Today’s piece explores how royalties in the NFT markets trend to the lowest possible amount. We have seen Asset.money build a portfolio management app over the months in our community and had the pleasure of collaborating with them for this piece. NFT markets in their current form are a lot like the internet before Google. You invest, track and hold portfolios on a mix of apps. If you hold these primitives on multiple chains, you must also maintain wallets on each chain. Asset.money brings it all under a single roof, so you can worry less about losing your assets to hacks and rug pulls. Take it for a spin here.
Whenever I reflect on our economy and society, I often realize how similar it is to a large biosystem with small interdependent actors: Workers, small and medium enterprises, banks, customers, and regulators are all individual components of this global organism. When a business (or employee) no longer serves the purpose of the overall system, it is made redundant – either through competition, under-resourcing, or self-interest. For instance, a rational actor who believes their venture or effort is bound to fail would shut it down. This is the definition of self-interest.
Of course, my idea that markets and evolution have much in common is nothing new. Before Adam Smith’s writings on the economy inspired me, they motivated Darwin to become a naturalist and redefine modern biology. I would have loved to nerd out with them about the similarities of how markets and ecological systems evolve! But our time machine remains broken, so that is not what we will do today.
Instead, today’s piece is co-authored with Siddharth, who has been nerding out about the future of NFT markets – specifically about an ongoing battle to determine how royalties will be structured for creators in the months to come. But before we do that, let’s start by going back a few years.
Gem of a Memory
The year is 2019. We are in the middle of a cold winter. The bear markets made the masses abandon almost all crypto. Not even the nice girl you matched with on Bumble cares about your Bitcoin anymore. DeFi is this weird thing finance nerds did once in an obscure corner of the world wide web. People are excited about getting magical internet money loans for their useless digital tokens. So-called Simple Agreements for Future Tokens (SAFTs) is the most common form of NFTs; these are investment contracts venture capitalists (VCs) invested in with hopes of getting more tokens down the line.
But most founders keep pushing off their token launches, and VCs pretend they want to continue building with the founders while trying to find an OTC buyer for the token agreement. The only meaningful NFT collection people know is a collection of cats that repeatedly clogs the Ethereum network. How fun. The consultants that came in hordes with enterprise and government use cases faded away. People no longer think putting land records on a blockchain is a good idea. And decentralised Uber is nowhere to be seen
Cryptokitties were one of the earliest NFT primitives that captured public pysche. Source : Quartz
If you were an NFT marketplace in 2019, you had a real problem. You see, tokens had product market fit thanks to the initial coin offering (ICO) boom of 2017. At that time, users had become used to transferring, trading, and losing their crypto in hacks. But NFTs? Only an isolated group of Silicon Valley bros were talking about them. Even hardcore crypto folks barely bothered with this non-fungible nonsense.
In the physical world, an artist sold a piece of work and made money from it only once. So their earnings were linear, and the artist had to keep producing art to make a living. NFTs allowed art to evolve into financial assets that accrued value for the creator whenever a person traded their art.
How does that work? This is the magical concept of royalties. Let me explain with an example for those that don’t follow the NFT markets closely. Assume you purchase an image of a pizza from a guy for $100. The artist makes $100 once. By some draw of luck, a hedge fund manager visits your office tomorrow and decides the beautifully painted pizza is worth $1000. You sell it to the manager for a profit of $900. The artist makes nothing.
If tomorrow, a friend of the hedge fund manager (who happens to make a killing speculating on crypto) notices the work, feels it is now worth $1 million and buys it, the artist gets nothing. Neither do you. Well, you probably get tons of remorse for undervaluing your past asset. But you can’t pay the bills with remorse.
Royalties allow a portion of every trade on a piece of work to be transferred back to the artist. This is usually anywhere between 3% to 5%. If tens of thousands of NFTs are released in a new collection, the royalty sum is large enough to support entire teams. There will be hundreds of trades daily thanks to constant speculation on where the price will go. We already see this type of trading behaviour in stock markets. The pizza artist above would have made $50,000 on that million-dollar trade… if he had made it an NFT that pays out creator royalties.
Before you think, “Oh, this sounds like a classic pyramid scheme,” explain why it is not. Only the artist earns royalties. The traders in the middle don’t earn anything other than the difference in the asset’s price. This makes me think it’s a good example of the greater fool theory, but I digress.
