. From pump-and-dumps, to false disclosures, to price manipulation, you have the whole pre-SEC history of securities fraud from which to draw inspiration.
Even for those whose moral compasses will not lead them into such grey areas, there is still plenty of money to be made. Let’s face it, selling virtual goods for real money will always be an attractive business model. The NFT market has a few artists trying to make money, a lot of speculators dreaming of striking it rich, and even large companies are getting into the game.
The level of NFT hype is amazing right now. OpenSea is bringing in $80M a month in revenue and was recently valued at $13 billion. With the market so frothy and irrational, it seems perfectly reasonable that an NFT of a cat wearing a monocle sold for $5 million.
Was this money-laundering, a pump-and-dump, or a wide-eyed speculation?
There is just no way to know, and that’s what makes the whole system work.
The Future of NFTs
NFTs will turn out to be a medium-term phenomenon. NFTs will be big news (and big money) for another three or four years and then start to fizzle out.
It’s always a cheap laugh to make fun of politicians and government bureaucrats, but there are plenty of smart lawmakers and regulators. They know what’s going on.
Over the past months, everyone has been pouring over the US Bank Secrecy Act of 2021 and the Anti-Money Laundering Act of 2020, trying to determine if they can be applied to NFTs.
And the definitive answer is … maybe?
The basic design of NFTs makes them highly resistant to this kind of regulation. There seems to be a consensus that legislative changes will be required before buying and selling NFTs would be covered by these laws.
New legislation takes time, so it will probably take the law three or four years to catch up with reality and then start being enforced. Until that happens, NFTs will continue to be useful, and insane amounts of money will continue to flow through them.
Five years from now, we’ll look back on today’s NFT craze the same way we now look back on the hype-filled ICO craze of five years ago.
Hey! Do you remember ICOs? Do you remember how ICOs were going to disrupt finance, democratize investment, take venture capital away from the elites, and unleash a huge wave of innovation? I remember that too!
It didn’t happen.
A Personal Plea
In addition to the financial similarities between yesterday’s ICO craze and today’s NFT craze, I’d like to share a personal one.
A the start 2018, at the height of the ICO hype, I published an article in Forbes explaining how ICO-based startups were locking themselves into a cash flow structure that put them at a horrible competitive disadvantage, and that this basically guaranteed ICO-based startups could never develop into real businesses.
I considered the article a fairly straightforward financial analysis, and one that turned out to be 100% correct. A few readers did contact me to talk about my financial analysis, but the overwhelming response was anger and accusations.
The takeaway for most people was not the financial modeling that I found so fascinating, but that by talking about it I was somehow accusing everyone involved with ICOs as being criminals or scammers.
Which was absolutely not true. It was not true then, and it’s not true now. I know maybe a dozen people who ran successful ICOs. Every one of them sincerely believed in their vision and worked their ass off to deliver the vision they promised their investors.
Of course, every one of them failed!
Not because of dishonesty or lack of effort, but largely because of the structural pressures I outlined in that article.
And it’s the same with NFTs.
The NFT craze will end in a few years when KYC laws are tightened and NFTs’ core value proposition disappears. And while there is certainly no shortage of scammers in NFTs, or in anything related to crypto, the NFT craze is simply not a good-guys vs bad-guys story.
At its heart, the NFT craze is a dry financial story with a layer of thick, juicy hype slathered on top. I totally understand why almost everyone wants to talk about the hype, but I’ve always been a sucker for a bit of dry, financial deconstruction.
Bragging rights may not be legally enforceable, but they do have real economic value. We now have celebrities showing off their NFTs, and promoters hyping the fact that celebrities are buying NFTs, and consumers buying those NFTs hoping that they too can be one of the cool kids.
And that’s all perfectly fine.
I don’t think modern capitalism would continue to function if we all suddenly stopped caring if we were one of the cool kids.
If you want to buy or sell NFTs, please don’t let me stop you. If you want to slap down a $20 bill and play a round of three-card monte, I say “Go for it!”.
I’m not here to judge.
My only real advice is that you should understand how these games actually work. You should know what you are getting into.