What are NFTs: How They Work and Why They're a Game Changer

Gaurav Roy

Non-fungible tokens (NFT) are one such innovation that is the fastest-growing sector in crypto currently. The NFT coins market has grown past $37 billion, while NFT collections have been sold for millions of dollars.

Back in March 2021, digital artist Beeple sold his NFT for $69 million, making him the third most expensive living artist after David Hockney and Jeff Koons.

But what exactly are NFTs, how do they work, and how can you buy them? Let’s answer it all for you.

What are NFTs?

Non-fungible tokens are digital assets that represent ownership of internet collectibles for items like art, games, and music. These assets contain identifying information recorded in smart contracts, and it is this information that makes NFTs unique.

Being unique and non-fungible means no two NFTs are the same and one NFT can’t be replaced by another one.

For instance, Bitcoin is a fungible token, meaning one Bitcoin can be exchanged for another one. While the value of a Bitcoin changes, you can get another BTC in exchange for your BTC.

Additionally, fungible tokens are divisible so that you can send or receive smaller amounts than one full Bitcoin, which is measured in satoshis. One Bitcoin is equivalent to 100 million satoshis.

Much like Bitcoin, banknotes are also fungible, and you can swap them for another. As long as they hold the same value, it makes no difference to the parties exchanging the banknotes if they are getting one bill of ten dollars for another bill of ten dollars.

Now, as for NFTs, it has a non-interchangeable unit of data stored on the blockchain. Thanks to this information, there is proof of ownership or a public certificate of authenticity. However, this does not restrict the sharing of the digital file itself.

Are NFTs divisible?

Typically, NFTs are not divisible. However, lately, we have seen experiments with fractionalizing NFTs. While NFTs can usually have only a single owner at a time, fractionalizing allows NFT owners to mint tokenized fractional NFTs and share the ownership of the assets with others.

For high-value and exclusive NFTs, fractional NFTs allow several people to invest a small sum of money and gain fractional ownership of the asset.

So, with fractional NFTs, anyone can own a high-value asset at a low cost. To fractionalize a purchase on Ethereum, the NFT owners divide the ERC-721 token into multiple ERC-20 tokens, and then each of these ERC-20 tokens becomes a fractional NFT of the asset.

CryptoKitties collectible were some of the first NFTs originally launched as ERC-721 tokens on the Ethereum blockchain, but they have since then been migrated to their own blockchain Flow.

Recently, Bankys’s ‘Love Is in the Air’ art, which was sold for $12.9 million, was segmented into 10,000 NFTs. Each of these segments represents a unique section of the painting, which will be sold in January 2022.

Why NFTs?

NFTs have been around since 2015, but it has been in late 2020 and throughout 2021 that they had a resurgence and gained mainstream attention. Now, everyone from companies, celebrities, and countries is launching their own NFTs. Now, the question is--what is so special about them anyway?

For starters, the normalization of crypto and then the excitement around them during the bull market made everyone notice the latest trends in the crypto industry. Similarly, the speculation captured the NFTs concept as well, and in turn, attracted even more people.

Moreover, the combination of popularity, the law of scarcity, and the economics of royalties have people wanting in on the opportunity to own unique digital content.

As mentioned above, non-fungible tokens have unique attributes that are linked to a specific asset, unlike fungible tokens, which are identical and have the same attribute and value. And they can be used to prove the ownership of any digital items.

Because digital collectibles contain distinguishing information, creating fake collectibles doesn’t really work here. Authenticity is the core of NFTs, and on top of that, you cannot directly exchange one NFT with another like you can with your baseball cards in real life.

As pseudonymous non-fungible token (NFT) trader and influencer Punk 6529 said, currently NFTs are just flipping art, but after that, they “will start eating brands, they will start eating culture, they will start creating decentralized alternatives to centralized orgs.”

