Bringing Physical Assets to Life
What can the tokenization of physical assets unlock? What are the considerations, and who are the upstarts forging this new paradigm?
I often hear two criticisms when it comes to NFTs and their perceived lack of value:
There is a glut of NFTs; the majority will be worthless.
There is no tangible value.
I can’t wholly refute either claim. With regard to the former, there are relatively low barriers to entry for creation, which in turn has led to a Cambrian explosion of NFT projects. Some projects have gone to zero, and many more will. As with art expressed via other/more traditional mediums, the creator in this new paradigm is still a major determinant of the NFT’s value. An NFT project helmed by Banksy would surely be worth more than one that I created, even though we used the same technological format.
The glut of worthless NFT projects shouldn’t be conflated with the overall usefulness (or lack thereof) of the underlying technology. An NFT is merely a programmable digital canvas, superior to prior digital art forms in its ability to house metadata, track provenance, and execute economic actions in perpetuity; the glut of worthless NFT projects doesn’t negate that.
There are examples abound of projects that have bundled physical products with NFTs. But, at its core, the NFT is underpinning a new digital, rather than tangible, economy. This has understandably led some artists to de-prioritize NFTs from their product stack - Kanye West being the most prominent example:
But what about NFTs being used to complement or bolster our experiences with real world physical products? Perhaps the tokenization of authentic Yeezys could have mitigated the rampant counterfeiting that plagued the secondary market upon their 2016 release. Or maybe tokenization could have all together unlocked the secondary market for Kanye and Adidas - a meaningful revenue opportunity as Yeezys were routinely being flipped for 500%+ above their primary sale price…of which Kanye and Adidas received nothing.
I’ve become increasingly interested in a new breed of companies/projects that are bridging physical commerce with NFTs to enhance the purchase, ownership, and exchange experiences. I would argue that these companies are proving out the technological utility of NFTs and decoupling the standard from the speculative asset class. I would bifurcate the space into two overly-simplified buckets, although there are some companies that take a hybrid approach:
Representation: These are marketplaces, projects, or protocols that use NFTs to digitally represent ownership of the physical products. Tokens are minted to represent either fractional or whole ownership stakes in the product (multi-token vs. single token structures). Buyers can purchase and trade the token without actual possession of the product, which is oftentimes managed or “vaulted” by the marketplace or project. In most instances, the associated NFTs are burned (destroyed) upon redemption of the physical product. In other cases, the token’s smart contract contains a non-transfer function to limit token trading while the product is in the hands of the owner. In most cases, there is no alteration of the physical product with a smart chip to execute.
Integration (hybrid): This approach involves the actual integration of a smart chip - either RFID or NFC - into the product. RFID chips are one-way communication systems with long range scan capabilities, and used primarily to improve inventory management processes like tagging and authentication. NFC chips are two-way communication systems with a shorter scan range, and can enable things like P2P exchanges and card emulation. Both chips shift products from being static to dynamic, and enhance the bond between brand, buyer, and asset. In some cases, vaulting infrastructure is also used. Some companies in this category - specifically One of None and Americana Technologies - have also layered community-building efforts on top of their product offerings through NFT drops of their own. These NFTs provide collectors with different perks like priority access to drops, IRL events, and proximity to creators.
Representation - Multi-Token Structures (i.e., Fractionalization)
You don’t need to tokenize an asset in order to fractionalize it; there are a collection of upstart marketplaces - Masterworks, Rally, and Otis, to name a few - that have proven that in recent years. These marketplaces are unlocking previously inaccessible asset classes for new swaths of everyday investors. Contemporary art investing - a $1.7tn asset class that has demonstrated strong and largely uncorrelated returns - through Masterworks is a prime example. The marketplace has enabled investment access to more than 100 premium art pieces (typically $1M+ price) and, in doing so, democratized an asset class that was once reserved for the wealthy. The offerings on Masterworks, along with those on Rally and Otis, which focus more on alternative assets (sports cards, sneakers, NFTs, collectibles, etc.), are all securitized through the SEC and, as of now, not tokenized.
