What the heck are digital collectibles and why are so many people talking about it right now?
The urge to collect fascinating items is primeval and is not limited to humans (Link). There are birds who collect shiny objects to attract mates and humans have collected everything from gleaming stones to stamps. For humans, you can differentiate between manufactured collectibles and natural collectibles. Natural collectibles are naturally occurring objects that are being collected like seashells or stones. Manufactured collectibles are items specifically designed and produced for the sake of being collected. An example that many people in my generation know and possibly fondly remember are trading cards like Pokémon or Yu-Gi-Oh!. There are also manufactured goods that are being collected whose primary purpose is not necessarily being collected like stamps.
Digital collectibles have been around for almost as long as the internet has existed. People like to collect stuff and there are people who have cherished their collections of memes or other digital items. However, digital collectibles had a significant disadvantage against analog competitors for a long while. Digital collectibles were never really unique and could be easily copied by someone else. They were just an assortment of computer code that other people could copy and therefore, the inherent value of freely flowing collectibles on the internet was reasonably low. Once you post a meme or a song or any digital product anywhere, it is easily accessible by everyone else.
There were some closed systems in which items could increase in value since their supply is artificially limited and could not easily be copied, e.g. inside of video games. Especially in Online role-playing games (mostly in MMORPGs) rare items have always been coveted and sold for high amounts of in-game money and sometimes even for thousands of real-world dollars. However, all of this never came close to actually collecting items in the same way as collecting stamps or action figures in the real world. Until the Blockchain changed it all.
I know that Blockchain is one of the terms being thrown around a lot (usually closely followed by AI and Big Data) but in this instance, it is a clear and valuable use case of the technology.
This is because Blockchain can solve the most important problem digital collectibles had earlier: fungibility. Fungibility describes the interchangeability of things. Since two digital pictures with the same source code look exactly the same, theoretically it does not make a difference which of the pictures is stored on your PC and you would not even notice if someone swapped your picture with an identical one or one of the million copies someone could create easily. This is also why assessing the authenticity of real-world collectibles is its own industry, it is very important to know whether an item is “real” or a fake.
Let us use an example to further illustrate why non-fungibility is important for collectibles. If you swap a ten-dollar note with a different ten-dollar note, you can be certain that both have the same value (if both are real). If you swap two diamonds with each other, you can almost be certain that they do not have the exact same value. Indeed, their values can diverge extremely if one of them is deemed a particular masterpiece. This implies that ten-dollar notes are fungible and diamonds are not. Now let's use this principle in our example of two digital pictures again. Let's assume, that the "original picture" has a certain market value, e.g. 1000€. But since everyone can easily make copies of it, you can no longer tell which one is the original and which one isn't. Therefore, no one will be willing to pay the 1000€ bucks for that image.
What if, with Blockchain, we could now somehow "proof" which one is the original?
This is where "Non-fungible tokens" or "NFTs" come in. NFTs can represent ownership over digital or physical assets. This is because these tokens are distinguishable from each other and because there can only ever be one owner of a specific NFT. As a simplified analogy, think about a piece of art that shines green if the real owner touches it. In this case, touching the piece of art implies owning the correct password or cryptographic key that can prove your ownership.1
Since this is the internet, the first famous use-case of this technology were pictures of (digital) cats, literally called "Cryptokitties". Some of them are not only cute but also extremely expensive.
The most expensive Cryptokitty was sold for 600 ETH which represented almost $400,000 at the time, with the current ETH price it would be over a million dollars. Cryptokitties can have over 4 billion different phenotypes (how they look like) and genotypes (not visible but depicted in the data). Users can let two Cryptokitties breed to create a new Cryptokitty and can buy and sell them on a marketplace.
More recently, the firm behind Cryptokitties, Dapper Labs, has launched "NBA Topshot", a digital collectible platform officially licensed by the NBA that uses NFT to distribute unique clips from NBA moments. The clips are sorted into different tiers and based on that the number of times the same clip exists differs. For example, the dunk of one player might exist 1000 times as a clip and the block of someone else only 10 times. However, each of these 1000 or 10 clips has its own associated serial number and token which means you could own number 387 of the dunk or number 8 of the block. Therefore, the specific token you own is still unique. One clip depicting LeBron James has already been sold for over $70,000 and I expect that this is just the start. The company has just raised $250mm and is poised to go into other verticals after growing its NBA presence.
