What is an NFT
An NFT is a type of digital token stored on a blockchain, and the term "non-fungible" refers to the fact that every token is unique. In contrast to a cryptocurrency unit like Bitcoin or Ether, which can be exchanged on a one-for-one basis, an NFT represents a unique entity.
Each NFT includes identifying information within its own smart contract, and this identifying information could include a token ID, metadata, and a reference to the digital file that the NFT is related to. The blockchain maintains a permanent record of who owns the NFT, as well as all subsequent transactions between different wallets.
In most cases, the token itself does not contain the entire digital file on the blockchain; rather, it typically contains a reference to where the digital file is located, such as a decentralized file storage network. As long as the blockchain contains the correct record of ownership, the file size is irrelevant.
How NFTs Differ From Cryptocurrencies
Cryptocurrencies are fungible (interchangeable) units; one unit of cryptocurrency is identical to another unit of the same type, making them viable alternatives for a medium of exchange or store of value.
Each NFT (non-fungible token) is created with a singular identity that cannot be exchanged for another token of any kind. The fundamental difference in design leads to different uses of these tokens.
Key Differences Between NFTs and Cryptocurrencies
The key differences in the underlying structure of NFTs and cryptocurrencies explain why NFTs are primarily used for art and collectibles and not as general-purpose payment tools.
- Cryptocurrencies are fungible tokens and thus are interchangeable. An example would be if you were given $10 in cash and then received $5 in cash back on your last purchase at a restaurant; the two $5 bills you have now are interchangeable, and both are still worth $5 each.
- The number of cryptocurrencies you hold in your wallet is typically represented as a numerical amount (e.g., 100 units). Conversely, the total number of individual NFTs you have stored in your wallet represents a count of the individual NFTs, rather than an amount of some sort (i.e., there are simply 2 NFTs in your wallet).
- Many people use cryptocurrencies as a method of payment, and many platforms accept cryptocurrencies as a form of payment. However, the primary use case for NFTs is as proof of ownership of a digital asset.
- When you transfer a cryptocurrency, what you are doing is adjusting the numerical balance in your wallet by an amount equal to the size of the transaction (e.g., sending 0.05 ETH will reduce your balance by 0.05 ETH). When you transfer an NFT, you are simply moving a specific token from one wallet to another.
Blockchain and Verifiable Ownership
Blockchain technology serves as the backbone for NFT ownership. Blockchain is essentially a decentralized ledger that is spread out over numerous computers. Once a transaction is executed and confirmed, it is added to the permanent history of the blockchain.
Once an NFT is minted (created), a new token is generated and assigned to a specific blockchain address. This blockchain address can serve as a digital version of a bank account and is secured using private keys. Anybody can verify ownership of an NFT using a public blockchain query tool and check the blockchain records to determine whether the token is currently owned by somebody else, and if so, who owns it.
By providing an independent means of verifying ownership, this removes the need to trust a central authority. Instead of relying on a centralized authority to prove the authenticity of something, users can rely upon their own inspection of the blockchain records to verify the ownership and provenance of an item.
Authenticity of an NFT is determined using the following methods:
- The unique identifier of an NFT is embedded within its smart contract.
- All activity related to ownership of an NFT is available to view on the blockchain.
- All transfers of an NFT require a valid signature from the current owner.
- The rules governing creation and transfer of an NFT are defined by a smart contract.
Together, these elements help to establish a completely open record of provenance.
Minting and Smart Contracts
Minting refers to the creation of a new NFT. When a creator mints a new NFT, a smart contract will generate a token and enter the token onto the blockchain as a new entry. The smart contract is also responsible for defining the behavior of the generated token.
Smart Contracts
Smart contracts are computer programs stored on a blockchain which execute automatically. Smart contracts define the rules for ownership of tokens, when tokens can be transferred and in some cases, what type of royalty structures can be applied to the sale of the token.
