NFTs explained: Why these blockchain-based digital assets are attracting investors

Media coverage of NFTs has been dominated by one-off transactions, such as the virtual yacht that sold for $650,000 or the music video auctioned for $389,000. Millions of dollars have also been invested in virtual real estate. These and other transactions have been fuelling rapid growth in the global NFT market, which ballooned to $41 billion in 2021.

This article looks at the nature of NFTs, why they are generating interest and whether they should be treated differently from other investments.

NFT basics

NFTs are essentially small pieces of software — often just 14 lines of code — stored on a blockchain network.

Each piece of NFT software, or token, is unique and can’t easily be exchanged for something of equal value, which explains why they are “non-fungible.” And unlike cryptocurrencies, NFTs can store information, such as a digital image or music.

In the physical world, original paintings, fine wine, limited-edition music and collectibles are scarce and in high demand, increasing their investment value. Until now, this scarcity has been difficult to replicate online, because digital content is so easily copied and shared.

NFTs solve this problem, allowing investors to achieve sole ownership and individual rights to unique digital content.

How NFTs are being used

The online games industry has been quick to see the potential of NFTs. Motorsport game F1 Delta Time, for example, has been built around NFT technology.

Players use cryptocurrency to buy cars that exist in NFT form. They can also buy NFT vehicle upgrades and decorate their vehicles with NFT imagery. In addition, they can purchase sections of NFT-generated racetracks and share “dividends” from all activity taking place on those circuits, including race entry fees.

To put this in context, a 5 percent share of F1 Delta Time’s Monaco circuit sold for around $222,000 in 2021, while an NFT racing car fetched around $111,000 the year before.

Meanwhile, many in the movie industry believe NFTs present a prime opportunity to rethink the antiquated film-funding system. Danish film producer Niels Juul recently announced his intention to raise up to $10 million using NFTs — in this case, digital certificates proving part-ownership of the film. Every investor buying an NFT will get a share of the box office profits from the film, as well as licensing rights and an opportunity to meet the stars of the production on location.

Rock band Kings of Leon also showed the music industry how to leverage blockchain in 2021 by releasing a version of their latest album with an NFT element. While the album was released through all the usual formats and channels, “golden ticket” NFT versions were also created.

These unique NFTs entitle the purchaser to a digital download of the recording (with an animated digital album cover), a limited-edition vinyl record, and guaranteed front row seats to Kings of Leon concerts for life. To increase collectability, only 18 golden ticket NFTs were created; six were auctioned and 12 were placed in storage.

The rise of NFTs

The current multi-billion-dollar NFT market is evidence that many investors see long-term value in NFTs and believe the tokens will appreciate. Many are also bullish about the technology that surrounds NFTs, especially as the number of innovative use cases has increased dramatically over a short time.

Ownership of NFTs also confers social status, which may be particularly important for young investors, many of whom spend a significant portion of their lives online and in crypto communities. Investing hundreds of thousands of dollars in a virtual yacht may seem incomprehensible to many, but if Mark Zuckerberg’s vision of a metaverse where we will work, rest and play online becomes a reality, then NFT assets may have a bright future.

Some see current NFT activity as a virtual land grab, with investors scrambling to secure a stake in assets that will play a pivotal, historic role in the metaverse. Some critics, however, have voiced concerns about the stability of NFT investments. For example, Michael Every — Rabobank’s head of financial markets research for Asia-Pacific — went as far to say he was “gobsmacked” by the “bubbilicious stupidity” of the NFT market.

How investors buy and store NFTs

Individuals and organisations can buy and sell NFTs through marketplaces such as Foundation, SuperRare and OpenSea, which are similar to conventional marketplaces like eBay. You can either buy an NFT at a fixed price or bid for one in an online auction. To buy or bid on an NFT, you must first open a digital wallet and ensure it contains sufficient cryptocurrency funds.

Because NFTs are stored on a blockchain network, an owner needs a complex digital password or “key” to gain access. A key can be stored in a digital wallet online, but it may be vulnerable to cybercriminals. Many investors choose to store their NFT keys on a physical USB device, known as a hardware wallet.

Whether NFT keys are stored online or on a device, there’s always a risk that passwords may be forgotten, or physical devices lost or destroyed, making it impossible to access the NFT.

Considering this risk and the complexity surrounding NFT investments, professional custodian services could become increasingly important in the market. Custodians typically have robust operational and security procedures in place enabling them to store and handle highly valued NFTs in a secure manner on behalf of their owners. They are also likely to have appropriate insurance, so they can compensate clients if their security is compromised.

What investors should keep in mind

Along with understanding the basics of NFTs, investors should consider the following when managing their NFT investments:

• Decide whether to hold NFT investments as an individual or a company.
• Consider establishing a family investment company that can enable individuals to pass on wealth while maintaining control of NFTs and other assets. This approach can also provide tax efficiencies.
• Consider integrating NFT ownership into estate planning to ensure ownership can be transferred and the asset accessed effectively.
• Understand that the sale of NFTs attracts capital gains tax. Tax treatment is likely to vary according to where an individual or company is based.

What NFT service providers should consider

NFT services providers, who facilitate NFT transactions on behalf of their clients, must understand that these relatively new investments are distinct from traditional investments and that the market landscape — including related regulations — is quickly evolving. Here are some areas providers should keep in mind.

• Service providers must establish a company and register for any related taxes (such as VAT) in the country where they operate.
• Service providers must fulfil accounting and financial reporting obligations in the country they operate in, whether they are directly buying or selling NFTs, or acting as an intermediary charging a commission for each transaction.
• NFTs are, at the time of writing, largely exempt from the kinds of regulatory measures cryptocurrencies are subject to. However, some specialist NFTs may have crypto-like attributes, which may make them subject to regulation. NFT service providers may wish to seek advice from a specialist if they think there’s a chance their products fall into this category, and they should keep in mind that regulations everywhere evolve.

NFTs are experiencing a boom, but as with any investment, there are risks related to valuation, taxation and more. Investors should use tried and true due-diligence practices, including seeking authoritative advice before diving in head-first.