Is NFT no royalty the key to winning the battle of trading markets?

Author: Joel John, Siddharth

Compiled by: aididiaojp.eth, Foresight News

This article will explore how the NFT market is trending towards charging as low royalty fees as possible. Currently, the competition among NFT markets resembles the internet before Google's dominance; who will ultimately prevail remains to be seen.

Whenever I reflect on our economy and society, I realize how similar it is to a large biological system with interdependent behaviors: workers, small businesses, banks, customers, and regulators are all components of this global organism. When a business (or employee) no longer serves the entire system, it becomes redundant and ultimately faces inevitable elimination. For example, a rational participant who believes their venture or effort is doomed to fail will stop, which is the result of considering self-interest.

Of course, the idea that markets and ecosystems share many commonalities is not new. Before being inspired by Adam Smith's writings on economics, they prompted Darwin to become a naturalist and redefine modern biology. I would love to discuss with them how markets and ecosystems have become so similar.

This article is a collaboration with Siddharth, who has been contemplating the future of the NFT market, particularly regarding an ongoing war to determine the royalty structure for creators in the coming months. But before we dive in, let's go back a few years.

1. The Gem of Memory

In 2019, we were in a cold winter where the bear market caused everyone to abandon almost all cryptocurrencies. DeFi was also seen as a strange thing that financial nerds did in a corner of the web, and people were excited about the magical internet loans they could get for their digital tokens. The so-called Simple Agreement for Future Tokens (SAFT) was the most common form of NFTs, which were investment contracts from venture capitalists (VCs) hoping to gain more tokens.

But most founders kept delaying the issuance of tokens, while venture capitalists pretended to want to continue building with them, all the while trying to find over-the-counter buyers for the token agreements. The only meaningful NFT collection known to people was Cryptokitties, which repeatedly clogged the Ethereum network. Groups of enterprise and government use case consultants gradually disappeared, and people no longer thought it was a good idea to put data on the blockchain; the advantages of decentralization were nowhere to be seen.

The NFT market in 2019 faced a real problem. During the ICO boom in 2017, tokens themselves had product-market fit, as users were already accustomed to transferring, trading, and losing their cryptocurrencies in hacks. But what about NFTs? Only a group of isolated Silicon Valley bros were talking about them, and even hardcore crypto enthusiasts hardly cared about this non-fungible nonsense.

In the real world, artists sell a piece of work and profit from it once. So their income is linear, and artists have to keep creating art to make a living. NFTs allow artworks to evolve into financial assets, creating value for creators every time people trade their art.

What’s the magic here? That’s the wonderful concept of royalties. Let me use an example to help those who are not closely following the NFT market understand this concept. Suppose you spend $100 to buy a picture of a pizza from someone, and the artist earns $100 once. Fortunately, a hedge fund manager visits your office tomorrow and decides that this beautifully painted pizza is worth $1,000. You sell it to the manager for a $900 profit, and in this transaction, the artist gets nothing.

If tomorrow, a friend of the hedge fund manager (who happens to have heavily speculated on cryptocurrencies) notices this piece and thinks it’s now worth $10,000 and buys it, the artist will also receive nothing. The artist might feel very regretful for underestimating the past asset.

Royalties allow a portion of each transaction of a piece to be returned to the artist, usually between 3% to 5% of the transaction amount. If thousands of NFTs are released in a new collection, the royalty amounts can support an entire team. With constant speculation on price trends, there will be hundreds of transactions daily. We have already seen this type of trading behavior in the stock market. If he turns it into an NFT that pays royalties to creators, the pizza artist above would earn $50,000 from this million-dollar transaction.

Before you think, "Oh, this sounds like a classic pyramid scheme," let me explain why it isn’t. Only the artist can earn royalties; the intermediary traders have no other income apart from the price difference of the assets.

In the past few years, this incentive has driven a significant portion of the NFT market's growth. We are talking about hundreds of millions in revenue; Yuga Labs (the creator of Bored Ape Yacht Club) alone generated $107 million last year.

Please consider the following image for an example:

Did you notice the fee breakdown above? OpenSea earned 2 ETH, while Yuga Labs made 2 ETH by selling a bored ape NFT for 80 ETH. The buyer who spent $140,000 on a JPEG of a monkey (possibly) didn’t just buy it for the artwork but might have had profit motives or speculative value in mind. So everyone is happy because they all benefit until the market starts to iterate.

OpenSea realized the idea that NFTs could enforce royalties and empower creators. Everyone loves empowerment, and it is irrational to oppose someone making a living without it. But here’s the problem: NFTs cannot autonomously pass royalties onto end users.

Typically, smart contracts established by markets like OpenSea would pass on royalties because the NFT market cannot discern whether a transaction is a simple transfer. If a 5% fee is charged on every transfer, users would be discouraged from simply transferring their precious NFTs to cold wallets. Therefore, royalties are usually collected by the market facilitating the transaction.

