The market for digital collectibles or NFTs (non-fungible tokens) has exploded in the last months. Due to this boom which is not stopping and has led to millions of dollars spent on art from digital artist Beeple, the first tweet of Twitter founder CEO Jack Dorsey to sports highlight clips from the NBA. But with all the hype there also come significant risks, which should be well understood by the people.
Liquidity Risk
The liquidity risk considers the time to exchange something into cash. Due to the properties of a NFT, especially the non-fungibility, the liquidity is more similar to trading cards or paintings than bitcoin or other frequently traded assets. To sell a NFT every seller needs to find a buyer who‘s willing to pay a certain price for a particular, unique item. In the current market environment that can put a collector in a difficult situation when the market sentiment starts to changes into opposite direction.
On the other hand, the illiquidity can also be seen as a good thing when markets are volatile, because it prevents investors from making rash decisions and getting to emotional. This in turn helps the markets from becoming even more volatile and from exaggerating further in one direction.
Market Risk
As discussed under the previous risk factor, under current market circumstances we can observe that NFT prices are showing massive volatility, mainly due to segregated platforms which hinder an efficient price finding mechanism and of course also due to the hype. As mentioned under the liquidity risk, at the moment the market only goes in one direction and also price history for digital art and other NFTs are not going back that far to draw conclusions from. Wether NFTs and digital art behave the same way as the traditional art market and wether it is suitable as a store of value remains to be seen.
Ownership Risk
The ownership risk connects various aspects, including hosting and chain risk. We will discuss the latter under the chain-factor. What most people new to this NFT craze do not realize, is that we have to differentiate between the token on the blockchain (which represents the ownership and other metadata) and the asset it refers to, which could be a photo, video or some other file that is stored with a cloud provider.
With this in mind, there are emerging several critical questions, like the following:
What if the NFT startup / platform or the hosting provider goes out of business?
In this case, the blockchain won‘t be affected and the buyer of NFTs could be left with tokens that are pointing to files that no longer exist. But a comprehensive risk management framework will counter this problem with a business continuity management (BCM) plan. A BCM plan could consider recovery options, like alternative hosting services where all the underlying data can be migrated. A better option provide decentralized services, like the Interplanetary File System (IPFS), which do not have to rely on one specific counterparty and could be the norm soon.
Chain Risk
The blockchain and its smart contracts is connecting all the dots and makes the whole NFT craze possible. For this reason, the blockchain risk is by far the biggest risk to NFT infrastructure in my opinion. Some blockchains like Ethereum have proven to be quite robust over the last years, but that does not mean that there is a zero probability for coding bugs, break downs or smart contract exploits. The smart contract complexity rises continuously with additional NFT qualities, applications and functionality, like the proposed EIP-2981 standard for built-in royalty payments for ERC-721 tokens.
Another immanent chain risk are hard forks. Especially with Ethereum, which will undergo the biggest transition from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus algorithm nobody knows how it will affect the blockchain and its smart contracts.
We also have to keep in mind that certain NFT marketplaces only function with certain blockchains. So the choice of marketplace and its underlying blockchain (e.g. Tezos, Flow) which is used to mint the NFT is crucial and could have real implications not only on the technical, but also on the economical side. E.g. when developers stop working on a project and the chain stops being used it could happen that your NFTs will be worthless in no time. In theory, there surely will be solutions to recover the valuable assets and migrate to another blockchain.
Legal and Regulatory Risk
Last but certainly not least, there are always legal and regulatory risks which have to be considered in the fast-changing crypto space. An example for the fast changing environment of NFTs are the above mentioned royalty and licensing payments or NFTs being posted as collateral for financial services. Such developments raise completely new legal questions and NFT issuers have to consider certain issues to not fall under securities law.
Besides these legal risks NFTs are currently not specifically regulated by any financial authority around the world (otherwise leave me a comment). Nowadays, nearly every fiat gateway into crypto must comply with extensive anti-money laundering (AML) and know-your-customer (KYC) regulations. As far as I know, this is still not the case for NFT marketplaces or platforms, but certainly authorities and regulators will also issue some directives and guidelines for NFT and its treatment in the near future.
Personally, I find it very interesting to be at the forefront of emerging technologies and to analyze its inherent risks. For many scenarios outlined, I hope that they will not occur and if so, I hope there is an adequate risk management in place. However, I would like to help NFT buyers as well as issuers, newbies in particular, to get a better understanding and overview of possible risks and pitfalls before throwing their money at some NFTs. If you have identified any other important risks or helpful risk measure for NFTs, please let me know!