In contrast, Dibbs, a pioneering new 24/7 spot marketplace to buy fractional shares in collectible cards, is tokenizing its assets via the Worldwide Asset eExchange (WAX blockchain). Each physical card is issued a single non-fungible “Item Token.” This NFT is then divided through “semi-fungible tokens” as fractional purchases are made. Collectors can purchase the Item Token outright and exchange it for the asset, which is housed securely in Dibbs’ vault until redemption. The tokenization benefits in this instance manifest in a few ways. First, trading of the fractional shares is instantaneous, whereas secondary market trading on Rally is routed through a third party called Dalmore Group LLC. Not to mention, similar to the traditional equity markets, Rally operates under weekly market hours (M-F, 10:30am-3:30pm EST) which limits execution windows. Second, tokenization enhances asset provenance by providing an immutable and auditable ownership record for each asset through an impartial, decentralized party: WAX. Third, Dibbs assets are fully interoperable and tradable with others in the growing WAX network, which supports assets from the likes of Topps, NASCAR, Hot Wheels, Power Rangers and others. Tokenization is thus a physical asset’s access key to a burgeoning and diverse digital (the Metaverse isn’t here yet, folks) economy.
Benefits aside, questions remain around whether fractionalized NFTs could actually be classified as securities. Speaking at Draper Goren Holm’s Security Token Summit in March 2021, SEC Commissioner Hester Peirce warned issuers:
“The whole concept of an NFT is supposed to be non-fungible meaning that it’s less likely to be a security. That said, people are getting very creative in the types of NFTs they’re putting out there. You better be careful you’re not creating something that’s an investment product - that is a security.”
The implication from the SEC is that fractionalization might equate to financial productization putting companies like Dibbs, which lacks SEC registration, in a questionable spot. It makes sense, then, why Masterworks and others have been proactive in their SEC compliance. Despite the gray area, Founder & CEO Evan Vandenberg asserted the company’s position on its assets following a fundraising round last year that included Amazon:
"Where fractional ownership — whether ownership of a network like Ethereum, or a particular NFT — can be accomplished in a transparent, open-source manner, without making purchasers beholden to the management efforts of the promoters, we see that as a win-win."
He’s referring to the Howey Test which denotes a security as an investment of money into a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. In the case of Masterworks, each art piece is identified, purchased, held, and then sold by the company. It’s difficult to not see Masterworks as an investment product when the Howey Test is applied; investors rely upon Masterworks as the “common enterprise” to purchase the art piece, fractionalize it, create demand, and generate a return through a sale at the right time (though investors can trade their shares in the secondary market at any time).
There are a few fundamental differences between Dibbs and Masterworks, however. For one, Dibbs offers a self-serve feature that allows for collectors to sell their verified collectibles through the marketplace; in this case, Dibbs is not proactively sourcing all assets like Masterworks, rather merely acting as a facilitator. Could this be considered a deflection of responsibility that then shields Dibbs from being labeled a “common enterprise” in this scenario? Second, there are mechanics in place on Dibbs that enable individuals from the demand side to purchase the asset outright. This is not the case on Masterworks where the process is controlled end-to-end by the platform. Perhaps this buyout mechanic, which provides a more direct route to the underlying asset, again shields Dibbs from being the “common enterprise” that controls the process from source to sale?
The reality is we really don’t know definitively. The SEC’s stance, or lack thereof, has created nothing but opacity for upstarts trying to navigate this space. NFTNow underscored this lack of transparency in a recent article on fractional NFTs:
“Securities are fungible and tradable financial assets used to raise capital. In contrast with NFTs, they are interchangeable. As fractional NFTs provide partial ownership of an NFT, they more or less could be viewed as fungible securities in the eyes of the SEC.”
Time will tell how the SEC will play it.
Representation - Single Token Structures
Whereas fractionalization may present questions about an offering’s status as a security, single token representation structures should be subject to less regulatory scrutiny. In this construct, a physical asset is issued a lone corresponding NFT. This NFT can be freely traded and ultimately redeemed for the physical product. The corresponding NFT is a 1 of 1 product representation, which ultimately should dispel any questions around its fungibility and classification as a security. Alt, like Dibbs, is a marketplace providing access to tokenized sports cards. In contrast to Dibbs, however, Alt doesn’t fractionalize its offerings, rather each card is issued a single NFT counterpart. The corresponding NFT is primarily designed to improve exchange dynamics and liquidity, with Co-Founder & CEO Leore Avidar revealing that:
“99% of the cards stay in the vault after a transaction. [Buyers] are mostly buying these cards as investments, not to put on display.”
Even as marketplace constituents are viewing their transactions as investments, that doesn’t necessarily mean Alt’s offerings are “investment products.” The single token construct is simply providing a new way to access and trade ownership of a single physical product.
