What are Non-Fungible Tokens (NFTs)?
Non-Fungible Tokens (NFTs) are assets that have been tokenized using a blockchain. They are assigned a unique identification code and metadata that sets them apart from other tokens.
NFTs can be traded and exchanged for money, cryptocurrencies, or other NFTs, depending on the value assigned to them by the market and owners. For example, you could use an exchange to create a token for an image of a banana. Some people might pay millions for the NFT, while others might think it has no value.
Cryptocurrencies are also tokens; however, the key difference is that two cryptocurrencies on the same blockchain are interchangeable - they are fungible. Two NFTs on the same blockchain may look identical, but they are not interchangeable.
Key Concepts
- NFTs (Non-Fungible Tokens) are unique cryptographic tokens that exist on a blockchain and cannot be replicated.
- NFTs can represent digital or real-world objects such as artwork and real estate.
- "Tokenizing" these tangible real-world assets makes buying, selling, and trading more efficient, minimizing the likelihood of fraud.
- NFTs can represent people's identities, ownership rights, and more.
History of Non-Fungible Tokens (NFTs)
NFTs were created long before they became popular in the mainstream. The first NFT sold is said to be "Quantum," designed and tokenized by Kevin McKoy in 2014 on a blockchain called Namecoin. It was later minted and sold in 2021 on Ethereum.
NFTs are built following the ERC-721 standard (Ethereum Request for Comment #721), which establishes how ownership is transferred, methods for confirming transactions, and how applications handle secure transfers, among other requirements. The ERC-1155 standard, approved six months after ERC-721, improves upon the former by grouping multiple non-fungible tokens into a single contract, reducing transaction costs.
How Do NFTs Work
NFTs are created through a process called "minting," which involves recording the NFT's information on a blockchain. In summary, the "minting" process requires creating a new block, validating the NFT's information by a validator, and closing the block. Often, this "minting" process involves the use of smart contracts that handle the ownership and transferability of the NFT.
During token creation, they are assigned a unique identifier directly linked to a blockchain address. Each token has an owner, and ownership information, i.e., the address where the minted token is located, is publicly available. Even if 5,000 NFTs of the exact same item are generated (analogous to tickets for a movie screening), each token has a unique identifier and can be distinguished from the others.
Blockchain and Fungibility
Like physical money, cryptocurrencies are usually fungible from a financial perspective, meaning they can be traded or exchanged with one another. For example, one bitcoin is always equal in value to another bitcoin on a given exchange, similar to how each US dollar bill has an implicit exchange value of $1. This fungibility characteristic makes cryptocurrencies suitable as a secure means of transaction in the digital economy.
For this reason, NFTs change the paradigm of cryptocurrencies by making each token unique and non-replicable, making it impossible for a non-fungible token to be "equal" to another. They are digital representations of assets and have been compared to digital passports because each token contains a unique and non-transferable identity to distinguish it from other tokens. They are also extensible, meaning you can combine one NFT with another to create a third unique NFT.
Examples of NFTs
One of the most famous use cases of NFTs is Cryptokitties. Launched in November 2017, Cryptokitties are digital representations of cats with unique identifications on the Ethereum blockchain. Each kitten is unique and has a different price. They "breed" with each other and create new offspring with different characteristics and valuations than the "parents."
Within weeks of their launch, Cryptokitties amassed a fan base that spent 20 million ether to purchase, nurture, and take care of them. Some enthusiasts even spent over $100,000 for a purchase. More recently, the Bored Ape Yacht Club has gained attention for its high prices, celebrity following, and thefts of some of its 10,000 NFTs.
Much of the previous NFT market was focused on digital art and collectibles, but it has evolved much further. For example, the popular NFT marketplace OpenSea has several categories of NFTs:
- Photography: Photographers can tokenize their work and offer full or partial ownership. For example, OpenSea user erubes1 has a collection "Ocean Intersection" of beautiful ocean and surfing photos with various sales and owners.
