NFT Distribution Models

This note explores various distribution models for Non-Fungible Tokens (NFTs) and their implications on project success, efficiency, and equity. NFTs offer creators anovel means to build a community and fund projects, turning buyers into vested partners. The initial sale, however, poses several challenges, including pricing strategies and the balance between revenues and efficiency, fairness, and sustained participation.

Introduction

Non-Fungible Tokens (NFTs) give creators a unique way of bootstrapping a new community of users, while funding their project at the same time. The users who buy the NFTs of a collection become ‘partners’, not just consumers, because the success of the project means that the value of their NFTs will rise as well. They therefore have an incentive to contribute to the project and attract new members, thus creating network effects.

The most difficult period for an NFT project is at the beginning, when the creators need to decide how to structure the initial sale and how to set the price level. If the price is too high, the demand might be too weak, so the NFTs will not sell, and the project might fail altogether. Even if all NFTs are sold, there is a possibility that the users think that they have paid too much relative to the perceived value, hence they might dump the NFTs in secondary sales and abandon the project. If the price is lower than the perceived value, it will reward early adopters who will then contribute to the project and generate network effects. However, if the price is too low, the competition among bidders to secure an NFT might lead to a gas war, where a big part of the buyers’ payments flow to the miners/validators of the blockchain, instead of the project creators. Creators can also charge different prices to the users, for example using an auction, so they face a trade-off between efficiency, which is achieved when revenues are maximised, and equity, which means that the buyers are treated fairly. 

In this note, we explore the most significant NFT distribution models that have been used and evaluate them in terms of the above considerations.

Standard Mints

A standard mint is the most popular distribution model. The creators specify a fixed supply of NFTs, a fixed initial price and a time at which the minting will start. This is the simplest possible price mechanism and therefore easy for potential buyers to understand. The main disadvantage of this model is that it is very difficult to know in advance what the ideal initial NFT sale price is. If it is very high, many NFTs will be unsold, and the project might lose momentum. A very low price will lead to increased competition among buyers, as they will compete to secure an NFT, once the minting begins. A very high volume of simultaneous bids will increase the gas fees greatly leading to a gas war. Effectively, by not allowing the price to clear the market, the competition generates a negative externality, because users pay the miners/validators of the blockchain very high gas fees in order to process their orders. From the point of view of the buyers and the creators of the NFT collection, this is a waste of resources and an inefficiency, because a significant amount of the funds that users pay flow outside of the project.

One of the most extreme examples of a gas war was the Otherdeed sale from Yuga labs, in May 2022. The gas fees during the mint went as high as 10,000 Gwei, when the average gas fee currently is between 30-50 Gwei. This resulted in more than 55,000 ETH in gas fees, worth around $157M USD at the time.¹

Free mints

A special case of a standard mint is a free mint, where the NFT creators set a zero price because they want to widen the participation of users and bootstrap the creation of a new community, at the expense of getting less funding for their project. The most successful free mint was for the Cryptopunks, which was launched in 2017 and it is considered one of the most valuable collections to this day. Another reason can be to reward holders of an existing collection, which then increases in value. For example, the members of the Bored Ape Yacht Club were issued free mints of new collections, such as the Mutant Ape Yacht Club. Another use case is free mints of digital items that are used in a game. These items incentivise users to try a game for the first time. If they like the game, they will then buy more advanced digital items.  This is analogous to the freemium model in web 2, where users can download a game for free, but more advanced features require payment.

A low or zero price can still generate high revenue, if it is coupled with high royalties, which are applied to every subsequent resale of the NFTs. Royalties can mitigate the problem of price discovery that is muted when the minting price if fixed. The reason is that after the mint the price will eventually reach an equilibrium. If the transaction volume is high, then the creators will receive a percentage of the ‘correct’ price with each transaction, hence the initial minting price is less relevant.

Free mints can be very democratic because, in principle, anyone can participate. However, if the mint is not managed carefully, a few insiders may claim most of the NFTs and then sell them at high prices in the secondary market, leading to a concentrated market and disappointed members of the community.

Restricting demand

The biggest problem of a fixed price is that it may create a big discrepancy between supply and demand. One way of mitigating this discrepancy, without increasing the price, is to constrain the demand. The most popular way is an allow-list, which restricts who can buy an NFT in the initial mint. If managed well, an allow-list can help avoid a gas war. However, the competition per se cannot be avoided, it just moves from paying high gas fees to expending effort in order to be included in the allow-list. If this effort is beneficial for the project, however, it is not a negative externality. The fundamental problem is that, in high demand projects, it is very difficult to determine how big the allow-list should be and if this is not correctly specified, as with the Otherdeed sale, a gas war is unavoidable.