But what if the market doesn’t want to enforce royalties to lower users' transaction costs? This is the crux of the problem plaguing today’s NFT market.

2. Unregulated Chaotic High Seas

2022 was a year of dramatic changes in the NFT market, with ample liquidity and fee incentives prompting markets to try alternatives to the original model. It all began in January when LooksRare launched its token, with a simple value proposition: users would receive token incentives when trading on the platform.

Users didn’t need to burn cash to build a brand, advertise, and educate users; instead, they could invest tokens to govern the platform and earn fees as token holders. The tokens also had a liquidity market; I previously wrote an article on tokenized marketplace game theory.

Every trader needs to pay the platform 2% and pay the artist a royalty of 5% to 10%. In reality, wash traders are buying assets on the platform at spot market prices.

If the platform fees + paid royalties exceed the price of the reward tokens, users will have no incentive to continue trading on the platform. You might think this is foolish, but LooksRare has completed $11 billion in trading volume and generated $220 million in revenue, while users are just a small fraction of what OpenSea currently has.

At that time, LooksRare gained market recognition because it had liquidity tokens, while OpenSea did not. When NFTs launched, you could hardly sort NFTs by price on LooksRare. Over the past year, due to the bear market and declining token rewards, the product has struggled to build a true moat against OpenSea.

OpenSea's management may have realized the threat of a new era platform to the company's monopoly and acquired Gem a few months later, which at the time was one of the fastest-growing aggregation markets.

At this point, the NFT market had experimented with liquidity token incentive schemes. Undoubtedly, incentivizing users to trade on your platform with tokens can help improve metrics. But there’s another lever that needs fixing: creator fees. Over the past year, several NFT trading platforms have begun to cut creator fees.

The DeFi market provides primitives for the same thing. For example, SudoSwap makes it possible to set up trading pools for NFTs like in Uniswap. Platform fees have dropped to 0.5% to compete with major players like OpenSea.

Suppose you are a trader looking to buy a bored ape NFT, just like we discussed in the transfer above. If you could eliminate the 2 ETH paid to the creator and reduce the 2 ETH paid to the platform, traders would be incentivized to switch to your platform.

And that’s exactly what happened.

The costs of NFTs in certain markets outside of OpenSea could drop by 5%, which is a massive cost reduction. Suddenly, the historical royalty model that empowered artists collapsed, dreams shattered, and narratives changed.

Nevertheless, the leading player in the NFT world remains functional, and no one sees the threat from a few hundred traders and their trading volume, most of which are still wash trades. OpenSea saw most of its user loss due to token incentives. As incentives declined, the activity of emerging competitors like X2Y2 would decrease. But aside from broken dreams, the industry was about to awaken from a nightmare in October 2022. A new player with an excellent product aimed at traders was ready to launch, and its name was Blur.

There are a few things that set Blur apart:

1) First, they attracted users with potential airdrops to increase liquidity for buyers and sellers, making the settlement prices of NFTs and ETH usually very close, with enough liquidity allowing many traders to freely enter and exit.

2) Second, they did not focus on retail traders but pursued serving traders with large volumes of NFTs. Their product has several complex trading options that traditional platforms lack, akin to moving from a meme coin spot market to a full suite of trading products that meet all your professional trading needs.

3) Finally, just like when Gem launched, Blur integrated a range of charting and data features into its core product. Suddenly, traders could access information about historical pricing, order book depth, rarity, and general trading volume trends through their trading platform.

You might think these things are not important. But before launching their token, Blur captured 40% of Ethereum's weekly NFT trading volume. As of February 2023, Blur's trading volume was 77%, while OpenSea's was 16% during the same period.

Please note that Blur also issued a token, so skepticism about this data is warranted. In fact, the Blur token issuance had some innovative elements; Blur offered users "boxes" that could generate tokens at some point in the future. So no one knows how many tokens they could get between October and February, further driving user trading behavior.

Nevertheless, Blur managed to achieve two things in one quarter. First, it began to make the idea of mandatory royalties disappear into thin air in a short time. Traders became increasingly accustomed to not paying creator royalties in market transactions. When a trader's intent is speculative, paying creator tax for each transaction makes no sense at all. Secondly, until December 2022, the Blur platform was entirely free; prior to that, they adopted a 0.5% royalty fee model.

To understand the long-term impact of Blur's launch, we need to look at what happened to royalties. A user named Beetle published a Dune Dashboard that shows the effective royalty rates. Beetle defined ERR as "the total royalties earned by all platforms divided by the total sales across all platforms." Since markets like Blur initially had no royalties, the increase in quantity and decrease in royalties would show a downward trend, and that’s exactly what happened.

