Since publishing the original Trouble in NFT Paradise article, I’ve gone down a virtual rabbit hole of additional revelations and it turns out the brave new world of NFTs has more land mines than most people are aware of. What also struck me was that my article on Where to buy NFTs garnered more than 15 times the views of the “Trouble” article, which suggests that the excitement for NFTs still far outweighs the concerns.
In the exuberance of the speculation, novelty, and sheer abundance in the NFT world, it is not all that surprising that people would put on blinders to the risks. People get complacent with the downside risks of stocks as well, and we have also seen multiple major corrections in cryptos. That’s what markets do because markets are people and people have behavioral biases.
I don’t write this to dissuade people from joining the excitement in NFTs. I simply feel it makes good sense to be aware of potential issues that could potentially turn your NFT investment from software to vaporware. I am still very positive about the ultimate outlook for NFTs, but until some sort of regulations and investor protections are introduced, people need to be extra vigilant about protecting their interests.
With Ease of Creation Comes Ease of Corruption
By their nature, NFTs are about the easiest form of investment (or at least potential investment) to create and offer for sale. For a few hundred dollars or less, one can “mint” an NFT and post it for sale on one of the more than two dozen online marketplaces. As for the underlying asset represented by the NFT, it can be just about anything. Digital assets such as graphic art are probably the most common assets, but even physical items can be represented.
For your reference, Wall Street Journal reporter Joanna Stern produced an NFT of her 4-year-old’s artwork in December 2021 and made a video of how she did it.
In this environment, as in the real art world, you therefore get everything from graphic masterpieces by well-known artists to pure junk from aspiring wannabes. But NFTs take things further than that. Graphic art is easily replicated and can even be originated entirely by a computer. As a result, where we might have once purchased a limited edition print with a maximum of 150 copies made, we now have themed NFT collections with 10,000 originals like the Bored Ape Yacht Club (BAYC) series, each altered slightly enough by a computer program algorithm to justify being its own distinct NFT. So, while each NFT remains unique, they are literally being mass-produced.
To take it a step further still, you can obtain a “mutant serum” that will alter your original bored ape image, creating a “mutant ape” and there are three levels of such serums. All this has spawned an offshoot of the BACY called the Mutant Ape Yacht Club (MAYC), which has 20,000 NFTs. This may be all fun and games, but who knows what it’s doing to the value of your original image or your rights to the altered image. For now, it’s a big game and there is a lot of money being thrown at it (the cheapest bored ape NFT reportedly goes for around $50K). Will the value hold up? You can decide. Meanwhile, these “collections” are growing like weeds.
The games people play
Copycatting is no surprise at all. It’s a fixture of capitalism. When a single bored ape NFT sells for more than $50k in a collection of 10,000, you can bet that thousands of onlookers are going bonkers thinking up every other combination of an emotionalized animal species to jump on. But again, imitation is perfectly legal, despite the potential for over-proliferation. That’s what makes a market. It’s the underhanded stuff that is what you really need to be aware of.
Here’s a sampling:
Phishing – This usually involves some sort of fraudulent enticement to part with your NFT, perhaps “offline” to get a better price. Once you’ve relinquished your NFT, the Phish swims away.
Wash trades – These are essentially fake trades, made between multiple accounts of the same person or a person and an accomplice. The perpetrator creates trades at successively higher prices to give the impression value is climbing in order to create FOMO (fear of missing out). The trades are real and payments are made but they are going back and forth between the same person.
Since Jan. 11, for example, a particular “Meebit” NFT transacted over 100 times between just three wallets. Sales ranged between $3 and $15 million.
In Feb 2022, Crypto Research firm Chainalysis reported that “Wash traders made profits of more than $8.9 million in 2021 in the nascent, multi-billion dollar space.” Many of the wash trades actually lose money as the owners pay more to themselves in each successive transaction. But then the eventual sale to an outsider results in a healthy profit overall.
Pump-and-dumps – P&Ds are just like their cousins in stock trading. An NFT or a collection of some kind is created and hyped (and probably wash traded to show the appearance of new players jumping on). Once actual new buyers get sucked in, the originators sell out to them at inflated prices. When the price subsequently collapses, it looks like it simply fell out of favor.
