What are NFTs and how do they work?

NFTs, or non-fungible tokens, are the latest new obsession among cryptocurrency and blockchain enthusiasts at the moment. You may have heard of them in the context of crazy price tags and valuations. Indeed, the concept has found tremendous success among collectors, with many NFTs selling for thousands or even millions of dollars. From Twitter co-founder Jack Dorsey to smartphone manufacturers like Samsung, it seems like just about everyone’s trying to cash in on this new paradigm.

Naturally, this raises some important questions: what are NFTs and why are they suddenly being heralded as a revolutionary technology? After all, digital collectibles aren’t exactly a new concept.

The answer’s pretty simple — an NFT represents permanent digital ownership and can be used for much more than just digital art, even though that’s their primary use today. Eventually, they could also be used to record ownership over physical assets like real estate and vehicles. NFTs can also improve the process of transferring assets between individuals, alleviating a major pain point and expense we’ve probably all dealt with at some point.

Keeping all of these possibilities in mind then, it’s clear that the NFT landscape is still finding its footing and has a long way to go. To that end, let’s set aside the hype and speculation and take a closer look at the underlying technology first.

Related: 10 best NFT apps for Android

What does fungible even mean?

We already know that NFT stands for non-fungible token. But to many of us, that’s still a rather cryptic definition, so it’s worth discussing what makes something fungible in the first place.

The term fungibility descends from economics, where it’s used to describe identical commodities or goods. Take assets like oil, gold, or even dollars — a unit of each of these can be interchanged by another unit and the value wouldn’t change.

One dollar, for instance, is functionally the same as any other dollar, unless you’re looking for a specific serial number on a banknote. Similarly, an ounce of pure gold is the same as an ounce of gold from a different source. In fact, fungibility is an important property of money in general.

Non-fungible assets represent the opposite of that. They are one-of-a-kind assets that have a completely different value if interchanged with a different unit. A used vehicle or an art collection, for example, are potentially worth more or less than others like them. This is because their value depends on factors such as the rarity and condition.

So what is an NFT?

Circling back to NFTs, they’re simply unique digital tokens that cannot be interchanged. This is unlike most other digital tokens you’ve likely heard about. Bitcoin and Ethereum, for instance, are fungible because each unit is identical.

If you’re wondering why these so-called “unique” tokens are such a big deal among cryptocurrency enthusiasts, it’s because NFTs can offer irrefutable proof of ownership. NFTs are minted on existing cryptocurrency networks like Ethereum. In other words, all you need to own an NFT is an internet connection and a digital wallet on your smartphone or computer. Creating or “minting” a new NFT is not too difficult either. You’ll find that several services and apps have already simplified the process.

Since NFTs are built on top of already-successful cryptocurrencies, they are extremely resistant to hacks and theft. It’s impossible to counterfeit an NFT too, since each token is verifiably unique. That’s an important property because it means that the origin of the token can be traced back to the issuer.

For example, you could check the authenticity of a tokenized degree simply by checking the records to see if the NFT was once held by the university’s digital wallet. Similarly, these tokens represent a lucrative revenue source for artists, since they can earn royalties each time their artworks change hands.

See also: The best crypto wallets for Android

While you may think of NFTs as “tokens”, a better way to imagine them would be as some amount of data stored on a blockchain network. This is an important distinction, because today’s NFTs can’t actually hold raw music, art, or tweets. In fact, they can only really hold a few lines of text.

You see, storage space on blockchain networks is finite — and can get really expensive if you want to occupy large amounts of it. The solution early developers came up with was clever: NFTs just linked to an external website with the actual asset. Want a token to represent a piece of art? Just link to a copy of it.

Five years on, NFT developers still rely on this method to overcome the limited space problem. However, this is a rather imperfect workaround and is the subject of much debate — as we’ll discuss in a later section.

What do NFTs offer that previous technologies don’t?

Besides the aforementioned permanent ownership aspect, NFTs are appealing because you can trade them without the involvement of a third-party or intermediary. Once in your possession, you can sell or auction the NFT on an online marketplace. Alternatively, you could just send it to a different wallet of your choice.

On the other hand, transferring property or assets the conventional route isn’t exactly easy or straightforward. If anything, it’s a process that’s often fraught with paperwork and fees. In the event of a dispute, you may require legal representation and other expensive resources.

NFTs can be combined with another blockchain-based technology called smart contracts to simplify the transfer process. These are essentially programmable digital agreements that execute immediately once a condition is met. For example, you could create a smart contract that transfers the rights to a house (which exists in the form of an NFT) as soon as payment is received.

In other words, you don’t need a bank or middle-man to verify the funds and legitimacy of the property transfer — the contract automates all of that for both parties. Smart contracts are stored on a blockchain and cannot be tampered with, similar to NFTs themselves. In the event of a dispute, anyone can check the records to see if you hold the original version or not.

