I’ve recently been looking into the changing market microstructure for NFTs, and a recent discussion on the benefits of platforms like Sudoswap has highlighted some of the inherent tension between the current NFT audience and the future of the asset class. There is a huge wave of platforms coming that will bring more robust market structure oriented towards traders to NFTs, and soon, other esoteric assets. The evolution of NFT market structure can help us understand where all markets are trending, over time, as a result of technology innovation and new models for financialization.
In this post, I’ll discuss why market inefficiencies present opportunities for arbitrage, why market microstructure is important, and why NFTs are not exempt from arbitrage. Even though efficient markets will eventually be arbitraged by shrewd traders, it could take many years. However, the digital properties of NFTs could speed up this process, as we saw with bitcoin and other tokens. I’ll also offer some thoughts on how capital and cultural arbitrage might play out in the future, and how efficient markets can help reduce grift in new asset classes.
Inefficient Markets 101
There are a number of factors that can contribute to an inefficient market, including: – Information asymmetry (e.g. insider trading) – Transaction costs – Psychology and human emotion – Various types of market manipulation (e.g. collusion)
The markets for “unique” assets like NFTs, real estate, collectibles, fine wine, art, and others are highly inefficient. However, technology can unlock new efficiencies. Real estate has started to become more efficient thanks to the advent of new platforms like Zillow, Open Door, Compass, and others that surface unified property information at scale – minimizing information asymmetry, enable simplified trade execution – minimizing transaction cost, and better workflows to manage these assets at scale. This has resulted in more firms trading in real estate.
One of the reasons that NFT markets are inefficient is because our understanding of NFTs is limited to the subjective world of art. However, the biggest factor contributing to the inefficiency of NFT markets is the lack of market microstructure that would enable efficient trading.
What is Market Microstructure?
Market microstructure refers to the minute details of how a particular market exchange works. This includes the processes, technology, and platforms used in each stage of an exchange, which then impacts order book depth, transaction costs, clearing volume, trading behavior, and other important market measures. In other words, market microstructure is the study of how these trading mechanisms impact price formation.
Programmatic buying and selling of NFTs without having to evaluate them could potentially unlock a lot of trading volume and liquidity for the asset class.
The trade lifecycle of an NFT can be broken down into market microstructure. It is helpful to understand the trade lifecycle at a high level in order to understand the challenges in the current NFT market.
For NFT markets to grow, there need to be more protocols and platforms that enable every stage of the trade lifecycle to function more efficiently. These modular components should fit together to form an automated, scalable workflow. This would enable market participants of all types to deploy various trading and investing strategies.
The NFT ecosystem today is mostly used by collectors and hobbyists, but will soon serve a wider audience of traders who want to speculate on the value of NFTs. This will cause a shift in the way people interact with the NFT market, and some people may become very wealthy as a result. This process is called financialization, and it happens with every market and asset class.
NFTs are Not Immune to Arbitrage
Some people are upset about the financialization of NFT markets because it means that market inefficiencies will be corrected. The claim is that only people who are considered to be experts in the field will be able to trade in NFT markets. I disagree with this claim and believe that most NFT market participants are not good traders and are only in it for the money.
Arbitrage is a normal part of every market. Whenever traders witness market inefficiencies, they create a trading strategy to profit from it and keep doing it until the inefficiency is gone. In the past, traders took massive physical and financial risks to exploit geographic arbitrages, leading caravans of camels loaded with spices along the Silk Road and gaining wealth for their families along the way. In the year 2022, traders who identify as cartoon PFPs will build strategies to exploit NFT arbitrages, pressing buttons to send JPEGs at lightning speed and also gaining wealth for their families along the way.
The ERC-20 token is fungible, meaning it can be replaced by another identical token, while the ERC-721 token is non-fungible and unique. This largely clarifies the economic use of each asset and may also dictate the market microstructure around each asset. The trend is accelerating with Uniswap integrating NFTs by acquiring Genie.
What makes ERC-20 tokens useful is that they can act as a unit of account and a medium of exchange, and potentially as a store of value. This makes it easier to understand and predict the evolution of market microstructure for these assets, because our current behavior with money and money assets is already based on the belief that market efficiency is a good thing. We don’t question the direction of progress when it comes to these assets, because they fit into a mental model that we’ve all had since we were children.
