NFTs & Sneakers

NFTs have made an extraordinary impact on the sneaker market by revamping the way designers and brands interact with their customers. Just last month, RTFKT Studios teamed up with an 18-year old artist known as FEWOCiOUS to create an entire line of digital sneakers. The team sold all 600 pairs in seven minutes, making $3.1 million.

In December 2020, an anonymous buyer known as WhaleShark secured a pair of digital sneakers designed by RTFKT Studios for 22 ETH, equivalent to $13,000 at the time of purchase. When the auction began, “The X Evolutions” sneakers started off as just a plain pair of white high-tops, but each time someone placed a bid, a splash of paint appeared on the shoes. As the winning bidder, not only did Whaleshark receive a physical pair of the shoes, but he also gained exclusive rights to an AR filter that allowed him to “wear” the shoes virtually on social media channels like Snapchat or Instagram. He could also show his sneakers off as artwork on a digital screen.

The X Evolutions. Source: RTFKT Studios

RTFKT Studios harnessed one of the most important characteristics of NFTs: scarcity. The company auctions off one pair of sneakers per month; the sneakers sell out in minutes, selling for an average price of $15,000. By only minting one NFT per pair of sneakers, RTFKT drives up demand by maximizing exclusivity.

The fact that people are paying ridiculously exorbitant prices for digital sneakers is just one of the many reasons people doubt the significance of NFTs. To many, the recent NFT hype is just a form of speculation that the market will eventually correct. Once the dust settles, people will realize NFTs have no intrinsic value, and the hype will die down.

I believe NFTs have a lot more potential than many would think. Other than simply serving as a tool to inflate the exclusivity of sneakers, NFTs can resolve major issues that currently exist in the sneaker industry because they can verify the authenticity of goods and allow designers to keep earning royalties even when their creations are resold in the secondary market. On a grander scale, manufacturers and distributors across any industry can fight against counterfeit markets and bring more value to designers for their work. By leveraging its special characteristics to offer tangible benefits to businesses, NFTs can find its niche in countless markets.

What are NFTs?

In the most basic sense, non-fungible tokens (NFTs) represent ownership of an item. They are non-fungible because they are unique, meaning they are not interchangeable with one another. For instance, 1 ETH is interchangeable with another ETH, but no two NFTs are interchangeable.

From a technological standpoint, NFTs exist on the Ethereum blockchain. To create an NFT, developers must abide by the ERC-721 standard. According to ERC-721, NFTs must be:

  • Unique. Each token has a unique and permanent ‘uint256' identifier in the ERC-721 smart contract. When its identifier is paired with a contract address, the NFT becomes a one-of-a-kind, fully qualified asset on the ETH chain that can be attributed to a specific owner.
  • Transferrable. ERC-721 contains standardized functions that only allow the owner of the NFT, the approved address of the NFT, or an authorized operator to initiate transfers of that NFT. These functions are baked into the smart contract, making NFT transactions trustless and decentralized. All parties can trust the contract to correctly execute transactions because they can verify the contract’s code.

Due to these characteristics, NFTs can be used to claim ownership over any unique good, such as a collectible pair of sneakers.

The Sneaker Resale Market

Social media and online marketplaces have connected people from all over the world, unifying localized sneaker resale markets into one global market. Nowadays, anyone can easily buy a pair of sneakers online so long as he is willing to pay the price. Since the Internet has made it so easy to buy and sell shoes, many people generate significant returns by investing in sneakers rather than in stocks and bonds, sometimes making up to $1 million a year. Overall, the size of the global secondary sneaker market was $6 billion in 2019, and it is expected to reach $30 billion by 2030.

At the heart of this booming market sits StockX, the foremost online marketplace for sneakers. To further the concept of “investing” in sneakers like a security, StockX is designed like an exchange. Sneakers are represented by their own unique “stock symbol” as the homepage of StockX’s website features a live stock ticker that tracks their price movements.

Source: StockX

When a customer selects a pair of sneakers, StockX will show real-time bid and ask prices.

Source: StockX

In 2020 alone, the company made $1.8 billion in gross merchandise value, closing over 7.5 million transactions. However, as large and as institutionalized as it may seem, the sneaker market is plagued with counterfeits, and designers do not earn any of the value generated for resold sneakers.

The Fake Sneaker Market

The Problem

The resale market might be big, but the fake sneaker market is even bigger. As of January 2020, the fake sneaker market was valued at $450 billion, almost 80 times the size of the secondary market for real sneakers.

