NFTs - Digital Property Rights
April 14, 2021
Life, Liberty, and (Digital) Property
At present, the primary application for NFTs is the ownership of digital collectibles. While traditional systems (in some Western countries) do a robust job of transcribing ownership of physical assets, sovereignty of digital goods is less certain. Whereas the government acts as the sole registrar in physical space, large tech companies are the sole registrars in cyberspace. There is a wide-spread concern about tech companies’ control over our digital lives; where the government is politically accountable to its citizens, large tech companies are not. Netizens desire genuine, unexploitable ownership of digital assets independent of proprietary systems. The growth in NFT adoption is largely driven by the improvements in public-private key wallets (the software that enables users to custody their keys and interact with blockchains). With the wallets being “good enough”, people are excited to experiment with an ownership model that obviates our dependency on digital intermediaries.
A Nifty Primer
Non-fungible tokens, or NFTs, are deeds instantiated on a blockchain. An NFT is an artifact that represents ownership of a digital, physical or financial asset. It is not the underlying asset itself. Just as deeds are recorded in a property registry, NFTs are recorded on a blockchain. Property registries and blockchains are information systems that track ownership of assets in the real (or virtual) world.
On a blockchain, each user generates a public and private key using asymmetric cryptography. Users can generate an indefinite number of public-private key pairs. A public key provides an identity on the blockchain (think username). A private key allows the user to take actions under that identity (think password). NFTs track ownership by:
Linking an NFT to a public key
Allowing owners to transfer NFTs using their corresponding private key
Logging the history of transfers via cryptographic hashing
Blockchains offer two advantages over traditional property registries: immutability and transparency. First, immutability. While traditional property registries are controlled by a single registrar (e.g. the state or large company), no single entity controls a blockchain. In a traditional system, the registrar maintains the record of ownership and can modify it without its users’ consent. On a blockchain, only private key holders can transfer ownership of their corresponding NFTs. Second, transparency. Traditional property registries are inaccurate and opaque. Blockchains are transparent by design—provenance is easily determined. The origination and transfer of NFTs is indelibly recorded in the blockchain’s history and is inspectable by anyone.
NFTs start by securitizing digital goods such as visual art, music, domain names and video game collectibles. There is already OpenSea, a marketplace for visual art, Audius, a catalog for music, and Unstoppable Domains, a domain name registry. Portending the future of NFTs, Centrifuge has created a protocol for securitizing customer invoices, royalty payments and warehouse receipts, enabling businesses to collateralize previously dead capital. NFTs will become the gold standard for securitizing real-world assets that are too complex and expensive to be expressed in legacy registries.
NFTs and blockchains provide the foundation for a property system that expands access to capital. Property systems need 1) an information system demarcating who owns what 2) mechanisms to resolve disputes regarding the state of the information system and 3) social consensus around the information system’s validity. A blockchain’s immutability and transparency engender respect for the property system that it supports. This invites wider participation, extending the universe of what can be securitized. As the quality of the data informing blockchains improves, traditional asset classes like stocks, bonds, derivatives, real estate, and insurance all move on-chain.
Unlocking Dead Capital
Blockchains act as a runway for entities to more confidently mobilize capital. Much creativity and innovation remains latent because existing systems do not allow agents to “fix” the economic potential of their assets. A digital deed does not merely track ownership but also depicts the economic viability and purpose of the asset it represents. This depiction is a packet of knowledge that informs the decisions of owners, buyers, and investors, reducing asymmetry and creating alignment. Owners can then mobilize their assets by issuing interests and parlaying the proceeds into further productive activity. With a deeper market for exchange, creators specialize in riskier pursuits, consumers get access to a broader range of products and services, and investors allocate capital more efficiently. The NFT, in effect, converts dead capital to productive capital. ¹
Consider for a moment the billions of farmers in developing nations. These farmers can not fully specialize and grow their production because crop insurance is largely inaccessible or unaffordable. Would-be insurers are often unwilling to underwrite coverage because data collection is prohibitively expensive. Even when insurance is available, farmers distrust underwriters because the terms underpinning the insurance contracts are subject to dispute and thus ill-enforcement. So instead of investing earnings in productive capital like machines or silos, farmers must retain savings to offset weather events, surges in pests or blight, and fluctuating commodity prices. The capacity to insure against catastrophic risks is a requisite building block for capital accumulation. Without hedging production uncertainty, farmers cannot redirect savings to productive capital assets and are thus fossilized in stagnancy.
