The art of reigning in royalties
In this week’s edition of Nami’s Nexus, we explore how royalties are changing the game for creators of digital assets and discuss ways secondary sales can be promoted via different NFT designs.
One of the big “unlocks” that comes from digital assets being fully trackable on-chain is the ability to integrate royalties into a business model. However, just because royalties can now be used does not necessarily mean it is always a sensible option. It is important to understand how royalties work and what their advantages and disadvantages are to determine whether it is appropriate to use them.
Primary vs Secondary Sales
To begin, we discuss what royalties are and how they work in web3. The creator of an NFT (smart contract author) sells the NFTs to initial customers in what is called a “Primary Sale”, even if it is a free mint or giveaway. Any sales made to third parties after the initial sale to these customers are referred to as 'Secondary Sales'. Typically, businesses in most real world markets profit only from the Primary Sale, as Secondary Sales often occur outside of their purview. In the physical world, Secondary Sales are usually for used goods and sell for less than the Primary Sale price. However, art and collectibles are two exceptions to this rule, as scarcity due to their limited production can increase their value.
Secondary Sales can be problematic
The inability to profit from Secondary Sales has been a problem for digital products with physical distribution such as DVDs and video games, as the wear and tear is limited to the packaging, while the actual product remains pristine due to its digital nature. GameStop has been cited as a major contributor to this issue as gamers often complete the content and then sell it to GameStop to recoup some of the cost. This is problematic for the game publishers as it may lead to Secondary Sales cannibalizing Primary Sales shortly after the release, as those who are willing to wait purchase the game at a slightly cheaper price as a secondary copy. Even if the discount is only a few dollars, the game publisher loses out on the entire Primary Sale revenue and receives nothing from the Secondary Sale.
This trend is especially prevalent in sports game franchises like Madden and FIFA, which are released annually. To combat this, publishers/developers have two main strategies: Account Locking and Digital Sales. Account Locking involves including a one-time use code or unique ID with the Primary Sale that links the game to a player's account, although this usually only affects multiplayer or online features. Digital Sales involve selling the game digitally instead of physically and are also Account Locked, which generally prevents any form of Secondary Sale unless the player sells their entire account.
A product code prompt on Steam
Royalties and marketplace fees
One problem with allowing Secondary Sales is that digital copies are identical, so it is crucial to ensure that a sale is a transfer and not a copy. Steam, for instance, could enable games to be resold on its marketplace, validate the transfer, and receive a profit from the transaction via a marketplace fee. However, there is a distinction between a royalty and a marketplace fee: royalties go to the game publisher/developer, whereas marketplace fees go to the facilitator, like Valve.
So why isn’t Valve doing this? It still hurts Primary Sales of the game since entertainment is consumable, and preventing Secondary Sales is more profitable than receiving royalties, which is why game publishers/developers do not allow it. Valve for instance solves this issue with Team Fortress 2 and Counter-Strike: Global Offensive by offering marketplace support for digital cosmetic items, such as gun skins. As Valve serves as both publisher and marketplace, it can view the marketplace fee as a royalty too. However, since there is no built-in royalty system, other game publishers/devs have little incentive to participate.
Listing an item for sale on Steam
How blockchain technology switches things up
The blockchain provides an advantage of proving that digital assets have been transferred and controlling how the transfer occurs. In theory, every game can have its own marketplace with full control over both marketplace fees and royalties. In reality, however, there are a few caveats to consider.
Non-limited trading options: The notion of an NFT implies the ability to buy or sell it anywhere, not just on a specific game marketplace.
Transfer royalty problem: Enforcing royalties in third-party markets is challenging with the current ERC-721 NFT standard since it requires controlling how any NFT transfer happens. A common example of the transfer royalty problem is how to handle a simple transfer of an NFT from one wallet to another without charging a royalty. Limiting the ability to transfer involves working with marketplaces to follow a standard, which may work against their interests.
Liquidity considerations: If your goal is to earn royalties from NFTs, it is essential to ensure that they are compatible with high-volume marketplaces to maintain high liquidity and facilitate transactions, which can limit your marketplace choices.
