The NFT Crypto Art market

Edit 25.04.2021 - An important counterpoint to this analysis from a friend who's heavily involved in the tech: the processing fees are exceptionally high this quarter because of the technology still being relatively new. Scaling the Ethereum network with layer 2 solutions such as Optimistic and Zero Knowledge rollups would reduce transaction fees up to 1000x, making the economics work.

After a few years of working in fintech, there are three topics that still manage to confuse me: corporate taxes, HR (the department), and the economics of cryptocurrencies markets. I think it's time to address the least complex of the three, focusing specifically on a market I'm very familiar with - and that has been in the news a lot recently: the crypto NFT art market.

Deconstructing art markets

The best approach to talk about a crypto-something market, is to start by disassembling the existing product, understand how adding crypto into the mix aims to improve it - and see whether the 'new and improved' version is effectively better than the vanilla one.

So let's look at the art market: a longstanding institution that can be traced back all the way back to ancient Greece in the West, and the Qin dynasty in the East. Items sold on an art market command a price based on their rarity, and of course on an underlying appreciation of their subjective beauty and meaning - evaluated by the buyer, or by a knowledgeable third party. The bid-ask spread is generally large, as this is not a liquid market, goods are not interchangeable, and sales are either executed by private deals or by non-efficient English public-bid auctions.

It is by and large a speculative investment market, with returns that are lower than other investment vehicles (estimated around 2 to 3%), but relatively difficult to tax and regulate. Sure enough, the Art market is one of the shadiest around, with  untraceable, harmless, difficult to sanction goods moving across borders and geographies with relative ease.

What about the creators? Looking at at the latest UBS/Art Basel report on the Art Market's sale price distribution, the 'starving artist' cliché seems to hold true: out of an estimated 30-40 million private artworks sales every year, only about 5% falls north of the 250,000 USD strike price milestone, with around 80% of the goods sold for less than 50,000 USD. In the auction space, we can see a similar story: of the 17 billion USD of auctioned goods in 2020, less than 3% was sold for more than 250,000 USD - and more than half of all auction sales are executed below 5,000 USD. Most artists make little or no money at all.

Add some crypto

Crypto art markets have been around for a while (OpenSea, which I use for my analysis, was founded all the way back in 2014), but it's only recently - driven by a global pandemic, record cash supply, and general ennui - that these markets have become mainstream, with new large platforms like Rarible or Foundation starting operations in 2020.

These platforms are digital auction houses, allowing (anonymous) sellers to list, buy, and sell Non Fungible Tokens (NFTs), which are at their core digital certificates of authenticity and ownership for an underlying artwork. The artwork itself is digital - usually viewable on the platform itself, on third party storage, or on peer to peer data platforms like the Interplanetary File Sytem (IPFS). By itself, the artwork is worthless: what gets sold is its digital representation, baked into the NFT contract. It's not the artwork, but the NFT itself, that is transferred from buyer to seller.

Crypto art markets claim to improve on the existing setup in three ways:

1. they are more democratic: by moving sales into the digital realm, they allow anyone to buy the art they like straight from the creators, therefore allowing underrepresented categories of buyers (think anyone who might not feel confident walking around at Art Basel or visiting an art gallery) to purchase art.
2. they offer an higher degree of trust: because the NFT is traded on a blockchain, ownership is determined by node consensus and origination is as easy as following the trade all the way to the initial wallet. While it is possible to duplicate or copy the underlying artwork, unlike traditional art it is not possible to modify it (since its representation is traded with the ownership contract), nor to forge the ownership certificate (the NFT)
3. they drive liquidity back to the artist. Unlike traditional art markets, where valuations are driven by gatekeepers (critics and dealers), crypto art markets let artworks sell for their actual value by demand and offer, therefore liberating artists from the complex structures of social economics, and allowing any worthy artwork to be sold for a high price, with the artist pocketing most of it.

These are compelling arguments - but do they hold true?

Art for the little man

The first and arguably most interesting claim is that crypto art markets allow anyone to buy and sell art online, in an easy and approachable way. As I write this, NonFungible - which aggregates multi-platform sales data - lists around 125,000 monthly artwork sales, with a total sales value of around 180 million USD, and around 36,000 unique wallets transacting.

Ignoring a few caveats, we can draw a general comparison with the global art market, which moves around 5 billion USD a month, of which around 1 billion sold online during the Covid pandemic. Getting an estimate of unique buyers is harder, but the UBS/Art Basel survey goes out to 9000 different dealers and art galleries, each reporting an average of 54 unique buyers. If we draw a parallel between these 486,000 buyers with the 36,000 unique wallets, we can see how the accessibility of the traditional art market is actually quite similar to that of the vanilla online art market - just on a different order of magnitude.