- Sports: Collections of digital art based on celebrities and sports figures.
- Trading cards: Tokenized digital trading cards. Some are collectibles, while others can be used in video games.
- Utility: NFTs that can represent membership or unlock benefits.
- Virtual worlds: NFTs of virtual worlds grant you ownership of anything from avatar clothing to digital property.
- Art: A generalized category of NFTs that includes everything from pixel art to abstract art.
- Collectibles: Bored Ape Yacht Club, Crypto Punks, and Pudgy Panda are some examples of NFTs in this category.
- Domain names: NFTs representing ownership of domain names for your website(s).
- Music: Artists can tokenize their music, granting buyers the rights the artist desires.
Advantages of Non-Fungible Tokens
One of the main advantages of NFTs is the increased efficiency of the market. Tokenizing physical assets simplifies the sales process and eliminates intermediaries. In particular, NFTs representing digital or physical artwork on a blockchain eliminate the need for intermediaries and allow sellers to directly connect with their target audience. Of course, it is important for artists to know how to securely host their NFTs.
Investments
NFTs can be used to simplify investments. For example, consulting firm Ernst & Young has already developed an NFT solution for a fine wine investor, storing the wine in a secure environment and using NFTs to protect provenance.
The real estate sector can also be tokenized: a property can be divided into multiple sections, each with different characteristics. For example, one section can be near the lake, while another can be closer to the forest. Based on its characteristics, each piece of land can be unique, have a different price, and be represented by an NFT. This would simplify real estate trading, which is usually complex and bureaucratic, by incorporating relevant data into a unique NFT associated only with the corresponding portion of the property.
NFTs can represent ownership of a company, just like stocks. In fact, ownership of stocks is already tracked through registries that contain information such as the shareholder's name, issuance date, certificate number, and number of shares. A blockchain is a distributed and secure ledger, so issuing NFTs to represent stocks serves the same purpose as issuing stocks. The main advantage of using NFTs and blockchain instead of a stock registry is that smart contracts can automate ownership transfers: once an NFT stock is sold, the blockchain can handle everything else.
Security
Non-fungible tokens are also very useful for ensuring identity security. For example, personal information stored on an immutable blockchain cannot be accessed, stolen, or used by anyone without the access keys.
Furthermore, NFTs can democratize investments by fractionalizing physical assets, such as real estate. It is much easier to divide a digital real estate asset among multiple owners compared to a physical one. This practice of tokenization does not have to be limited to real estate but can be extended to other assets, such as artwork. This way, a painting does not necessarily have to have a single owner, but multiple people can buy a portion of it, gaining ownership of a fraction of the physical artwork. Such arrangements can increase the value and revenue of the artwork, as more people can buy parts of expensive pieces compared to those who can afford whole pieces.
Are NFTs Secure?
NFTs, leveraging blockchain technology like cryptocurrencies, are generally secure from any computer attacks. However, the weak point of all blockchains lies in the private key of the wallet where your NFT resides. The software managing the keys could be compromised, and the devices on which the keys themselves are stored could be lost or damaged, so the general rule of blockchains applies: "not your keys, not your coins," which also applies to NFTs. The security of NFTs depends on properly safeguarding the keys.
What Does Non-Fungible Mean?
Fungibility describes the interchangeability of goods. For example, suppose you have three notes with identical smiley faces drawn on them. When one of them is tokenized, that note becomes distinguishable from the others - it is non-fungible. The other two notes are indistinguishable, so they can be substituted for each other.
Conclusion
NFTs are an evolution of the relatively simple concept of cryptocurrencies. Modern financial systems consist of sophisticated trading and lending systems for various types of assets, from real estate to loan contracts to artwork. By enabling digital representations of assets, NFTs represent a step forward in reinventing this infrastructure.
Undoubtedly, the idea of digital representations of physical assets is not new, nor is the use of unique identifications. However, when these concepts are combined with the advantages of a tamper-resistant blockchain with smart contracts and automation, they become a powerful force for change.