Zora, a prominent NFT protocol layer and early mover in the space, has blazed a trail with the single token representation mechanic. In May 2020, Zora partnered with RAC to facilitate the tokenization of a limited edition cassette tape collectible of his album Boy. For each of the 100 cassette tapes, there were 100 corresponding $TAPE tokens which had a starting price of $20. Tokens were minted and sold on a bonding curve which essentially drives the price up as more tokens are are created, and down as tokens are sold or burned. At one point, $TAPE reached ~$14k, a ~69,000% increase from its starting price, before settling in the low thousands. $TAPE holders could redeem their token for the tape at any time, which resulted in a token burn. Buyers of $TAPE were rewarded with $RAC, the ERC-20 token underpinning the artist’s ‘RAC.FM’ ecosystem which I wrote at length in a recent piece on music NFTs.
The success case drove Zora to productize this offering in what it’s calling “redeemable NFTs.” Recently, the Nouns Foundation tapped into this product, and others in Zora’s robust creator toolset (outlined in a piece by Rex Woodbury), to spin up its own marketplace for the launch of Nouns Vision glasses. Similar in mechanics to $TAPE, Nouns Vision features 8,250 pairs of glasses with their own corresponding NFT that can be traded and redeemed (burned) for the physical asset.
Creating a liquid token representation for physical commerce is merely the first step in a broad universe of possibilities. 4K, a marketplace featuring tokenized luxury items (watches, sneakers, fashion, etc.) which it refers to as “physically-backed NFTs,” is aiming to help build that universe. The team at 4K is building a diverse offering that provides “absolute utility” for physical assets that were once stagnant and illiquid, as detailed in a recent Twitter thread. These additional use cases include:
Collateralization: Platforms like Arcade and JPEG'D are enabling NFT holders to borrow and lend against their assets. Loan-to-value (LTV) ratios typically range between 10-60% of the asset value. The beauty of tokenized physical assets is that their value is less volatile than their purely digital counterparts. Take this example of a user who tokenized their Rolex Cosmograph Daytona Steel 2021 40mm through 4K and then secured a $16k USDC loan against the physical watch (valued at ~$40k which represents a 40% LTV).
Virtual Environment Access: Transport your physical asset via its token representation vessel into the virtual environments - like Fluf World Burrows or BAYC’s Otherside - that are beginning to define the metaverse.
Yield Farming: Lending out your tokenized physical asset in exchange for % interest.
Fractionalization: Similar to Masterworks and Dibbs, creating fractional NFTs that represent portions of the asset. Though this approach could create aforementioned security concerns.
It’s not just crypto-native companies driving the movement here; physical asset tokenization is beginning to permeate the traditional art world as well. Sotheby’s, in partnership with innovative art authentication startup MIRA Imaging, has begun tokenizing select assets to improve metadata storage and provenance tracking. MIRA Imaging’s process is enacted in three parts, first through an in-depth scan of the piece that captures even the most granular ‘cellular-level’ details. Second, the image scan is used to create a unique digital signature which is then embedded into a MIRAImage NFT. The NFT is housed with the owner of the work and serves as an ongoing verification of the piece’s authenticity.
In July, a collection of 69 artifacts from astronaut Buzz Aldrin were auctioned off for a combined $8M. It was the most valuable single space exploration auction ever, a category that has become one of Sotheby’s most popular. Ten of the assets were analyzed by MIRAImage and issued a corresponding NFT - “a first for an auction” -according to Forbes. Proof of authenticity is especially important in this context as “space-flown artifacts can only be legally owned if acquired from an astronaut, according to Sotheby’s.”
Time will tell if Sotheby’s integrates MIRA across its portfolio of assets. But this is a monumental proof point and leap forward in the usage of NFT as a tech standard to improve the ownership and transfer of premium physical assets.
Integration
While token representation is provably creating more efficient exchange dynamics, the integration category has the potential to redefine the relationship between brand and collector. Interestingly, companies in this category are taking more of a hybrid approach, issuing a corresponding NFT and also fusing select products with smart chips. There are three trailblazers, with slightly different approaches, beginning to penetrate the cultural zeitgeist and prove out this model:
Spatial Labs: Led by visionary technologist Iddris Sandu, Spatial Labs announced its LNQ One Chip at an Apple-esque product reveal event in May. The event is worth a watch as Sandu outlines how the NFC chip will serve as a key infrastructural piece in what he terms “The Wearable Internet.” The company recently launched with two of its own blockchain-enabled (tokenized via Polygon) products to prove out this new ‘phygital’ paradigm: 1) The Gen One Sweater and 2) The Gen One Cloud Clog (in partnership with Ales Grey). You can think of Spatial Labs as the first operating system for blockchain-enabled apparel, equipped with both hardware and software that will enable file storage and sharing, payments, community messaging, and P2P sales of garments. Through the chip, Spatial Labs can issue software updates that trigger different unlocks for the collector - e.g., ‘garment-gated’ access. Spatial Labs’ ultimate ambition is for the O/S to support a diverse ecosystem of brands.
