To our Valued Investors:
Last week, an intriguing bit of news related to US-based cryptocurrency exchange Kraken was released. The timing was not optimal; two days after Christmas is a time that many are still in decompression mode, or indulging in a quick getaway, or simply not prepared to get back to business. At Iron Edge VC, though, our substantial investment in San Francisco’s Payward, Inc., which owns and operates Kraken, demanded that we pay close attention to the meaningful headlines. They told us that Kraken’s new NFT marketplace is expected to offer loans, using the tokens on the platform as collateral.
An effective explanation of what we consider to be a very exciting development requires a couple of steps backwards. In order to understand the collateralization, one must know how non-fungible tokens (NFTs) work. Before that, though, the concept of provenance must be explained.
Although the term is increasingly associated with developing blockchain projects, “provenance” has been a part of the English language for about 250 years. Oxford defines it as “the place of origin or earliest known history of something”, “the beginning of something's existence”, and, most relevant to our purposes, “a record of ownership of a work of art or an antique, used as a guide to authenticity or quality”. For the moment, let’s keep the discussion grounded in the easily comprehended realm of art dealing --- the actual buying and selling of physical works like paintings or sculptures. This form of trading often involves great sums of money, so insidious temptations can naturally subject it to the threat of forgery and other fraudulent activity. What the buyer believes to be an authentic piece created by a renowned artist could actually be a well-crafted replica. To secure protection from this kind of rip-off, an art investor would typically have to consult an expert for verification. This step is often expensive and time-consuming, and it doesn’t yield a bulletproof guarantee of legitimacy. Provenance, as defined as a historical record of ownership, would effectively trace the work back to its genesis, specifically, to the moment an artist applied paint to a canvas. In the pre-NFT era, meaning any time more than eight years ago, the best way to establish such provenance would have been with some sort of deed or certificate that would accompany the artwork. Of course, such a document could just as easily be faked!
Enter the magic of the NFT. The term “non-fungible” is a slightly fancier way to say that something is unique. A non-fungible item has no equivalent, so it cannot be exchanged for something of equal value. NFT assets are rendered non-fungible by their one-of-a-kind properties. Because only one original exists, as is the case with a piece of music or a work of art, its appraisal is by nature unscientific. It cannot be exchanged for something exactly like it. A comparative look at fungible items might add further clarity. A one-hundred-dollar bill can be fairly exchanged for five twenties. One euro could be swapped at today’s exchange rate for 84.13 rupees without sacrificing parity. A Bitcoin can be exchanged for another Bitcoin.
Once a non-replicable item, or an NFT, is created on the Ethereum blockchain, it has its staring point. Every change in ownership that follows that moment ad infinitum is recorded on the permanent, immutable, and publicly visible distributed ledger. How, you may ask, can this demonstrate the provenance of a painting hanging on one’s wall? The answer is quite simple, really. People have been bridging this divide between the digital and physical worlds by affixing tamper-proof microchips upon some pieces of physical artwork. Any attempt to remove or alter the chip will send an alert to the owner. Embedded in the chip is a private “key” for the owner’s use, and the public key is stored on the blockchain where everyone can see it for verification purposes. The actual chip is registered to the blockchain, allowing not only for an authentic record of ownership but also for a nearly limitless range of other details, such as where the painting has been displayed over the course of its existence or perhaps a biographical profile of the artist. For a digital asset such as a computer-generated illustration or a song recording, the provenance of an NFT is even more direct. The historical data and the art are embedded together on the blockchain, making them even more intertwined than a microchip affixed to a painting. An NFT is technically what is called an ERC-721 token on the Ethereum blockchain. While anybody can upload a digital image that belongs to somebody else and then post it on social media, the ERC-721 token is like a sealed envelope that contains the image, with ownership data and other information written on the face of the envelope.
The NFT concept, tracing its origins only as far back as 2014 or so, is quite young. Many associate NFTs with the stories of people paying hundreds of thousands of dollars for a low-res digital cartoon of a bandana-wearing ape smoking a cigarette, or when, last March, a crypto investor named Vignesh Sundaresan went to Christie’s Auction House and paid $69 million for an NFT of a digital collage of the images created by an artist named Beeple. Such occurrences raise eyebrows and generate skepticism over NFTs’ legitimacy. Is Mr. Sundaresan a fintech visionary, a raving lunatic, or a little of both? That question can be pondered and debated all day long, but one truth about NFTs seems to be emerging with increasingly broad acceptance. The practice of establishing provenance and protecting intellectual property with NFTs is here to stay. What’s more, NFTs will provide a more reliable and efficient means for artists of all kinds to rightfully profit from their labors. One unmistakable indication that an idea has crossed the threshold from a trendy millennial trading fad to a no-nonsense form of legitimate financial activity is when it is embraced by an established --- and regulated --- entity. That happened, and not for the first time, for NFTs last month when Payward announced that Kraken would soon develop an NFT trading platform. In the statement, Kraken CEO Jesse Powell cited the desire to give Kraken clients “exposure to the burgeoning NFT market", and he stated a belief that the NFT sector is going to continue to grow throughout 2022, with innovations in virtual land, digital clothing, and membership in virtual clubs. Crypto exchanges Coinbase, FTX, and Binance are also getting into the act, as they all are in different stages of launching their own NFT platforms.
With this little primer, let’s circle back to the headlines we talked about at the beginning of the story, and see if you now find them as intriguing as we do. Kraken’s new NFT marketplace is expected to offer loans, using the tokens on the platform as collateral. Bolstered by his anticipation of an NFT explosion this year, Mr. Powell wants to permit Kraken users to deposit an NFT (like a song, a meme, or even a tweet passed down by a well-known celebrity) into the platform and borrow funds against whatever value the platform reflects for the NFT. He calls this novel use of NFTs "phase three" of a growing ecosystem for digital art and collectibles, after the first phase of speculation and the second phase of directly supporting creators by buying their NFTs.
As difficult as it may be to fully grasp the mechanism of purchasing a digital item with cryptocurrency and then using that intangible as collateral for a loan, it is not as far-fetched as it may sound upon initial consideration. NFT-backed loans are becoming increasingly commonplace as more decentralized finance (DeFi) platforms are entering the game. Nexo is doing it, and Arcade recently closed a $15-million funding round to grow its offerings and attract more investors to its collateralized NFT platform. Simply put, this new way of securing loans is clearly displaying how DeFi is evolving at a breakneck pace. It is one of the many ways that the digital universe is just beginning to comprehensively disrupt finance as we know it.
A forward-looking and potentially lucrative innovation like the collateralization of NFTs might prompt shrewd investors to consider scooping up a few Kraken shares with their Charles Schwab or E*TRADE accounts, but that simply cannot be done at the moment. Kraken is a private company, and as such its equity cannot be bought on any public stock exchange. Iron Edge VC can, nonetheless, provide you with access to our Fund that has ownership interests in this company that stands to benefit nicely from the currently unfolding crypto resurgence with these unique tokens taking center stage. If you would like to learn more, or if you know anybody else who would, please don’t hesitate to contact us by clicking “Get in Touch” below.
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All the Best,
Founder & Managing Partner