NFT, short for a non-fungible token, is defined as a blockchain record intrinsically connected to a real word or digital asset with clear ownership via smart contract technology, which allows NFT to be bought, sold, traded, or transferred. This article uses examples to explain how a non-fungible token (NFT) works and its seven main uses.
What Is an NFT?
NFT, short for a non-fungible token, is defined as a blockchain record intrinsically connected to a real word or digital asset with clear ownership via smart contract technology, which allows NFT to be bought, sold, traded, or transferred.
Non-fungible tokens are a relatively new technology that has become popular due to the rise of blockchain and cryptocurrency. Blockchain allows data to be transparently and immutably held in an interconnected chain of records called blocks. This data could be applied to various use cases, from consumer data in marketing and loyalty programs to entire currency systems. As a result, blockchain records turn into an asset class held together by smart contracts that are impossible to violate or defraud.
These asset classes powered by blockchain can be of two types – an interchangeable (or fungible) asset or a non-fungible asset. Fungibility refers to a property that allows assets to be traded for another without change in value or allows one asset to stand in for another. Regular fiat currency has the quality of fungibility, which means that one dollar is the same in value as another dollar.
Non-interchangeable or non-fungible assets have an intrinsic value of their own and cannot stand in for another so easily. For example, real estate does not have fungibility quality, nor does artwork. NFT or non-fungible token, falls into this asset category, unlike cryptocurrency, which is also a blockchain-based asset class. However, cryptocurrency is characterized by its fungibility, making it somewhat like the fiat currencies we use daily.
NFTs, by their very nature, resemble physical assets with a clear line of ownership and provenance. However, since it is built on a bedrock of digital IT infrastructure, NFTs can accumulate a massive variety of assets that are unimaginable in the real world. For example, one can create a non-fungible token from the gaming avatar, a graphics interchange format (GIF) file, or even a meme.
The first known NFT, going by its current definition, was created by U.S.-based artist Kevin McCoy and American entrepreneur Anil Dash. The duo made an octagonal animation, the first-ever work of art to have smart contract-based ownership. Interestingly, this animation – titled Quantum – was created before the term NFT was officially coined, and in 2021, Quantum was auctioned off by Sotheby’s. This example of an early NFT illustrates how non-fungible tokens can be ascribed with enormous value, competing with traditional asset classes like real estate, precious metals, physical art, etc.
Indeed, non-fungible tokens or NFTs become all the more critical in the era of the metaverse – i.e., digital or virtual worlds where people and objects exist as avatars and can interact with their surroundings. In such rich digital environments, NFTs open up possibilities for property ownership and real-world economics, laying the foundations for a governance system. Artificial intelligence (AI) is another technology central to understanding NFTs, as AI-powered NFT generators like StarryAI, Fotor, DeepAI, etc., come to the forefront.
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How Does an NFT Work?
To understand how NFTs work, one must first look at how blockchains work. At its core, a blockchain is a distributed database that contains an ever-increasing list of sequentially arranged records or blocks. Interestingly, since the blocks are immutable, they do not come under the ambit of traditional database management systems (DBMS). Each block has within it a cryptographic hash that describes the contents of the previous block on the chain, the time stamp, and transactional data.
There are various blockchain systems worldwide, and Ethereum is among the most popular ones. Based on blockchains like Ethereum, one can create a digital asset defined by a smart contract (following the rules of the blockchain system, known as a token). Non-fungible tokens, or NFTs, are a type of token based on Ethereum’s ERC-721 standard, which essentially mentions the technical specifications powering an NFT. Here is a quick summary of the ERC-721 standard to help you understand how an NFT works:
- Ethereum Request for Comments 721, or ERC-721, is a standard introduced in 2018 that implements an application programming interface (API) for smart contract-based tokens. This allows tokens to be transferred from one account to another, a key functionality of NFTs.
- The API also supports various other functions such as transactions by third-party accounts, checking account balances, calculating the total supply of a token, etc.
