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What Advisors Need To Know About NFTs

From Lindsey Lohan to Elon Musk to Beeple, non-fungible tokens are a multimillion dollar business—for now.

Coins, art, a 1992 Screaming Eagle Cabernet Sauvignon—all can be valuable given the confluence of rarity and demand.

But what about something that "exists" as digital code and could be copied almost effortlessly?

Enter non-fungible tokens, or NFTs. Advisors have no doubt heard a lot about them lately, with eye-popping auctions over digital artwork, sneakers, slam-dunk gifs and trading card reveals.

Like other tokens, NFTs use the same blockchain principles employed in cryptocurrency to program and record identifiers, transactions and "ownership" of a digital asset. Just as a piano will reliably play each note as a key is hit, tokens are tuned with certain attributes. But unlike a piano, the blockchain will (theoretically) never be out of tune or in need of repair. By tokenizing an asset—assigning it a unique string of code—and memorializing that code in a decentralized ledger, the "ownership" of the asset becomes a discrete thing that can be bought and sold.

For advisors, the most readily accessible analogy is property, said Will Trout, director at Javelin Strategy & Research’s wealth management division. “An NFT is a digital property that has its own identity on the blockchain,” he explained. “It's assigned a unique registration on the blockchain.”

Another way of thinking about NFTs is a concert ticket, said Ben Weiss, co-founder and president of CoinFlip, a bitcoin ATM operator. "Most concert tickets look the same, but the barcode on the ticket contains specific information that is unique to the purchaser, the date of the event, the venue," he said. "This data makes it impossible for all concert tickets to be traded interchangeably."

The decentralized, open-source blockchain and associated smart contract functionality commonly used for NFTs is Ethereum, though other networks can be used as well.

Unlike drawing up contracts or deeds, where an attorney would normally at least review the process, the minting of NFTs is not subject to any such formalities. NFTs are therefore more accessible, but also riskier. Artists, or even celebrities like Lindsey Lohan, who mint NFTs simply need to be able to write their own code, according to a report in The Business of Business (a blog from data provider Thinknum).

Importantly, the NFT is not the actual digital property. “The newly minted NFT usually doesn’t contain the graphic file or other data that make up an artwork,” according to the report. Instead, the NFT will point to the file’s location off the blockchain.

Understanding why NFTs are valuable is less of a stretch than understanding how they are made. “Social media is starving for capitalism,” writes Lex Sokolin, fintech analyst and author of The Fintech Blueprint. “Blockchain-based NFTs reintroduce the concept of property rights into digital media markets, and they do so through software-enforced capitalist logic.”

It's a growing marketplace. Last month, NFT trading platform OpenSea saw $95 million in trading volume, while Rarible, another NFT trading platform, saw $18 million in trading volume, according to Dune Analytics. This month, OpenSea has already seen $83 million in trading volume and Rarible surpassed last month's volume, already topping $20 million in trading volume. 

It's just scratching the surface, said Sasha Fleyshman, portfolio manager at Arca, a financial services firm building products utilizing, and investing in, digital assets. "There are already subsectors within the NFT space, [like] digital land, gaming, sports, music, social, [and] art/collectibles, which all have different value drivers," she said. "It is my belief that as the space proliferates, new subsectors emerge as the next generation of NFTs offer products with a wider breadth than what is currently available."

Advisors would be wise to learn about NFTs, even if they don't (or can't) include them in official channels of financial advice, said Wally Okby, a senior analyst for Aite Group’s wealth management division. NFTs are not regulated and disclosing any sorts of conflicts of interest is all but impossible, he said. They don’t even seem to follow the rules of traditional finance. But they are being discussed, and shouldn’t be dismissed.

Advisors need look no further than crypto. “Wealth managers who completely blew off bitcoin are somewhat missing out,” he explained. “If you don’t have an opinion on something, it’s fine to say you don’t have an opinion on it. But if you disparage it, that sends a signal to the customer that this wealth manager is not really paying attention to what’s going on in the market.”

Additionally, advisors' clients could very well be making investments in crypto or NFTs on their own without thinking of it as a part of their overall financial picture. It pays to ask the client, but what if the advisor isn't even sure what he or she is asking about? 

Advisors are comfortable with private capital investing and platforms like iCapital Network, added Trout. Private banks will hold fine art as collateral for loans. The wealth management industry needs to get comfortable with cryptocurrency and NFTs, too, he said.

“Advisors do need to get their heads around emerging stores of value,” he said. “You've seen an embrace of non-traditional assets, both liquid and illiquid.”

Even events like the run up in GameStop Corp.’s stock price in early 2021 can be partially explained by a similar line of thinking, according to entrepreneur Mark Cuban.

“The [WallStreetBets] traders are applying the same principles of the digital/CryptoAsset world to the stock market and they are loving the fact that the old schoolers are hating it,” he wrote earlier this year. “They know that Wall Street hasn’t changed much in generations. Sure, it has gone digital in many respects, but the way the game has been played has not changed. Wall Street is 100 percent top down controlled and regulated.”

“A stock is just another digital store of value,” he observed.

But understanding the value is different than identifying the valuable. Collectors know their field, whether digital or not; amateurs are often guessing. Investors need to be cautious, warned Okby. “Cryptos are safer than NFTs,” he said. “With bitcoin, one bitcoin can be exchanged for another, no matter who the counterparty is. With an NFT, that’s not the case. Each NFT is unique.”

Disagreements over value are why NFT marketplaces have emerged in the first place. Potential investors need to be wary—and understand the "value" of the underlying asset now, and have an educated guess about the value in the future. Much like any tradable security.

Also, needless to say, investors need confidence in cryptocurrency and blockchain networks. Both of those aspects underpin NFTs. 

“Advisors need to reckon with the phenomenon of digital assets, whether it's crypto coins or NFTs, because the genie is unlikely to go back in the bottle,” said Trout. “There'll be ups and downs. It might be a wild ride, but the park is going to stay open.”

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