What are NFTs and what can they be used for?
Written by Pedro Mesquita, New Investments Analyst at Mindset Ventures
If you visited any tech news website in the last couple of months, chances are you bumped into the prase Non-Fungible Tokens or its abbreviation NFTs. The reason for this coverage can be attributed to recent million-dollar transactions happening with these assets, such as Beeple’s “The First 5000 days” digital artwork sold for $69M, the first tweet posted by Twitter founder and CEO Jack Dorsey sold for $2.9M, and the virtual property from the Axie Infinity game sold for $1.5M. This has sparked many discussions in creative industries, such as art, music, and gaming, but also in non-creative industries including real estate and the financial market. But what actually are NFTs and, most importantly, what are their current and future potential use cases?
What are NFTs?
Simply put, Non-Fungible Tokens or NFTs are a digital representation of unique assets. Art pieces, music albums, sports trading cards, limited edition clothing, are all examples of physical unique assets that people have been collecting for ages now. What gives value to these assets is their uniqueness and scarcity that can be verified by analyzing specific traits, serial numbers, with manual verification processes, among others. NFTs augment these traditional verification processes by allowing all these physical assets and also digital assets, such as digital artworks or music albums, to be digitally represented in a trustworthy, secure, and transparent way.
Breaking it down word by word, non-fungibility means the asset is unique and can’t be replaced with a similar asset without changing its quality (e.g. exchange the original Mona Lisa painting for a Mona Lisa replica). Fungibility on the other hand means an asset can be replaced with a similar asset without losing its quality (e.g. exchange a 5 dollar bill for another 5 dollar bill). Token means that NFTs are verified using blockchain, the same technology powering bitcoin and other cryptocurrencies, in which a network of distributed computers records transactions and gives buyers proof of authenticity and ownership.
While it is difficult to copy a physical asset, it is easy to copy a digital asset by simply downloading the music, image, video, or text file. However, with NFTs, it is impossible to copy and paste or alter the whole chain of custody that comes with this asset, which is what guarantees the users’ ownership and authenticity of the work. Using blockchain, anyone can trace back the origins of the file and see exactly which transactions took place and when. Let’s take the example of Nyan Cat, a meme from 2011 that was sold as an NFT for $600k. Anyone could just download the “.gif” file and make an NFT out of the meme, but it would most probably have no value. What makes the Nyan Cat NFT be valued at $600k is the fact that it was issued by Chris Torres, the original creator of the meme, who gave the ownership to the buyer of the NFT.
To summarize what makes an NFT an NFT, they have three unique characteristics:
- Limited: The value of NFTs comes from their scarcity so, just like in traditional physical collectibles, being the owner of something that only has 10 copies of it is different from owning something that has 1 million copies of it.
- Indivisible: NFTs are indivisible into smaller units. You either buy the complete digital item or buy no item. However, this is evolving with social tokens and shared ownership.
- Unique: NFTs have a strong information tab that explains their uniqueness and makes it so that it can’t be replaced for something else. This information is fully secured and genuine via blockchain technology.
What are the benefits and challenges of NFTs?
Since NFTs are based on blockchain, they get all the benefits of the technology. Some of these benefits are:
- Easily Transferable: NFTs are purchased and sold by anyone around the world on special marketplaces, such as OpenSea and Rarible. After bought, owners can do whatever they please with their NFTs (we go over some of the use cases in the next section), including selling them to another person.
- Trustworthy: The chain of custody allows you to know that your NFT is accurate since it’s hard to create counterfeits with a decentralized and permanent record.
- Maintain Ownership Rights: This refers to an NFT’s worth of decentralized platforms that guarantee provenance and no purchaser can change the data later.
Of course, with every new technology and especially the ones that get a lot of hype and media coverage, comes a lot of criticism. Here are some of the challenges NFTs will or are already facing:
- Environmental Implications: proof-of-work (PoW) blockchain, such as Ethereum in which most NFTs operate today, requires an immense energy consumption due to the computationally intensive mining process needed to secure and verify every transaction happening in the chain.
- Security: Blockchain is one of the (if not the) most secure ways to store digital items. But users are the ones responsible for storing their own keys to access their NFTs and for adopting secure practices on marketplaces or other front-end applications that are subject to cyber-attacks.
- Manual Work: One of the biggest advantages of NFTs or any blockchain-based technology is its chain of custody that allows for traceability. But accessing this information is cumbersome and marketplaces are not taking responsibility for this process. This makes it easy for anyone to say they are the creators of the specific NFT without actually being it.
