A beginner-friendly introduction to the NFT phenomena, explaining what they are and why they matter
Nonfungible tokens, or NFTs, are tokens representing some digital asset that reside on a blockchain linked to a distinct digital signature that cannot be duplicated. Like how blockchain technology is disrupting how the world transacts, nascent NFT technology can leverage blockchains to disrupt how the world thinks about assets.
Table of contents:
- What are NFTs?
- How do NFTs work?
- Types of NFTs
- Why are NFTs popular?
- Top NFT projects
- NFT criticism
- How to invest in NFTs
What are NFTs?
An NFT can be considered a one-of-a-kind, uniquely identifiable digital asset whose origin and history of ownership are publicly viewable by all. Data stored on a blockchain is immutable by nature, meaning the details will be kept on record for as long as a blockchain is operating.
A tangible example of a nonfungible asset would be your car. You could have the same make and model as your neighbor, but the color might be different, and the registration plate is unique to your vehicle. You could not reasonably swap this car with another car.
This is not the case with fungible assets such as fiat currency. For example, a $1 note is the same as any other $1 note, which can be used in exchange for goods and services.
In the early 2000s, the trading card game Pokémon became a huge hit. Created in Japan, the game was culturally significant to the generation growing up at the time. Because only a limited number of first-edition cards were printed, these are now highly valued, with rarer cards such as the one pictured below selling for $420,000.
NFTs — particularly those representing digital collectibles — often share similar properties to a trading card, just that the medium is digital and digital items use blockchain technology to establish ownership.
How do NFTs work?
The process by which an NFT is created is called minting — the token is minted to a blockchain. When minting an NFT, the user interacts with code in a smart contract that creates a new token on the blockchain linked to the public address from which the transaction was executed.
This creates provable ownership as the blockchain records a new block with the token details and the address the token belongs to — i.e., if you own the private keys associated with the public address, you own the NFT.
NFTs can then be bought and sold on an NFT-specific marketplace like OKX, OpenSea or LooksRare. Ethereum-based marketplaces account for the most NFT trading volume because Ethereum pioneered the ERC-721 token standard.
CryptoKitties and the ERC-721 standard
ERC stands for Ethereum Request for Comment. ERCs are rule sets defining the parameters to which a smart contract adheres. Fungible tokens on the Ethereum blockchain use the ERC-20 token standard. An example is USDT.
Most nonfungible tokens use the ERC-721 standard, which provides different functionality to ERC-20 tokens, namely, other ownership parameters. For example, an NFT cannot be divided into fractions as fungible tokens can.
One of the first NFT projects implementing ERC-721, CryptoKitties, sparked a craze. The project’s founder, Dieter Shirley, also proposed ERC-721 as a token standard.
Because of the Ethereum blockchain’s inherent limitations, it can be costly to store an NFT’s metadata on-chain. This is why most NFT collections keep the metadata for the tokens off-chain, usually using an IPFS hash.
Types of NFTs
NFTs have taken many forms since the inception of the token standard.
For years, digital artists have had to rely on commissions to sustain their creativity economically. Pieces of digital artwork are regularly copied online, sometimes making it difficult to credit the creator. NFT art provides a way for digital artists to monetize their artwork by being able to sell NFTs to an audience that they have built up.
In this way, the artist can see the public addresses of their audience, and the owner can prove that they hold a piece of art from the original artist using blockchain technology.
Representing pieces of digital art via NFTs is a new medium of expression, and new mediums of expression come with it their own pioneers. The NFT art renaissance is spearheaded by artists such as Beeple, Pak, XCOPY and Fewocious. Digital art sales via NFTs have already exceeded $2 billion, as of April 2022.
By volume, the collectible side of NFTs has gained the most traction. Popularized by CryptoPunks, the 10,000-piece NFT collection has become a staple in the digital collectible world.
Collections are unified by a common project design and a single smart contract. However, individual NFTs within a collection have their own traits, making some rarer than others. There are now thousands of NFT collectible projects launching a 10,000-piece collection because of the success of CryptoPunks. While most have failed to capture the same enthusiasm as CryptoPunks, some — like the Bored Ape Yacht Club — have also found similar success.
Twitter CEO Jack Dorsey famously sold his first tweet as an NFT collectible for $2.9 million. The tweet posted in March 2006 reads, “just setting up my twttr.” It was bought by Sina Estavi, the CEO of blockchain project Bridge Oracle, on March 22, 2021. It has since been listed for sale again, priced at 14,969 ETH — or $48,362,294.
Gaming is an upcoming frontier for the use of NFT technology. Economic systems can be built around gaming NFT assets, and experiments in the GameFi sector are already garnering a lot of excitement. For example, in-game land can be purchased in the popular game Axie Infinity, enabling users to farm the in-game resources if they hold the land NFT.
One of the first NFT-like products on the internet was domain names. These can be registered to an individual using personal credentials. On the Ethereum blockchain, domain names using the Ethereum Name Service are registered as a human-readable Web3 wallet address.
