Why Traders Shouldn't Hate Royalties: A Microeconomic Analysis

October 20, 2022

The NFT trading community is deeply divided about royalties. Should people be required to pay them? Is it ethical (and even legal) to not pay them? What are the consequences if royalties are enforced vs. not enforced?

This debate has basically two camps:

  1. From a micro point of view, traders are tired of paying a percentage of a trade on an NFT that lost value in the bear market or on a project that rugged or failed. They also see that 5% (or so) fee eating into their profits (which they suppose would be higher if that fee were not a thing).
  2. From a macro perspective, founders and artists try to explain how essential royalties are to the overall ecosystem (and to their own success in the space, as it is currently designed). 

However, there hasn't been enough discussion about the role that royalties play in shaping the market, and enabling the profits that traders have seen in the past. Royalties are a primary market driver that impact supply, floor price, volume, and velocity of trading, and as such, they are an essential factor in creating and maintaining a profitable industry for trading. There is also the question of whether not paying royalties is legal, and I take a look at what the market might look like this time next year in a world without creator royalties.

We need to start at the most basic level of how a market works: supply and demand. Royalties very much impact both sides of this equation. First, supply is created by artists or NFT projects, and their role is to:

  1. Create a product, and,
  2. Drive up demand for that product.

The current monetization model includes driving up demand in order to increase floor price on a collection (or on the value of art) with scarce supply. The incentive to the creator here, which is created by royalties, is to continue to invest in generating value and the they take a cut of that value through royalties when that NFT is resold, while sharing that value with the community (i.e. traders). This is a function of royalties. It costs money (often a massive amount of money and energy) to give value and create demand, so if a project or artist depends on generating revenue from a collection with scarce supply, then they rely on revenue from secondary markets. Without royalties, there is no reason to have a scarce supply. Thus, if they can't expect any return on secondary sales, then there is no incentive to increase the value of the NFT after primary and no incentive to share that value with the trader. Under these circumstances, the market can expect:

  1. Unlimited supply of NFTs of little to no value beyond their utility.
  2. Virtually zero supply of high-value NFTs.
  3. Extremely thin profit margins for traders.

Any profit to traders will be seen in an initial pump before a dump, and the only game for traders will be to try to not be the one left holding the bag. That's assuming there even is a limited supply mint to pump and dump. If the supply is unlimited then there will not be a pump, and as such, no value to traders. Projects and artists will rely on creating demand on a slow and steady model and sell their NFTs at market value, so there is no room for profit for traders.

Because royalties are a key driver of creating high-value NFTs, they are also essential to creating demand. Without the potential for a digital asset to appreciate in value, few traders will have any interest in investing or holding beyond a few-hour pump-and-dump window during the initial mint (assuming the market even maintains a a model of minting a scarce supply). Without a market that incentivizes creators to build a scarce, valuable asset, traders will stop trading with this hope or expectation.

Additionally, royalties drive down the price of the primary sale of an NFT because creators often sell at below-market-value in order to create demand which generates the trade volume and velocity that indicates to the market that this is a valuable asset, thus creating more demand. They do this knowing they can recoup that lost value by earning royalties on secondary. This allows traders to capture more value as they resell and trade the NFTs. On the other hand, without royalties and the expectation of future returns, the primary sale price would likely be much higher, leading to slower trading volume and fewer wins, with lower profit margins (if any) for traders.

We've seen how royalties impact supply, demand, and price, but they also impact trade volume and velocity. Currently, (when the market isn't frozen) volume and velocity are created by speculation on future prices and the hope for high-margin returns. As we've seen, though, there would not be the hope for future, high-profit returns, so trade volume and velocity would suffer, as well.

Wash-trading also becomes a serious issue without royalties, so it will be incredibly difficult, if not impossible, to determine true market sentiment and direct your trades according to legitimate indicators. This would seriously dampen overall enthusiasm to participate in speculation, which, again, restricts volume and velocity of trades.

Another thing to consider is that though smart contracts have not yet been brought into a courtroom for legal enforcement, there is no reason to believe that they aren’t legally enforceable. There is a contract, signature, and an exchange of value–all the necessary ingredients for a legally binding contract. Granted, it’s complicated by the fact that creators can change royalties, so it’s possible that a contract can be invalidated if the agreement was changed unilaterally. Nevertheless, if smart contracts are considered legally binding, then zero-royalty marketplaces may not even be legal, and if someone makes a trade without paying the creator fee, they may be financially liable not only for the fee they avoided but also for all legal fees plus punitive damages. So overall, it would be wise to tread carefully.

However, if royalties cease to be a thing in Web3, then there might be a silver lining (though not for traders). NFTs would cease to be a speculative, (potentially) high-profit asset, one which brings massive regulatory pressure and questionable market demographics, and instead, Web3 would settle into a market characterized by tokens of varying utility, access, and collectability on the level of Pokemon cards, which could lead to the mass adoption we all envision by attracting the fandoms and other normies who are turned off by the blind greed and scammy environment of the current state of the industry. We would also probably see an increase in overall security as scammers cease to see great opportunity in the market.

No matter what direction the market takes, however, royalties may mean a small reduction of profits, but they are essential for maintaining a thriving, dynamic, and profitable NFT market for traders. So embrace those royalties, fellow traders! They are the reason you have anything worthwhile to trade.

(Photo by Alesia  Kozik: https://www.pexels.com/photo/black-and-silver-laptop-with-stock-market-display-on-screen-6770609/)


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