Rug Pulls – Rug pulls are just what their name suggests. They are typically come-ons for a new concept involving NFTs for all kinds of creative purposes. Once enough people get on board and prepay for something not yet even built, the rug gets pulled out from under them and the project either collapses or the originators simply disappear.
One reported rug pull recently took investors for $1.5 million when Sacramento Kings guard De’Aaron Fox closed a budding NFT project titled “SwipaTheFox”. The website used to launch and mint the NFT is now offline.
Crypto and blockchain research company Chainalysis compiles statistics on scams and shows in the chart below that the number is definitely increasing.
Unfortunately, even when scams are clearly illegal, you will have big challenges even identifying the perpetrators, much less recovering any money or assets you lost.
Some scams are openly condoned and even encouraged
The sad truth is that the market for NFTs grew up much faster than our legal and regulatory wheels could turn, so many questions remain unanswered about the rules of the game. In the absence of rules, and in the presence of so much money, the lines of business ethics tend to become blurred. In this situation, they are so blurry that proponents are openly advocating bad behavior.
Reuters reported on NFT marketplace LooksRare, which was pegged as having a large number of trades in expensive NFTs going back and forth between just two wallets, a suggestion that wash trades were occurring. An Investor in the LooksRare platform was quoted as saying on Jan. 12 that “wash trading on the platform looked bad but may be part of the ‘necessary steps’ to gain market share and provide a more transparent, decentralized marketplace for the NFT community. People have been real mad about wash trading, but I’m struggling to understand why. It’s a free market.”
In other situations, people have openly advocated software that can scrape the web for existing artwork that can potentially be minted into NFTs. In one instance the relatives of a deceased artist found NFTs bearing his art openly offered on multiple sites.
The fact that these actions are occurring is distressing enough, but when they do, investors will have very little recourse. There are no paper trails, no built-in protections, and in many cases, no identifiable people or entities to go after in the case of a scam.
Other Recent Issues
- Leading NFT marketplace OpenSea suffered a “phishing” attack losing its customers as much as $2 million worth of NFTs. Hackers apparently broke into wallets and stole the NFTs. As of Feb 20th, OpenSea was still trying to figure out what happened.
- Dan Howard, a concept artist for gaming companies, passed away in 2019. In 2021, his work started showing up on NFT marketplaces.
An investor thought they had scored when they purchased NFTs from eccentric entrepreneur Heather Morgan, only to find that hours later the NFTs had suddenly disappeared from the OpenSea marketplace where they were purchased. Morgan and her husband were later arrested for laundering $4.2 billion.
What About the Tax Consequences?
Many people may be under the false impression that NFT transactions aren’t taxed. While the IRS has yet to issue a specific ruling on the matter, the question is not whether NFT transactions are taxable but whether they will be taxed as property (meaning as a collectible) or as a capital asset. If sales don’t get reported, that’s another matter, but remember, they are on a blockchain by definition, and if your marketplace is reputable (and still around), they will also likely have records. If you want to urge the IRS to declare them property vs. capital, push for capital. The tax rate is lower and then they could be eligible for IRAs. If they are ruled collectibles, then IRAs are out.
Oh, and as of Jan 1, 2023, NFT transactions will be subject to the Bank Secrecy Act, which means transactions over $10,000 must be reported and penalties are imposed (to the dealers and marketplaces) for non-compliance.
Like their cousins, the cryptos, NFTs have lots of allure and the amount of money that is chasing some of them is considerable. The emotions behind FOMO, a sense of community, being part of a new revolution, and owner’s bragging rights are powerful forces that tempt us. Most of the marketplaces that offer NFTs are likely reputable as well. But there are numerous bad actors who are abusing the ease of entry in the NFT market and exploiting these emotions to make quick easy money from unsuspecting investors/collectors. It pays for investors to be extra vigilant – the wild west lives on.
This article was written by
Adjunct Finance Professor at UCLA and UC Berkeley (18 yrs), author of three investment books, and Wall Street veteran. Helping people understand and invest in alternatives (Cryptos, NFTs, art and collectibles, private debt and equity, real estate, venture capital, derivatives, etc.)
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.