Liquidity provider tokens
Decentralized exchange Uniswap allows users to concentrate their liquidity position by minting an NFT within a specific price range. Users can provide liquidity to the exchange by pairing ERC-20 tokens and, in return, receive an NFT representing the position.
Digital representation of real-world assets
An NFT can be tied to a real-world asset to secure its provenance and authenticate the item. It is still debated how best to do this. However, projects like Vidt are making strides toward making this a reality. On Feb. 12, 2022, someone sold their home through an NFT sale — making it one of the first real-estate transactions on the blockchain.
Why are NFTs popular?
NFTs have gained widespread popularity and mainstream coverage because of numerous factors. Firstly, they create scarcity in an infinite digital world.
Secondly, communities form around different collections. Collections only have a finite number of items, playing into the supply-and-demand factors that cause some collections to be worth millions of dollars. The sense of ownership of digital items is powerful and also contributes to the success of NFTs as a medium.
Composability is one of the hallmark traits of NFTs. When integrated, tokens can be used on multiple platforms. For example, someone owning a CryptoPunk can choose to display it in a digital gallery but could also use it as their avatar inside a metaverse space.
Top NFT projects
Popularizing the avatar/profile-picture trend, CryptoPunks has become synonymous with the “crypto” subculture. Launched as a free-to-claim collection by Larva Labs, the average price for a Punk NFT on the secondary market in 2017 was $50 to $150. Fast-forward five years and the average cost is over $200,000 per NFT.
From obscurity, multiple high-value CryptoPunks sales raised eyebrows at the start of 2021 and propelled the market into an NFT trading frenzy. CryptoPunks is one of the first collections to gain mainstream popularity.
The Bored Ape Yacht Club
Launched on April 23, 2021, the Bored Ape Yacht Club didn’t fully mint out until one week later. It is currently the only avatar collection to have reached the same heights as the CryptoPunks.
Yuga Labs, the company behind BAYC, has rewarded owners of their NFTs by airdropping other NFTs and creating a token — ApeCoin — for them to claim.
The most recent NFT collection to rise to similar levels to CryptoPunks and BAYC is Azuki. This anime-style collection was one of the quickest to hit a 10 ETH floor price in just under a month.
Seemingly following the same path as BAYC, Azuki holders have been rewarded by airdrops, and the team has teased future innovations that may bring additional value to the collection.
Generative art platform Art Blocks pioneered algorithmic art NFTs. Multiple generative artists have used the platform to launch their own art projects, with the buyer getting a unique, random piece of digital art based on the artist’s design.
The cumulative volume of Art Blocks trading is over $1.6 billion, making it one of the most successful digital art platforms to date.
The wave of excitement surrounding large sales of NFTs has brought with it controversy. The main criticism of NFTs is that their minting produces emissions because of the proof-of-work mechanism that the Ethereum blockchain currently runs on. This is set to change in 2022 as Ethereum transitions to a proof-of-stake consensus mechanism, making the blockchain more eco-friendly.
Other critics highlight wash trading, arguing that some NFT traders are duping the market with significant sales to themselves to drive up volume. While this certainly does occur — see the LooksRare marketplace — its importance is often overstated.
How to invest in NFTs
To buy NFTs, you need a Web3 wallet such as Metamask or OKX’s MetaX. This allows you to interact with NFT marketplaces. Most Ethereum-based NFTs are priced in ETH, so you must fund your wallet by transferring funds from an exchange like OKX.
Even though Ethereum is the most prominent, NFTs exist on most smart contract-enabled blockchains. There are marketplaces on Solana, Tezos, Polygon and many other networks, although there are trade-offs to consider when buying NFTs on other blockchains.
Of all smart contract-enabled blockchains, Ethereum has been around the longest. Naturally, it has developed the most established NFT community. When you buy an NFT on the Ethereum blockchain, you are paying a premium for security and provenance, as most market participants expect the Ethereum blockchain to be around long into the future.
The same may not be the case for many other blockchains. The caveat is that when using other blockchains to buy or sell NFTs, you are paying less in gas fees and usually less, in general, for a piece in a collection.
More options for investors are coming to the market, such as Fractional — where you can purchase pieces of digital assets as ERC-20 tokens to enable more investors to take exposure to high-priced NFTs. Platforms like this make a digital asset more fungible and also more accessible to a broader audience.
Are NFTs a good investment?
NFT technology is just that — a technology. For now, the market values collectibles very highly, but as more sophisticated use cases emerge, new NFT subgroups may become popular. However, it’s clear that NFTs are here to stay. They are quickly emerging as one of blockchain technology’s killer applications.
The growth of NFTs has been phenomenal over the past two years, with over 1.5 million users interacting with OpenSea alone. This trend is set to continue as the technology onboards more users.
For now, the valuation of the top NFT collections is driven by speculation. However, we could be witnessing the start of the first Web3 native brands as the market capitalization of some collections exceeds $1 billion. In the future, examples like BAYC could compete with large, mainstream brands like Nike.
While it is unclear what the market will find value in during the coming years, there will be many great opportunities within this space going forward.
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