What Are NFTs? What You Need to Know Before You Invest

The term “NFT,” short for non-fungible token, is a way to claim ownership in or of an asset. For many, the concept seemingly emerged overnight – and in a sense, it’s true. Transaction volumes in non-fungible tokens rose from tens of millions to tens of billions in the span of a year. 

Memes, digital videos, and even tweets have sold for millions of dollars as NFTs. So, why are NFTs important and how do they function or hold any value at all?

One way – arguably the most intuitive –  to understand how NFTs function is to consider an existing piece of art like “The Starry Night,” by Vincent van Gogh. There are many pictures and copies of the painting, but there’s only one original, hanging in New York’s Museum of Modern Art since 1941 at an art collector’s bequest.

If Van Gogh created the work today, but in digital form, he could assign a unique code in the form of an NFT, or in other words, a certificate of authenticity. This would ensure it is unique, as it sits on the blockchain with a provable chain of custody. To the extent that rarity for the work is an aspect of its value, provable authentication serves a function for each owner. NFTs are a way to track and sell items that live online that would be otherwise easily duplicated. 

Here’s what to know about how digital asset ownership and NFTs work, including if you want to buy, sell or hold.

What Is a Non-Fungible Token?

According to the Cambridge Dictionary, non-fungible means “not easy to exchange or mix with other similar goods or assets.” Therefore, a non-fungible token is a digital unit of data that cannot be exchanged, mixed, or replicated; it is used to identify ownership of an asset. The non-fungible token is a one-of-a-kind digital marker assigned to the asset.

For example, an artist draws a picture of a digital stick figure and uploads it into an NFT marketplace, an e-commerce platform where products or services may be purchased or sold by multiple third parties. The platform then assigns the artwork a non-fungible token (the number) and stores the information in a secure, public electronic database called a blockchain. 

Similar to a physical art gallery, where a patron could purchase a piece of artwork, in the NFT world, a marketplace buyer could purchase a digital piece of art. The marketplace platform then transfers the ownership of the “original” image to the buyer and its associated NFT. Like a physical art gallery, the marketplace platform is likely to take a percentage or commission of the sale as its fee for marketing the art and putting it up for sale.

It’s important to distinguish between the non-fungible token and its assigned asset. The asset itself is not the NFT — the NFT is just the hexadecimal code (a number system that uses 16 unique symbols from 0 to 9 and A to F) stored within the secure blockchain.

How Do NFTs Work?

Non-fungible tokens are based on the smart contract technology within the Ethereum blockchain. A blockchain is a distributed ledger, which predates cryptocurrencies and NFTs. In this circumstance, the purpose is to secure work and transactions among many individuals. 

In a blockchain, information is stored in what is called a “block” and encrypted via an algorithm. You can think of the blockchain as a spreadsheet, where the original token was placed in the first cell of a column.

In cryptocurrency, the first block created is usually called the Genesis block. In our NFT example, the original asset and the information stored in the block is the Genesis block. The digital item could even be called the Genesis asset.

When the asset is officially sold or ownership transferred, the algorithm creates a hexadecimal number representing the original item and the sale. The information is stored in the next block (cell) and encrypted. Each sale is documented this way, creating a unique identifier for each sale that links the original asset’s creator and subsequent owners.

While many people associate NFTs with digital assets, they are now being used in conjunction with trading physical possessions such as cars, real estate, or collectibles on digital marketplaces, too.

Why Are Non-Fungible Tokens Important?

The growth of the NFT industry has skyrocketed. According to DappRadar, 2021 was the best year yet for the NFT market, generating more than $23 billion in trading volume. NFTs open a new market for creators, investors, and other digital communities alike. They are transforming how people buy and sell digital assets and help unique assets hold their value.

NFTs for Creators

NFTs help creators monetise digital artwork and collectibles, potentially providing a new income stream and industry. Even if someone attempts to duplicate the file, the original record of ownership can’t be changed without permission from the current owner.

For example, in 2021, a 10,000 unit CryptoPunk NFT was sold at auction on Sotheby’s for $11.75 million. And Jack Dorsey, the former Twitter CEO, sold the first-ever published Tweet as an NFT for $2.9 million. But one of the most significant events so far in NFT history was the sale of a picture by the artist Beeple, who posted an image online every day for 13 ½ years. He placed them all into one picture, which the Christie’s art auction house later sold for $69 million during an online auction.

Source: Christie's, Beeple

NFTs for Investors

NFTs may be a way to further diversify a portfolio, similar to how traditional artwork and other collectibles function, and their value may be less correlated to other markets. But remember, just like with other investments, there’s no guarantee an NFT’s value will increase in the future. 

There is also the issue of disruption to consider. Established auction houses, like Christie’s or Sotheby’s, which used to be publicly traded, may need to evolve to handle the attention this new marketplace is receiving. Emergent NFT platforms, like OpenSea and LooksRare, are handling scores of transactions in this new area and are attracting investor capital.

NFTs for Gamers

Investors and creators aren’t the only ones taking advantage of NFT usage; they are becoming popular in the gaming world, too. For example, Axie Infinity is a game that uses the Ethereum blockchain and generates the cryptocurrency Smooth Love Potion (SLP). Players ‘play to earn’, with the SLP used to buy in-game items or it can be purchased, traded, or exchanged on select cryptocurrency exchanges for fiat currency (government-issued currency, such as the U.S. dollar or euro). You can also earn the Axie Infinity token, AXS, which governs the game and has its own monetary value.

How Do You Buy an NFT?

Most NFT marketplaces function similarly to auction sites, like eBay. You win your chosen NFT if you’re the highest bidder. Other sites also have NFTs that are sold for a fixed price. Prices are typically listed in decimals of ether (the cryptocurrency of Ethereum), though they may display a dollar value as well. This amount can frequently change due to the volatility of the cryptocurrency trading price at any moment.

As a first step, you will need to create a digital wallet and have cryptocurrency to spend. You can refer to our Bitcoin guide that describes how you can go about acquiring crypto.

Risks and Rewards of NFTs

If you decide to venture into the world of NFTs, understand that like other e-commerce sites, you can fall victim to scammers if you’re not careful. Some sellers and assets may also be unverified, so you should do your own due diligence on the marketplace.

Be careful about those from which you receive advice. Following digital safety protocols, such as protecting your passwords, account names, and other personal information, are just as important with an NFT as they are with your bank account. 

Another consideration for NFTs is that prices and values can be extremely volatile. There aren't protocols or guidelines in place yet to help people price assets. The value of NFTs comes down to how the buyers perceive their price, which can lead to drastic fluctuations.

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