Over the last few years, this incentive has driven a huge part of the NFT market. We are talking hundreds of millions of dollars in revenue. Yuga Labs (the creators of Bored Ape Yacht Club) alone made $107 million in revenue last year.
Consider the image below to see an example of a transfer:
Image sourced from Etherscan
Notice the breakdown of fees above? OpenSea made ~2 ETH, and Yuga Labs made ~2 ETH by selling a Bored Ape NFT for ~80 ETH. Not even a monkey would find that level of recurring revenue boring! The buyer who spent $140,000 for the JPEG of a monkey is (possibly) not buying it for the art alone. There is likely a motive for profit or a desire to speculate on the underlying value. So they are spending money today to sell and turn a profit tomorrow. Everybody’s happy as they all stand to benefit beneficially. Until the market decides to evolve.
OpenSea’s genius drove the idea that NFTs can enforce royalties and empower creators. Everybody loves empowerment. It is not rational behaviour to argue against someone making a livelihood where there existed none. But here’s the problem. NFTs cannot pass on royalties to the end user on their own.
Usually, smart contracts set up by a marketplace like OpenSea pass on the royalty. Why? Because it is impossible to discern a simple transfer from a trade. If 5% were charged on every transfer, users would be dissuaded from simply moving their precious NFTs to a cold storage wallet. So the royalties are generally collected by the marketplace enabling the trade.
But what do you do if a marketplace does not want to enforce royalties to make trading cheaper for users? That is the crux of the problem plaguing the world of NFTs today.
Blurry in the Open Sea
2022 was the year of mutations for the NFT market. Sufficient liquidity and fees incentivised markets to experiment with alternative models. It all started in January when LooksRare released its token. The value proposition was simple. Users would receive tokens in exchange for trading on the platform.
Instead of burning money to build a brand, run ads, and educate users, users could dedicate tokens to govern the platform and receive fees as token holders. There was also a liquid market for the token. At the time, I wrote about the game theory of the platform on Tokenised Marketplaces.
“Each of these traders is required to pay 2% to the platform and anywhere between 5% to 10% in royalty to the artist. Effectively, wash traders are doing on the platform to acquire assets at a discount to the spot market.
If the platform fee + royalty paid is higher than the price of the tokens rewarded, users will have no incentive to continue trading on the platform.
You may think that is dumb, but LooksRare has done ~$11 billion in volume and $220 million in revenue with a fraction of the users OpenSea currently has.”
At the time, LooksRare captured mindshare because it had a liquid token and OpenSea did not. LooksRare, even had an inferior product at the time. You could barely sort NFTs by price on LooksRare when they launched. Over the year – thanks to the bear market and declining token rewards – the product struggled to build a moat against OpenSea truly.
Management at OpenSea likely realised the threat new-age platforms posed to the firm’s monopoly, and it acquired Gem a few months later. At the time of acquisition, Gem was one of the fastest-growing aggregators in the market.
The market had experimented with tokens at this point. It had become common knowledge that incentivising users with tokens to trade on your platform could help improve metrics. But there was one more lever to tinker with: creator fees. Over the year, multiple exchanges began chipping away at creator fees.
DeFi markets provided primitives for the same. SudoSwap, for instance, made it possible to set up pools for NFTs the way it’s done in Uniswap. Users could buy into or sell large numbers of a particular NFT by trading against a pool. The platform fees were reduced to 0.5% to be competitive against major players like OpenSea.
Let’s say you are a trader looking to buy a Bored Ape NFT like the one we discussed in the transfer above. If you can eradicate the 2 ETH paid to the creator and reduce the 2 ETH paid to the platform, traders will be incentivised to move towards you.
And that is exactly what happened.
An NFT could cost 5% less in certain marketplaces outside of OpenSea. This was a massive cost reduction. All of a sudden, the historic royalty model involving empowering artists collapsed. The dream was broken. And so was the narrative.
The big daddy of the NFT world was fine despite this. Nobody saw the threat from a few hundred traders and their volume, much of which comprised wash trades. Financial incentives powered most of the churn that OpenSea saw. The assumption might have been that as incentives decline, the activity on emerging competitors like X2Y2 will diminish. But beyond a broken dream, the industry was about to wake up to a nightmare in October 2022. A new player with a far superior product oriented towards traders was ready to market. The name? Blur.
Several things set Blur apart:
- First and foremost, they teased users with potential airdrops for adding liquidity on both the bid and ask sides, as close to where the settlement price generally is for NFTs and ETH. This allowed traders to enter and leave the system in droves.