He expects NFTs to be used by companies and decentralized organizations to organize their communities because unlike customer databases, they are public, composable, and uncensorable. Also, they help solve both the problem with trusted third parties, which are responsible for databases on which modern society is running on.

How are NFTs used?

The most significant use of NFTs is in digital content. Non-fungible tokens are particularly helpful in cases where digital assets need to be differentiated from each other to prove their scarcity and value. NFTs help counter the issue of fake art in the real world by being verifiable.

In the world of art and music, artists also find it difficult to get a fair share of the royalties. And, here, many NFT platforms allow artists to earn their "creator share" each time their art is resold. These creator shares are also paid out automatically with smart contracts and are auditable on the blockchain, meaning the creator does not have to be concerned with the compensation.

In March, Ethereum Improvement Proposal (EIP) 2981 was introduced to create an ERC-721 Royalty Standard, a modified NFT standard so that non-fungible tokens created, purchased, or sold on one marketplace can still pay royalties even if it is then sold on another marketplace.

Besides its use in representing digital collectibles like CryptoKitties, NFTs can also represent everything from real estate, domain name ownership, real-world assets, and identification and documentation.

Gaming and DeFi

NFTs are also seeing a lot of interest from game developers. The most popular NFT-based play-to-earn (P2E) game is Axie Infinity which has earned $1.25 billion in revenue in the past year. This game is thriving in emerging economies like the Philippines, Venezuela, Indonesia, Brazil, Thailand, Malaysia, Turkey, Nigeria, and Ghana, where it is enabling hundreds of thousands of people to earn significant money, having a positive impact on their people and economy.

Image via Tokenterminal

Sorare is another one. It is a fantasy football game based on NFTs where managers can trade official digital collectibles. The startup has partnered with 180 football organizations and recently raised $680 million from SoftBank at a $4.3 billion valuation.

As seen with Axie Infinity, Non-fungible tokens are certainly bound to make waves in the innovative DeFi space.

Decentralized app Rarible is currently working on bridging the NFT and DeFi communities by enabling users to sell digital artwork on its platform. In 2020, Rarible launched its governance token RARI and introduced the "marketplace liquidity mining” program, under which it rewarded creators and collectors with the token for their active participation.

DeFi lending protocol Aave also introduced an NFT collectible Aavegotchi, where every collectible or avatar has Aaave’s aTokens staked inside them as collateral, allowing them to earn a yield on the platform. Once the Aavegotchi owner liquidates their stake, their ‘digital fren’ also disappears.

Trade those NFTs

NFTs can be bought and sold on NFT marketplaces such as OpenSea. OpenSea is the market leader, which was recently valued at $10 billion. In August 2021, it posted a record $3.42 billion in volume, an increase of 425x since the beginning of the year.

As NFTs become more popular, cryptocurrency exchanges are launching their own NFT marketplaces.

Binance and FTX have already launched their marketplace early this year, and Coinbase’s waitlist for its own platform is over 1.4 million users long, while Kraken announced very recently that it is working on a platform to support NFT as well.

Given that these crypto exchanges already have millions of users, such an initiative will only take NFTs further into the mainstream.

How do NFTs Work?

Now that we know the widening and elaborate scope of NFTs, how exactly are they being created, you ask?

Currently, Ethereum is the most popular blockchain where NFTs are being created. Its ERC-20 standard is for fungible tokens, while ERC-721 and ERC-1155 are standards for non-fungible tokens.

The ERC-721 implements an API for tokens, which is unique and has a different value than another token based on factors like rarity, age, or anything else, within smart contracts. ERC-1155 is a multi-token standard that can do the same functions as an ERC-20 and ERC-721 token or both at the same time.

So far in 2021, till December, users have sent at least $26.9 billion worth of crypto to ERC-721 and ERC-1155 contracts, according to a Chainalysis report.

Besides Ethereum, NFTs can also be created on other smart contract-enabled blockchains, including Solana, Tezos, Flow, NEO, Secret Network, and Tron, which have introduced tools to support non-fungible tokens.

