The Rational Irrationality of NFTs
The Rational Irrationality of NFTs
Let’s play a game:
Pick a number 1-100
The person who picks the closest number to 2/3 the average of all the other guesses wins 50 ETH.
The Rational Actor:
Lets exclude the numbers that can't win first - no one would guess between 67 and 100 because if all of the other players selected 100, 2/3 of 100 = ~67, making 67 the highest possible winning answer if all the other players selected the maximum number. Next, the rational player would assume everyone else would guess 67 making the winning answer 45, however, all the other players are simultaneously thinking that way so it quickly leads to vicious undercutting cycle. If you continue with the same group of players -the guesses all eventually approach 0, which is the Nash Equilibrium.*
The academic objective of this game is to demonstrate that in order to have the optimal strategy you must forecast the behavior of the other players, which forces you to create a set of “rational” assumptions that would dictate behavior (guesses)... which are also the assumptions that would apply to your own rational behavior.
The other main takeaway from the 2/3 game is even though the rational actor would always guess “0”, this is not the case in reality. Anyone guessing above 0 could be considered an irrational actor, which occurs quite frequently for newer players of the 2/3 game, this repeated irrationality for newer players (less game specific education) creates incredible opportunity in a trading market context. This also serves as an introduction to the "rationality vs common knowledge of rationality" thought experiments in game theory....
A ton of people (Keynes) also compare the 2/3 game to trading a market top as well. For example, you own a stock that you know is overpriced but think it has more upside so you want to wait until people sell, so you have to predict the point at which a market participant would want to sell, you see where this goes...
A Danish newspaper ran a promotion with prize money for participants for what is probably the largest 2/3 game ever played with the general public – around 20k people participated and the winning answer was 21.6 (see histogram below). This answer corresponds to appropriately 3 “K-levels” of reasoning. I will link the Danish study and a book below more focused on k-levels but you can apply the 3-4 K-level rule generically in many other “games” in real life.
I will dig more into the irrational actor in relation to NFTs below.
The reason I included the game above is to demonstrate the strong relationship between predicting behavior, irrational actors, and price action. In order to successfully understand/predict NFT price action you have to understand the behavior behind it. Technically, only one condition needs to exist for an asset to have upwards price pressure – more buyers than sellers. Vice versa as well, more sellers than buyers and the asset will have negative pricing pressure. In order to figure out if more buyers or sellers exist you have to understand what incentives create buying or selling behavior. Finally, for that you need to have a set of assumptions or beliefs for how participants rationally act in NFT markets.
For reference, NFTs are what most of the population would consider an irrational asset. Leaving that alone for now, we have to assume a set of rational behavior exist for the small % of people who have internet access who are also buying NFTs.
Rational Reasons for Buying a NFT
In the context of game theory, the blanket reason for a rational person to buy an NFT is to expect profit. The most obvious form of profit in the NFT world comes from arbitrage. So a fair reason to buy an NFT is arbitrage, extending that further it could be an arbitrage opportunity stemming from listings on different marketplaces, fat finger mistakes, discounted cash flow vs floor price, expected (future) value of an airdrop / NFT white-list access, etc.
Apart from the expectation of profit, arguably only two other reasons exist why a rational person would buy an NFT.
1. Utility
2. Art
Now is where the title of the newsletter comes in – In order to understand why a rational person would buy an NFT based off utility or art you have understand the irrational reasons that would impact behavior.
Utility is one of the most overused words in web 3 because it's super generic. It can describe everything from a wrist band to an incredible IRL experience and everything in between. I would also categorize “community” within a projects utility. For most projects, the community is the most critical component to success, without a passionate/informed community the floor price would not be supported (more sellers than buyers) making this a prerequisite for a collections success. Defining the value of a community is too subjective to be rational – the reason behind this is that two traders could have two different reasons of why a community is attractive to them, one may be considered rational, the other irrational but, they will both have the same impact (buying). So it doesn't really matter if someone’s individual thinking is considered rational or irrational in terms of community assessment because the end result is the same. This also speaks to the constant twitter noise as to what community is superior because it's impossible to objectively value a community at scale and community perspective/vibes can change very quickly with new information (think Azuki scandal), which also partly explains why NFTs are so volatile.
The IRL utility focused projects are too nuanced to dig into here in a meaningful way and realistically only represent a small % of projects currently. - More on that in future letters.
Art is the traditional asset associated with “irrational value” and is much more widely accepted by the general population compared to NFTs as a speculative store of value. Not making the distinction between pfp art and 1 of 1 art, its value explanation sounds very similar to the “community” analysis above. Obviously art is incredibly subjective, however, it's a lot less subjective in the 1 of 1 world as it has a slightly higher correlation to the physical art market (vs PFPs) that allows for tons of historical analysis. For example, well known artist, artist of a certain time period, artist that originated new styles/mediums, cultural relevancy, high sale history, scarcity, are all generally agreed upon by the market to hold a higher value compared to the inverse population.
Valuing art and utility in the context of NFTs is a relatively new “problem”. Currently, no “ESG rating” like measurement or standardization to score communities/art exist. Some bozo probably tries to start a project scoring other NFT communities but at the end of the day, I think you can't forecast behavior around art and communities accurately consistently as an infinite amount of subjective variables would have to be accounted for that are changing rapidly on the individual level and market level.
Where am I going with this?
