Experimental Strategies for Investing in Decentralized Finance & NFTs
Updated: Mar 23, 2022
Introduction
This article was designed to introduce cryptocurrency and NFT newbies to many of the concepts that are now commonplace in the Web3 world, as well as suggest some intermediate strategies for how NFTs and cryptocurrency can be combined to help prevent excessive exposure to cryptocurrency volatility. It is far from comprehensive or complete and I will continue to update it as I learn more.
Please note that investing in cryptocurrencies or NFTs is extremely risky for many reasons. Never invest more money in risky assets such as cryptocurrencies or NFTs than you can afford to lose. There is never a guarantee of profit. Always do your own research. Good luck, stay safe, and never respond to DMs from strangers because they are always scams. I am not a financial adviser. This article is not financial advice. The ideas and opinions expressed in this publication are those of the the authors.
Section I: Definitions
What is an NFT
NFT stands for “non-fungible token,” a name that barely describes what it is. The best way to think of NFTs is as a decentralized book of deeds, or ledger, that describes which individuals own what assets, both real and digital. NFTs cannot enforce ownership or punish theft, they can only prove which assets belong to whom (or more specifically, which assets belong to which cryptocurrency wallet address). The underlying blockchain technology makes this ledger trustworthy in the same way that it makes cryptocurrency trustworthy.
What is Utility
Utility is an NFT’s purpose beyond any visual or artistic merits (if any), and typically involves some kind of cryptocurrency and/or software functionality. Early NFT projects were mainly composed of randomized images with various properties that are assigned rarity scores to induce artificial scarcity, but have no real utility.
What is a Token
A token is a type of cryptocurrency that is generated from the NFT or otherwise involved with the NFT project. Tokens can have many utilities beyond currency and can often be exchanged on a Dex for other cryptocurrencies.
What is a DEX
DEX stands for decentralized exchange, and is a type of cryptocurrency exchange where individuals contribute their own money to the liquidity pool in return for fees. Examples of this include Uniswap and Cake Defi/Defichain.
What is a Liquidity Pool
Liquidity means movable money, and pool means storage. Exchanges need liquidity pools to facilitate trades in the marketplace. This term can be used for any monetary exchange, not just cryptocurrency. Liquidity Pools are important tools for investment strategies as they can produce excellent returns when used correctly.
How is Money Made in Liquidity Pools
To enter a pool, money must be contributed in equal parts. For example, to contribute to a Bitcoin/USD liquidity pool, you must provide 50% Bitcoin and 50% USD. The pool sets a % of each trade on the exchange as a fee, typically between 0.1% and 1% depending on the perceived risk and volatility of the underlying assets. Every time a trade occurs in the marketplace, the liquidity pool holders receive a cut of the fee proportional to their contribution to the liquidity pool.
Passive vs. Active Income
Passive income is generated from sources that require setup but once in motion they need minimal input to continue their output. In active gameplay, users must continually play the game for tokens to be generated.
Uniswap
Uniswap is an extremely popular decentralized cryptocurrency exchange. Anyone can contribute to liquidity pools in Uniswap, all they need is a wallet with some crypto in it.
OpenSea
OpenSea is the leading NFT marketplace. It currently has 500k unique visitors each month.
Section 2: Three NFT Models
The value underpinning NFTs can come from different sources. Thus far three models for NFT value sources have been identified, although its likely there are others in development or currently in the wild.
1. Pure Art Value Source
Many of the earliest (and most famous) NFT projects started with art collections, the value of which is highly speculative but nonetheless considered extremely desirable. The source of these project’s value is mainly conspicuous (entry to exclusive events, acceptances into elite social circles, bragging rights, etc.) but nonetheless remains strong, with many individual art NFTs selling for millions of dollars USD. Examples of these projects are Bored Ape Yacht Club, Crypto Punks, and Azuki. Never underestimate the value of meme culture in the pure art model.
Hot fact:
An NFT smart contract can include code written in it that allows its authors to set commission fee (as % of sale, typically 5%) each time an NFT in their project is bought/sold on the open market. This has net some projects millions in kickbacks. (This is not the same thing as earning fees in a liquidity pool).
2. Gameplay Value Source
As mentioned previously, there are two types of NFT gameplay: active and passive. Not all NFT projects feature gameplay (Pure Art has none) but those that do fit in either the active or passive gameplay category. NFT projects with the active gameplay model derive their underlying value from the gameplay itself. For example, beating enemies in an NFT based game could result in a token being awarded to the player that could be exchanged for a more popular cryptocurrency such as Ethereum. A major downside of this model is that the user must be at their computer actively playing the game to generate income from their NFT. This precise issue is what makes passive gameplay so appealing: the user is not required to participate in the generation of their NFT’s value in real-time. There are numerous active and passive gameplay projects, and these are considered to be more advanced and cutting edge than the Pure Art model NFT projects.
