What is an NFT and how does it work? Non-Fungible Tokens Explained

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What is an NFT and how does it work? Non-Fungible Tokens Explained

Key takeaways:

  • Non-fungible tokens (NFTs) are unique digital assets that store ownership data on the blockchain
  • NFTs provide a multitude of different use cases spanning across entertainment, gaming, and social media sectors
  • The popularity of NFTs skyrocketed in 2021, with the total NFT trading volume growing by 21,000% to $17.6 billion

What are non-fungible tokens (NFTs) and how do they work?

Non-fungible tokens (NFTs) are unique, non-replaceable digital assets that house ownership data stored on the blockchain. The built-in authentication that serves as proof of ownership allows NFT holders to own digital images, gaming items, music, videos, and anything else than can be tokenized as an NFT. Many cryptocurrency wallets can act as NFT wallets, making NFTs convenient to store.

Contrary to digital assets like Bitcoin and Ethereum–both of which have uncapped or very high circulating supplies–NFTs are generally one of a kind, or at the very least very limited. This characteristic makes NFTs scarce and drives their value through supply and demand dynamics. Some of the most expensive NFTs of all time have sold for tens of millions of dollars.

Ethereum is the largest blockchain network for NFTs and home to the most popular digital art collections such as Bored Ape Yacht Club (BAYC) and CryptoPunks. While Ethereum was the first network to feature NFTs thanks to its ERC-721 token standard, several blockchain ecosystems have become a hotbed of NFT activity in recent years, including Solana, Flow, and BNB Chain.

Growth of the NFT market cap

The growth of the NFT market in recent years has been nothing short of explosive. According to a study conducted by BNP Paribas-owned research firm L’Atelier, the NFT market reached $17.6 billion in trading volume in 2021, up from just $82 million in 2020 - an extraordinary 21,000% year-over-year increase. Nothing showcases the growth of the NFT sector more than last year’s $69.3 million sale of Beeple’s digital art collage called "The First 5,000 Days".

2021 was undoubtedly a great year for NFTs–-both in terms of trading volume and their exposure to mainstream audiences– and 2022 started on the same note. Case in point, OpenSea, the world’s largest NFT marketplace, recorded over $5 billion in trading volume in January alone.

Beeple's digital image collage called "The First 5000 Days" is the most expensive NFT tiem sold to date

Popular digital artist Mike Winklemann’s (Beeple) digital art collage sold for over $69 million. Image source: Beeple

While the most expensive NFT sold to date was a piece of digital art, the overall NFT activity has been driven mainly by blockchain gaming use cases in recent months. Blockchain-powered games like Axie Infinity and The Sandbox allow players to own pieces of digital land and in-game items like skins, weapons, and characters, tokenized as NFTs. 

While NFTs are still in their early days, current iterations of blockchain games do present a glimpse into the future in which users will be able to seamlessly transfer and trade their in-game items between various titles and genres. 

Beyond gaming, NFTs are uniquely positioned to benefit from a world that is increasingly more digitized and needs an efficient way to keep tabs on ownership of digital items. This will likely become even more apparent in the near future with the proliferation of the metaverse and various gaming and non-gaming virtual reality platforms.

What is fungibility?

To explain the benefits and explore the myriad of use-cases for non-fungible tokens, we first have to define the meaning of fungibility. Probably the most common area where we are faced with the concept of fungibility in our everyday lives is the use of money.

When dealing with fungibility in monetary supply, we are talking about the fact that any $10 bill must be treated the same and hold the same value as any other bill with the same denomination - no store or vendor will accept a $10 bill and treat like it is worth $1000 or $11 or $1.

Fungibility is the property of a good or commodity that implies equal value between the units of the particular good or commodity and their interchangeability. For example, if we get paid for a service and receive a payment of $100, it does not matter whether it is paid out in ten bills of $10 or in a single $100 bill.

Fungibility in Crypto

The same principles hold true for the majority of cryptocurrencies. If we lend one Bitcoin, we do not care whether we are repaid in a single payment of one BTC or in multiple smaller transactions, as long as the sum of those transactions equals the amount we lent.

As Bitcoin’s popularity reached a critical point in its early days, it began serving as real-life evidence that digital currencies can offer secure, verifiable, and transparent transactions thanks to public, distributed ledger (i.e., blockchain) that can act as a substitute for the traditional middleman (i.e., banks). Bitcoin succeeded in decentralizing the transaction record, but it was never meant to be anything more than a currency. 

Some people, however, realized that the same technology that enables Bitcoin may also be used to decentralize not only transaction data, but much more complex information. One of those people was Vitalik Buterin, who was instrumental in creating the Ethereum project. Ethereum brought the ability to easily create new cryptocurrencies as well as decentralized applications (dApps)

DappRadar's chart showcasing blockchain activity between the start of 2021 and April 2022

Average daily unique wallets connecting to dApps across gaming, NFT, and DeFi services between Jan. ‘21 and Apr. ‘22. Image source: DappRadar

As the complexity of decentralized data increased, new standards were needed to ensure that different tokens and applications share the same components and follow the same rules so that the Ethereum ecosystem remains cohesive. ERC-20 is probably the most well-known among Ethereum standards. It standardized fungible tokens and enabled the launch of major projects such as EOS, TRON, etc. 

What is Non-fungibility?