The assumption of collectors skewing younger in the crypto art asset class might also be uncalled for: in the general art collector space, more than half of all buyers are actually millennials. The image of older demographics going to art fairs, and rich kids buying crypto assets on Rarible is not accurate at all: despite the difference in total scale, the divide between the crypto crowd and the modern art collector looks to be relatively small; way less than the one between extreme trading communities like Wallstreetbets and the traditional retail private investors.

Most importantly, this difference is most likely driven by the online aspect of sales - and not by the underlying technology. The internet is the true catalyst for differentiation here, and the introduction of the crypto token component is simply a different way for similar investors to purchase the same class of assets. Art for the little man? Maybe, but most likely, art for the little investor.

Digital deeds

The second assumption is that of security: art forgeries date back to the very origins of the art market, and centuries of thievery and counterfeits have given rise to an entire cottage industry of trusted action houses, authenticators, deeds and certificates.

On one hand, credit where credit is due: NFTs on a digital decentralized ledger are indeed more trustworthy than any deed in the physical realm. For as long as there are nodes (computers) running instances of the blockchain on which the art tokens are registered, it is possible to trace their origin and subsequent sales with relative ease.

One important caveat here is that the asset and its underlying NFT token are entirely decoupled. Much like a certificate of authenticity and the artwork it authenticates, digital artworks and digital tokens are in fact two separate entities. The deed itself is virtually impossible to falsify, but the artwork it represents can in fact be duplicated like any digital asset. The price of any artwork in a collectors' world is driven by authenticity, but also by scarcity: if anyone could conjure an atomic copy of a Picasso or a Klimt out of thin air, as you can for digital assets, would their price be impacted?

The answer is yes and no. Digital artworks have indeed commanded a lower price, on average, than their physicals counterparts. But art forgeries have existed forever, so indeed the price of any piece of art is mostly driven by an entity certifying its authenticity, regardless of whether it exists in the real world or not. For traditional art, that's either an authenticator or the auction house. For digital artworks on the blockchain, that's the NFT itself. And for as long as the blockchain on which they are registered and the place where the artwork is stored exist, the piece has value.

This last point - the preservation of value in time - is an important one to make. NFTs are decentralized, meaning they only keep existing as long as enough people have the incentive to run instances of the ledger they are minted on. And digital assets are in constant flux as well, either because of technological change (who, today, can open artwork made with Amigas or Commodore 64? Or play a floppy disk?) or by the extinction of the platform on which they are stored.

Art survives global disasters, wars, famines, fires and floods not by being fully traceable, but by being resilient - with resiliency driven by a very flexible network of authenticators, collectors, art lovers, and dealers. It is largely unclear to me how well the digital equivalent of these - in the form of NFTs and future evolutions thereof - will display the same level of resilience and adaptation: the introduction of crypto assets into the mix increases trust in the short term, but (in my opinion, at least) introduces brittleness in the long run.

Feeding the starving artist

So what about the third point: giving the art back to the artist? We've already seen how the art market isn't filled with the multi-million-dollar sales that are reported in the newspaper: on the contrary, almost half of all private sales, and more than 2/3 of all auctions end up at a sale price below 5,000 USD.

On top of that, many art pieces don't reach the sale floor at all: the UBS/Art Basel report points out how, especially during the pandemic, many lots have been withdrawn from sale altogether - because of curators fearing low value or no bids at all. Once again, the marketplace - and not the artist - is the gatekeeper here.

So how does a crypto marketplace fares instead? Unlike traditional auctions, NFTs are trackable by design, and accessible via API. So I scraped the 50,000 most recent sales on OpenSea and converted the sale price to a fiat currency (in this case, USD).

This is what we get:

The bottom 50% of all artworks here sold for under 1,867 USD - a significantly lower tail than the traditional art market. And in fact, in our representative sample, only the top 5% of the market gets close to the 5,000 USD mark: a number that pales compared to the right-hand tail price distribution of the top 5% of traditional art sales.

More importantly, as we discussed earlier, many lots never reach the sales floor in a traditional auction house. Conversely, in the NFT crypto market every single lot is listed as either direct sale or auction.

Yet many of those lots are not being sold at all. In a representative stream of over 10,000 events on OpenSea in April 2021, only 5% of all events were artworks actually being sold (either in a direct sale, or as a completed auction), with an additional 6% of events being bid placed on ongoing auctions.

A whopping 89% of all event traffic on OpenSea was due to new artworks being listed. Since the sale rate includes secondary sales, this concretely means that 9 out of 10 artworks on sale on the largest NFT market in the world never get sold at all.