The data below shows the royalties paid for bored apes at some point during the year. It started below 5% in August as some markets began offering royalty-free trading. But this trend became popular in October, right when Blur launched.

Not just royalties. Across various markets, the number of transactions generating royalties for bored apes has begun to decline, as shown in the table below:

3. Sea Port Filter

If you are a participant in the NFT trading platform ecosystem, you are about to be caught in a storm. Suddenly, a new player swept into the market, stealing your users and trading volume, disrupting your business model. For a time, multiple NFT markets took a stand to protect creator income. OpenSea launched an operator filter registry. If a platform (like Blur) allows users to trade while bypassing creator income, and the same project generates creator royalties on OpenSea, that project will be added to the registry.

Months passed, and it was clear that the market had changed its view on paying royalties. OpenSea now only has a small fraction of its former users and was forced to cancel royalties three days ago.

If you think OpenSea is just sitting idle, that’s not the case. The platform launched a complete protocol and acquired an aggregator within a year to remain relatively competitive. Sea Port, launched by OpenSea in May 2022, is a complete market contract similar to 0x in DeFi. We can think of it as a communication protocol for acquiring liquidity and routing orders across markets. The Web2 equivalent is the API for listing the same items on eBay, Amazon, and various regional e-commerce platforms.

Why would a market like OpenSea bother to release the Sea Port protocol? Their goal is to attract more users to participate in the NFT market; if the entire market expands, OpenSea will have more users and the potential to maintain its leading position.

But to some extent, this backfired on OpenSea. Earlier, creators could simply blacklist Blur. Now, whenever a collection blocks Blur, they provide liquidity for assets through the OpenSea protocol, and there’s almost no way to stop Blur from using the protocol and seeking liquidity for assets. A user named PandaJackson explained on Twitter how this works.

Sewer Pass conducted over 4,000 transactions through Blur, avoiding about $2.2 million in fees to OpenSea, essentially dodging a 40% fee loss. Because Blur uses Sea Port to bypass the block, the blocklist registry has become a joke. Even if OpenSea finds a way to stop Blur from querying liquidity from Sea Port, it contradicts the original intention of introducing Sea Port. (Moreover, OpenSea cannot modify Sea Port at will).

You might think this is no big deal, but considering the changes in order fulfillment and sourcing over the past few months, the threat becomes apparent.

Figure one shows the percentage of trading volume by order source, i.e., the market of the order source. As you can see, when Blur launched in October 2022, they captured nearly 60% of the order source. By February 2023, it had dropped to 21%. This means that more and more users are placing orders through Blur. In itself, this is not a significant threat. You can place orders from any aggregator, and liquidity can be sourced from elsewhere.

In fact, from the perspective of B2C investors, Blur may not pose a real threat to OpenSea. As you can see in figure two, OpenSea still occupies a large percentage of independent users. New entrants like Blur cannot overnight surpass their brand. The problem is that Blur has transformed from a place where orders are initiated to a place where users can find liquidity.

In the data below, orange represents the percentage of Blur's trading volume, peaking at 83% on February 19. But by February 20, it was only 26%, as the initial token airdrop for Blur had just ended.

The above figure elegantly explains this fact. Here, the filling source refers to the market that completes the order. If you are an emerging aggregator, you might be the source of the order, but the filling could be done through a third party. When you can complete a large number of order matches on your platform, you become an independent market. As of February 2023, only about 16% of orders on Blur were completed using liquidity from OpenSea.

The transition from aggregator to platform for Blur is at the core of the threat to OpenSea's future. A significant volume of trades flowing to third-party platforms creates little incentive for the market to maintain high fees. OpenSea's move from launching a registry to blacklisting markets that do not enforce creator royalties has led to these markets charging any fees.

This evolution of the market, from an ecosystem that viewed creator royalties as a sacred right that should be protected and enforced across markets to a place seeking unique ways to avoid paying creators, encapsulates the entire process. Equally fascinating is how, in just six months, a startup convinced the global NFT market that abolishing royalties was reasonable.

4. The Justification for Royalties

A year ago, when we first wrote about LooksRare, we hypothesized that launching tokens could completely disrupt the NFT market. The script seemed simple: just eliminate platform fees and introduce tokens. The team profits from the tokens they issue rather than any revenue they generate. I was wrong, as the platform's DAU has trended below 200 over the past year.

Blur poses a greater threat, capturing over 70% of the market share compared to the 11% that LooksRare captured at the time. OpenSea had to go from setting up registry management to blocking markets that do not provide fees, to reducing fees to a minimum, demonstrating the threat Blur poses in the market. Their efforts carry weight and credibility. But once the market continues to evolve, will their trading volume and users stick around? That’s hard to say.

