Why NFTs can be a riskier investment than cryptocurrencies, report

October 1, 2021 by Dev Alis in News

Investors who survived the 2008 financial crisis understand the importance of liquidity. When an economic recession starts, deflationary pressure hits the market, and buyers disappear. Sellers frantically try to sell assets before their prices drop further, but buyers want to de-risk and go into safe-haven assets, such as treasury bonds and money market funds. 

The lack of liquidity associated with nonfungible assets is the one reason why investors may think they are riskier than cryptocurrencies. When an investor wants to sell Bitcoin (BTC), they can easily sell to an order book of buyers at various price points. If a seller doesn’t sell their Bitcoin today, they can easily come back tomorrow and part ways with their Bitcoin in favor of willing buyers.

In contrast, nonfungible tokens (NFT) are unique, and matching sellers with buyers is much more difficult. Cointelegraph Research analyzed what liquidity looked like for NFTs and whether some collections were traded more frequently than others. Cointelegraph Research is releasing its first-ever report on NFTs in October to answer exactly this question and many more surrounding the risks associated with NFTs. 

What does liquidity mean in the context of NFTs?

There isn’t a market for “Mona Lisa” paintings because there is only one “Mona Lisa.” Similarly, NFTs have a low level of liquidity compared to fungible currencies. One reason is that collectors often wish to keep their NFTs rather than trade on speculative markets. Another reason is that NFTs are traded bilaterally on marketplaces, with a small pool of potential participants for each sale.

For example, a sports card NFT of a specific player might only be in demand by a subgroup of collectors. Furthermore, not every NFT is a perfect substitution for another NFT. If, for example, Mike wants a 1988 Michael Jordan NFT for his birthday but gets a 2014 Lebron James instead, Mike might not be very happy. Due to the difficulty of comparing different NFTs being offered by sellers and the low number of bids being made by buyers, there is a low number of total transactions. This low turnover makes it more difficult to determine each NFT’s value.

For fungible assets, such as stock shares, liquidity can be measured by dividing the total number of shares traded during a particular period (such as a month) by the average number of shares outstanding for the same period. The higher the share turnover, the more liquid a company’s shares are. But how to go about measuring the liquidity of a unique nonfungible asset?

For markets with low transaction volumes per item, such as real estate or collectibles, the two main types of liquidity measures include “time on the market” and “level of transaction activity.” For example, real estate liquidity can be measured by the average time between a home being listed and when it is sold. In NFT terms, this would be the “average time between when the NFT was listed on a secondary market and when it sold.”