Which is a problem, because - unlike in the real world - listing artworks can have a significant cost.

Gas Gas Gas

Because of the decentralized nature of the NFT ledger, parties running consensus nodes must be incentivized to participate in processing new transactions being added to said ledger. Most NFTs (around 95% in our OpenSea sample) are minted and exchanged on the Ethereum network, where the incentive is a monetary reward in Ethereum tokens.

Minting (i.e. creating) the artwork has a processing cost, which is paid by the artist. Buying the artwork (and transferring ownership of the NFT) also has a processing cost, borne by the buyer.

Platforms like OpenSea offer two types of minting. With standard minting, the NFT is immediately decentralized: it gets created and placed onto the ledger for a fee, and a second fee is levied when the NFT is sold and transferred. With light or lazy minting, on the other hand, the artwork is only listed on the (centralized) marketplace, and not on the blockchain. Only when the artwork is sold (or a winning bid is reached) is the processing price paid for both minting at selling at once. This difference is important, because only standard minting preserves the fully decentralized artwork authentication assumption NFT markets aim to solve for. Unfortunately, it also has a much higher upfront processing cost, which is paid by the artist.

This processing cost is paid in what is basically a secondary auction that rewards decentralized parties (miners or enthusiasts) with gas for processing instances of the ledger. The more gas offered, the faster the contract will be added to the ledger. And the more complex the contract is to process, the more gas will be needed. Unlike traditional payment or authentication systems, that have a fixed and a variable fee, the gas cost fluctuates (just like the value of the currency itself) based on demand and offer.

Much like the underlying currency, the gas price is highly volatile when denominated in its native currency (because of demand and offer), but also additionally volatile when converted in dollars (because of fiat/crypto forex volatility). Since there is a time difference between when the artwork is minted (for a certain ETH gas fee) and when it's sold (netting a certain amount of ETH), fluctuation in the ETH/USD exchange rate leave the artist holding significant risk. Finally, additional complexity is driven by the fact that different contracts may require different amount of gas - an amount that is quite hard to estimate.

On average, for the transactions I scraped, minting an artwork cost around 100 USD in gas fees, with the lowest total gas prices hovering around 22 USD (mint and sale), and the highest processing fee well north of 200 USD.

If, as we've seen, the average NFT sells for around 1000 USD, and the average transaction costs 100 USD to process - but only 5% of actual listed artwork end up being sold, then the community as a whole is losing money.

In fact if the entire OpenSea sample were to be run as a fully decentralized crypto art market product, then for every dollar of revenue, the artist community on aggregate would be paying up to a whopping 5 dollars in gas fees. And this is before platform fees, conversion, forex, registration and commissions are taken into account.

Cui Bono?

'Cui Bono' is a saying minted by Cicero - one of history's first recorded art collectors. 'Who stands to benefit?' is indeed the question that we should ask ourselves when trying to make sense of complex systems.

The traditional art market does work as a product, employing more than 3 million people on top of countless artists worldwide; the crypto market does not. Like many crypto-related "innovations", its benefits in terms of democratizing regulated systems and empowering individual creators are dubious at best. And the claims of security and resilience, while not entirely incorrect, lead to a system that is both opaque and complex. Sure, the innovative NFT-based authentication and increased democratization of an insular market might look like a step forward; but unlike the traditional art market, the underlying economics here look utterly unable to sustain this system - not even during the initial gold rush.

The most heartbreaking part of this scheme is that NFTs are being positioned by the crypto community and the mainstream press as a way to empower artists to claim back the reward for their endless, beautiful creativity. In reality, artists are losing money - to the tune of up to 5 dollars lost on every single dollar of revenue before fees if their artwork is minted direcly on-chain. They are left holding the bag here for large institutional investors who do benefit from Ethereum's meteoric rise, for the miners being rewarded running the proof of stake algorithms, and for the marketplaces like OpenSea or Rarible who pocket between 3 and 15% of an artist's sales.

Platforms like Patreon, Ko-Fi, Bandcamp,GoFundMe and, yes, even OnlyFans, have shown that there could be a way for connected marketplaces to empower artists, connect them with supporters, and provide stable and significant sources of revenue that allow anyone with talent and drive to focus on their creativity rather than on paying rent.

Crypto art marketplaces, on the other hand, are volatile constructs that are inherently inefficient, opaque and complex, easy to manipulate, and whose ultimate cost is borne by the more vulnerable amongst the artists they claim to help.

More than a payment scheme, they are a pyramid scheme. Avoid them if you can.