Anatomy of a Digital Bubble: Lessons Learned from the NFT and Metaverse Frenzy

In the past few years, "metaverse" and "non-fungible tokens (NFT)" have become buzzwords, and the prices of related assets have shown speculative bubble-like behavior. In this paper, we attempt to better understand the underlying economic dynamics. To do so, we look at Decentraland, a virtual world platform where land parcels are sold as NFT collections. We find that initially, land prices followed traditional real estate pricing models -- in particular, value decreased with distance from the most desirable areas -- suggesting Decentraland behaved much like a virtual city. However, these real estate pricing models stopped applying when both the metaverse and NFTs gained increased popular attention and enthusiasm in 2021, suggesting a new driving force for the underlying asset prices. At that time, following a substantial rise in NFT market values, short-term holders of multiple parcels began to take major selling positions in the Decentraland market, which hints that, rather than building a metaverse community, early Decentraland investors preferred to cash out when land valuations became overly inflated. Our analysis also shows that while the majority of buyers are new entrants to the market (many of whom joined during the bubble), liquidity (i.e., parcels) was mostly provided by early adopters selling, which caused stark differences in monetary gains. Early adopters made money -- more than 10,000 USD on average per parcel sold -- but users who joined later typically made no profit or even incurred losses in the order of 1,000 USD per parcel. Unlike established markets such as financial and real estate markets, newly emergent digital marketplaces are mostly self-regulated. As a result, the significant financial risks we identify indicate a strong need for establishing appropriate standards of business conduct and improving user awareness.