What Are NFTs and How Do They Work?

NFTs are crypto assets that grant gamers and collectors ownership over their digital items.
Updated Mar 24, 2022 at 6:14 p.m. UTC
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Ollie is the Learn editor for the Crypto Explainer+ section. He holds some SOL, RAY, CHSB and BTC.

Non-fungible tokens (NFTs) are a special type of crypto asset that allows holders to prove their ownership of real or digital items – but most importantly, the latter.

These intangible items can include things like plots of virtual real estate in games like The Sandbox and Decentraland, to digital artwork like Beeple’s Everydays - The 2020 collection, and even images of cartoon apes.

While this might sound pretty underwhelming to the average person, you need to appreciate that in today’s ever-increasing digital world it’s incredibly difficult to authenticate or exercise ownership over things that anyone can simply screenshot, copy or download.

Imagine you’re a concept artist who creates digital artwork for gaming companies like Ubisoft or Treyarch. Now imagine you want to go it alone and sell your digital artwork online. To achieve this, you’d need to find some way of marking and tracking ownership of your pieces so that purchasers could prove they had original pieces and not just some screenshot. Otherwise, what’s the point of spending your money on it?

This is where NFTs come in.

What are NFTs?

Non-fungible tokens are tradable digital assets that contain information that essentially says, “the person in control of this crypto wallet address is the owner of a computer file, stored in this location.”

The computer file, as we’ve discussed, can be anything from an image to a GIF or audio clip.

What’s interesting about NFTs is even if you create 1,000 copies of the same image or file and mint the same number of NFTs to represent ownership of them, each copy of the image will be uniquely identifiable from the other 999 pieces based on the special type of information (called metadata) that each NFT token contains.

This means that while 1,000 investors might all have the same looking image in their wallets, they can each say “I specifically own copy number #.”

Think of it as an edition of a trading card with 1,000 exclusive copies, but where each card has its own serial number to distinguish it from others. In addition, the card with the serial number #1 on it would most likely go for a higher price and be more desirable than other copies in the edition.

Taking this concept even further, creators of these types of NFT collections incorporate different traits of varying degrees of rarity to further increase the value and scarcity of their pieces.

For instance, among the 1,000 pieces, a creator might decide that 10 of them will have a different colored background and only one of them will have a patterned background. By doing this, some purchasers interested in investing in the collection will naturally want to own the rarest pieces in the collection in the hope their value will rise more over time – assuming demand for the collection remains high.

Now, let’s talk about fungibility – the part that gives non-fungible tokens their name. By definition, fungible tokens are those that can be mutually exchanged for another token like-for-like. For example, Bob can swap his one bitcoin for Alice’s one bitcoin and neither party will be better or worse off. With NFTs, this is not so straightforward.

While NFTs themselves are exchangeable (in the sense that you can buy and sell NFTs from/ to other people) the unique traits of each NFT mean it has its own distinct value. For instance, you couldn’t trade a shiny Charizard Pokemon card for a “Shoeless” Joe Jackson, 1909 American Caramel baseball card like-for-like. This is what’s meant by “non-fungible” when people talk about NFTs.

Other key characteristics of NFTs include:

  • Indestructible: Because all NFT data is stored on the blockchain via smart contracts, each token cannot be destroyed, removed or replicated. Ownership of these tokens is also immutable, which means gamers and collectors actually possess their NFTs, not the companies that create them. This contrasts with buying things like music from the iTunes store where users don't actually own what they’re buying, they just purchase the license to listen to the music.
  • Verifiable: Another benefit of storing historical ownership data on the blockchain is that items such as digital artwork can be traced back to the original creator, which allows pieces to be authenticated without the need for third-party verification.

How do NFTs work?

We’ve already identified that in order to be able to prove ownership of something digital, there needs to be some form of a transparent, immutable ledger that maintains a constant record of all NFTs, who owns them and where the files that they point to are kept.

This is where blockchain technology comes in. By leveraging the publicly distributed, immutable nature of blockchains, all NFTs can be stored in a transparent way, allowing anyone to check the authenticity of any NFT at any time.

Each time an NFT is transferred or created, the action is permanently recorded on the blockchain and timestamped, meaning it’s possible to trace any single NFT right back to its genesis – something that’s pretty handy if you want to make sure your cartoon ape or virtual kitty is genuine or not.