- Secondly, instead of focusing on retail traders, they pursued high-volume NFT traders. Their product has several complex trading options that traditional platforms do not offer. This was like moving from a spot market for altcoins to a full suite of trading products that satisfies all your professional trading needs.
- And finally, much like Gem at its launch, Blur integrated a series of charting and data functions into its core product. Suddenly, traders had access to information on historical pricing, depth of the books, rarity, and general volume trends via the same platform they were trading on.
You may think these things don’t matter much. But between teasing a token and rolling out a superior product, Blur took ~40% of the weekly NFTs traded on Ethereum. As of February 2023, Blur did ~77% of the volume vs OpenSea’s 16% in the same period.
Please note that Blur also released a token, so these data must be taken with a giant grain of salt. Even the token launch had a few innovative elements. The abstracted away the tokens and gave users “boxes”. These boxes could hypothetically yield tokens at some point in the future. So nobody knew how many tokens they’d stand to get between October and February. And this drove user behavior.
Data from the legendary wizard and overall big brain @hildobby on Dune.xyz
And still, there are two things Blur managed to do in a single quarter. Firstly, it began making the idea that royalties are a necessity vanish into thin air for a brief while. Traders increasingly became comfortable with not paying creator royalties on marketplace trades. When the intent is speculation, paying a creator tax on every trade does simply not make sense. Secondly, Blur eradicated its royalty. Until December 2022, there were no royalties on Blur at all. Since then, they have transitioned to a 0.5% royalty model.
To understand the long-term effects of the launch of Blur, we need to look at what happened to royalties. A user named Beetle released a Dune Dashboard that looks at an effective royalty rate. Beetle defines ERR as the “total royalties earned across all marketplaces, divided by the total volume across all marketplaces.” Since marketplaces like Blur initially launched with no royalties, an increasing volume and declining royalty would lower the figure trends. And that is exactly what happened.
The data below looks at the royalty being paid on Bored Apes over some time in the year. It started at under 5% in August because a few marketplaces already offered royalty-free trading. But the trend took off in October. When Blur went live.
Data from 1kBeetleJuice. Follow him on Twitter here.
It is not just the royalty rate that went for a toss. Across marketplaces, the number of trades now creating royalty began trending lower for Bored Apes, as the data below shows.
Filters at the Sea Port
If you are a player in the NFT ecosystem, you are now caught amid a major storm. Suddenly, a new player has swept the market, stolen your users and trading volume, and disrupted your business model. For a brief moment, multiple NFT marketplaces took the noble stance of protecting creator income. OpenSea released an operator filter registry. Members were added to the registry if a platform (like Blur) allowed users to bypass creator earnings when the same item would incur creator royalties on OpenSea.
As the months passed, it became evident that the market shifted its view on paying royalties. OpenSea, now home to only a fraction of the volume it once commanded, was forced to remove royalties three days back.
We may need to hire someone to make better memes.
If you think OpenSea was a sitting duck through the whole fiasco, it was not. The platform launched an entire protocol and acquired an aggregator over the year to stay relevant. Seaport, launched by OpenSea in May 2022, was an entire marketplace contract, much like 0x in DeFi. Think of it as a communications protocol that sources liquidity and routes orders across marketplaces. The Web2 equivalent would be APIs listing the same item on eBay, Amazon, and various regional e-commerce platforms.
Why would a marketplace like OpenSea bother with releasing a protocol? They aimed to add new avenues for more people to be onboarded to NFTs. If the entire market expands and OpenSea continues to be the largest marketplace, they will see more users.
But in a way, this has come back to bite OpenSea. Earlier, creators could simply blacklist Blur and call it a day. Now, whenever a collection blocks Blur, they source the liquidity for the asset through OpenSea’s protocol. And there’s practically no way to block Blur from going to a protocol and sourcing liquidity for the asset. A user named PandaJackson explains how this worked quite eloquently in a twitter thread.
PandaJackson has some great tweets - make sure to follow him here.
Blur did over 4000 transactions for Sewer Passes and circumvented paying OpenSea some $220k in fees. That is a 40% loss in fees. This made a joke of the Blocklist registry as Blur used Seaport to get around the blockade. Even if OpenSea finds a way to block Blur from querying for liquidity from Seaport, it would be antithetical to why they introduced Seaport in the first place.(Also, Opensea can’t make changes to Seaport on a whim).
You may think this is not a big deal, but considering how order fills and sources have evolved in the last few months, the challenge comes to light.