There is currently no good way to verify the authenticity of sneakers. Even if the seller had a receipt and the sneakers came in a shoe box, the buyer is still not safe. Nowadays, everything can be faked: receipts can be faked, shoe boxes can be faked, and even the barcode on the shoe box can be faked. If a buyer truly wants to verify the authenticity of the sneakers, he would have to read through an online guide or find a YouTube tutorial and determine the authenticity himself. Otherwise, he would have to go to a consignment store and hope that the staff can verify the shoes for him. Nevertheless, as the astronomical size of the fake sneaker market shows, these measures do not work. It is almost impossible for a buyer to impartially authenticate his sneakers especially since he is so financially and emotionally invested in the shoes (trust me, I have been there).

These are the Yeezy Boost 700 Wave Runners. One shoe is real and the other is fake. Try to determine which is which by using resources online. The answer is at the bottom of this article. Source: Kingsdown Roots

Companies have tried to find ways to combat counterfeit sneakers, but existing solutions are ineffective. For example, StockX has its own in-house staff dedicated to verifying the authenticity of their sneakers. Each pair of sneakers delivered to the buyer has a tag that reads, “Please inspect item before removing tag. All claims null & void if removed.” This solution is inefficient because StockX is not optimizing its opportunity cost. The company incurs operating expenses to validate sneakers, but the proof of authenticity is nullified as soon as the buyer receives the shoes and cuts off the tag. The value of StockX’s services would go a lot farther if the company can permanently maintain the proof of authenticity. Not to mention the fact that people can create fake StockX tags too.

Source: Yahoo Finance

The Solution: Proof of Authenticity

NFTs are the key to ensuring that any sneakers sold on the secondary market are authentic. By minting an NFT for each pair of shoes, manufacturers essentially create a unique and irreproducible ID for each pair. Since blockchains are open source, the NFT’s provenance is recorded on-chain, serving as a proof of private key ownership that people can use to easily verify the legitimacy of a pair of sneakers. If a scammer tries to create a counterfeit sneaker, he would not have an NFT to verify the legitimacy of the shoes.

VIDT outlines an existing use case in which NFTs are used to validate the authenticity of the 1956 Rolex Milgauss watch, one of the most valuable watches in the world due to its intriguing origins:

In 1956, Rolex launched the Milgauss, a toolwatch engineered for scientists who work in environments with extreme electromagnetic fields. It became known to be worn by the scientists of CERN. The Milgauss, with its integrated Faraday cage, is able to withstand electromagnetic forces of up to a 1000 Gauss. Today, it is one of the rarest and most expensive Rolex watches in existence (Source: VIDT Datalink).

In a collaboration with Amsterdam Vintage Watches (AVW), VIDT implemented the following authentication process:

  1. An AVW expert inspects the watch to verify its authenticity.
  2. Once the expert confirms the watch is real, AVW issues a certificate of authenticity in PDF format that contains detailed descriptions and photos of the watch.
  3. The hash of the certificate is added to an NFT, which is then stored in the new watch owner’s digital wallet. The NFT serves as a proof of legitimate ownership and authenticity, and it follows the watch whenever it is transferred to a new owner.

Other brands in the fashion industry have also begun to explore NFT-enabled solutions. For instance, Nike had already patented its own version of NFT shoes called CryptoKicks back in December 2019. Once a buyer receives his physical sneakers, he can scan a barcode on the shoe box with an app to unlock the NFT. Ultimately, the process is generally the same for every company: either the original manufacturer creates an NFT for each good it produces, or a distributor creates an NFT after verifying the authenticity of the good.

In my view, the technology is not the most exciting element. I am more fascinated by how the sneaker industry will adopt this technology. LVMH, the owner of over 60 world-famous luxury brands such as Louis Vuitton, Dior, and Dom Pérignon, announced the creation of AURA, a blockchain network created by ConsenSys that allows consumers to trace the history of the luxury goods they purchase. Rather than allowing third parties to wedge themselves between its brands and partners, LVMH wanted to stay true to the spirit of decentralization by cutting out intermediaries and offering a white label solution to all luxury brands, including its competitors. Each participating brand would have its own authentication app, and AURA would run the underlying technology. To successfully onboard competing brands with as little friction as possible, LVMH plans to donate all of its intellectual property (IP) to a separate entity and allow each participating brand to be a shareholder of that entity. Through this arrangement, for example, Gucci and LVMH can have the same level of ownership in the IP. The entire industry would therefore have a standardized authentication solution across all brands.

LVMH has thus created a model on how the sneaker industry can adopt its own industry-wide standard. By following the LVMH model, big competing players in the space like Nike and Adidas can employ the same authentication process without the risk of losing their IP or giving one company an advantage over the other. Secondary marketplaces like StockX, Goat, Grailed, and eBay can join as well, forming an entire consortium of companies that share one standardized method for authenticating sneakers.