Now, let’s go back one step and discuss what NFTs are from a technical standpoint.

Crypto assets can be created from scratch but most developers when setting out to launch tokens will typically use an existing blueprint to streamline the process and save costs. Leading crypto projects such as Ethereum recognized early on that there needed to be some form of standardization among newly created crypto tokens to establish interoperability.

Ethereum token standards were developed to achieve exactly this. These involve specific sets of smart contract functions that a token must be able to perform in order to be compatible with all other tokens, platforms and services in the broader Ethereum ecosystem.

Ethereum token standards ERC-721 and ERC-1155 are the main blueprints created by Ethereum that allow developers to create and deploy their own non-fungible tokens on top of its blockchain.

Eos, Neo and Tron are examples of other leading blockchains that have also released their own NFT token standards to encourage developers to build and host NFTs on their blockchain networks.

Finally, it’s important to note that it’s not just the fungibility of NFTs – albeit their lack of – that sets them aside from other types of cryptocurrencies. The infrastructure that supports NFTs is also different.

Unlike all other cryptocurrencies, NFTs cannot be listed, bought or sold on centralized or decentralized exchanges. Instead, users must use tailor-made NFT marketplaces to participate in the listing and trading of these assets. OpenSea and Rarible are among the most popular, but there are countless other options available depending on which NFT collection you’re interested in.

Why do NFTs matter?

Non-fungible tokens (NFT) have become hugely popular with crypto users and companies alike because of the way they revolutionized the gaming and collectibles space. Since June 2017 there has been a total of $25 billion spent on NFTs, including a further $21 billion in secondary sales.

For gamers and collectors, NFTs provide an opportunity for them to become the immutable owners of in-game items and other unique assets, as well as create and monetize structures like casinos and theme parks in virtual worlds.

They can also sell individual digitals items they accrue during gameplay such as costumes, avatars and in-game currency on a secondary market.

For artists, being able to sell artwork in digital form directly to a global audience of buyers without using an auction house or gallery allows them to keep a significantly greater portion of the profits they make from sales.

Royalties can also be programmed into digital artwork so that the creator receives a percentage of sale profits each time the artwork is sold to a new owner.

William Shatner, best known as Captain Kirk from “Star Trek,” ventured into digital collectibles in 2020 and issued 90,000 digital cards on the WAX blockchain showcasing various images of himself. Each card was initially sold for approximately $1 and now provides Shatner with passive royalty income every time one is resold.

Why do NFTs have value?

Like all assets, supply and demand are the key market drivers for price. Due to the scarce nature of NFTs and the high demand from gamers, collectors and investors, people are often prepared to pay a lot of money for them.

Some NFTs also have the potential to make their owners a lot of money. For instance, one gamer on the Decentraland virtual land platform decided to purchase 64 lots and combine them into a single estate. Dubbed “The Secrets of Satoshi’s Tea Garden,” it sold for $80,000 purely because of its desirable location and road access.

Another investor parted with $222,000 to purchase a segment of a digital Monaco racing track in the F1 Delta Time game. The NFT representing the piece of digital track allows the owner to receive 5% dividends from all races that take place on it, including entry ticket fees.

What are the most expensive NFTs?

The most expensive NFT sale to date took place in December 2021, when a fractionalized NFT artwork piece called “The Merge” was sold; 312,686 pieces of the artwork were shared among 28,983 different buyers for a collective price of $91.8 million.

Beeple’s Everydays: The First 5,000 Days piece takes second place, fetching $69.3 million at auction from a single buyer.

Finally, an NFT named “Clock” currently stands as the third-most expensive NFT ever bought – with 10,000 individuals forming an “AssangeDAO” to purchase the piece for $52.7 million. This piece is essentially a stopwatch that shows the total time WikiLeaks founder Julian Assange has been imprisoned. It was launched by Assange in partnership with digital artist Pak to raise funds for Assange’s ongoing, high-profile court case.

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This article was originally published on Feb 1, 2021 at 8:25 p.m. UTC

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Ollie is the Learn editor for the Crypto Explainer+ section. He holds some SOL, RAY, CHSB and BTC.

CoinDesk - Unknown

Ollie is the Learn editor for the Crypto Explainer+ section. He holds some SOL, RAY, CHSB and BTC.

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