- Using the standard, anyone can use an application binary interface (ABI) to connect to a token. That makes NFTs so widely accessible, even among users with little to no technical background.
- The standard includes methods and events governing the NFT API’s functionality. This collection of methods and events permits non-fungible tokens or NFTs to behave like real-world assets.
When creating an NFT, one essentially creates a unique asset with a distinguishable set of metadata and identifiers and sets up a smart contract on the blockchain, following the ERC-721 standard. The value of an NFT depends on how unique it is and not necessarily the amount of effort put into creating it. In some cases, one can convert real-world assets into non-fungible tokens, and these assets are typically visual in nature. However, items like video game collectibles, music, text, or even virtual land can work as an NFT.
Once an NFT artist has selected a digital asset, they can sign into any NFT marketplace, with OpenSea being the biggest one. These marketplaces have all the mechanisms necessary to “mint” an NFT from the digital asset. Minting refers to consuming computing power to form a smart contract and validate transactions on the Ethereum blockchain. Since the technology is extremely energy intensive, the minting process involves a certain portion of gas fees that the NFT creator must pay.
Once the minting is over, the NFT artist can list the asset on the marketplace and sell it. This creates a new avenue for generating artwork revenues and allows investors to diversify their portfolios.
Another critical component of an NFT’s functionality is a cryptocurrency wallet. A crypto wallet is central to any blockchain system, allowing users to perform transactions securely and transparently. When an NFT is created, the artist must pay the gas fee using their crypto wallet, and revenues from NFT sales are also credited to the wallet.
While this is essentially how an NFT works, different marketplaces may have different rules for their operations. For example, OpenSea and Rarible are self-service NFT marketplaces where anyone can create and list a non-fungible token. However, Nifty Gateway is a curated marketplace where artists must submit an application form before they can create an NFTfrom their digital content.
Now that we have considered the development side, let us look at a few key concepts of NFT functionality from their usability end:
1. Non-fungible tokens are indestructible and interoperable
An NFT is stored and managed through a blockchain system like Ethereum. This means that it can never be accidentally destroyed, unlike a physical work of art. The NFT owner would have to intentionally undertake the destruction process through a process known as burning. When an NFT is burnt, they are sent to an unspendable verified account address, and no further transactions will be added to the NFT system. Destruction as a Service (DaaS) applies Software as a Service (SaaS) principles to simplify NFT burning.
Further, owing to the ERC-721 standard, NFTs are not interoperable. In other words, information within an NFT cannot be linked to an external system.
2. NFTs derive their value from scarcity
Like real-world properties or assets, non-fungible tokens are valuable because they are few in number. The NFT creator can decide how rare they want to make a digital item. For example, they could mint 20 copies of a video game collectible, where each has a unique identity, but there are several of them available. This is similar to real-world goods like clothes, which have multiple copies but are unique and identifiable through something like a barcode.
Or, there could be only one copy of a non-fungible token. This is usually the case with artwork or extremely rare digital collectibles. A real-world equivalent of this type of NFT could be a specially designed, tailored dress. However, whether 1 or 20, the number of NFTs is always limited, and this scarcity is needed for their functionality.
3. NFTs support royalty systems
A key feature of non-fungible tokens is that you can program the code in its smart contracts to support royalty systems. By default, NFT contracts power ownership verification and transferability from one owner to another. You can configure the agreement beyond these basics to accommodate a variety of functionalities like royalties.
In this system, the smart contract specifies that a certain amount of crypto will be paid out whenever the NFT is purchased or rented out. For example, a video gaming environment could have a particular avatar as an NFT. The token could be programmed in such a way that whenever a player purchases the avatar, the original artist earns an amount as a royalty fee. In addition to ERC-721, the ERC-1155 standard on the Ethereum blockchain enables this capability.
