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nonfungible token (NFT)

What is a nonfungible token?

A nonfungible token (NFT) is a type of cryptographic asset that is unique and used to create and authenticate ownership of digital assets. These include cartoons, music, film and video clips, JPEGs, postcards, sports trading cards, and virtual real estate or pets. NFTs provide a secure record that is stamped with unique identifying code stored on blockchain.

In contrast to stocks, bonds and other traditional investments, NFTs are considered an alternative investment that is not fungible, or replaceable, with a similar item. Demand for NFTs, which are like rare collectibles, picked up steam in 2020 and increased dramatically in 2021. This drove up the price of digital artworks, with celebrities, content creators, auction houses and others participating in the market.

How do NFTs work?

The one-of-a-kind qualities of NFTs make them "nonfungible." This contrasts with "fungible" assets, such as Bitcoin and other cryptocurrencies, dollar bills, gold bars or stock, that are worth a specific amount and are interchangeable. Although one dollar bill can be exchanged for another dollar bill, or one bitcoin can easily be swapped for another, that is not the case with NFTs.

NFTs are also nondivisible. The basic unit of the NFT is the token, which cannot be divided into smaller denominations, as a dollar might be divided into 10 dimes. However, NFTs may be divisible in the future.

Additionally, NFTs are immutable. NFTs cannot be altered once they have been encoded using blockchain technology. The originality and legitimacy of the item is validated through the blockchain in which it is stored.

How blockchain works
The 5 steps for verifying and executing transactions using blockchain technology.

Blockchain technology establishes ownership of the NFT. Blockchain acts as a decentralized ledger, enabling NFTs to be authenticated publicly to provide a digital signature to prove who owns it and that it is an original work. An NFT buyer would not own a piece of art to hang on a wall but rather a digital image of that artwork and digital certificate of authentication.

The NFT buyer does not own the copyright or trademark of the item. Although there may also be numerous versions it on the internet, NFT buyers have an original in the virtual world.

Furthermore, royalties can be programmed into the token, enabling artists to collect a portion of sales in the future. Other possible technical features include fractional ownership, in which individual investors own a percentage of the NFT and its benefits.

Why are NFTs important?

The surge in popularity of NFTs is a result of their "improved ease of onboarding, speculative nature as both a collectible and investment and grassroots communities developed around the products," explained Justin Herzig, co-founder of Own the Moment, which provides content, tools and analytics on NFTs.

NFTs enable individuals to buy and sell digital assets in new ways. They help artists and other content creators display their skills digitally and provide the ability to securely value, buy and exchange digital art using a digital ledger. Using NFTs, new and previously decentralized actors can develop innovative value exchanges to build new market structures.

NFTs are a significant form of alternative investment that appeals to buyers' "personal interests and passions," explained Herzig, pointing to figures from Preqin projecting a $14 trillion alternative investment industry by 2023. With NFTs, retail investors will be able to have a more personal connection to an interest while investing in areas of financial and utility value.

The NFT buyer hopes the value of the token will increase with time, similar to all investments. Just like their fungible cousins, NFTs are subject to shifts in supply and demand.

According to the NFT Yearly Report 2020, published by NFT market analysis firm Nonfungible.com, the total value of NFT transactions is estimated to have surged from to $62.9 million in 2019 to $250.8 million in 2020. In the first quarter of 2021, more than $2 billion was invested in NFTs, compared with $93 million in the fourth quarter of 2020.

What are uses and examples of NFTs?

An early use of NFTs was a game launched in 2017 called CryptoKitties, in which users could trade and sell virtual kittens. In 2021, NFTs that sparked attention included Twitter CEO Jack Dorsey's first-ever tweet and work by Beeple, the professional name used by artist Mike Winkelmann, who sold his piece "Everydays: The First 5000 Days" for $69 million.

NFTs are currently being used to sell a range of virtual collectibles, including the following:

  • NBA virtual trading cards
  • Digital sneakers from Nike
  • Trading cards featuring personal memorabilia from actor William Shatner
  • A full studio album by rock band Kings of Leon
  • The original "nyan cat" meme
  • Collectible virtual characters called CryptoPunks
  • A variety of GIFs and images commissioned by Taco Bell, with proceeds going towards the restaurant chain's charity organization
  • Virtual real estate in Decentraland, a 3D virtual reality platform

Today, the primary owners and collectors of NFTs are enthusiasts with a strong interest in a domain or project. However, NFTs are expected to become mainstream and attract retail investors eventually as the products and technology improve.

How are NFTs created?

NFTs are created using smart contracts. Smart contract code is incorporated into the token when it is created or minted. Stored on blockchain, the smart contract determines the NFT's qualities, such as ownership and transferability.

The smart contract is autonomous, containing the terms and conditions of an agreement directly within the lines of code. Each NFT is linked to a single token that is stored in a smart contract, which runs on top of the distributed ledger to provide proof of ownership and verifiable originality. Even though there are other copies of the same content, only one person can own the particular token that authenticates ownership of the NFT.

Smart contracts are a crucial feature of blockchain technology. While most NFTs reside on the Ethereum blockchain, some are based on other blockchain technologies, such as TRON and NEO. Blockchain also helps ensure that NFTs remain secure.

While NFTs gain popularity, market participants and observers are becoming increasingly aware of the impact that NFTs will have on the environment. The use of blockchain generates greenhouse gases, which have a significant effect on the world's carbon footprint.

How are NFTs bought and sold?

As demand for NFTs grows, new marketplaces continue to surface. Popular marketplaces for creators to sell NFTs include:

  • OpenSea
  • Rarible
  • Myth Market
  • BakerySwap
  • SuperRare
  • Foundation
  • AtomicMarket
  • KnownOrigin
  • Enjin Marketplace
  • Portion

The typical process to buy or sell an NFT as follows:

  1. Set up a digital wallet and purchase cryptocurrency, such as ether, using an app, such as Coinbase, Robinhood or MetaMask.
  2. Connect the digital wallet to an NFT marketplace
  3. Mint or list the NFT for sale, or start bidding on or purchasing pieces of content.

Users can auction bids or purchase outright, depending on the seller and marketplace.

The future of NFTs

As with all market assets, principles of supply and demand apply to the NFT marketplace. Buyers should be cautious, as they should be with any type of investment, and keep their eyes open as the market evolves.

"An NFT is only as valuable as what others are willing to pay for it," Herzig said. "NFTs that can build a deep connection with collectors and investors have shown an increased likelihood of having long-term staying power."

Collectors and investors can understand the current value for NFTs better by viewing previous and similar sales on established marketplaces. The long-term viability of NFTs will depend on the distinction of their utility value, not just theoretical. Like with other collectables, this will happen once owners view NFTs as uniquely valuable experiences or features. NFT communities will develop and grow, helping to maintain prices and markets and strengthen the trust in their long-term survival.

This was last updated in July 2021

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