NFTs and Viral Network Effects

NFTs are strange. Why would someone spend millions on a JPEG if screenshots are free? I was looking for a quarantine project, so I spent the last week reading everything I could find. When I pulled back the curtain on this niche corner of the art world, I found an entirely new economic model driving viral network effects. The rabbit hole goes a lot deeper, but I’d like to share some of my key takeaways with you. We’ll break it down as follows:

• A Blockchain Crash Course
• The NFT Gold Rush
• The Value of Digital Goods
• Viral Network Effects

A Blockchain Crash Course

Blockchain is the infrastructure behind Bitcoin and NFTs. So before we dive into NFTs, it’s worth summarizing two of the key properties of blockchain technology that make it possible:

1. Trustless
2. Open-Sourced

Blockchain is trustless because it is decentralized: instead of paying a central 3rd party, like a bank, to be the middle man and make sure everyone involved in a transaction plays fair, a distributed peer-to-peer network of computers does this for us. The blockchain then provides rewards to the network for their public service. It turns out we spend a lot of money on trust, and when you remove central parties by crowdsourcing your auditors, the overall transaction costs drop dramatically.

Although blockchain is known for its security, it manages to do this without a secret sauce. In fact, the blockchains we are talking about today are all open-sourced. This allows a community of developers to audit, update, and improve the infrastructure over time. They can even borrow the code, remix it, and “fork” their own project in an entirely new direction! This encourages the decision-makers behind blockchain products to stay active and respect their users.

Let’s briefly cover Bitcoin and Ethereum, the ground floor of blockchain technology, aka Layer 1. Bitcoin (BTC) was first on the block and aimed to replace central bank currencies. Now the narrative has shifted towards digital gold. With a maximum supply of 21m, Bitcoin scarcity creates a store of value that isn’t correlated with the stock market or at risk of inflation. In addition to its scarcity, the price of Bitcoin keeps rising because of its passionate user base, the success of other blockchains, and the fact it still hasn’t been hacked.

Ethereum, on the other hand, was designed to be a platform for decentralized applications (DApps). Essentially, Bitcoin enables the exchange of cash, while Ethereum allows us to create automated and complex smart contracts on the blockchain. Basically, they are programs that run when predetermined conditions are met. Ether (ETH) is the digital currency embedded within the Ethereum blockchain. ETH is the fee to use the platform and the reward for supporting it. Developers can build DApps and entirely new digital currencies on top of the Ethereum in Layer 2 of the decentralized ecosystem. NFTs, however, are mostly built on Ethereum in Layer 1.

The NFT Gold Rush

At a high level, NFTs are a new way of owning and using digital media. NFT stands for a Non-Fungible Token. They are “non-fungible” because, unlike cryptocurrencies, each NFT is unique and not interchangeable. NFTs are a combination of two items:

1. The Token: the NFT’s digital fingerprint and associated info that exist on a blockchain such as Ethereum.
2. A Media File: what the token “points” to on the internet, whether as a URL or on a distributed file storage service.

A range of marketplaces help people onboard (aka “mint”) NFTs and act as digital media galleries to display the art and run auctions, typically paid in ETH. In this way, NFTs have started to catalog a universal digital library. Then last month, things got a little crazy.

First, NBA Top Shots was selling over $30m a day in basketball highlight videos, and two computer-generated pixelated photos of CryptoPunks sold for $7.5m each. Then, Jack Dorsey sold the first-ever Tweet for $2.9m, and digital artist Beeple sold the NFT below for $69m at Christie’s Auction House.

We are witnessing the peak of a classic hype cycle for NFTs combined with a bull run for cryptocurrencies. All the headlines are in USD, but the actual purchases are made in ETH. For context, the record sale by Beeple was 42k ETH, which would’ve been worth $5.5m USD a year earlier. In either case, even when you account for the increased price of ETH, the NFT market has grown by 10x in volume over the past six months. Beyond the potential for a market bubble, what are we missing?

The Value of Digital Goods

Why would someone spend millions on a JPEG if screenshots are free?

Returning to our original question, I see NFTs as having three key value drivers:

1. Authenticity
2. Scarcity
3. Conviction

Authenticity is a concept we see often. For example, when an athlete auctions off their game-used memorabilia or a celebrity signs a photo with their autograph, the item increases in value. Blockchain adapts these same concepts to digital media. Since it is open-sourced, the history of each NFT is available to all. With websites like Etherscan, you can trace the ownership all the way back to the creator’s digital signature at the time of minting. You could list an exact copy of an NFT, but without the initial creator’s digital signature, it lacks authenticity, and you’re unlikely to find a marketplace willing to host it for auction.

For scarcity, the best comparison might be to collectibles, or anytime an item is labeled as “limited edition.” When the supply is limited, demand generally goes up, and so does the entry price. Fashion brands have regularly destroyed unsold merchandise to maintain that scarcity and exclusivity. However, the issue with NFTs is we often can’t tell the difference between a pre-war bottle of wine and a Beanie Baby. Some items will hold their value over time, and others will look silly in retrospect. To add to this confusion, creators can reduce the scarcity of an item in the future with additional print runs. Herein lies one of the key risks with blockchain: as cheap as it is to create trust, it’s even cheaper to bring it all crashing down.

This leaves the last key driver of value: conviction. As long as someone believes a cartoon cat is worth purchasing, there will be a market for some NFTs. Just as blockchain lowers the cost of trust, it accelerates the growth of communities online. When a community gathers around an NFT, it gains in value. Then the community shares in the upside and goes on to convince more to join in. It was this same network effect that sent Gamestop’s stock to the moon in January.

Viral Network Effects

NFTs are strange because they are counterintuitive. They make digital assets simultaneously individually owned and universally available. Creators can now skip the intermediaries and create a more interactive experience for their super fans. Then, when fans share the upside of a creator’s asset, they are compelled to tell their friends and bring more people into the community. Next, we’ll see communities form not just around an NFT or an individual but a common purpose or passion.

When we talked about conviction earlier, we were really talking about network effects: the viral force behind social media, ridesharing, and e-commerce, where each additional user makes the network more valuable. The problem, however, is that the central party in these networks, like Facebook or Amazon, has taken the community value for themselves. With blockchain removing the central party, communities retain their value and momentum in what can be described as viral network effects. This will power a new wave of communities that are built, owned, and operated by their users.

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Inspiration for this article came from many people, including Jesse Walden, Packy McCormick, Chris Dixon, and Linda Xie.