The Blockchain Beginners Guide — NFTs
Learn all you need to know about Non-Fungible-Tokens (NFTs). How they work, why they exist, what to do with them and where the shortcomings are.
When back in 2017 people started trading digital pictures of kittens in the form of an NFT, few would have thought that a few years later this would become a multi-billion dollar market. And now there is not a day where you wont read about Non-Fungible Tokens (NFTs).
But in order to understand the hype about NFTs we need to dig a little deeper. In this article I try to explain how NFTs work, how they fit into todays world and what the future holds.
Key Takeaways:
- NFTs are unique and non-interchangeable tokens linked to a blockchain
- NFTs first appeared in 2014 but only attracted large public interest in 2019
- NFTs are most known in the form of collectible (digital) artworks
- NFTs have a wide variety of use cases including real estate and digital IDs
What Are NFTs?
A Non-Fungible Token is essentially a piece of data with a unique digital signature that is stored on a blockchain, a digital ledger, that can be traded. They represent an evolution of simple cryptocurrencies, although they operate in a similar way. With its signature an NFT, unlike a cryptocurrency, is not interchangeable and thus provides proof of authenticity. But what does that mean?
NFT vs. Crypto
Crypto currencies are interchangeable tokens, meaning one unit of a token can always be exchanged for another unit on a 1:1 basis. For example; a Bitcoin can always be exchanged against another bitcoin at with the same value.
In its simplest form an NFT carries a unique digital signature which makes it irreplaceable. While an NFT can be exchanged against crypto, fiat or even another NFT, their uniqueness means they can always only be traded for another value.
Where do NFTs come from?
Although the first NFT was created in 2014 it wasn’t until 2017 that NFT’s received widespread attention. Through the implementation of a standard (definition) on the Ethereum blockchain and a slew of NFT projects that year.
Today Ethereum is the most widely used blockchain for the creation and trade of NFT’s, although other chains are increasingly gaining market share for reasons we will discuss later. For now lets focus on the ETH standard.
The Etherum protocol (ERC-20) were first outlined NFTs in an Ehereum Improvment Proposal (EIP) in 2017. This standard was approved and manifested as ERC-721. In 2019 and enhancement in the form ERC-1155 followed. The results were two new token standards ERC-721 and ERC-1155 that defined what we today know as NFT.
Sidenote: ERC-721 requires a new smart contract for every type of token, granting total uniqueness of each NFT. ERC-1155 on the other hand provides somewhat more flexibility as it allows for the creation of semi-fungible tokens and batch processing (trading multiple NFTs in one single transaction).
What can NFTs be used for?
Besides collecting imagery of kittens and apes, NFTs have actually wide variety of uses cases. They can be used to authenticate pretty much an real world or digital asset while the underlying blockchain acts as a safe and transparent ledger.
Lets have a look at some of the use cases for NFTs;
Art
Today NFTs are most known for their use on works of art, digital as well as physical. The digital signature of an NFT allows to distinguish the authenticity of the artwork. Furthermore the transaction history of the artwork is trackable on the blockchain. NFTs also allow artists to reach and transact with a large audience without relying on middleman such as auction houses.
Music
Similar to artworks musicians can release their songs as NFTs directly to their audience without relying on labels while maintaining copyrights and royalties embedded in the NFT.
Film
Film studios for example can create stills of an existing movie and sell them as NFTs in order to raise funding for the next project. The NFTs on the other hand can be outfitted with certain perks such as the ability to act as a ticket to the premier of the movie as an additional incentive for purchase.
Gaming
NFTs have become increasingly important in online gaming where they are being used in multitude of aspects. Gamer avatars come in the form of NFTs serving as digital ID, incorporate virtual land or items that gamers can trade.
Digital Identity
The uniqueness of NFTs allows them to represent a digital identity. This can range from providing access to your online services instead of a password all the way to digitizing a passport or health record. They can also be used to provide real life benefits where the NFT acts as a membership card that grants access to certain services, locations or events.
Real Estate
Every house, every apartment and every piece of land is unique. Real estate transactions are often costly and involve a lot of middleman such as notaries or local authorities. Tokenizing real estate assets as NFTs could facilitate not only the buying and selling of real estate but also help streamlining registries and provide more real time data for property markets.
Supply Chain Management
The use of an NFT as a product ID can help to streamline supply chain management where everyone with access can determine origin and destination of a certain product without papertrails and totally immutable on a blockchain. It can also be used to verify the authenticity of a product and serve against counterfeiting.
While some of these use cases also inherit certain risks, it certainly shows that an NFT can have many real world applications besides just collecting art. NFTs can provide an alternative in how we authenticate ownership of an asset and the way we conduct trade.
Pros & Cons of NFT
Now that we understand what NFTs are, lets discuss some of their benefits and drawbacks.
Benefits
- Transferability; thanks to the underlying blockchain technology NFTs can easily be transferred and traded. All that is needed is internet access.
- Security; the immutability of the blockchain ensures the security of an NFT and allows participants to track and trace transactions.
- Flexibility; as long as the underlying protocol allows it, NFTs can incorporate a multitude of functions and perks such as copyrights and royalty payments on future transactions for the creator.
- Speed & Transaction costs; the lack of middleman when transacting with NFTs increases speed and eliminates 3rd party costs.
- Responsibility; The owner of the NFT incorporates full responsibility for the token and is the sole owner to a unique asset.
Drawbacks
- Interoperability; NFTs rely on their underlying blockchain and transferring them between different chains can be difficult or simply impossible.
- Dependency on Blockchain; any NFT is reliant on the stability of the underlying blockchain.
- Cost; depending on the underlying blockchain, creating and transferring NFTs can occur high costs in the form of gas fees. NFT market places can impose additional costs for trading.
- Market Places; NFTs (especially for artworks) heavily depend on market places, this leads to a concentration risk of market places and the dependency on them
- Responsibility; While the blockchain offers decentralization and autonomy, it also means that users users are fully responsible for the security of their data.
- Environmental impact; today most NFTs run on proof of work chains which have proven to be highly energy intensive.
- Uncertain Regulations; like most crypto assets the NFT market currently lacks a regulatory framework which can lead to uncertainty and hinder widespread adaptation in everyday use.
Conclusion
While being most known for (digital) art collectibles, the open architecture behind the NFT protocols allows for the tokenization of pretty much any asset, while the uniqueness of each NFT authenticates that asset.
NFT technology can help to facilitate trade, streamline supply chain management, secure copyrights and provides immutable and secure information about the tokenized assets.
While all this sounds great the concept of NFTs is still young and like the underlying blockchain technology faces hurdles. And while the current hype around NFTs is great for opening up a dialogue around the utility of this technology, clearer rules and regulations around the topic will be required before a widespread adoption is possible.
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Disclaimer: Any information in this article is based on my personal experience and has been written out of personal interest. This article has no promotional purpose, does not represent investment advice and any names, brands and tickers mentioned in this article are for illustrative purposes only. Use any of the associated links with care and at your own risk. Always do your own research.
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