Royalties in the Resale Market

The Problem

Another issue with the secondary market is that the original designers do not earn any of the resale value for their sneakers. Zora, a marketplace to buy, sell, and trade tokenized goods, calls this the Yeezy Problem: a pair of Yeezys that Kanye designs sells for a retail price of $220. However, since Yeezys are highly coveted shoes, people can sell them for over $3,000, more than ten times the retail price. Meanwhile, Kanye does not get any of that resale value; he is not fully compensated for the labor he expended to produce his product.

The Solution: Royalties in Perpetuity

Even with the advent of NFTs, there is currently no standardized way for designers to receive royalties when their sneakers are resold. Many NFT marketplaces do have mechanisms to pay out royalties, but the issue is that these mechanisms are not interoperable across each marketplace. Going back to the Yeezy Problem, Zora created a solution that would allow Kanye to mint 1 $YEEZY token per physical pair of Yeezys. Kanye can thus create his own market by allowing customers to trade these dynamically priced tokens on a mini exchange. Users can cash out their tokens and obtain one physical pair per token, or they can liquidate their tokens by selling them back to the market. Before he launched his mini exchange, Kanye would have set up a “creator share,” which is a percentage of the trading fees he would receive whenever a $YEEZY transaction takes place. Kanye would therefore earn royalties in perpetuity as his creator share is automatically paid through smart contracts.

Kanye continues to earn a percentage of trading fees as the price of $YEEZY fluctuates. Source: Zora

This solution works, but the problem is that royalties are only paid out if the transactions stay on Zora’s marketplace. If someone were to sell an NFT minted by Zora on a different marketplace like OpenSea, Kanye would not receive his creator share.

There are projects out there that aim to standardize royalty payments (I recommend reading about the ERC-1155 Multi Token Standard), but the solution I find the most compelling is the “ERC-721 Royalty Standard,” otherwise known as EIP-2981, written by Zack Burks and James Morgan. EIP-2981 outlines how an NFT can keep paying royalties to its original creator even if it is sold on a different marketplace. The proposed standards are as follows:

  • Fixed percentage to 10^5 (10000). To uphold uniformity across various marketplaces, royalty percentage amounts must be calculated with a scaling factor of 10000. Rates across all marketplaces will be limited to 5 decimal places, ranging from 0.00001% to 100%.
  • Emitting event for payment. Unless creators are constantly monitoring the marketplace to check whether a secondary sale of their NFTs have been made, there is no good way to verify whether they have received a royalty payment other than to check for an increase in the ETH balance of their wallet. To institute an easy way for creators to verify payments, each NFT contract should be designed to emit an event for payment by calling a function on the parent contract.

In my opinion, EIP-2981 is the most viable solution for solving the Yeezy Problem across all NFT platforms because it is backwards compatible. In other words, it is completely compatible with the ERC-721 standards that are already in place. Marketplaces simply need to adjust their smart contracts to meet these standards to join. If enough marketplaces comply with these standards, creators and customers will gravitate to their platforms, thus forcing other marketplaces to comply as well.

Conclusion

NFTs have brought innovation to the sneaker market by giving designers a new way to share their creations with consumers. Now, designers have the technology to create an entire digital experience around a pair of sneakers. Though the technological mechanism by which designers distribute their sneakers is new, the economic mechanism is old. At the end of the day, designers are simply using NFTs to amplify the exclusivity of sneakers to drive up demand. This is no different from the implementation of a new marketing tactic.

For NFTs to truly be a disruptor in the sneaker market, they must have real-world applications that not only improve, but completely revamp the systems that are presently in place. The sneaker market as it is today is hobbled by two critical issues: (1) since the authenticity of sneakers is difficult to verify, a counterfeit sneaker market has expanded to almost 80 times the size of the real sneaker market, and (2) the creativity of designers is not fully recognized because their profit margin is way less than that of resellers. Since they are unique and easily transferrable, NFTs can potentially eradicate the entire counterfeit sneaker market if shoe manufacturers and distributors adopted an industry-wide standard for authenticating their products. Since NFT contracts can be programmed to pay out royalties whenever a transaction occurs, designers can realize full financial potential for their labor if every NFT marketplace maintained a uniform set of specifications.

The truly impactful solutions that NFTs bring to the sneaker market may reverberate throughout the retail sector as a whole. With the power of NFTs, manufacturers and distributors can shrink the size of counterfeit markets and ensure that designers are fully compensated for their work. Rather than simply acting as a tool to drive up market demand by amplifying the scarcity of goods, I believe NFTs have the potential of addressing two major issues that currently persist in the retail sector.

Answer: The top shoe is real and the bottom shoe is fake. Let me know in the comments if you got it right!

Works Cited

https://docs.google.com/document/d/1wJcg0uxv0x-gPq18-zBfiVOF9y1J0d5VMAnVcxOm2-I/edit?usp=sharing

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Investor at Wave Financial | Twitter: @AChang_888

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Aric Chang

Aric Chang

Investor at Wave Financial | Twitter: @AChang_888

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