Liquidity in NFTs – What are the alternatives?

This is a thought experiment on whether the technology we are using to solve for liquidity in the diamond market, has a potential application towards NFTs – digital art, video game assets and others.

Disclaimer: We are no experts in the NFT space but have experience building a marketplace for similar non-fungible items – diamonds. This article explores existing NFT trading mechanisms, current attempts to create liquidity and offers another alternative. We welcome any feedback / thoughts on this blog post.

Some may say that we are going through an NFT bubble, which we may very well be – in the short term. In the long term, however, potential applications of NFTs go much further than digital art and video game assets – think decentralized and democratized ownership of books, music, movies, patents and who knows what else.

So far though, the short “history of NFTs has shown that a very small percentage of NFTs stay relevant over time, with most NFTs losing their value after a few months. NFTs quickly become illiquid and therefore holder can’t sell.”

NFTSwaps

How are NFTs currently traded?

While blockchain solves the problem of ownership, trust and provenance, NFTs are bought and sold on marketplaces that use different trading mechanisms:
1. Outright purchases – Etsy-style listings allow sellers to offer NFTs for sale with an asking price. Buyers can either buy at that price or not.
2. Auctions – eBay-style auctions allow sellers to put buyers into competition with each other by way of an auction. Highest bidder wins. This is the most common way NFTs are currently traded and are used by marketplaces such as Opensea and Rarible.
3. Fractionalization – allows buyers to buy a small fraction of a more expensive NFT.
4. Index Funds (NFTX) – of NFTs allow buyers to trade a fractional part of a collection of NFTs via fungible tokens.

All of these alternatives work well when a few, rare NFTs are put up for sale but most NFTs have no bids on them and remain completely illiquid. And as we know, there are now millions of NFTs. Some may say that introducing more buyers to NFTs may partially solve the liquidity problem. But, as the number of NFTs listed for sale also increases, the bids are going to be spread out across even more items, reducing market depth and resulting in items becoming even more illiquid.

How to determine the price of an NFT?

There are ways to determine the price of an item, without them being traded. This might not necessarily be useful to liquidate the item but it is helpful if owners of NFTs want to take a loan against the NFT as collateral or buy insurance:
1. Historical sale prices – For NFTs that are already liquid, looking at a history of the prices that an NFT was traded at is useful.
2. Use adjacent items – Asking prices or sale prices of similar NFTs can be used for pricing e.g. similar cryptokitties. This is a good way to estimate the potential market price. Does it work for exuberant and subjectively-valued goods?
3. Expert Networks / Peer prediction – Users can get a valuation of the item done by experts in the field. Very much like an appraisal of a house or jewelry. While this may be difficult to scale, a new approach (see Upshot One), crowdsources appraisals to individuals and weighs their prediction based on honesty and ability of the appraiser. This is a promising opportunity.

In any case, price discovery without the sale of an item is a notional value at best. True current market price can only be arrived at when an item is traded in a liquid market. Price discovery and liquidity go hand and hand. If you try to attain liquidity without price discovery, a seller may be able to sell an item, but he may feel that he left money on the table or the buyer may feel he overpaid for the item.

Cartoon cats
Cryptokitties

Order-book based Exchanges

Current NFT exchanges use a traditional auction methodology that is more akin to a eBay, Christie’s and Sotheby’s than the NYSE. These allow sellers to put buyers into competition with each other. However, buyers cannot put sellers into competition i.e. there is no way for buyers to express demand independent of supply. This ends up resulting in buyers limiting the number of bids as opposed to also bidding on other potential alternatives. Opensea does allow buyers to bid on multiple items using the same pool of funds (WETH). But, without putting sellers into competition with each other. Fewer bids from buyers results in shallower market depth.

We believe that accurate price discovery and true liquidity can only be had in an order book-based exchange – CEXs like Coinbase or NYSE and DEXs like Uniswap. But, such exchanges only work when the items being traded on it are identical or fungible – like bitcoin, gold or Google stock. But, each NFT is unique.

Double Auction Technology

We can solve this problem by creating a liquid exchange for NFTs by using our patented double auction technology that brings the benefits of an order-book-based exchange to non-fungible items. This technology already powers our marketplace for similar non-fungible items – diamonds. See Liquid Diamonds.

Using our platform:

  • Buyers can bid on all acceptable alternatives at the same time, at different prices. As soon as one of the bids has been accepted, the other bids are automatically removed so there is no risk of the buyer buying more than the number that he needs.
  • Sellers can not only see the bids placed on their own item, but also on all the alternatives that the buyer is bidding on, putting them into open competition with all other sellers.

This symmetric buyer and seller competition achieves price discovery and liquidity in NFTs. It achieves both price confidence for a seller and price optimization for a buyer. See how we’re doing this with our diamond exchange in the video below.

See how our double-auction technology works for non-fungible items such as diamonds

Physical Assets vs NFTs

NFTs, in fact, are even better to trade using this double auction technology than diamonds are, because:

  1. Digital asset – NFTs do not need to be physically inspected or physically transported when a transaction happens.
  2. Behavior change – people trading NFTs are fairly familiar with online auctions and are quick in adopting new technologies compared to physical asset industries such as diamonds, real estate, used cars, etc.

Further, “as NFTs become increasingly financial, they will require new kinds of exchanges, lending protocols, and derivatives. Thus, I claim that price discovery is the next major problem set in the NFT space. Capital efficient mechanisms for price discovery will enable participants to transact more quickly, improve liquidity through tokenization, allow nonfungibles to be collateral without order books, and create a rich set of derivatives with nonfungibles as underlying. In other words, price discovery will enable the financialization of the NFT asset class.”

Jake Brukhman from Coinfund

Questions on our mind

  • From an NFT trader’s perspective, how big of a problem is liquidity in NFTs in the first place? Are there other more fundamental problems in the NFT markets?
  • Are buyers of NFTs in the market only for a specific NFT or are they open to other similar alternatives? i.e. Would a buyer by open to buying one cryptokitty vs another?
  • How do gas costs for minting new NFTs / transacting existing ones affect market liquidity?
  • Regulatory – What are the regulatory implications of NFT ownership / trading? KYC / AML? Is fractionalization of NFTs dependent on jurisdictions and securities laws?

We’d love to hear thoughts / feedback on this blog post – you may reach out to me on LinkedIn – please add a note when sending a connection request.

References

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Diamond Liquidity Liquidity NFT

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