ASPECTS OF MONETIZATION THROUGH DERIVATIVE TRADES IN THE ART MARKET
Preliminary Considerations
In order to understand the monetary implications of the proposed introduction of derivative trades in the art market, it is best to use an analogy. Thus we make the assumptions that
- Artists (graduates of art schools) are the equivalent to corporations or companies;
- The art produced by each artist is equivalent to the number of shares issued by each company;
- The value of the art produced by each artist (shares issues by a corporation) depends on the performance of that artist (corporation);
- The investor in shares is equivalent to the collector in art.
From these four assumptions, it follows that art, like shares, can be traded for the benefit of all participants if a few rules are followed and the appropriate platforms are provided.
At present, the art market operates in a niche and has been successful in maintaining as well as augmenting its value by operating as a private club. The sort of art that is to be promoted is mostly decided by the art market (the club management). The type of collector permitted to buy such art is also chosen by the market. The chosen collector is thus analogous to a member of the club and the first requirement is that the member should have a large enough purse.
Family trusts, investment funds, etc. are automatically admitted as members of the club. The general public, on the other hand, is merely there to be milked for its adoration which constitutes the index for valuation. For instance, if the public can be persuaded to hold the work of a particular artist in high enough esteem then the output of that artist will attract high prices.
In order for the art market to continue in this rather successful enterprise, it is imperative that unsuitable people be prevented from acquiring approved art. The well-being of the art market depends entirely on the fact that a small number of the “right sort” is able to own “important” art and the public is acquiescent enough to worship it by visiting galleries or exhibitions.
There are constant attempts to “democratize” the art market but it is easy for the establishment to thwart these efforts. In the first instance, they simply have to declare that the “democratic” art market (like artsy.net) deals in “unimportant” art. The favoured and dependable line of attack was summarized by Kipling in “The Conundrum of the Workshops”.
The organization of the overall art market in New York is noticeably different from that in London, Paris or other European capitals. Galleries in New York tend to act like agents for artists and between these galleries and collectors are advisers who act as gatekeepers or assayers.
Whatever the internal composition of these markets, art that is deemed “important” must come with the seal of approval in the form of exposure to the public. The public must not, of course, be permitted to participate in the ownership as this will tend to lower the value of the art through the breakdown of scarcity.
An Alternative
Notwithstanding the advantages of incumbency and the imprimatur of the state, the established art market can be bypassed without being adversely affected by their disdain. To achieve this, the two fundamental elements of the established art market have to be reproduced (in a different form): collectors’ financial capacity and conventional exposure for the artists. The solution lies in converting the nature of the transactional relationship between the artist and the collector.
In the established art market as well as in the general market, collectors with sufficient financial resources will acquire the works of artists by paying the agreed price. The sort of artist who is able to sell to these collectors is selected by galleries typically. Sometimes the artist can reach the collector directly but this sector of the market is often dismissed as “informal” and the resale value of art in this sector may not be robust.
The proposed change in the form of the transaction between artist and collector is that it should be through derivative trades and not direct sales. The main features are:
- The gallery is an exchange which acts an intermediary between artists and collectors. In addition to this, the gallery is a participant in providing exposure to the art it helps to sell.
- The artist sells a piece of art to a collector through an options (or futures) contract in which a premium is charged (say, 25% + interest) and the balance of the asking price paid at an agreed delivery date (say, one year). The interest will be determined by the duration (expiration date) of the contract. The gallery will be the custodian of the piece before expiration of the contract.
- The options contract is securitized and is tradable on the gallery’s website up to expiration.
- With the premium set at 25%, the artist obtains an immediate payment while the purchasing power of the collector increases fourfold.
- It is in the interest of both artist and collector to increase the value of the piece through exposure to the public. For the collector, an increase in value would mean the chance to sell the options contract to a third party and realize a profit without taking delivery of the piece.
- Equally, if the piece of art proves unpopular (does not increase in value), the collector may choose not to take delivery and let the options contract expire. In this case, the artist will be able to retain the premium plus interest.
- The gallery, acting as intermediary, will be the guarantor of good conduct and will be responsible for guiding both artist and collector. Its remuneration will be based on this function.
- All transactions will be via tokens (NFTs, smart contracts, etc) recorded on blockchains.
The sort of artist who will be on the gallery’s books will typically be graduates of art schools (in the first instance). It would be difficult for the established market to dismiss such artists as they have the same antecedents as established artists. The gallery may also represent non-conventional artists such as digital or street artists but its first line of defence against attack will have to be artists with degrees.
Future Developments
The current structure of blockchains does not lend itself to the easy tokenization of option and futures contracts. The long-term aim of the gallery will be to create a different form of blockchain which is more adapted to derivative trades like futures. The objective will be to serve not only the art market but also the physical commodity markets.
A natural question arises: why attempt to restructure them when the physical futures markets are extremely well-established? The answer lies in the medium of exchange: if there is a blockchain which accommodates futures trades then all the transactions can be tokenized and transactions can be denominated in its native cryptocurrency.
To appreciate the unsuitability of current blockchains for options contracts, the first concept to understand is that of a hash function. A hash function is an algorithm which essentially takes the fingerprints of data-sets. Just as a human fingerprint identifies a particular individual but provides no other information (such as height, weight, complexion, etc.), the hash value of a set of data is its reduction to a string of numbers of fixed length. The hash value of a set of data cannot be reverse-engineered to recover the original data. For instance, the hash values of an entire book and of the single letter “a” are both strings of numbers of equal length when the same hash function is used.
Next, a blockchain consists of a series of ledgers (analogous to pages of a spreadsheet) which contain entries. These entries may be records of transactions, pieces of executable code (i.e. apps or smart contracts), economic data, weather reports, etc. There is no real restriction on the nature of these entries so long as they can be represented in digital form.
What makes a blockchain different from other types of ledgers is the presence of a header and a footer for every block subsequent to the parent block. The header is the hash value of the contents of the previous block and the footer is the hash value of the contents of the current block. When the current block has been validated by some agreed means, its footer then becomes the header of the next block. And so on.
Since hash values cannot be reverse-engineered, the contents of each block can be secured because any attempt to change the contents will generate a hash value at odds with the existing footer of the block. Any attempted fraud can therefore be easily detected.
Consider now an options contract recorded in the current block that expires twelve months hence. Accompanying the record of the transaction is a smart contract which must carry out the following:
- Keep a track of who the owner of the contract is at any given time before expiration;
- Determine at expiration whether the owner of the contract wishes to exercise the option or let it expire;
- Keep records of the changes in value of the contract if it is traded before expiration.
All these records will inevitably be recorded in blocks subsequent to the current one. This could mean that the smart contract would need to search through hundreds of millions of transaction records if the option is a long-dated one. Not only is this time consuming but also prone to error if misleading information is inadvertently or maliciously included the transactional history of the contract.
The obvious solution is to allow for triple entry in the current block. That is, there is a record of an open position for the option along with its smart contract, a register containing its current ownership and, finally, its status at expiration. Only the first type of entry (open positions and smart contracts) is hashed and sealed when the block is validated. The smart contract will be able modify the second and third types of entries (ownership and deliver respectively). Only when all the open positions in the block have expired would the entire contents be hashed, validated and sealed.
Such an exercise would be impossible in the current design of blockchain and would entail serious security risks if adaptations were attempted. In order to serve the options or physical futures markets, a new design of blockchain is necessary.
It must also be noted that blockchains are not suitable for financial futures because the reaction time must be of the order of milliseconds whereas the actual reaction times of blockchains is comparatively very long (about 12 seconds on Ethereum).