What you need to know about NFTs and the blockchain

Roger Montgomery

Montgomery Investment Management

Move over cryptocurrencies. There’s a new kid on the block(chain) – non-fungible tokens (NFTs). And if you’re an investor, you need to know about them. Because there is real money being spent, and fortunes being made.

For some people, cryptocurrencies represent all that is wrong with unbridled capitalism, ultra-low interest rates, investor behaviour, and even millennials. 

For many investors, if not most, ‘cryptos’ represent a parallel universe.

NFTs have become one of the hottest topics in the cryptosphere. And yet, despite a rapidly growing adoption, NFTs are an enigma to almost everyone outside the blockchain omniverse.

Here’s an excerpt from a recent news item on The Block Crypto news site:

An animated video that was recently used by Uniswap to promote its V3 platform has been sold in the form of a non-fungible token (NFT).

“The video and the NFT were created by the artist named “@pplpleasr1,” and it has fetched the price of 310 ether (ETH), currently worth about $520,000. The buyer of the NFT is a first-of-its-kind decentralized autonomous organization (DAO) called “pleasrdao.” The DAO, ideated by PoolTogether co-founder Leighton Cusack, was specifically formed to buy the NFT.

What are NFTs? How are they created? Who prices them?

What is tokenisation and is it the future of the digital economy? My criticism of the cryptocurrency market is that many have purchased Bitcoin (BTC) on a flawed thesis that BTC will replace fiat money and ultimately become a universal currency. The consequent buying pushes the BTC price up, reinforcing the thesis, even though the possibility of Bitcoin becoming a universal currency is slim.

Nobody has been able to articulate precisely how Bitcoin becomes a universal currency, and how it is accepted by a multiplicity of divergent sovereign regulators, who are rightly incentivised by their own societal stability and fiscal and monetary control.

Meanwhile, those who dismiss the universal currency thesis might also miss an opportunity elsewhere on the blockchain.

But the lack of a coherent argument for Bitcoin becoming a universal currency does not mean the rest of the crypto space is a worthless folly. There are many blockchain-based projects with merit and the related or associated cryptocurrencies may indeed have value in those ecosystems and beyond.

A visit to DappRadar.com reveals an entire universe of decentralised applications (Dapps) including games, gambling, collectibles, market places, exchanges, DeFis (decentralised finance apps that hope to replace the banking and peer-to-peer services of traditional financial institutions), social media Dapps and NFTs. And each has its own or preferred currency.

The rising popularity of NFTs might represent the next evolution of blockchain machinery (the digital distributed ledger) that facilitates the autonomous validation, recording and review of the transaction and ownership of virtually any asset.

According to Trading Platforms, NFT trading volume exceeded a record US$400 million in February and the first few days of March, more than the total volume traded in 2020. With Google searches for “NFT” at a record and the number of weekly users on digital-collectible platforms exceeding 450,000 last week the exponential growth may continue.

How are NFTs valued?

A NFT is a tokenisation of asset ownership on the blockchain. The purchase of a work of physical art is analogous. When a work of art is acquired, the buyer signs a purchase contract transferring ownership, and receives a receipt and/or a certificate of authenticity. Copies and fakes may exist but the possession of the Certificate of Authenticity is proof of ownership of the original.

NFTs create a digital token in the blockchain (the distributed ledger) that cannot be duplicated or swapped for another and is therefore ‘non fungible’. The NFT autonomously tracks and records the entire provenance and selling price history of the underlying file(s) (digital artwork, for example). This transparency means any potential buyer of an NFT knows when the underlying asset was ‘minted’, purchased, sold, and at what price, and by whom.

One of the first outcomes of the above development is that record keeping is decentralised. The absence of centralised repositories of ownership and title information would mean, for example, that Private Equity could not make any money from buying the NSW Land Titles Office and subsequently selling it. Such institutions have no purpose and therefore no value in the new blockchain-driven world. Of course, this potentially sets up the owners of such repositories, such as governments, share registries and established financial institutions, against the blockchain.

Furthermore, all transaction history is completely transparent, further democratising information pertaining to asset transactions.