Valuation of digital collectibles
But how are these digital collectibles valued? Well, very similar to all other goods, it is a function of supply and demand. Or at least that would be the boring non-answer. Obviously, these items are only worth as much as someone is willing to pay for them since they do not possess much inherent value. Have you ever been confused about a rather ugly painting being sold for millions of dollars? Well, I bid you the pixel art of this green alien that was sold for $761,888. It must be really annoying having sold this one in 2017 for a couple of bucks. But how do people decide which of these collectibles they prefer over others? Or looking from a different perspective which of the collectibles will increase in value and are therefore good investments?
While Cryptokitties and NBA TopShots target different groups of people, there are similarities in how the value of the individual tokens can be assessed. With analog collectibles, the condition of the collectible is a huge contributor to its value, meaning a flawlessly looking stamp of the same kind is worth more than one that has spots on it. Since digital collectibles do not change their condition over time their value is a function of the popularity of the type of collectible, scarcity, group-led attribute values, cultural significance and personal preference.
Before anything else, there must be sufficient interest in the type of collectible. If there is no market for it, the item will not have any monetary value. In addition, the more people are collecting the items, the more valuable it possibly is. However, for the prices to reach certain heights, it is not necessarily important that millions of people collect the items but rather that wealthy individuals or institutions do. Fewer people collect Van Gogh's paintings than trading cards but still, the paintings are much more valuable since the people who buy them have much more money on average. It is important to note that collecting items is not necessarily a financial investment and can have multiple underlying psychological reasons.2
While the number of (affluent) buyers influences all collectibles in a certain market, we will now look at how individual collectibles differ from each other in value. The most important factor for this is scarcity. Cryptokitties with rarer phenotypes are (ceteris paribus) more valuable than kitties that look like every other kitty. Similarly, NBA TopShots that exist thousands of times are less valuable than those that only exist four times.
Over time, the groups also decide on giving specific attributes ofa these collectibles more value than others. For example, let us assume that Cryptokitties can have blue or red helmets and they appear the same number of times. The community can just decide, often indirectly to value blue helmets higher than red helmets. These kinds of trends are also sometimes fostered by the producers of the collectibles. For example, NBA TopShots with the serial number that matches the jersey number of the player featured in the Clip are advertised as being more valuable on the official website which contributes to increasing the value of these tokens.
When specific collectibles have cultural value to the community, their prices can be very high. For example, the first edition of a collectible that was ever released might be more valuable to the community than the 8th generation. Potentially, the release of a later generation coincided with a major change in the community and therefore it gains additional value. Note that this can be independent of scarcity. Often, early editions are scarce compared to later ones. However, if there are 10 pieces of a first edition and only 5 of an 8th generation collectible, the individual first generation pieces might still be worth much more despite technically being less rare.
Lastly, personal preference can also play a role. Maybe someone just really likes a specific cat or a specific NBA player and therefore values it much higher than others. I, for example, value cute cats much more than angry-looking cats and would reflect that preference in my purchasing decisions.
The decade of digital collectibles
I am certain that this will be the decade of digital collectibles. More companies are following into the space, both new ones as well as some of the established collectible companies. Other companies will want to copy the success the NBA is already having with their NFTs.3 Investors are already flocking into the market and buying an increasing number of collectibles to speculate for value increases. The children born today will probably play with digital trading cards when they grow up and adults all over the world will spend their money on building collections of digital items, whether they are LeBron's dunks, cute Kitties or something completely different.
1 On the Ethereum Blockchain, there is a standard called ERC-721 that "allows for the implementation of a standard API for NFTs within smart contracts. This standard provides basic functionality to track and transfer NFTs.
2 More background about psychological reasons for collecting art can be found here
3 I am certain that whoever pushed this initiative at the NBA should and will get promoted.
Further reading: Fungibility in tokens