Sourced via a fork of SeaLaunch’s dashboard. Link
Sourced via a fork of SeaLaunch’s Dashboard. Link
The first chart shows the volume percentage by order source, i.e., the marketplace where an order originated. As you can see, when Blur went live to the public in October 2022, they commanded close to 60% of the order source. As of February 2023, it is down to ~21%. This means an ever-increasing number of users have placed orders via Blur’s marketplace. This, on its own, is not a big threat. You could place orders from any aggregator, and the liquidity could be sourced elsewhere.
In fact, in the lens of a B2C investor, Blur may pose no real threat to OpenSea. As you can see in the second chart, the bulk of the percentage of unique users is still on OpenSea. A new entrant like Blur cannot replicate their brand equity overnight. The issue is that Blur has gone from a place that originates orders to a place where users can find liquidity in a single quarter.
For the data below, Blur is represented in Orange and was doing 83% of the volume for fill-source for 19th Feb. By 20th Feb - it declined to 26%. A massive drop because the initial token airdrops for Blur had just wrapped up.
The next chart above breaks that fact down quite elegantly. Here, fill source refers to the marketplace where the order was fulfilled. If you are an up-and-coming aggregator that is up and coming, you may be a source for orders, but the fill could happen via a third party. When you can complete the bulk of order matching on your platform, you emerge as a stand-alone marketplace. As of February 2023, only about 16% of the orders on Blur are filled using liquidity on OpenSea.
Blur’s transition from aggregator to platform is at the core of what threatens OpenSea’s future. Losing volume in large tranches to third-party platforms leaves little incentive for marketplaces to maintain high fees. OpenSea moved from releasing a registry to blacklist marketplaces that don’t enforce creator royalties to having any fees.
This evolution of the market – from an ecosystem that believed creator royalties are a sacred right and deserve to be protected and enforced across markets to a place motivated by finding unique ways to avoid paying creators – is a real-time representation of how markets evolve. It is also fascinating to realise that within just six months, one single startup convinced the global NFT market that doing away with royalties is rational. Even if it is for a brief period.
Royalties Look Rare
A year back, when we first wrote about LooksRare, the assumption was that releasing a token could upend the NFT markets altogether. The playbook seemed simple. You strip away the take rate (fees) and introduce a token. Teams profit from the token they release instead of any revenue they generate. I was wrong about it because, over the year, the platform trended to as low as ~200 DAUs.
Blur posed a much more significant threat because, compared to the ~11% of volume, LooksRare was grabbing at the time, Blur captured over 70%. The fact that OpenSea had to go from playing with a registry to block marketplaces that don’t offer fees to reducing fees to a bare minimum themselves shows the threat Blur poses in the market. So there is some weight and credence to their effort. But will their volume and users stick once the market moves on? It is hard to say.
There are bets on both sides of the matter. One would argue that Blur has a much better product for traders and that the volume would stick with them. A superior product and users “owning” the product through the token will empower them to grow substantially. The other argument is that perhaps this is a temporary blip, and we will be back to OpenSea reigning within a few months. There are a few reasons this could happen.
First and foremost, they have already reduced fees to a bare minimum. So for users that moved elsewhere, if the unit economics were the problem, they can return to OpenSea now. Secondly, with the fee trending to a bare minimum, it is possible that an IPO no longer happens. Especially in the battered tech stock markets we are now. In such a situation, a token is a possibility.
OpenSea does not need to rush into tokenising itself. The angle could be through tokenising assets the firm holds. For example, gem was an aggregator it acquired a year back. Introducing a token to them may be the first line of assault.
And if that doesn’t suffice, they could go ahead and tokenise Seaport - the protocol they had launched a year back. Tokenising the protocol and incentivising individual, smaller marketplaces could be a net positive for OpenSea. They could enforce royalties at the protocol level and blacklist bad actors so long as Seaport becomes the standard for trading NFTs.
Much like Ronin today, any protocol released by OpenSea could have a consortium of gaming studios, large NFT issuers and traditional retailers that determine how the shared standard will evolve.
The standoff in the market is a function of two behemoths that have raised enough in venture capital to survive with no revenue for a few years if needed. It affects creators and smaller products that believed the royalty model would continue. Remember how I mentioned NFT royalties could enable user-generated game content markets?
It entirely collapses in the absence of NFTs. Games would be incentivised to run their closed-ended markets to avoid scrutiny from regulators or dealing with app store policies around digital assets.
