The first half of 2021 has seen an explosion of interest around non-fungible tokens (NFTs), as everyone from musicians and artists to sports celebrities have piled in. Attention-grabbing headlines pop up on almost a weekly basis. We’ve seen the world’s first tokenised digital house (on Mars, no less, and sold for USD500,000), the Kings of Leon have released a new album as a collection of NFTs, and sports collectibles-based NFTs are gathering momentum. So far, so zeitgeist-y. Many financial markets participants could easily be forgiven for ignoring the rise of NFTs, ascribing them to a millennial trend, perhaps, or the latest blockchain fad. However, this could be ignoring a harbinger of the digital markets to come – and what they might mean for the future of financial markets.
What is an NFT, anyway? There are many definitions, but the most apt is probably that of the ever-reliable Investopedia: “NFTs are cryptographic assets on blockchain with unique identification codes and metadata that distinguish them from each other. Unlike cryptocurrencies, they cannot be traded or exchanged at equivalency. This differs from fungible tokens like cryptocurrencies, which are identical to each other and, therefore, can be used as a medium for commercial transactions.” This blockchain link is crucial – it’s blockchain technology, also known as distributed ledger technology (DLT), which allows for the creation of unique digital assets that are cryptographically secured, and for which ownership can be fully transferred without risk of copying or duplicate entries.
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An NFT is a representation of value which is an asset in and of itself. It can represent an underlying physical or digital asset – a house on Mars, say, or a digital representation of a house on Mars. The NFT could also be the asset itself – such as the Aavegotchi, a pixel-art ghost NFT that owners can accessorise, customise and use as an avatar in a gaming environment. In fact, just about any type of unique asset can be tokenised, and turned into an NFT. And NFTs can be bought and sold in their entirety, or they can be “fractionalised” – broken down into smaller components which could themselves be structured as fungible tokens and bought and sold on a marketplace. The NFT of a Picasso, for example, could be fractionalised and partly sold off to investors, thus financing its upkeep by the museum holding the painting “in custody”, and allowing investors to benefit from any appreciation in value.
And now we begin to see the prospects for financial markets… There’s nothing inherently radical about tokenising shares, or bonds, and realising the benefits of digital-native trading and settlement; in fact, it’s arguably the next stage of their digital evolution. When we look beyond existing and largely liquid assets, however, things become more interesting. Commercial property is currently a highly illiquid asset, and transferring ownership requires the buyer to have access to large amounts of capital, and the completion of significant, onerous paperwork. How about creating an NFT representing ownership of the Shard, for example, and then fractionalising that NFT and making it available to trade on a secondary market? The relative ease of trading structured, fungible fractionalised-ownership tokens of otherwise illiquid assets can help create new liquidity – and new investment opportunities – where these previously did not exist.
NFTs are also programmable; they can be accompanied by “smart contracts” that govern them and build in various rules and processes, such as regulatory and tax reporting, or suitability checks on transfer of ownership, or… The list is potentially endless. Programmability introduces new opportunities for automation of events in the lifecycle of the NFT, or integrating the NFT with other frontier technologies such as AI / ML or the internet of things (IoT), so that the performance of an underlying asset can be monitored and reflected in factors affecting the valuation of the NFT in real-time.
Real estate investment trusts (REITs) are another great example of how NFTs can be used to streamline the overhead of transferring ownership, thus helping to build liquidity. A traditional REIT is a legal structure providing what is essentially a wrapper around a number of individual mortgages. They require significant amount of legal documentation and are notoriously difficult and complex when it comes to changes of ownership. An NFT version of a REIT can have built-in code to ensure that it is verifiably linked to the underlying mortgages and that ownership of these is transferred as well.
Fractionalised NFTs – of property, loans, or any other large, clunky and illiquid assets currently occupying the balance sheets of financial institutions – could become the future of conventional finance. It’s not only about creating liquidity, but also enabling the development of more innovative and sustainable forms of financing. NFTs can offer new ways of representing value and impact, and obtaining investment based on that as opposed to traditional equity or debt. For example, a company, municipality or government could create an NFT representing a forest that it intends to plant, with a valuation based on the forest’s carbon offset. This could be fractionalised and sold to investors, who would realise gains or losses based on the actual and measurable effectiveness of the forest in offsetting carbon emissions and be used by the investors themselves to demonstrate their own carbon offsets.
And the benefits are not limited to capital markets. Insurers could issue insurance policies as NFTs, since insurance policies are unique assets having attributes specific to a given policyholder. These NFT insurance policies could be programmed with parametric triggers linked to sensor networks, that in turn automatically trigger payouts to the bank account of the policyholder in the event of a parameter being breached. They could also automatically trigger renewal processes on an annual or periodic basis. For insurers, this could massively reduce the operational overheads associated with maintaining policies and processing claims – leading to reduced costs of cover for policyholders and improved profit margins for investors, a win-win situation all round.
As always, in order to realise these benefits, innovators will need to work with regulators and financial incumbents in developing products and services that can better serve customers and markets. It’s a fast-moving arena in which the ability to think creatively about the possibilities and opportunities that are opened up by tokenisation and digitisation of assets is a critical differentiator. We haven’t even had time to touch on the potential role of NFTs in the emerging decentralised finance space, and the impact of gamification on the future of the digital economy – but all that is another story, and for another time! The good news – or bad news, depending on how far along the curve one is – is that some of this innovation is already happening, and in sectors of the industry both far and surprisingly near.