Everybody, at some point in their lives, has looked at a dollar bill and asked themselves, “Why is this worth anything? It’s just a piece of paper.” You may have even asked someone this question directly. If you did, you were probably told something along the lines of, “Money has value because people agree it has value.” Normally, this is the point where the conversation ends. Though this answer we all got wasn’t an incorrect answer, it is leaving out a vital second half to that conversation. The most important part of understanding the prices of goods or services, the value of money, and the value of the investments is answering the question, “Why do people conclude that this thing has value?”
The US Dollar provides a great first example of applying our question because there are tons of direct reasons why we all agree the US Dollar has substantial value. For example, as stated by the IRS, “Payments of U.S. tax must be remitted to the U.S. Internal Revenue Service (IRS) in U.S. dollars.” Thus, paying your taxes requires you to use USD. Just taxes alone would give a huge reason for all people and businesses, who make enough money in the US to have to pay taxes on it, to place a high value on USD. Laws and regulations in the US also make it so that the most convenient way to pay employees wages is in USD. A good example is The Federal Minimum Wage since this mandatory minimum wage is defined in USD. Thus, for anybody that wants to work within the US or interact with the US in any way financially, there is a laundry list of reasons why they would want to be accepting USD and placing a significant value on it.
But what about an example where an asset’s value is even more complicated than convincing yourself that a piece of paper could have as much value as food or water, things we literally need to not die. This brings us to non-fungible tokens or NFTs. First, what actually is an NFT? An NFT is a digital file that is guaranteed to be completely unique. The exact process by which this is handled is quite complicated, requiring an understanding of both advanced concepts in cryptography and computer science. This process is called block chain and is actually the same technology that is currently underlying cryptocurrencies. This technology’s applications mainly come in the form of security. You may have seen that many NFTs are pictures, but they certainly don’t have to be. Any digital file could be tied to an NFT, representing that it is guaranteed that you own this unique version of this file.
So, why do NFTs have value? Well, if NFTs are just about security, then clearly the value of an NFT should be the value of the file the NFT is securing, with possibly a little extra for knowing that the asset is secure. Well, if that’s actually true, then why did this Wired article just say that, in 2019, somebody paid $120,000 for instructions on how to duct tape a banana to a wall?
Ok, maybe it’s a bit more complicated.
It turns out that a common trend has emerged where people have begun treating NFTs as investments. This is to say they aren’t necessarily treating the underlying assets as investments, but an NFT itself as an asset. Now obviously, the NFT market is not just unoriginal pictures of cartoon apes being sold for hundreds of thousands of dollars, but there’s also a large portion that definitely is that. Of course, none of this information would be new to major investors in the NFT marketplace, so why are they sticking around despite all this?
One of the reasons is definitely scamming people, however this will become more difficult in the future. Prior to the Biden Administration, NFTs were essentially an unregulated market. After all, it’s a lot easier to get away with illegal or questionably legal schemes when the market is not well understood by regulators. The Biden Administration did step in by placing the first regulations in the US on NFTs through his infrastructure bill. While these were small regulations, this also means that it left many questions unanswered such as what types of regulations NFTs will eventually fall under. For example, some in the industry think that NFTs could potentially end up being considered “commodities”. This would result in all of the regulations placed on commodities applying to NFTs, however this is not the only regulatory category that NFTs could end up in meaning no one is really sure what the rules are when it comes to NFTs.
Another reason investors are sticking around concerns the concept of economic bubbles and the Greater Fool Theory. In economics, a bubble is when some asset surges in price due to people buying up that asset in speculation that it will surge. If this sounds like a loop, that’s because it is. The loop results in a cycle of people buying and selling the asset at higher and higher prices. The Greater Fool Theory concerns what happens at the end of all of this because, eventually, people aren’t willing to pay a higher price on the asset. The Greater Fool Theory is this notion that you can buy this overpriced asset and still turn a profit as long as there is a “greater fool” willing to buy it from you at a higher price. Of course eventually, there are no more greater fools. At that point, the price falls and whoever still had this asset is now stuck with it at a now far lower price. Many NFT bubbles have already inflated and burst already.
Imagine a game of hot potato where winning means making huge gains on your money and losing means trading away your savings account for a collection of cartoon animal pictures. That is the story behind NFTs.
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