What NFT mania can tell us about market bubbles

Remember NFTs? They were like Pet Rocks, but instead of a rock it was fraud. Now they’re dead, mostly, and what’s left is data.

It’s data that could prove quite useful, in a way that proprietary digital receipts for JPGs from monkeys never were, because it promises a 360-degree view of speculation in its purest form.

As well as being absent of any fundamental value, NFTs were virtually impossible to short or hedge, so they appealed almost exclusively to retail punters. Add in public blockchains that give every trade origin and traceability, and we have what is probably the first diagrammatic description of how the actions of individuals create a frenzy of crowds.

That’s the premise of a paper by Swiss Finance Institute professors Andrea Barbon and Angelo Ranaldo, who trawled more than 15 million NFT transactions in search of what creates bubbles. Their conclusions—that in markets full of pump-and-dumps, the same few traders can turn out to be bandits—may not be entirely surprising, but it’s good to look at the evidence.

From more than $18 billion of NFT trades between January 2021 and September 2022, Barbon and Ranaldo identify around 1,000 events where the average sale price of an NFT collection at least doubled within 24 hours. A little more than half the time, a pop was immediately followed by a drop.

High volatility on low turnover is a clear warning that a crash is coming, regardless of what happens in the broader market. Barbon and Ranaldo also find that price jumps involving fewer participants are less durable, perhaps because they attract a higher concentration of optimistic and overconfident investors.

Since the same dynamics are also factors in trading bubbles, the authors argue that “the NFT market is not inherently more irrational than traditional financial markets”. Right.

Where the article builds most on existing research is the study of whales versus fish. Wallet analysis identifies the NFT traders who were consistently the best at timing the market without getting drawn into instant hype. They were the ones who traded in relatively greater volume across multiple exchanges, held their positions longer and were more likely to use leverage.

The implication, that sophisticated retail investors are more talented at making money than speculators, may seem obvious to anyone but a student of price discovery. Nevertheless, the conclusion that it is safest to follow whales will probably sound like nonsense to anyone who has been paying attention in recent years.

Fraud, of course, is the giant pixelated elephant in this paper. Barbon and Ranaldo do not venture into causation, only passingly referring to the likelihood of the sophisticated cohort hiding their intentions by running multiple wallets and avoiding crashes by causing them.

A section on laundering notes its detrimental effect on market quality, but also finds that whales do not fare worse even after these fraudulent trades are excluded. The chart below shows an NFT portfolio picked for investor sophistication and ownership diversity (“agent-based variables”) outperforms one picked on the traditional bubble signals of high volatility on low volume (“aggregate variables”).

The conclusions are twofold: market quality measures can “significantly predict bubbles and price crashes”; and “sophisticated investors” use “superior information and skill” to avoid the harm.

However, how much these findings are shaped by the unique pointlessness and lawlessness of NFTs is impossible to guess. Was not it everyone NFT markets a bubble, with duration the only variable? Is there really much to be learned when the findings are applied to established, regulated markets for assets that have a real utility beyond money laundering?

The full paper is here; Our comment box is below.

And in case you were wondering: yes, there are Pet Rock NFTs. Their peak was in August 2021, when one sold for $1.3 million and another was bought by crypto shillmaster Justin Sun for $500k. A fraction of an original EtherRock can be bought today for $0.00002667, after losing 99 percent of its value in a year. This is apparently what counts as “not inherently more irrational than traditional financial markets.”