As a real-world representation of a non-fungible asset, let’s take a plane ticket as an example. There are minor differences between plane tickets on the outside; however, each ticket holds unique information (departure time, seat number, flight destination, ticket cost) that makes it non-interchangeable. This example implies the two critical differences between fungible and non-fungible assets: the amount of information they hold and their (non-) interchangeability.

Non-fungibility is transcribed into the digital world through the advent of non-fungible tokens, which can store far more data compared to fungible tokens. Ethereum’s ERC-721 standard facilitates the development and standardization of NFTs in the same way the ERC-20 standard does for fungible tokens. In essence, NFTs are digital assets that contain unique data that makes them different from each other.

NFT Use Cases - What are NFTs Used For

NFTs’ uniqueness opens the door for new and exciting possibilities across different industries. Let’s take a look at three sectors that arguably benefit the most from using NFT technology.

Art and Entertainment

Digital art is an obvious area where the NFTs get to shine. Blockchain ensures the uniqueness of an artist’s creation so that buyers can be certain that the art they purchased is indeed one of a kind and not a digital copy. Thanks to the public and immutable record of transactions, NTFs have radically changed the approach the art and entertainment industry, in general, has towards digital intellectual property.

A collection of digital images from the Bored Ape Yacht Club NFT collection

Bored Ape Yacht Club is one of the most popular NFT collections. Image source: Ape DAO

Similar to traditional art, NFT-powered digital art has attracted collectors due to its exclusivity and, for lack of a better word, bragging rights. Items belonging to the most popular NFT collections generate millions in trading volume each day. Rare NFTs from popular collections like CryptoPunks and Bored Ape Yacht Club have sold for upwards of $1 million. 

In recent months, industry giants like Samsung, Nike, Adidas, and even banking behemoth JPMorgan, have launched or announced plans to launch NFT-related features to provide their users with access to various forms of NFT-enabled art and entertainment products and services.

Gaming

A big subset of the entertainment industry where blockchain and NFTs have a considerable impact is gaming. NFTs can be used to represent different in-game items, like skins or special weapons, and allow the transfer of such items among different games. But this ability is not limited only to digital items, a player’s whole gaming record, including achievements and other user data, can be transferred between games, thus enriching the gaming experience.

Image showing The Sandbox gameplay

Players can interact with each other, complete quests, and earn crypto rewards in The Sandbox’s virtual world. Image source: Jack Liu/Tentango

Some game developers have already taken advantage of these new technological capabilities. Virtual gaming worlds like The Sandbox and Decentraland allow users to participate in a digital economy by trading NFT-powered gaming items. In addition, the emergence of the Play-to-Earn (P2E) monetization model allows players to earn crypto and NFT rewards simply by completing in-game tasks. 

Moreover, the virtual land in these games is a non-fungible, transferrable, scarce digital asset stored in a smart contract. The scarcity of virtual real estate has driven the price of singular plots to new heights. For context, at the tail end of 2021, an anonymous investor paid $450,000 for a piece of digital land bordering rap superstar Snoop Dogg in The Sandbox, while the most expensive plot of Axie Infinity land sold for $2.5 million.

Social Media

The social media space is plagued by plagiarized content, which unfortunately hinders the ability of creators to get their due and makes it possible for a certain subset of the user base to profit off of work done by other people. 

What Plans for NFTs Have the Largest Social Networks Announced?

Given the fact that NFTs provide a way to protect intellectual property in the digital space, it is no surprise that large social media networks are turning to the nascent technology to both protect content creators and provide new monetization mechanics.

Instagram, Twitter, YouTube, and Reddit are all fast-tracking the integration of NFTs in their respective platforms. Case in point, Twitter already allows its users to authenticate ownership of NFT-based profile pictures, while Instagram CEO Mark Zuckerberg revealed earlier this year that NFTs and minting functionality are coming to the leading photo-sharing platform in the coming months. 

Screenshot of Jack Dorsey's first Tweet that was bought as an NFT for $2.9 million

Crypto entrepreneur Sina Estavi bought an NFT of former Twitter CEO Jack Dorsey's first tweet for $2.9 million. Image source: Twitter (@sinaEstavi)

According to YouTube CEO Susan Wojcicki, the video-streaming giant is not only looking to integrate NFTs but also provide a venue for the creators to sell digital collectibles to their fans directly on the platform. Moreover, the CEO also hinted in a podcast with the recently signed live streaming star Ludwig Ahgren that the company could use its advanced content ID system to detect potentially stolen NFTs.

Final thoughts

In addition to digital art, gaming, and digital content monetization aspects, the inherent properties NFTs possess make them an excellent tool to store data that was historically easy to fabricate. As paper records are increasingly becoming more digitized, real-world assets such as real-estate documentation, IDs, birth certificates, event tickets, and similar non-fungible assets may take advantage of the new technology to increase security and transparency.

While NFTs have received a lot of flack in the recent past, with many people claiming they are mostly used for price speculation, their long-term potential cannot be overstated. They represent ownership in the digital realm, where plagiarizing content is far easier than in the real world. At its core, NFTs are essentially a certificate of authenticity that allows anything to be tokenized and traded. With huge swaths of the economy and social interactions rapidly moving online, NFTs seem poised to benefit from the ongoing trend.

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Ted has been closely following the blockchain sector since 2018. He first became a CoinCodex contributor in 2019, covering primarily crypto regulation and macroeconomics. Since then, Ted has expanded his interest to general crypto-related topics and is now a senior editor at CoinCodex. When he is not writing about crypto or traditional finance, Ted enjoys watching and playing basketball.

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