What are NFTs & How Do They Work?
Non-fungible tokens (NFTs) are digital assets which, like cryptocurrency are recorded on a blockchain such as Ethereum. Unlike most cryptocurrencies however, NFTs are unique, meaning they can be used in interesting ways that conventional cryptographic tokens such as Bitcoin and Eth can't.
You’ve likely heard of Cryptokitties, a blockchain game on Ethereum, which helped bring NFTs into the spotlight in 2017. Since then the market has moved on from just gaming to include unique items including art collections, trading cards, and even real estate. According to the recent report from Nonfungibles.com and L’Atelier, the NFT market grew 299% in 2020, jumping to $250 million from the $62 million it was worth in 2019.
And if 2020 was a great year for NFTs, then 2021 is on track to beat that: Leading marketplace, Opensea has experienced month on month growth during the first quarter of the year, reporting a 100 fold increase in sales compared to 6 months ago, new, more mainstream artists have flocked to the emerging space and digital artist Mike Winklemann, better known as Beeple became one of the three most valuable living artists after his piece “The First 5000 days” was sold for $69 million at an auction held by Christies.
Outside of art, NFTs are being used in everything from gaming, music and ticketing to improving how provenance is measured for luxury goods.
What attracts collectors to the emerging asset class is that every token is unique and unlike other digital collectibles, NFTs are recorded on immutable ledgers (Blockchains) meaning that a collector always actually owns their collectible and knows the true scarcity of the item due to this information being publicly available.
What is Fungibility?
The concept of fungibility is not unique to the crypto-space, it refers to items that can be interchanged with other individual goods or assets of the same type, for example, money is fungible: If you trade a £1 coin for another £1 coin, it is still has the value of £1. While there may be some determining factors between the 2 coins, they can still both be used to purchase goods and services of the same value.
Fungible assets are different however, for example, trading cards where the value is defined based on multiple factors such as scarcity, to physical factors such as the condition of the card, centering and print quality.
It is these principles that are applied to non fungible tokens: Due to their uniqueness and the fact that they are non-fungible means that they can’t be replaced for something similar. No two NFTs are the same. An example of an NFT would be a limited edition piece of crypto art, and because of its scarcity, it helps to push that item’s value up.
Advantages of NFTs
Quickly gaining mainstream attention, non-fungible tokens are helping to replace how many industries function. But while they are changing how people buy and sell digital collectibles, what are the advantages of NFTs?
As every non fungible token is stored on a digital ledger (a Blockchain) proving the authenticity and provenance of a piece of art is easier than with conventional art.
Scarcity plays an important role in understanding the value of any non fungible asset. In the case of something like Pokemon cards, it’s impossible to know the exact amount of a card that has been produced, non fungible tokens however don’t suffer from the same issue, with all tokens having a token ID and the amount that has been produced, recorded on a blockchain.
Easy to Transfer
Transferring physical art or collectibles can be a stressful, cumbersome and expensive process. Transferring NFTs is much simpler, all that is needed is a marketplace, the recipient's address and enough money for gas to initiate the transfer.
The condition of an item is of key importance when assessing the value of a physical collectible and collectors often hire the services of professional grading companies who grade and protect these.
NFTs do not suffer the same issues as digital collectibles are not susceptible to issues such as sunlight and moisture. It is worth noting however that access to your NFTs should always be a consideration when upgrading hardware, in the same way you’d consider this when thinking about how you store any other cryptocurrencies.
Have you heard the motto “not your keys, not your coins?” Well, being a type of crypto asset means that this also applies to NFTs too, so it’s important to always consider security and where you’re going to store them.
In order to purchase and store NFTs, you’ll first need to have a wallet. These come in two forms: software or hot wallets and hardware or cold wallets. There are numerous different options available, but the favoured solution is Metamask which is a Web3 plugin that allows you to interact with decentralised applications and store crypto assets in your wallets.
Options such as Metamask, My Ether Wallet and Coinbase wallet are simple to set up and use, however the downside is that these types of software wallets are connected to the internet and come with some risk as a person’s private keys could be hacked, resulting in loss of tokens.
For those who are more security conscious, hardware wallets store a user’s data offline, giving maximum security. Because they are offline, however, moving non fungible tokens from a hardware wallet can be difficult due to the differing support offered by manufacturers. One solution is to store NFTs on a hardware wallet, but then use one of the many software wallet providers that support them, Mew and Metamask both support Trezor, meaning that tokens can only be viewed and transferred in a simple way, but requires the physical device to actually initiate a transaction.
The addresses you use to deposit crypto assets on an exchange should never be used to transfer non fungible tokens: Exchanges have potentially millions of different addresses and rarely support non fungible tokens, meaning that if you were to transfer yours to one of these, they would likely be lost.
Being cryptographic tokens recorded on a blockchain means that you don’t need permission from a 3rd party to trade NFTs. As long as a marketplace supports the blockchain your assets were minted on and recognises the contract that your tokens are part of, you can freely sell your tokens.
One example and probably the biggest is Opensea which is the leading marketplace for trading non fungible tokens. Here, you can buy, sell, and discover digital assets such as Cryptokitties, Decentraland, and KnownOrigin art.
The specifics of trading NFTs on these marketplaces does differ per platform, but typically, selling entails giving the marketplace permission via your wallet and then simply listing for the price. At no point does the marketplace claim custody of your token and they are only transferred once a sale has been initiated.
In most cases, buying and selling NFTs on a marketplace does involve paying gas to make the transfer between users.
The Future is Bright for NFTs
It’s certainly an interesting time for the NFT industry and one that’s set to continue growing. Combine this with the fact that more projects are experimenting with NFTs and it’s hard not to see the market increase in years to come.
The sector may be relatively small, particularly compared to decentralised finance (DeFi), but the promise it presents is already encouraging those participating that wasn’t possible before. As time goes by, more artists and creators will turn to NFTs and more platforms will help power these tokens as they rise in demand.