ERC-721 or non-fungible tokens cannot be used as “money” because each asset is unique, but that does not mean they are not subject to the same market evolution. The cultural narrative around NFTs is a powerful way to get a broader audience involved in the market than with money assets, because culture is more fun and often easier to understand than finance (although I would argue finance is super fun and I write this because I want to make finance easier to understand).
The message stays the same even if the medium is different- like all on-chain markets, NFTs are great for efficient trading strategies. There is probably a more detailed and technical discussion to be had on this topic, but I’m just a woman who wants to arbitrate culture.
Imagining Efficient NFT Markets
What would an efficient NFT market look like?
Price Discovery
What are the best ways to collect data about NFTs? How can you determine the value of an NFT? How can you find the most favorable pricing for your trade? How can you view all listings for all collections in one easily accessible place?
The OpenSea discovery platform is the most commonly used today, but the data available in the OpenSea interface is quite light and offers very little insight other than what can be gathered on-chain. OpenSea also limits you to viewing listings on their platform, which doesn’t always represent the full breadth of the order book.
Genie gathers pricing information from multiple marketplaces, including OpenSea and LooksRare. It also incorporates appraisals from Upshot*, which takes into account various qualitative and quantitative data points. Additionally, it factors in rarity data from RaritySniper. Ultimately, this allows users to access a comprehensive overview of the NFT market.
transaction execution
I want to trade the asset I have identified and feel confident about the price I will get for it. Many trade platforms today offer trade execution, price discovery and settlement all in one interface. Some Non-Fungible Token (NFT) collections even have their own protocols or interfaces for trade execution. For example, LarvaLabs has a marketplace for CryptoPunks built into its website, while EtherRocks can only be traded on the EtherRock website. In the past, these were the only options available. Today, there are platforms that offer more efficient ways to trade. Sudoswap is one such platform that makes large-scale aggregation and execution simpler by enabling the development of liquidity pools that allow for market making across entire ensembles through glue curves that respond to market dynamics.
Uniswap will be adding NFTs to its protocol, which will convergence of the token and NFT markets and enable more applications to take advantage of Uniswap’s liquidity. The key is to make execution simple, programmatic and scalable, regardless of order type.
The best way to buy in large quantities is to either (a) use OpenSea, Genie, or Uniswap Gems to sweep the listing floor, or (b) find big players and negotiate bulk bids. However, this has unique risks which will be discussed in the settlement section.
There are very few brokers who trade in NFTs today, and most sales are between specific collectors. It is difficult to source them on a large scale, but I believe we will see more professional brokers and market makers who trade in NFT markets emerge, both off-chain and on-chain. They will specialize in liquidating or accumulating sizable positions without affecting market prices. As always, the main challenge with OTC trade execution is the opacity of such trades and how to integrate this market data into pricing models, especially if the trades are settled off-chain.
Margin and Clearing
One of the biggest things holding NFTs back from being more liquid is the cumbersome process of clearing and settling, as well as the requirement that trading venues put up collateral when making a bid. For example, if I want to bid on 100 CryptoDickbutts all at once, OpenSea would make me wrap my ETH into wETH, and then place 100 bids that would lock up my wETH for several days. While I can offer a minimum amount of wETH to minimize the amount of capital being used, it also means that I might have multiple bid matches that I can’t definitively match up. This is very inefficient and can lead to less than ideal execution. To make NFTs more liquid, we need to be able to bid with any other asset at scale and with lower collateral requirements.
An integration of Credora, an on-chain clearinghouse, could help drive better capital efficiency. A prime broker that provides short-term credit for bidding may also emerge. However, this structural problem is one of the biggest challenges to solve, especially for on-chain transactions where most NFT transactions take place. The process becomes more centralized if NFT clearing moves to a hub-and-spoke model with daily settlements rather than instant settlements. However, decentralization and efficiency are always at odds.
NFTFi’s platform allows NFT holders to collateralize their existing NFTs to gain more liquidity to trade. The upcoming Astaria* promises to provide instant liquidity to NFTs by grouping borrowers into a pool of funds that pays yields instead of splitting by payee. OTC firms and prime brokers that accept NFTs as loan collateral include Genesis, which in January 2022 used funds raised from NFTs to lend $6 million to NFT fund Meta4. This is called leverage, and leverage is the lifeblood of modern financial markets.
Gaining leverage today is expensive and often happens outside of the existing order process. You have to go to a separate platform, transfer your NFTs into an escrow account, and carefully manage the margin. Integrating margin directly into the trading workflow can help traders gain leverage more consistently and at scale. But lenders need better pricers, and that goes back to why step 1, which is that price discovery is not just is why it matters to traders.