All in all, the hype surrounding NFTs stems from blockchain’s potential to disrupt several industries, ranging from art to domain names and even physical goods. Admittedly though, most applications today focus on the digital collectible aspect. Still, it’s early days for the technology.

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Who decides NFT prices?

So far, we’ve focused on the practical potential of NFTs and how they might prove disruptive in the long term. However, we’ve strayed away from discussing the technology’s primary appeal today — buying and selling digital art online.

Indeed, you’ll find several examples of NFTs that have sold for hundreds of thousands, and even millions of dollars. In March 2021, a digital artist nicknamed Beeple successfully auctioned an NFT for a record $69 million. This single sale made him one of the top three most valuable living artists. Elsewhere, you’ll find the National Basketball Association (NBA) routinely auctioning video clips of memorable sporting moments in the form of NFTs for tens or even hundreds of thousands of dollars.

In both instances, you can think of NFTs as trading cards — except digital in nature. Much like any piece of art, people are buying them almost exclusively for their rarity.

To be clear though, it’s not like you own the exclusive rights to a video clip if you buy an NBA-issued NFT. You just own an officially licensed and numbered version of it. Anyone can still view the clip, because the data is stored elsewhere. The owner of the NFT simply gets the bragging rights to the virtual trading card and the ability to sell it as a collector’s item.

What all of this means is an NFT is valued pretty much like any other collectible item — it’s worth exactly how much someone else is willing to pay for it. There have been several instances where an NFT has sold for far more than expected and others where the opposite has happened. Still, this hasn’t detracted speculators from buying up NFTs as an investment, hoping to sell them for a profit at a later date.

See also: The best cryptocurrency apps for Android

Can you make money trading NFTs?

It’s clear by now that NFTs are not too difficult to create, but extremely difficult to value. To that end, it’s somewhat unlikely that most people will profit from buying and selling NFTs. As you’d expect, there are thousands of digital artists trying to sell their works and very few have found much success so far. More importantly, there’s no guarantee that someone else will pay more than what you paid for an NFT.

To better understand how the NFT market works, keep an eye on secondary marketplaces like OpenSea and Rarible. You’ll find that only a handful of non-fungible tokens sell for thousands of dollars. Most others don’t receive any bids at all. Making a quick buck through trading NFTs is no easy task.

There are some notable exceptions, of course. Known artists and collections like the Bored Ape Yacht Club command respect and demand. Similarly, some individuals have successfully used NFT sales as a form of crowdfunding. Finally, you have the digital trading card use-case that will likely stay relevant as well.

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Take CryptoKitties, for example, which is an online platform that allows you to collect and “breed” virtual, collectible cats. The value of a particular “CryptoKitty” token may range from a dollar to well over a million, depending on the digital cat’s exclusivity, appearance, ID number, and a host of other variables.

This may all seem arbitrary, but it’s pretty much how the collectible market has always worked. Remember, brands like Supreme, Gucci, and Louis Vuitton already rely on the same kind of exclusivity to sell their products for thousands of dollars. That’s not to say NFT speculation makes sense — just that there’s plenty of precedent for it in the world already.

Why are NFTs so controversial?

NFTs, in their current form anyway, are a subject of much controversy. While few dispute the technology’s long-term potential, the speculative nature of the market has drawn the ire of even some staunch cryptocurrency proponents. Indeed, the current NFT market is difficult to fathom and even harder to predict. With low-effort art and copies of old tweets selling for millions of dollars, the trend is admittedly somewhat unsustainable.

Moreover, most NFTs simply link to an external source or website hosting the image, tweet, or whatever else the token is meant to represent. But what if the website goes offline or becomes inaccessible in the future? There’s a rather tangible risk of the NFT turning worthless overnight. That’s simply not a problem that physical collectibles have.

Another major argument against NFTs is the current system does very little to protect artists. As such, anyone can create an NFT pointing to a legitimate piece of art — all without the knowledge or consent of the actual artist. What’s worse is malicious actors could profit from this and leave the original artist without any recourse.

Finally, some NFT critics will point out that several blockchain platforms, including Ethereum, rely on an electricity-intensive process known as mining to verify new transactions. Cryptocurrency mining has long been criticized for its high carbon footprint, but Ethereum and other blockchain platforms are working on solving this problem by adopting alternative mechanisms like Proof of Stake.

As for the other criticisms and problems, there aren’t any definitive solutions in sight. Either NFTs are completely incompatible with current applications like digital art, or the industry needs a new breakthrough to fix the technology’s limitations. However you see it, it’s clear that the NFT ecosystem has too many downsides today and has a long way to go before it’s ready for mass adoption.