Consistent with official or limited prints of famed works of art, when a NFT is ‘minted’, the owner of the asset may elect to mint more than one “edition.” Of course, the number of editions will impact their perceived value. Editions of most NFTs are also able to be “burned” or digitally destroyed. Recently a blockchain company, Injective Protocal, took burning once step further…

From CBS News:

A blockchain company bought a $95,000 Banksy artwork, burned it and broadcast it live on Twitter — all part of a process of turning the work into a virtual asset called a non-fungible token, or NFT.

“Moments later, Injective Protocol employees created a digital representation of the art using blockchain technology on OpenSea.io”

Importantly, Injective Protocol recreated the physical piece and the input specifications, including the art version number into the smart contract code, permanently preventing the alteration of the digital art. According to the company, “The physical piece will forever be memorialized in this NFT.

The piece was then sold as a NFT for 228.69 ETH, or roughly US$380,000.

Ironically, the Banksy artwork tokenised was called ‘Morons’ and featured an art auction scene in which the work being auctioned was entitled, “I can’t believe you morons buy this s*!t”.

DeFis anyone?

The development of interest-earning cryptocurrency accounts is perhaps one of the other more important relatively recent developments in the sphere.

Ethereum, on which NFTs have been developed, is a decentralised, open-source blockchain that features smart contract functionality that a number of cryptocurrencies have also taken advantage of. More importantly, however, the growth of NFTs demonstrates the potential of the blockchain for digital assets and therefore an emerging value for the currencies that can be transacted on it.

In addition to NFTs, Ethereum has also become the largest platform for DeFi decentralised applications (dapps). An example is Compound.finance, which has US$12 billion worth of crypto assets earning interest across ten markets. Compound.finance uses an autonomous interest rate protocol algorithm on which developers build open-source financial applications. Decentralised interest rate markets now allow lenders and borrowers to supply and access a pool of Ethereum-based tokens.

The consequence of the development and NFTs and DeFis on the Ethereum blockchain is that the cryptocurrency Ethereum (ETH) is now the second largest cryptocurrency by market capitalisation behind Bitcoin.

And therein lies the potential of some, but not all, cryptocurrencies to become a valid investment class.

Returning to NFTs – Ethereum versus Wax-denominated NFTs

The most popular dapps for NFTs include asset exchanges such as Opensea, Rarible, CryptoPunks and NBA TopShot, the latter being an online forum for the trading virtual basketball cards. The most popular crypto used as payment for NFTs on these dapps is Ethereum (ETH).

One issue with Ethereum is the speed of its adoption and the ability of it to keep up with the complex smart contract terms required for NFT transactions. The consequence is high frictional costs in the form of transaction fees. The fee, for example, for a US$10 NFT on Rarible.com may exceed the value of the NFT. This of course slows the adoption of the platform and limits the pace of growth of the ecosystem.

And while a network upgrade is said to be in the works that will reduce costs and therefore fees, alternatives such as Worldwide Asset eXchange (WAX) are gaining share. WAX employs its own native token (WAXP) designed specifically for instantaneous fee-free transacting of NFTs. Brands such as Bratz, Atari and StreetFighter are adopting WAX to create collectibles. And unlike the Ethereum network, which runs on a proof of work model, WAX runs on delegated proof of stake. In other words, owners of WAX can stake (“Staking”) their WAXP tokens on the network to power transactions and increase scalability instead of employing powerful computers to solve complex equations, as they currently must on ETH.

(Staking is an activity where a user locks or holds their funds in a cryptocurrency wallet to participate in maintaining the operations of a proof-of-stake (PoS)-based blockchain system).

Rather than the replacement of fiat currencies with Bitcoin, it is these kinds of developments and projects that provide an arguable fundamental basis for the ownership of some cryptocurrencies. Through marketplaces like wax.atomichub.io and nfthive.io, for example, WAXP popularity has grown exponentially. Consequently, so has its price.

Whether the market for NFTs continues to grow is anyone’s guess. It could become as large as the combined markets for physical collectibles, but it could also prove to be a fad like Ooshies. Regardless, new projects and ideas mean that some second and third tier currencies will continue to emerge and potentially skyrocket.

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Chief Investment Officer
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.

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