- Speculation: We are arguably in the middle of a hype cycle. Transactions are happening in extremely high values and there are many startups in the space raising funds at extremely high valuations. We are yet to see if we are in a speculative bubble or not.
What are NFTs useful for?
It has been a while since people started discussing how blockchain can help solve some of the music industry’s main challenges. With the technology’s proof of ownership and transparent record of transactions, labels can streamline the notoriously complex rights management and royalty payout process, and artists are consequently able to receive streaming money instantaneously and have a clearer view of their current income streams.
In addition to all the blockchain benefits, NFTs bring even more options to the table. Artists can, for instance, issue their new albums as NFTs, which helps with fan engagement (who feel as they are really supporting the artist and actually own the piece of content) and even add a new source of income in the form of royalty from the resale of their creations on secondary markets. Albums are not the only assets artists can issue as NFTs since any digital or physical merchandising, such as album covers, band photos, clothing can all become NFTs and be sold to fans.
Digital artists have long struggled to make relevant amounts of money mainly due to how easy it is for anyone to copy the digital files of the art pieces without paying for them. By turning their creations into NFTs, digital artists can get much more value out of them as collectors are attracted to the scarcity, proof of ownership, and traceability of the piece, making them prone to spend more on these assets.
NFTs also help non-digital artists to avoid the massive fraud problem in their industry. Artists can issue NFTs that are tied to their real-life creation, making it possible for any potential buyer to trace back every transaction that happened with the art and get to the original creator of the piece which of course gives it value. Many are already seeing NFTs as being the way not only digital art but any type of art will be acquired and traded going forward.
Gamers are no strangers to trading digital collectibles. In fact, they have been buying digital clothes (skins), items, weapons, and many other things for their game character for years now. However, there was no way for them to actually prove the scarcity of a rare item they acquired, sell it to other players or even take items bought in one game and bring them to be used in another game. These are all possible now with the use of NFTs.
I imagine all of us have or know someone who has already bought a fake ticket or paid much more than the original price of a ticket to a music concert or sports event. NFTs are perfect for combating identification fraud, meaning buyers of a secondary ticket sale can track the origins of the ticket, avoid buying fake ones and ultimately prove their ownership to the event organizer. Additionally, event organizers will be able to track the prices of these secondary sales and prevent people from charging exorbitant prices for tickets. After attending the event, the attendees will have their NFT tickets forever as they are immutable and permanent, allowing them to even resell them to fans who might be interested.
NFTs have several potential applications to real estate. The process of buying and selling physical real estate today is cumbersome, requiring a lot of paperwork and manual work. By issuing an NFT tied to the property, it becomes much easier to trade and manage the real-life asset as it instantly makes the history of transactions with that piece transparent and immutable. A startup called Propy is ahead of the curve here and already auctioned a real apartment as an NFT that will transfer ownership of the real estate to a future buyer almost instantly.
Talking about a more abstract concept, buying and selling digital real estate just became a possibility with NFTs. There are already a few games that let players buy actual spaces inside the games where their characters can live and interact with other players. Prices of this digital land could work just like any other physical real estate, so imagine that a busier area will be more valuable for a real-life brand that wants to add a digital store inside a game. Digital museums where players can put up an exhibition of art NFTs they own is also another use case for these digital lands.
NFTs may be central to Decentralized Financing (DeFi), which are fintech projects that use cryptocurrency and the blockchain to disrupt existing financial intermediaries. Right now, if you want to get a loan, you need to go to a bank, go through all the paperwork and KYC processes to potentially get approved. With DeFi, anyone will be able to use an NFT, such as valuable digital art, physical real estate, or any other asset they might own as collateral and get the loan without even going through a bank.
Art and music are certainly collectibles, but NFTs also work for basically any other kind of collectible. NBA top shot, for example, is currently one of the most successful NFT projects and allows people to buy and own moments of basketball games working similarly to real-life sports trading cards. Cryptokitties is also another great example of a project that basically started the NFTs market that lets users collect digital cats with different traits and actually take care of them, much like virtual Tamagotchi for anyone who remembers these.
We are definitely on the first days of the developing NFT market. Nonetheless, the technology has already shown potential for many different use cases and also sparked interest from millions of people around the world. If we are in a speculative bubble and none of these use cases actually work out in the long term, we are yet to see. But in any case, it is fun to think about all the amazing ways we can use NFTs!
Originally published at https://pedro-mesquita.medium.com on June 15, 2021.