Other blockchains are increasingly gaining traction as network congestion and the resulting high fees on Ethereum price out smaller users. While Ethereum is working on scalability, ETH 2.0 is still not here and will take some time. As a result, users are attracted to these cheaper and faster blockchains.

Solana is a popular alternative, and this year it launched a $5 million fund to onboard creators and fans to its ecosystem. Solanart is a popular NFT platform on the Solana blockchain, along with SolPunks, Aurory, and Degenerate Ape Academy. The former US First lady Melania Trump is also releasing her NFTs on Solana.

Last year, Dapper Labs, the creator of one of the very first NFTs CryptoKitties, launched its own blockchain called Flow, purpose-built to support NFT collectibles and large-scale crypto games.

After the success of NBA Top Shot, Dapper Labs migrated CryptoKitties to Flow, which uses a proof of stake consensus mechanism and has upgradeable smart contracts. Towards the end of 2021, Dapper raised $250 million at a $7.6 billion valuation.

NFTs are still a relatively new trend, and with blockchain development currently fragmented as developers work on their own projects and build new blockchains altogether, interoperability will go a long way to help them succeed.

How to Buy NFTs?

Has all this talk of NFT got you excited to own your very own piece of digital collectible? If so, let’s take a look at the platforms where you can get your hands on some NFTs.

As stated above, with crypto exchanges joining the NFT marketplace scene, it is becoming extremely easy for users to trade crypto assets, try DeFi, and collect NFTs all from one place.

Besides exchanges, you can purchase non-fungible tokens from dedicated NFT marketplaces like OpenSea, Rarible, SuperRare, Nifty Gateway, Axie Marketplace, MakerPlace, Foundation, and Solanart.

Buying an NFT would require you to have a digital wallet to store NFTs and crypto-assets. As for making the payment, you would need the crypto that the NFT provider accepts, such as Ether (ETH) and SOL.

Using these marketplaces usually requires you to go to their website and connect your wallets, such as MetaMask or Coinbase Wallet, to the platform. From here, you only have to browse through the various collections and select the NFT that you like. After clicking on the buy button, you have to make the payment, which would require your wallet to ask for your confirmation. Once the transaction is confirmed, it will be processed, and your NFT will be deposited to your address.

If you don’t want to pay high gas fees, make sure you do not buy NFTs during peak times or high periods of volatility, or it could end up being extremely costly.

Instead of buying an NFT, if you are looking to put your NFT for sale, that is pretty easy too. Just go to the “Create” tab on the platform, connect your wallet, upload your NFT and fill out the description. Now, wait for people to bid on it.

Which NFTs are the most sought after?

In 2021, NFTs gained mainstream adoption. When it comes to regions based on web traffic for popular NFT marketplaces, Central & Southern Asia, North America, Western Europe, and Latin America are leading the NFT usage. This widespread interest in NFT shows that NFTs have achieved global popularity.

Coming on to the NFT collections, there have been those that experienced brief but large spikes in transaction activity but did not gain consistent popularity, such as Mutant Ape Yacht Club. Hashmasks is another such example that saw over $380 million in transaction value in early July 2021, but its average weekly transaction volume between March to October remained just under $21 million, as per Chainalysis data.

But which NFTs are the most popular?

CryptoPunks is the most obvious answer. Established in 2017, well before the current NFT craze, CryptoPunks has been the most popular NFT collection. It has recorded more than $3 billion in transaction volume since March 2021.

Originally the limited 10,000 punks were released for free, but this year, the highest a CryptoPunk was sold was for 4,200 ETH ($7.58 million), while the current lowest price punk available is 61 ETH (about $240k).

Even payments giant Visa snapped the CryptoPunk #7610 as part of its collection of “historic commerce artefacts,” while its crypto head, Cuy Sheffield, described punk as a “cultural icon for the crypto community.”

