A Digital Picture is Worth a Thousand Ether: NFTs and Digital Art

This year has seen an explosion in the popularity and value of non-fungible tokens or NFTs. Many will have seen news reports of sometimes enormous sums of cryptocurrency being exchanged for NFTs and may be wondering: Why? This article considers a possible answer to that question by looking at one of the most compelling use cases for NFTs, that of digital art.

NFTs solve a problem with digital art

Digital art has arguably long been undervalued, as there rarely exists any identifiable “original” that a digital artist can sell. The process of creating a digital work will often involve the creation of many copies of that work (in volatile memory, on an internal storage device, on an external storage device, in cloud storage etc.) and each copy is identical to any other. While digital artists usually have the benefit of copyright in their work, which they can license for royalties, the same is usually true of artists working with tangible media such as painters or sculptors. The difference is that a painter or sculptor can also sell their original painting or sculpture, something which is often more valuable than licensing their work for royalties.

Enter NFTs. An NFT is a non-fungible (i.e. unique and irreplaceable) blockchain token (being a digital record on a blockchain ledger, that is capable of being traded), which represents ownership of a digital asset. In a sense, an NFT can be thought of as a digital certificate of ownership.

NFTs present a solution to the problem of digital art “originals” as they allow a digital artist to sell a unique, original digital record of their work in place of a tangible original. The owner of an NFT does not usually obtain ownership of any intellectual property in the artwork nor do they own, or possess a unique copy of, the underlying data making up the work. Instead, the owner has a unique token, originating from the artist, representing ownership of the digital work. In this way, NFTs enable digital art to be possessed, bought, sold and, if desired, destroyed or “burned”, much like a tangible painting or sculpture.

Artificial scarcity

At the heart of the value of NFTs – and the scepticism surrounding them – is the fact that they create artificial scarcity. Whereas a tangible asset is inherently unique, digital assets can normally be replicated perfectly an indefinite number of times. By creating or “minting” an NFT of a digital work, a digital artist creates something unique (and therefore scarce) to represent exclusive ownership of that digital work. As the many recent news headlines have shown, the ability via an NFT to “own” a digital work (in much the same way as a painting or sculpture) is something that in principle can have significant value. The most valuable NFT sold to date is an NFT of a digital work by the artist Beeple titled “Everydays – The First 5000 Days”, which was auctioned by Christie’s and sold for USD 69.3m, making it the third most valuable artwork by a living artist ever sold (after works by David Hockney and Jeff Koons).

However, it is the artificiality of the scarcity that NFTs create that causes some to struggle to see value in them. Sceptics focus on the fact that the owner of an NFT receives nothing tangible and the copy of the digital asset that the NFT owner has is usually identical to any other copy that someone else may have.

There are some interesting parallels here with intellectual property rights. Absent the monopolies created by intellectual property laws, intellectual creations could easily be exploited by anyone with the means to do so. While some remain sceptical of whether this artificial scarcity has, or creates, meaningful value, there is little doubt about the monetary value of intellectual property rights.

Additional benefits

In addition to solving the “originals” problem, a number of other benefits offered by NFTs perhaps help to explain some of the success they have experienced recently in the field of digital art:

Clear provenance. Unlike for tangible artworks where authenticity or provenance can be unclear or disputed, once it is known that an NFT was created by the original artist (which is usually clear based on an artist’s promotion of the NFT or the use of known digital accounts), the public and immutable nature of the blockchain ledger means there is usually no doubt about authenticity of a digital work or the chain of title back to the original artist.

Resale royalties. NFTs can be created so that a commission is automatically paid to the original artist on future resales of their work. This can avoid the need for artists to rely on statutory resale royalty schemes. These schemes differ by jurisdiction, usually provide relatively low royalty rates (in the UK: 4% decreasing as the sale price increases, subject to a cap of €12,500) and often have strict requirements (including, for example, in the UK that the re-sale is for €1,000 or more, that the work is by an EEA artist and that it is re-sold through an auction house or other art market professional). By way of example, the artist Beeple sold an NFT of a different digital work, “CROSSROAD”, in October 2020 for USD 66,666.66. Amidst the hype around NFTs, this work was re-sold in early 2021 for USD 6.6m. Beeple’s 10% commission earned him around 10 times more than the original sale.

Liquidity. Digital art marketplaces for NFTs provide artists with a relatively inexpensive and straightforward means of directly accessing a broad international audience of potential investors. NFTs can be traded on these marketplaces without any need to coordinate the movement of a physical artwork. This can avoid some of the difficulties associated with the movement of physical works such as logistics, insurance, import or export duties and navigating laws governing cultural property. NFTs can also be fractionalised, so ownership can be subdivided and sold to multiple investors.

Challenges

Notwithstanding their meteoric rise in popularity during 2021, digital art NFTs face several challenges to their enduring success and, indeed, their broader adoption:

Crypto-volatility. Trading NFTs usually requires transacting in cryptocurrencies, which are, for now, notoriously volatile. This volatility – illustrated recently by large price swings following Elon Musk’s tweet that Tesla was suspending the option for vehicle purchases using Bitcoin, as well as various restrictions being imposed by the Chinese government – may be off-putting for many potential investors. The rise of stablecoins (cryptocurrencies that are pegged to the value of a fiat currency such as US dollars or a physical asset like gold), may, however, offer a partial solution to this problem.

A bubble? The popularity of NFTs could also be a product of the times. With restrictions on travel and closure of galleries and auction houses in the wake of the COVID-19 pandemic, it is easy to see why the accessibility of digital artworks has increased their appeal. This, together with booming cryptocurrency markets, may well have tipped NFTs into the zeitgeist triggering an explosive, but potentially artificial, rise in value. It remains to be seen whether the easing of global lockdown restrictions or a cryptocurrency market crash may cause the bubble to burst.

Environmental impact. Probably the biggest current challenge for the digital art NFT market is the environmental impact of the blockchain networks on which it relies. Many popular blockchain platforms operate using a proof-of-work consensus mechanism, which is, by design, highly energy-intensive. They require vast amounts of computing power to execute calculations to validate transactions. The most popular blockchain network for trading NFTs, Ethereum, is estimated to consume more electricity than Chile (a country with a population of around 19 million). Controversy around this environmental impact has caused some artists to withdraw plans to sell NFTs of their works. Ethereum’s planned shift from a proof-of-work to a proof-of-stake consensus mechanism promises to dramatically reduce its energy consumption, which may present a partial near-term solution to some of these problems.

Final thoughts

The opportunities that NFTs present for digital art, including solving the fundamental problems of scarcity and ownership of digital works, are genuinely revolutionary. Digital artists now have a way to sell their digital works in much the same way as artists working with tangible media. The broader adoption of stablecoins and of less energy-intensive consensus mechanisms for blockchain networks may also help to address some of NFTs’ biggest drawbacks. So while making predictions about the future of blockchain technology is often unwise (and indeed it is unclear whether recent NFT prices will be maintained or whether that bubble may burst), it seems likely that digital art NFTs will have more than mere token significance.