Some might argue that Blur offers a better product for traders and will capture most of the trading volume; an excellent product can achieve significant growth through token incentives. Another argument is that perhaps this is just a flash in the pan, and we will return to the OpenSea dominance era in a few months, which is also a possibility.

First, OpenSea has already reduced fees to a minimum. So for users leaving the platform, if economics is the issue, they can now return to OpenSea. Second, as fees trend toward the lowest levels, IPOs may no longer happen, especially in the tech stock market, which is currently suffering. In this case, it is possible for OpenSea to issue tokens.

OpenSea does not need to rush to tokenize itself, but it could tokenize the assets it holds. For example, Gem, an aggregator acquired a year ago, could be tokenized.

If that’s not enough, they could continue to tokenize Sea Port, the protocol they launched a year ago. Tokenizing the protocol and incentivizing smaller individual markets could have a net positive impact on OpenSea. They could enforce royalties at the protocol level and blacklist bad actors as long as Sea Port becomes the standard for trading NFTs.

Just like today’s Ronin, any protocol released by OpenSea could have an alliance of game studios, large NFT issuers, and traditional retailers that decide how shared standards will be set.

The stalemate in the market is a battle between two behemoths that have raised enough venture capital to survive for years without revenue if necessary. It affects creators and niche products who believe the royalty model will continue; remember I mentioned that NFT royalties could enable a user-generated game content market?

Without NFTs, it completely collapses. Games will be forced to run closed markets to avoid regulatory scrutiny or deal with app store policies regarding digital assets.

This also overlooks the fact that a significant portion of NFT-related activities is intellectual property. Yuga Labs or Nike are incentivized to continue researching their NFTs because they see revenue from royalties. In scale, both companies earned over $100 million each from their NFT royalties in the past year. Without this model, the motivation to continue researching these primitives would disappear, and our rush to declare royalties as a flawed model could set us back years.

Artists can respond by launching related royalty markets, utilizing some great tools to build their own marketplaces and publish royalty licenses on them. In this process, artists will inevitably return to the historical challenge that operators and intermediaries will take a portion of their income. Perhaps the key to all this is that the industry fails to understand two things.

1) Trading constitutes a large part of today’s digital asset ecosystem. The majority of funds invested and revenue generated comes from financial applications, which will continue to trend toward the lowest fees for users and trading volume.

2) Not all assets need to be traded frequently. At least not non-fungible tools. There’s almost no reason to trade the copyright of an album by Jay Z from 2000; if the asset changes hands infrequently, then high royalties make sense.

We will have completely different user groups, each requiring different royalty models depending on the asset class being traded. One way to resolve the stalemate is to empower creators sufficiently to earn royalties at the protocol level, then the market can determine whether to set excessive trading fee standards. Ironically, despite years of innovation in NFTs, there has been almost no work done in this regard. Canto's contract-guaranteed revenue allows developers to earn a portion of the fees generated by a certain DApp user; perhaps this approach could be adjusted for NFTs.

This is not a new idea. In 2015, Jay Z launched Tidal in response to music artists earning very little during the shift to streaming. The app was priced at €25, and although almost all major artists in the U.S. supported it, it failed to scale. The only way to hear specific old albums by Jay-Z was to pay for Tidal, and a few years later, Square's Jack Dorsey acquired it for $300 million.

Our point is that as an artist, you want to optimize income without sacrificing distribution. Even today, artists often optimize for streaming plays of their work on YouTube because it affects their reputation. When a platform receives a lot of attention, it dictates terms to creators. At this point, creators are almost powerless; if you are optimizing for distribution, you can make it as easy as possible for users to discover you. Sometimes it might even mean listing on OpenSea.

As I write this, Blur is valued at $3.2 billion, higher than some protocols. This makes us wonder if we are transitioning from the era of fat protocols to value accumulation in applications. The team behind Blur has demonstrated that independent applications can often generate more volume and serve more users than entire protocols. Here’s a simplified script: launch a market in a low-cost or free manner, then incentivize trading volume through token rewards, transferring ownership to users through tokens to encourage their continued activity on the platform.

Essentially, build what people want rather than what people might build. We have finally reached a stage where a product-based moat focused on advanced users can become the standard for success.

The author of this article does not believe that zero-royalty markets will ultimately prevail. As I mentioned at the beginning of this article, evolution is the norm in markets, just as we see in nature; applications will continue to optimize to compete and gain niche users. After a quarter, the hype around Blur may subside, and we will return to normal. Creators may also completely stop issuing NFTs, and we will be left showcasing monkey pictures, which is sad for all the innovation and development the industry has undergone in the past three years.

We do not know what will happen. But if we take a cue from modern rocket connoisseur and Dogecoin minimalist Elon Musk, "the most interesting outcome is often the most likely outcome."