Blockchain Finance

What are Non-Fungible Tokens? And how do they Work?

You’ve heard about them in the media, but what are they, and what can you do with them?

Try talking about Bitcoin to many people, and they will either stare back at you blankly or pull a horrified expression. Cryptocurrency has had a rough time in the media lately – many of the world’s largest investors have labelled them as Ponzi or Pyramid schemes.

Many people have lost money after investing in these assets on the back of a media frenzy surrounding them – not realizing that it is precisely that frenzy that is about to cause the market to drop significantly. 

Yet, a single bitcoin is currently worth around $33,000 – 15% more than it was worth in January, but close to half the all-time it hit in April this year when one coin was worth an incredible $63,000.

How does this relate to Non-Fungible Tokens?

Non-Fungible Tokens, or NFT’s, are inextricably linked to another cryptocurrency – Ethereum. Vitalik Buterin created this alternative form of electronic money in 2014. However, it relies on the same underlying Blockchain architecture which was developed by Satoshi Nakamoto – the pseudonym of the mysterious programmer or team who created Bitcoin.

When the price of Bitcoin goes up or down, the value of Ethereum will usually follow not long afterwards. As the leading cryptocurrency at the time of writing, Bitcoin tends to be used as a base price by cryptocurrency exchanges. 

These exchanges convert fiat currency (such as dollars, euros or sterling) into cryptocurrency, and Bitcoin is currently functioning much as gold did before America’s exit from the Gold Standard in 1971.

Bitcoin, having been developed in response to the financial crash of 2008, was designed to function in this way – there is only a certain amount of it that can ever exist. There is no central bank that can create more bitcoins to stimulate the economy. The currency was designed to ensure that, over the long term, cryptocurrency will not be subject to the same kind of never-ending inflation that we see with fiat currencies.

So what exactly IS a Non-Fungible Token?

The first part, non-fungible, is hardly common vocabulary, making NFT’s all the more confusing to many people. All “non-fungible” means is that something is unique and irreplacable. For example, a regular banknote is non-fungible even though there are many of them.

If you destroy one, the note with that serial number is permanently destroyed and can never be replaced. Even if you burnt just half of it and sent it to the bank, they would send you a replacement note with a different serial number.

So you are probably wondering what all the fuss is about? The NFT’s being discussed in the news are digital NFT’s, which are being stored in the Ethereum blockchain. The data is stored in a way that makes it possible to mark that exact piece of data as belonging to a specific person.

Therefore, a digital NFT can be pretty much anything you can store on a computer – a drawing, photograph, sound, piece of music, program source code – anything. But the real buzz is about the possibility of using this technology to sell digital artworks.

Say you are interested in buying one of the 3d wall sculptures by David Krakov but didn’t have the money or space for the real thing. You could purchase this same 3d wall sculpture as an NFT, and you will receive a digital image file along with a certificate of ownership.

So how do NFT’s work? Surely anybody can download the same file from the internet?

And is this where it gets a little bit confusing. When you buy an NFT, you are purchasing a certificate of ownership, and the exact details of your purchase are stored on the blockchain. Most of this data is visible to anybody who looks at the blockchain, meaning you can prove that you are the one who owns the video of a famous last-minute winning dunk in a basketball game, for example.

The remaining data regarding the transaction is protected by the private keys linked to your digital wallet. It is that last part that ensures nobody else can duplicate the sale at a later date. I guess the way to think of it is that anybody can buy a print of a famous painting, but only one person can own the original.

What can I do with an NFT?

Because you now have ownership of that NFT, you can do almost anything with it. Continuing the previous example, if you purchased an NBA highlight video, you would then have the exclusive rights to publish it on YouTube. If you buy an image, you can use it as your profile picture.

The exact usage rights you get with a particular NFT are explained to you before buying and stated on the certificate of ownership. As an example, you might not be able to re-sell copies of the content of your NFT.

You can brag about it to your friends too -if you think it’s something that will impress them. I mean, you do have a blockchain entry to back it up after all!

But why are NFT’s worth so much money?

Ah! Now there’s a good question. As with any new technology, what is happening at the moment is very much speculation. People are purchasing these NFT’s, hoping they will increase in value over time. The hope is that the owner of an NFT will be able to sell it later for a profit.

The trouble with NFT’s from many analysts points of view is that there is no discernible difference between the “original” version stored on the blockchain and the hundreds of other copies that could be dotted around the internet.

Many trading cards are considered NFT’s because they have unique serial numbers. There is additional prestige to owning a lower-numbered card. With trading cards, the first few numbers can end up being worth considerable sums of money, while a re-issued card with a serial number in the fifty thousand range won’t even fetch you a dollar.

I’m not sure – should I buy an NFT? It sounds very risky

I believe it is sensible to be cautious about NFT’s at this time – there is no guarantee these assets will rise in value. Although you could say the same thing regarding every tradable asset, the ultra-expensive NFT’s seem like a precarious proposition to most investors.

On the other hand, if the price is reasonable and you want to financially support an artist you like, buying these tokens might not be as strange as it first sounds. From the artist’s point of view, NFT’s can be an additional income stream and even have a feature that allows you, as the creator of the work, to receive a portion of the proceeds each time the NFT is sold.

The blockchain ensures that if the value of your NFT explodes – say you sold it for $10, and it is now selling for $10,000 – you will automatically receive a portion of the proceeds from the new sale.