The big opportunity for NFTs is to increase capital efficiency. This is because NFTs can be traded with leverage, which amplifies the return on investment. For example, if you have 100 ETH and can trade 1x with leverage to get 6% ARB, your ROIC will be much higher than if you have 100 ETH and can use 4-5 multiple leverage to amplify your return per dollar as the 6% ARB is now multiplied several times.
Settlement and post-trade reconciliation
An on-chain marketplace is one where transactions are settled instantly, without the need for a third party to mediate. This has huge advantages over other types of assets, as the provenance of NFTs is easy to trace and authenticity can be verified on-chain.
The least structured part of the NFT transaction lifecycle is reconciliation. This is because collecting data and integrating it into risk management or back-office systems is often a manual and labor-intensive process that requires data to be aggregated, cleaned, and normalized. Maybe a tool like Cryptio* that implements back-office functionality more broadly for crypto assets will also develop an NFT reporting module, but then monitoring positions in real-time and assigning value to them will require better pricing data – so back to step 1, price Find!
I’m hopeful that, in time, there will be more standardized data APIs available that will make it easier to manage reconciliations without as much manual effort required. Additionally, it would be easier to apply tax and accounting overlays which would enable real-time Profit and loss tracking. For example, the FIX (Financial Information Interchange) standard is a vendor-neutral electronic communication protocol that was developed in 1992 by the trading community. FIX has become the messaging standard for order workflow communication and regulatory reporting, and the FIX API guarantees that your data will be compatible with every trading, accounting and risk management system that has been built for modern capital markets.
While reconciliation may seem like an unglamorous business, it’s incredibly important because all companies need it and build their processes around it, and it can also be a great source of recurring revenue.
summary
Eventually, people trading NFTs may not just stick to trading NFTs that are related to each other, new types of derivatives and markets for making predictions will show up and enable traders to bet on which direction something is going to go instead of just trading assets that are related. For now though, the opportunities are quite evident.
The market for NFTs is not fully developed yet, but it is easy to see what is coming. The way that NFTs are bought and sold is slowly becoming more defined and organized, which will allow for new types of businesses to form as well as new ways for investors to put money into NFT infrastructure. It is not yet clear which aspects of the NFT market will be developed as separate platforms or protocols, or if there will be companies that try to create or buy up all the different aspects of the NFT market in order to have a complete and integrated system.
But Meltem, this is bad for the culture!
A final point to consider is that many people say that traders who are driven by arbitrage opportunities are having a negative impact on the NFT space. Over the past 20 years, there has been a growing trend of injecting cultural capital into financial capital, and although this has been happening indirectly up until now through things like the rise of social media and influencers, this trend is only going to become more and more pronounced as cryptocurrencies become more mainstream. This will lead to a direct erosion of the line between these two worlds.
(The age of institutions is over, the age of influencers is coming, and the age of degens is coming.) This sentence is saying that the time when large organizations held a lot of power is finishing, and now individuals who have a lot of influence, and people who are not careful with their money, are becoming more important. (The Kardashians are richer than most hedge fund managers.) This sentence is saying that a family who are famous for appearing on a reality television show have more money than many people who work in the financial industry. (Coinbase ranks in the top 10 U.S. banks based on deposits.) This sentence is saying that a company which allows people to buy and sell cryptocurrencies is now one of the ten largest banks in the United States based on the amount of money which people have deposited there. (Anonymous traders have built gains and losses that rival the PMs of Wall Street’s most famous traditional trading firms.) This sentence is saying that some people who trade anonymously have made as much money as some of the most famous firms on Wall Street. (Soon, anonymous cartoon avatars will rule the NFT market, flipping beautiful JPEGs of the original provenance.) This sentence is saying that soon,
Whether you’re investing a small or large amount of money in cryptocurrencies, on-chain markets are beginning to even out the playing field by allowing anyone to become a market maker or liquidity provider. If you’re interested, you can find a full 20 minutes on how cryptocurrencies make us hedge fund managers here.
This text is saying that people who argue that cultural capital is somehow immune to the patterns of inefficient markets are wrong. The author is saying that mechanisms already determine how you consume culture, and that you shouldn’t fool yourself into thinking you have taste. The author uses the example of NFTs to explain how influencers can promote something that you may not have heard of otherwise. The author is saying that if you apply the cultural purity test to your participation in the marketplace, you are more likely to be poor and unhappy.
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