Hot fact:
In the NFT game Metroverse, value is derived from strategically combining different NFTs to generate the most tokens ($MET) possible each day. The tokens are automatically awarded and distributed based on the score achieved by combining blocks and requires no intervention from the user other than initial setup and token collection. Conversely, in the NFT game Axie Infinity, users must actively compete against one another in an RPG-style “battle” in order to generate income (The only exception is renting your character but this is a minor technicality). Losing battles is also possible which can result in much wasted time.
3. External Value Source
The most diverse (and newest) NFT value generation model is also the most promising. External value generation brings value into an NFT project without having to constantly recruit new users or extract further value from their existing users. This value could be characterized as “true value” because of its external origins from the NFT project.
Hot fact:
A very promising NFT project called BMC (Blockchain Miners) ties NFT ownership directly to bitcoin mining. The project will reward its NFT holders with a token called $HASH, the value of which is underpinned by BMC’s bitcoin mining operations. A portion of the overall mining rewards will be reinvested in further mining operations, other NFT projects, and may even fund larger projects such as video games.
Other thoughts:
Active gameplay may provide longevity for projects that passive gameplay might find harder to guarantee.
Section 3: Investment Strategy: Hedging Against Crypto Volatility Using Liquidity Mining and NFTs
Cryptocurrency has proven to be one of the most reliable investments of the last decade, having massively outperformed gold and the S&P 500. Its volatility, however, can easily disrupt otherwise well planned exit strategies, greatly increases cryptocurrencies’ risk as a short-term investment, and can generally cause consternation among investors. To mitigate these issues a more sophisticated set of strategies must be employed.
Mixed Investment Strategies (Liquidity Pools + Cryptocurrency)
In stable bear market periods contributing to liquidity pools can be extremely useful for maintaining portfolio value. LP also helps hedge against volatility because it can generate significant interest (APRs between 30% and 150%) to compensates for crypto’s decreased value. Market crashes often drive up APRs on Dexs providing much need relief to the overall portfolio’s value during bear markets.
NFTs as Cryptocurrency Hedges
Diversifying the standard “hodl” strategy is key to preventing volatility from denying profits. NFTs can help hedge against the volatility of cryptocurrencies because, a) they store the value of cryptocurrency, and b) they can increase in value for reasons external to the overall market. During an extreme bear market (such as the 50% decrease in value of ETH from Nov. 11 2021 to March 5, 2020) well researched portfolios of NFTs successfully maintained overall portfolio value, and some increased massively.
NFT + LP = Epic Combo
Certain NFTs generate tokens which themselves are placed on Dexs and are publicly exchanged. This excellent strategy, when available, can provide multiple revenue streams when conditions are right. In this case cryptocurrency is invested into NFTs which regularly produce their own proprietary cryptocurrency. This cryptocurrency is typically intended to be used for some functionality of the NFT project which gives it intrinsic value, or utility. Using Uniswap, an investor with sufficient holdings of the proprietary cryptocurrency produce from the NFT can set up their own liquidity pools and collect fees for facilitating exchanges. Typically several investors come together to do this, which helps mitigate the risks of Impermanent Loss. The combo is considered “epic” because three strategies are employed at once: NFT value investment, NFT crypto token production, and subsequently liquidity pool mining. Taken together this greatly diversifies decentralized finance portfolio beyond simply buying cryptocurrency and “hodl”ing it.
Until Next Time
This article was designed to introduce cryptocurrency and NFT newbies to many of the concepts that are now commonplace in the Web3 world, as well as suggest some intermediate strategies for how NFTs and cryptocurrency can be combined to help prevent excessive exposure to cryptocurrency volatility. It is far from comprehensive or complete and I will continue to update it as I learn more. In the future I will produce case studies in specific NFT projects I have joined and provide deeper examples of the strategies mentioned above.
Once again, please be careful out there, many scam artists and rug pullers are feasting upon the thousands of innocent souls currently wandering into chat rooms and project hubs. The easiest way to stay safe is by never sharing any of your information with anyone you don’t know personally, never engaging in private trades (always use Opensea), and generally ignoring any unsolicited messages in your DMs or feeds no matter how appealing the offer might seem. Lastly, its wroth saying again, always do your own research. Thank you for reading and I hope that you find it useful!