Many NFT systems allow artists to include a programmable royalty payment within their smart contract. This means that the artist can receive a certain percent of each time the token is sold. While there is no guarantee that the royalty payment will be enforced (as it depends on the platform), this demonstrates the programmable nature of ownership in the digital world and how it is different from the physical world where the owner of a work of art controls the ownership of the work.
Once a token is created through minting, the core data contained in the token cannot be modified without the generation of a new smart contract.
Digital Scarcity and Its Implications
The concept of scarcity has been used to explain why something is valuable. In the physical world, scarcity is the result of a finite number of products available for purchase. Historically, digital environments have provided the opposite of scarce products, i.e., infinite numbers of copies of digital products could exist.
NFT's provide a new paradigm for digital scarcity. An artist could theoretically copy a digital file of his artwork and distribute the file to others. However, while the file can be copied and distributed, the artist can only have one token representing the original artwork as defined by the artist's contract. Therefore, the token provides a way to prove authenticity and membership in a collection.
This ability to create scarcity in a digital environment is important for both the creator and collector of NFTs. Artists can now limit the number of times they issue a particular token (and therefore limit the total number of copies of the artwork) and collectors know that they own the actual original artwork and that the token verifies its authenticity.
It is worth noting that simply providing a system that limits the number of times an item can be reproduced does not automatically increase the value of the item. Rather, scarcity creates a framework for market activity. Ultimately, the market will determine the price of the token.
NFTs in Art
As early as 2017, the art world began using NFTs. Artists were able to sell their own digital works directly to collectors and thus no longer rely on galleries and auction houses to make sales.
The blockchain provides open record keeping that demonstrates origin. A buyer can view the artist's wallet address and confirm all minting details which helps to eliminate the questions of authenticity for buyers of digital art.
Although there is great fluctuation in NFT art markets, this concept has been an important and exciting development.
Using NFTs also allows artists to experiment with interactive or evolving forms of art.
How NFTs Appear in Gaming Environments
A major area for gaming applications is the use of NFTs. Most of today's on-line games provide "skins", "characters" and other "virtual goods" that are completely under the control of the game publisher.
The addition of NFTs provides an alternate model where players can store specific digital items (e.g. skins) in their own wallets instead of being stored exclusively in the game's database. Using NFTs, the digital asset can now exist independent of one singular game.
How NFTs will appear in gaming environments:
- Items available in the game can be represented as unique tokens.
- Players may be able to exchange items with each other via secondary markets beyond the confines of the original game marketplace.
- Records of ownership remain regardless of updates made by the game's internal system.
- Game developers can create interoperable digital assets across multiple games.
The rate at which NFTs are adopted remains unknown and many technical and regulatory hurdles remain before they become mainstream. Nevertheless, the concept of player ownership of digital assets has already begun to impact design discussions.
NFTs and Digital Collectibles
There have been collectibles in physical form for years; trading cards, rare stamps and limited edition memorabilia rely on the principles of scarcity and authenticity. NFTs expand upon those principles into digital spaces.
Digital collectibles can consist of virtually anything; art, music releases, sports events/moments, etc., and blockchain based technologies verify originality and the ownership history of the item.
Major brands and entertainment companies have experimented with issuing NFT based collectibles as a means to interact with consumers. The benefits of the structure allow for limited releases, and transparent tracking of the supply.
Similar to physical collectibles, the relevance of digital collectibles will be determined by consumer demand.
NFTs and Digital Identity
While the primary focus of NFTs has been related to art, there are also implications to digital identity. NFTs can act as digital representations of credentials, membership, and/or achievement.
In decentralized systems, a user's identity can be tied directly to their wallet address rather than a central account. The NFT can also serve as proof of participation and/or right of entry to a community.
Examples of potential uses of NFTs for digital identity include:
- Event tickets
- Academic certifications
- Membership tokens
These examples demonstrate the ability of NFTs to record ownership and entitlement to rights/claims rather than merely serving as visual representations.