Blockchains offer farmers an incorruptible and affordable mechanism to hedge uncertainty. Insurance protocols will provide crop coverage executed completely by smart contracts that are informed by decentralized oracles (i.e. a distributed network of data providers). The terms of coverage will be codified as an NFT on the blockchain. The coverage NFT will delineate the economic rights of its purchaser and pay claims automatically if certain conditions are verified by the oracle network. With data feed and execution logic standardized, the volume of potential underwriters (investors) and thus the pool of money that can be drawn upon for claims grows. The coverage instrument becomes liquid and the competition for the yield it pays pushes down the premiums for famers. By combining a network of consistent oracles, a deep pool of freely exchanging market participants, and smart contracts that reliably execute claims, decentralized insurance touches regions and industries that centralized insurance never could.
Now imagine an Ethiopian coffee farmer who elects to purchase crop coverage for drought. Rain gauges distributed throughout the coverage region would be randomly sampled and the measurements fed into the oracle network. Those maintaining the oracle network are incentivized to report accurate data. Oracles reporting accurate measurements receive a share of the premia pool while those that don’t receive a fine—a sort of Pigovian tax. This is enforced via a majority consensus mechanism, where the minority’s report gets punished via slashing. When the coverage expires, the smart contract compares the oracles’ rainfall data to the terms necessary for payout to the farmer, draws down the investment pool, and issues claims accordingly. There is neither nuance nor delay. In any state of the world, the farmer can rest assured that his business runs and his family eats. This security enables the farmer to invest in productive equipment like plows and tractors. The farmer can then pledge the equipment for cash, invest in further production capacity and supercharge his earning potential. A virtuous cycle is unleashed. The insurance NFT catalyzes the process of capital accumulation and thus the specialization of labor.
Pushing the Frontier
NFTs will increase capital accumulation to the extent that they improve upon existing property systems. To improve such systems, the NFT must bring additional immutability, transparency, or both. Combining immutability and transparency ultimately entails a shared, single source of truth that economic agents can reason about. This expands the set of assets that may be fixed as productive capital, empowering risk-taking and unlocking economic activity.
Many contemporary NFT applications fail to genuinely uphold immutability. Take Beeple’s “Everydays: The First 5000 Days” which sold for $69 million at Christie’s Auction House. While the digital deed is stored on a decentralized blockchain, the underlying asset it is meant to secure is hosted on a proprietary server. Thus while the underlying NFT is immutable, the digital file is not. But decentralized storage solutions do exist, so we can expect digital collectibles to migrate there, reconciling this fragility. Respect for NFTs will grow, charging digital capital accumulation.
The benefit of blockchains’ transparency is limited as the development of decentralized oracles is still nascent. Absent real-world data on blockchains, a world of tradeable NFTs remains unexplored. This is changing however. Take the recent integration of WorldWeatherOnline data into blockchain oracles.² This move will make a breadth of geographical, real-time weather data available to decentralized applications. NFTs like crop insurance coverage become possible. As broader sets of real-world data move on chain, the purview of NFTs expands. The set of capital permutations grows, emboldening entrepreneurs to explore new modes of creation.
Citation
Mystery of Capital: Hernando de Soto
https://www.worldweatheronline.com/blog/2021/02/23/world-weather-online-to-launch-a-chainlink-node-to-bring-high-quality-weather-data-to-blockchains/