One of None: Led by former NFL QB DeShone Kizer - who witnessed both the marvels and perils of limited edition product launches firsthand through his shoe deal with Jordan Brand - and co-founders Mike and Pat Darche, One of None is introducing a modernized ownership model for collectibles across categories. The company provides end-to-end management of assets through hybrid NFT creation, RFID chip enablement, secure warehousing, inventory management, product authentication, and fulfillment/redemption. The company’s ultimate aim is to “unlock the lifetime value” of collectibles and there is some higher touch work required to execute on that mission. Rather than burn the corresponding NFT upon product redemption, each smart contract contains a non-transfer function that prohibits trading while the physical asset is redeemed outside of the vault. This mechanism allows One of None to track the collectible through an entirely on-chain life cycle, whereas token burning takes us right back to the plagued off-chain world that leaves creators empty-handed as the product is resold. You can think of One of None as a protocol with layered infrastructure built to underpin redeemable, re-vaultable, and rewards-driven hybrid asset drops. The company minted 100 Vault Club NFTs (there will be 1k total), which will provide collectors with various token-gated perks.
Americana Technologies: Through its core product - the NFTA Universal Chip (NFC) - Americana Technologies is focused on tokenizing a variety of premium assets. Co-Founder & CEO Jake Frey comes from the world of digital product design having worked with the likes of Snap, Apple, Twitter, and Shopify. Similar to One of None, Americana Technologies manages a vault that houses assets ahead of redemption. Assets are minted on Ethereum, though the company has expressed interest in supporting other chains. The company’s 5-tiered Something Token is layered and thoughtfully designed, and has successfully kickstarted a rabid community around the brand. The tiers - Common, Rare, Epic, Legendary, and Probably Nothing - provide varying levels of utility which include things like Beta access, free shipping, governance rights in the ecosystem, and VIP event access.
Despite their different approaches, all companies are creating intriguing possibilities for both brand/creator and collector. In the same way that publishers issue downloadable content (DLC) to ensure video games remain dynamic, brands can now augment the asset ownership experience with new online and offline capabilities. These capabilities can be issued for free, or included as upsells to the product thereby increasing LTV. You can imagine an artist giving owners of her apparel line early access to exclusive content or free admission to a show by wearing the piece. NFC chips present an interesting attribution mechanism with both marketing and collector loyalty benefits. Brands can incentivize and confirm product usage in new ways; you can imagine a scenario where Drake tokenizes a new OVO apparel product and then drives purchasers to Dave’s Hot Chicken - in which he’s a large investor - for discounted sandwiches if they sport the new piece. Brands can now gamify usage of physical products - wear-to-earn (??) - rewarding collectors without requiring some radical shift in behavior. And of course these new potential unlocks will come with new layers of insights. Whether it’s token representation or a hybrid model, there is an added level of transparency around how assets are being valued and utilized, which will make for more informed creators and collectors.
Of course, given the nascency of the market, there are still questions around functionality and proper courses of action. For one, the durability of the chip is of the utmost importance; it needs to be tamper-resistant, weather-proof, laundry-proof etc. Until these products are out in the wild for a period of time, it’s impossible to know with precision how durable the chips might be. Product compatibility will be another question; do chips make sense for all types of products? Probably not. The products they do make sense for - higher ticket items with resale potential - will obviously have supply chain and logistics considerations around the most efficient methods for upstream integration. Dislocation events between token and product, either through a wallet hack or user circumvention of the system, will present unique challenges for companies. As products are released from vaults and into the hands of collectors, what’s to prevent someone from disregarding the token and selling the product over the counter? Perhaps this system might require a sense of buy-in from collectors. There is inherent custody risk with any approach that includes a vault regardless of the security measures put in place. Inevitably, there will be a contingent of folks that are wary of chip-infused assets, citing surveillance/tracking concerns. There will need to be a clear opt-in system for collectors to identify what they’re comfortable sharing back with creators/brands. None of these challenges are insurmountable; they merely come with uncharted territory.
Final Thoughts
Critics of web3 often cite a lack of proven, ‘real world’ applications as a primary reason for their pause. Completely fair. Web3 is rife with over-speculation, driven in large part by many superfluous tokens with inflating values that are often conflated with some sort of product-market fit. In my opinion, the companies building the physical-digital bridges, and effectively separating the NFT technology from the speculative (and somewhat stigmatized) asset class, are providing the best counterexamples to the above. When you pair a token with a physical asset, the item of value is still the physical asset. The token merely serves as a complement that can facilitate more seamless exchanges, more revenue back to the creators, and more transparency for all.