This also ignores the point that a large portion of what makes NFTs relevant is intellectual property. Yuga Labs or Nike is incentivised to work continually on their NFTs because they see revenue from the royalties. For scale, both firms have made over $100 million each from royalties alone from their NFTs over the last year. Without the model, the incentives to continue working on these primitives vanish—our rush to declare royalties a flawed model may set us back by a few years.
Artists may respond by launching their marketplaces. There are great tools to build one’s storefront and issue a royalty mandate on top of it. In that process, the inevitable return to the challenges artists historically had would happen. Gatekeepers and intermediaries take a portion of their incomes. Perhaps, at the crux of all of this is the industry’s inability to understand two things.
- Trading makes up a large portion of the digital asset ecosystem today. The bulk of the money invested and revenue generated comes from financial applications. These applications will continue to trend towards the lowest fees to capture users and volumes.
- Not all assets are to be traded heavily. At least not as non-fungible instruments. There is very little reason to be trading copyrights of Jay Z’s album from 2000 - multiple times in a given day. If the frequency in which an asset is changing hands is low, then the royalty being high makes sense.
We will have entirely distinct user bases. And each will need a different royalty model depending on the asset being traded. One way to resolve the standoff would be for creators to be empowered enough to get their royalties at the protocol level. The market can then determine if it wants to trade it excessively or not. Ironically, inspite of the years of innovation in NFTs, little work has gone towards that effort. Canto’s contract-secured revenue allows developers to get a portion of the fee generated by users of a certain DApp. Perhaps, there is a way to tweak it for NFTs.
Back when Jay-Z realised royalties were one of his 99 problems.
The irony of the situation is that this is nothing new. In 2015, Jay Z launched Tidal as a response to music artists making very little from the shift to streaming. Priced at 25 euros, the app failed to scale despite practically every major artist in the US backing it. At one point, the only way to hear specific old Jay-Z albums was to pay for Tidal. And how did that go? Well, the app was ranked over #700 a month from launch. A few year’s later, Jack Dorsey from Square acquired it for $300 million.
Our point is, as an artist, you want to optimise for income. But you do not want to do it at the cost of distribution. Even today, artists often optimise for YouTube streaming their work because it counts toward their ranking on the billboard. The moment a platform has substantial attention, it reigns over creators. And there are very little creators can do at that point. If you are optimising for distribution, you make it as easy for your users to discover you. Sometimes, it could be listing on OpenSea. Sometimes, it could be not putting this article behind a paywall.
(We have no plans of a paywall anytime soon - but shout out and much love to that guy who pledged $200 to this publication over the weekend. You made our day.)
As I write these words, Blur trades at a valuation of $3.2 billion. Higher than certain protocols. It made us wonder if we are transitioning from the age of fat protocols to value accrual in applications. Teams like the one behind Blur have proven that stand-alone applications can often generate more volume and service more users than entire protocols. There is an emergent playbook here. Launch a marketplace with little or no fees—Incentivise volume through tokens. Pass on ownership to the users via tokens in exchange for their activity on the platform.
In essence, build something people want as opposed to building something people may build on. We have finally reached a stage where product based moats focusing on power users can be a thing.
The authors of this piece do not believe a zero-royalty market is the one that will eventually prevail. As I said at the beginning of this piece, evolution is the market norm. And much like we see in nature - applications will mutate to compete and acquire niche users. A quarter on, it is possible that the hype around Blur will settle down, and we will return to normal. It is also possible that creators stop issuing NFTs entirely, and we sit around with just monkey pictures to show - for all the innovation and development the sector has done over the last three years.
We don't know what will happen. But if we take the wise words of a modern-day rocketship connoisseur & dogecoin maximalist - it is likely that the most entertaining outcome is the most likely one.
We will see you next with some work we have been doing on AI and blockchains.
Joel & Siddharth
Beta Testing Szn
- I dropped two articles as NFTs as an experiment on Mirror a few months back. If you are one of the 50 wallets that acquired the NFTs - you now have access to Gem’s V2, Jumper Exchange and Bungee. I may or may not make NFTs out of future articles.
- Users that had shared their wallet addresses on our Telegram recently were given access to Socket’s Bungee exchange beta.
- We have now taken a referral page live. We are giving away premium subscriptions to substacks of publications we admire and enjoy reading. You can be a part of it here.
We will drop beta access for more in the coming weeks. Join us on Telegram to stay updated on these.