Capitalising on greed?
Once the technical details have been sorted out, the question arises of whether royalties are even appropriate. Generally, royalties are a way for creators to receive a portion of the profit earned by others using their work. Currently, the most popular type of NFTs are primarily art or collectibles. Traditionally, artists make money from the initial sale of their artwork, but they also have the potential to earn money from commercial use of their art. With NFTs, however, royalties are not based on commercial use but rather on secondary sales.
Unlike the video game context previously mentioned, art is not something that is consumed and resold, and buying art does not take away from primary sales. Thus, charging royalties on art NFT resale effectively implies one of two things: either the NFT was sold at a very low initial price to gain market traction or primary buyers are purchasing the NFT in hopes of getting someone else to pay more for it. Unfortunately, the latter often applies in the real-world art market, so royalties on art NFTs may be seen as an attempt to capitalize on greed and deception rather than genuine appreciation for the artwork.
A balancing act
It is worth considering whether royalties are the primary source of income for a project or merely a supplementary benefit. If royalties are the main source of revenue, it implies that the Primary Sale may not generate reasonable profits for some reason. This may be appropriate for free mints as discussed in our previous piece (ADD LINK), where no Primary Sale occurs. However, it is important to consider that earning royalties necessitates creating a situation where the NFT recipient does not hold onto it. This is the exact opposite of conventional retail, where the goal is to make the product appealing to the buyer. The challenge here is to create an NFT that is desirable enough for others to want to buy, resulting in Secondary Sales and royalties. One way to think about the problem is to release NFTs that increase in potential value over time, which causes “paper hands” to sell to a more confident buyer and generate royalties. However, this strategy has several drawbacks, including the building of speculative bubbles around future mysterious NFT utility. First, it encourages the teasing of future utility, not the actual delivery of it. Second, it is unlikely there will be a high amount of transactions without frequent value fluctuations, and you want the prices to go high enough to make the royalties worthwhile.
Alternative incentives
A different perspective to consider instead is to find other ways to incentivize trading. In many games with collectible elements, having varying levels of rarity and a dynamic meta-game can encourage players to frequently change which NFTs they use and need. Axie Infinity pursued this strategy to some extent, but Sky Mavis demonstrated that breeding fees can be more profitable than marketplace fees by placing the primary sales of new copies in the hands of players, thereby subjecting them to more frequent taxes. A similar situation exists with DigiDaigaku, where Limit Break may be able to sell NFTs or tax production for a potentially higher profit than what it could make from royalties, but the final business model remains a mystery.
Another, more interesting perspective is to find ways to increase the value of an NFT through its exchange, thereby encouraging more frequent and higher value transactions. Instead of the traditional notion of used physical goods losing value, the NFT could gain value from being used or combined in unique ways. Rather than creating new assets through breeding, burning a more common asset could potentially enhance the primary one. DigiDaigaku has implemented an interesting approach by offering airdropped or free minted assets that can be burned or enhanced by burning another, incentivising transactions for value-boosting features such as Villain reveals. Another method to enhance value is through provenance, which can involve previous owners or past usage of the NFT. This could range from esports champions or winners of small competitions to defeating difficult bosses, or even just the history of the NFT itself, unlike a StatTrak gun skin in CS:GO that is reset each time it is sold.
StatTrak gun skins
There are numerous potential avenues to explore when considering Primary and Secondary Sale values and designing incentive structures. Hopefully, the industry can move beyond this initial stage of basic profit taxation and art speculation toward innovative business models that utilize blockchain technology in previously unfeasible ways. We hope that ideas such as free-to-own will evolve into a meaningful concept rather than simply a means of generating hype and speculation around scarcity.
Thanks for reading this week’s piece of our weekly series “Nami’s Nexus”, where we look to decode web3 gaming and dive into the various areas and nuances of the industry and beyond. Don't forget to subscribe to our blog and follow us on Twitter to receive more web3 gaming content.