CryptoPunk creator Larva Labs, founded by Matt Hall & John Watkinson, is now working with a Hollywood powerhouse to expand the NFT brand.

Image via Chainalysis

Besides CryptoPunks, the Bored Ape Yacht Club took the world by storm as it became a ticket to an exclusive club as owning a BAYC makes you eligible for additional NFT drops such as Mutant Ape Yacht Club and Bored Ape Kennel Club.

NBA Top Shot is another popular one with the highest number of transactions at 12.9 million and the second-highest number of owners at 615,300. This NFT project was the result of a partnership between the National Basketball Association (NBA) and Dapper Labs, the developers of the CryptoKitties game.

Among the most popular of its video reels was LeBron James “Cosmic” Dunk which sold at $208,000, and Zion Williamson “Holo MMXX” Block sold for $100k.

In terms of all-time sales volume, Axie Infinity has claimed the top spot with $3.7 billion in sales and over 2.89 million owners, according to CryptoSlam. Axie Infinity is followed by CryptoPunks, ArtBlocks, BAYC, NBA Top Shot, MAYC, Loot, Meebits, The Sandbox, and Cool Cats.

Recent Development in NFT Space

The NFT sector space has already amassed sales worth $13 billion. The total number of sales meanwhile has been over 18 million, according to Nonfungible.com. In Q3, NFT trading volume hit $10.67 billion, a year-over-year increase of over 38,000%, as per DappRadar.

The total number of active wallets, unique wallets which bought or sold an NFT, has now surpassed 1.4 million.

According to Chainalysis, the vast majority of NFT transactions are happening at the retail level, below $10,000 worth of cryptocurrency. But larger NFT transactions are also becoming more and more common.

“The data shows that the NFT market is far more retail-driven than the traditional cryptocurrency market, where retail transactions make up a negligible share of all transaction volume,” it said.

Image via Chainalysis

NFT growth attracted the attention of even the traditional auction houses like Christie’s and Sotheby’s. As a result, they are embracing NFTs and hosting sales in crypto, too. While NFT star Tom Brady launched his own NFT platform Autograph, rapper Snoop Dogg revealed himself as an NFT collector, and celebrities like Ashton Kucher launched their own NFTs.

In recent weeks, Adidas partnered with BAYC, Punks, Cosmics, and GMoney to sell its 30,000 Into the Metaverse NFTs, netting $23 million. Instagram is also actively exploring NFTs to make it more accessible.

While not everyone in the crypto community is in favor of big companies joining and taking over the NFT scene, others see it as positive in the long run. For instance, crypto trader Loomdart of eGirl Capital said, big corporations coming could help with the mass adoption for NFTs and will only make “the whole pie bigger.”

“We want the brands issuing NFTs. It will bring more people into decentralized permissionless systems,” said Punk6529.

When it comes to NFT regulation, the legal infrastructure is embracing non-fungible tokens, and currently, there are no regulations per se. South Korea, in particular, is currently exploring ways to tax NFTs, while the country’s Financial Services Commission (FSC) has said that NFTs are not virtual assets and won’t be subjected to regulation.

However, fractional NFTs could be considered investment contracts under the securities law, according to US SEC Commissioner Hester Pierce aka “Crypto Mom”.

The Future of NFTs

Much like the crypto and DeFi landscape, NFT is a fast-changing sector where new projects are popping up every day.

This year, we saw non-fungible tokens thriving, but for the time being, they are focused on collectibles and gaming only. NFTs actually have much wider potential and can see their application in copyright and intellectual property rights, ticketing, music and movies, streaming, medical, financial, video games, qualifications, software licensing, warranties, and much more.

NFTs are also expected to be the main component of the metaverse, a market expected to grow to $42 billion globally in the next five years, according to research firm Strategy Analytics, by facilitating identity, community, and social experiences in virtual reality.

NFTs are in the initial stage of their evolution. They have a long road ahead of them and a future full of endless possibilities.

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