The idea was to create a foundation for the argument that irrational behavior in NFT markets stems from rational behavior in other markets which potentially allows for some accurate floor price forecasting. The idea is to also demonstrate how crazy speculative the NFT market is as it lacks traditional measurements compared to other financial assets (coupon payment, P/E ratio, dividend yield...) that are agreed on by a “crowd” as value metrics. The crowd (algos) assigns certain values/multiples according to those ranges limiting volatility, which does not exist in NFTs. It also serves to deduce that forecasting an NFT floor price must include forecasting irrational behavior. However, I think the irrational behavior stems from utility and art which can arguably have rational behavior drivers. Specifically, art is the clear winner in terms of having historical context and pricing data to develop forecasting ideas that would be more likely to be accepted by the “crowd” as value. My main takeaway from thinking about this at length is that digital 1 of 1 art will reflect the value of rational/predictable behavior patterns with less deviation compared to other traditional NFT assets. This is already occurring with artist like Beeple and XCOPY having some of the highest nft sales across all digits assets. However, this could also create more upside into pfp collections as the “crowd” is still split.
Another way to look at it is that 1 of 1 art is the least common denominator In terms of bridging rational behavior related to IRL markets and the NFT market. As the general population somewhat understands why value is attached to certain artist and physical art, although they might not agree with specific valuations – the “crowd” accepts fine art as a store of value with somewhat rational behavior dictating pricing trends. This is evident looking at some of the top sales of digital art and also looking at who are the buyers are. Some of this is a function of where the art is sold - the top sales occurred at auction houses like Christies or Sothebys. Check out the recent Chrisites and MoMA news linked below for an idea of where this is headed.
The above text also minimizes the innovative aspects related to NFTs, although this is a real component responsible for serious speculation driving upwards price action – it's tough to frame that as a rational activity as it’s mostly around future speculation related to adoption of unproven technology. Thus, I didn't want to extrapolate a rational analysis of NFT market behavior to include that level of speculation. However, I will say there might be something to it as you can’t throw soup on an NFT.
In 1 of 1 art the advantage with a lack of liquidity is that one or a few dominant whales can drastically impact the price of a collection, especially if they plan to hold the NFTs for a long time. Additionally, if the artist rarely drops/controls supply tightly - there is very little open market price discovery, potentially allowing whales to “manipulate” pricing action easily. A common example of this is found when looking at some 1 of 1 artist with a tight supply – every available piece may be listed for 6 figures USD when perhaps the artists previous all-time high sale may have only been 5 figures USD, however, it only takes 1 misinformed/irrational actor to be impatient and buy a piece for 6 figures which instantly adds a sense of credibility to all the other art, potentially causing behavior resulting in consistently higher sales – all caused from lack of liquidity. A step further, the irrational 6 figure buyer may even prompt other irrational buyers to step into the market (after seeing a 6 figure sale on chain), that repeats and before you know it the irrational act becomes more rational as other misinformed buyers follow along....
On the PFP side, this occasion is somewhat evident in trading the top 1% or legendary rarities in a collection. However, the dominant investor sentiment driver for most pfp collections is related to the floor price, this is a significant disadvantage compared to 1 of 1 art. The floor price represents the most likely point of instant liquidity (check out my first letter) but the point is that retail traders obsess over the floor price and that floor price drives market action for the rares. For example, you usually only see record breaking collection sale when a floor price is also at all time highs (DeGod #270 sold for $220k the same week Degods FP hit an all time high).
I can elaborate on all the topics mentioned above quite easily but I think the above analysis serves as a basic primer for attempting to understand some of the “irrational” elements of NFT markets in a rational way. It also makes a solid argument that from a game theory perspective, buying 1 of 1 art is more likely to be widely accepted as “rational” before PFPs by the general public. However, given the amount of unique variables related to NFTs that can't be quantified easily, lack of liquidity, ownership distribution, lack of historical price analysis, subjectivity related to art and utility, combined with the fact that NFTs are denominated in a crypto that potentially encourages independent buying and selling behavior not related to the specific collection or art (dumping ETH nfts to stable up for example)... all this is purely theoretical and should be taken with a grain of salt.
All NFTs are extremely risky, especially thinly traded expensive digital art – please don't take this is an investment recommendation as its more of a thought experiment for me, trying to rationalize behavior in one of the most irrational asset classes in history.
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Have a good week,
zk SHARK
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This is just the way I think about it, I would be curious if anyone has a different take please shoot me a reply. I'm also not going to set up a specific timeline for when I'm releasing newsletters as I don't want to force myself to bullshit content – I'm aiming for 1 release bi-weekly.
I'm starting to include a few recommendations related to books, videos, podcast, threads, and articles that I find interesting/relevant with each release. I'm going to make it look pretty eventually but not really a priority I have right now. Check out the links below.
ZeroHedge - On a long enough timeline, the survival rate for everyone drops to zero
Let me know if you have any topics you want me to cover also.
Everything above represents my personal opinion and contains absolutely no financial advice or recommendations. Please read the full disclosures I copied from other crypto sites online below.
Disclosure: I may own NFTs or tokens related to the projects mentioned here. These statements are intended to disclose any conflict of interest and should not be misconstrued as a recommendation to purchase any token or participate in a mint. This content is for informational purposes only and you should not make decisions based solely on it. This is not investment advice. The information on this website is not intended to be construed as an offer to sell or a solicitation to buy or sell any products or services of any kind, including securities or any other financial instrument in the United States of America or any of its territories or possessions.
**no one wins 50 ETH, I just said that to try and hold your attention... it worked.