Ownership Versus Access
The nature of NFT ownership requires clarification. In most cases, being the owner of an NFT means that you own the token itself and all of the token's related metadata; however, this doesn't necessarily mean you've been granted ownership of the underlying work (i.e., copyright or other intellectual property rights) without the explicit agreement of the creators.
When buyers purchase an NFT, they're usually purchasing evidence of ownership rather than complete, absolute control over the work that the token represents. As mentioned previously, terms will vary from project to project and jurisdiction to jurisdiction.
Understandably, this distinction in ownership can create confusion for buyers and sellers alike. The ownership of the token itself is established through the blockchain record; however, the buyer/seller relationship regarding legal rights to the work are defined outside of the blockchain.
Market Infrastructure and Platforms
NFT marketplaces serve as the infrastructure for users to buy, sell, and mint their NFTs. These platforms communicate with the blockchain network through smart contracts.
To transact on these platforms, users must first connect their digital wallet to the marketplace. Once connected, transactions can be created using the user's private key and the transaction is then recorded onto the blockchain.
In addition to blockchain technology, there are many layers of infrastructure that support NFT marketplaces including data storage systems, indexing services and metadata hosting services. Although the blockchain provides the ability to track who owns the token, it is common for external systems to provide file hosting, user interface design and other functions for NFT marketplaces.
Because of this layer of complexity, it becomes clear that NFTs consist of both decentralized and centralized components.
Environmental and Technical Considerations
There is public concern about the environmental impact of NFTs. The amount of energy used to validate a transaction depends upon the specific blockchain network and how it validates transactions.
Some blockchain networks require energy intensive validation mechanisms (e.g., Proof-of-Work), while others do so using energy efficient methods (e.g., Proof-of-Stake). Ongoing technological advancements continually improve scalability and reduce the environmental impact of blockchain networks.
As such, understanding which blockchain networks are supporting your NFT helps quantify the potential environmental impact associated with your NFT rather than making a broad association with NFTs as a category.
Risks and Market Volatility
The NFT market has grown rapidly and subsequently declined sharply at times. Price volatility may occur in response to changes in investor sentiment and speculative activity.
Additionally, some NFT marketplaces have become subject to fraudulent activity including counterfeiting of collections. Before participating in an NFT marketplace, buyers must take care to verify the contract address and confirm that they are dealing directly with the original creator of the collection.
Although blockchain technology allows for the tracking of legitimate collections, buyers still need to perform adequate due diligence when engaging with an NFT marketplace.
Why NFTs Matter
The development of NFTs has changed the way that we define digital ownership. NFTs have enabled the creation of verifiable and transferable records of digital ownership without the need for a central intermediary.
NFTs affect different industries in varying ways. NFTs provide new revenue streams in the art world. NFTs have raised questions regarding whether players should be owners of characters or other digital goods in the gaming industry. NFTs provide a new method of verifying credentials in identity systems.
Whether NFTs are relevant in the long term is dependent upon the existence of viable use cases, as opposed to market hysteria.
The Foundation for Digital Ownership
Digital ownership is an evolving concept due to the expansion of digital environments. NFTs show how blockchain technology can create verifiable, decentralized records for claims of ownership.
NFTs may alleviate some legal complexities related to digital ownership. NFTs do not ensure value. NFTs provide infrastructure for creating and verifying records of digital ownership.
To understand NFTs, it is important to focus on the structure of NFTs, versus speculating about them. Essentially, NFTs are just entries in a distributed ledger, which represents a unique digital asset.
This foundation provides readers with a clear understanding of how to approach this subject. Digital ownership is no longer abstract, but instead it is recorded, traceable, and transferable via defined rules of code.
It is likely that the concept of owning digital objects will grow in conjunction with advancements in technology. NFTs provide one of the first broadly accepted frameworks for creating a verifiable record of digital ownership.