One issue that is not automatically addressed by allow-lists is that wallet addresses are pseudo anonymous. This means that the same person can have many addresses and therefore the opportunity to buy multiple NFTs, thus negating the effect of an allow-list. This problem can be mitigated if there is some form of KYC that disallows pseudo anonymity and restricts the number of items that each individual can purchase. This solution does not solve the problem entirely, because a highly motivated buyer can always hire helpers to buy NFTs for them, whereas it might discourage potential buyers who would prefer not to disclose their personal information.

Dutch auctions

In a Dutch auction, the sale starts at a very high price and then slowly descends, while buyers make their bids. As there are multiple NFTs, there are two ways of clearing the market. In a descending pay-as-bid auction (DPABA), every bid is fulfilled, so each buyer pays exactly the price that they bid.² This means that early buyers pay a higher price than all subsequent buyers. In a descending clearing-price auction (DCPA), everyone pays the price that was placed for the last NFT. This means that everyone pays the same price, which is the lowest that clears the market. Compared to a standard mint, Dutch auctions are better at price discovery and clearing the market at the ‘correct’ market price, hence they are more efficient.

A DPABA can partially mitigate the problem of a gas war because bids are spread out over time, as compared to a standard mint with a fixed price, where all bids are submitted together. However, it is also possible that a DPABA generates a ‘game of chicken’, where bidders wait for everyone else before submitting their bid, which could result in everyone submitting simultaneously and therefore a gas war. Moreover, although a DPABA can maximise revenues for the creators, it could lead to perceived inequality, because the members of the community that are more enthusiastic and place the highest value on the project end up bidding early and therefore paying a higher price than everyone else.³ This could disincentivise them from further participating in the project and eventually selling their NFTs at lower prices.

A DCPA is fairer because everyone pays the same price, and it avoids a gas war because it is less likely that there is congestion of bids at a particular price point. Buyers have the same upside if the project succeeds, hence the more enthusiastic members of the community are willing to contribute. However, a DCPA is technically more difficult to implement within a blockchain because each bidder must lock their funds when submitting a bid, and then get a refund when the price clears.

Dynamic Supply

Dutch auctions and standard mints usually specify a fixed supply of NFTs. This implies that the sale must end within a short period of time, hence it is possible that there is not enough time for potential buyers to be informed, especially in cases where the creators are not very well known. If the supply is not fixed but dynamic, this problem may be mitigated. By releasing the NFTs in batches over time, the project can grow gradually and implement their marketing and product strategies. This distribution model is also more equitable, because buyers who learn about the project later are not disadvantaged in terms of participating. The creators can adjust the selling price over time and enable a sustained capital formation that is analogous to their needs in terms of implementing their roadmap. One of the most successful examples of a dynamic supply project is Nouns, which auctions one Noun every day and has generated more than 28,000 ETH in sales.¹

A disadvantage of the dynamic supply model is that prices may get suppressed over time, because the NFT holders are discouraged by a potentially infinite supply, or from the possibility that the creators increase the supply arbitrarily. This problem can be mitigated if the supply is fixed but it is released gradually, or there are specific rules on how the supply increases, as is the case with Nouns.

Conclusion

While there is no single NFT distribution model that is universally superior, each has unique advantages and challenges. Standard mints are simple but struggle with price discovery and can lead to inefficient market outcomes like gas wars. Free mints democratise access but risk market concentration and price manipulation in the secondary market. Dutch auctions, in both their variants, offer better price discovery but differ in fairness and market dynamics implications. The dynamic supply model promotes gradual growth and fairness but could potentially devalue the NFT collection if the total supply is unlimited or manipulable. In conclusion, the choice of distribution model should align with the project's goals, community expectations, and market conditions.

Footnotes

¹ For more details, see “From Dutch Auctions to Open Editions: A Deep Dive into NFT Distribution Models” at https://members.delphidigital.io/reports/from-dutch-auctions-to-open-editions-a-deep-dive-into-nft-distribution-models.

²  See “NFT Sales: Clearing the Market, Avoiding Gas Wars” at https://a16zcrypto.com/posts/article/nft-sales-market-clearing-gas-wars-auction-mechanism-design-for-builders/.

³ For more details on the equity – efficiency trade-off that the marketplace designers face, see “Redistributive Allocation Mechanisms” by A. Akbarpour, P. Dworczak and S.D. Kominers, at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3609182.

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