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Uses of NFTs
Non-fungible tokens (NFTs) witnessed a sharp uptick in demand in mid-2021, and it was even named that year’s Word of the Year by the Collins Dictionary. In August 2022, the total trading volume of this asset class crossed $5 billion globally, per market analysis by CoinGecko. This demand is due to the sheer versatility of NFTs, which allows the technology to be applied in different use cases across industries. Some of the critical uses of NFTs include:
1. Supporting the Play-to-Earn (P2E) gaming model
Digital collectibles are probably the most popular use of non-fungible tokens, as they enable non-duplicable in-game assets. As they cross different levels, players can earn assets that have an intrinsic value and then trade or sell them later on. Unique in-game items can increase in value over time, helping players make a profit. Even when players exit the game, they continue to own the NFT and may generate value from them in the future.
2. Enabling true ownership of digital art
Traditionally, digital and physical art remain distinct, as the former was easy to copy, share, and defraud. For example, piracy of digital artwork or files in digital media formats is almost impossible to control. As a result, digital art could never have the same value as even a basic watercolor by a rising painter.
NFTs turn this model on its head. Artists worldwide can turn their graphical designs, digital artwork, or photographs into an NFT that can be bought and sold. The blockchain carries records of all transactions without the risk of tampering, and artists can even earn royalties when an image or media file is put to commercial use.
3. Verifying memberships through “digital tickets”
NFTs can also be used as digital tickets to prove membership in an online community, a paid video game, or any other digital forum behind a paywall. On the web, users do not enjoy the same ease of identity verification as in the real world. As demand for online spaces like metaverse platforms continues to grow, proving membership is a significant business problem. One can display an NFT as proof of membership or even turn their avatars into an NFT, demonstrating the authenticity of their online identity.
4. Removing fraud in the music industry
As digital media takes over the music industry, instances of fraud and piracy have continued to grow. Also, it can be challenging for emerging musicians to turn a profit in their early years, as record labels, music vendors, ticket distributors, etc., claim the lion’s share of revenues. In contrast, non-fungible tokens allow artists to connect directly with their audience by selling digital music files. NFTs can be programmed to restrict revenue sharing to a point and no more, ensuring that the artist’s rights are not violated. Companies like Autograph.io even enable the tokenization of autographs to support artists further.
5. Purchasing digital real estate in the metaverse
Digital real estate, known as parcels, is another top use case for NFTs. Popular metaverse platforms like Decentraland or The Sandbox have sprawling real estate that is in high demand. Individuals and companies can set up virtual offices in the metaverse (decentralized apps or dApps) to unlock new revenue streams. Investors can buy and sell these parcels for a profit or lease it out to a metaverse developer. The value of these parcels can run up to millions of dollars, making it crucial to establish ownership. NFTs are a secure and tamperproof way of managing digital real estate rights.
6. Complementing the ownership of physical assets
Sometimes, buyers of real-world assets may choose to purchase an NFT with it simply to prove the history of ownership and the asset’s authenticity. For example, CarForCoin.com allows users to buy NFTs; every token is associated with a real-world car. This assures the buyer that they are getting a high-quality product with digital proof of ownership. This use case is essentially enabled by smart contracts being more secure than physical ones, and NFTs may enable easier trading if the buyer wants to sell the asset later on.
7. Storing medical records and clinical data
NFTs are applicable in any use case that involves a record of data and transactions. This makes it especially relevant for the healthcare industry, where the veracity and authenticity of records are paramount. By converting a person’s healthcare record into an NFT, one can ensure that data is not lost or tampered with. Only authorized individuals can access the data without compromising security. One such use that is slowly gaining popularity is the idea of NFT birth certificates.
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Examples of NFTs
Now that we have explored the meaning of NFTs and how they work, here are a few interesting examples of non-fungible tokens currently/soon-to-be available:
- Starbucks Odyssey, an NFT loyalty program: In 2022, the global coffee chain plans to introduce a loyalty program based on NFT technology. Odyssey will combine the company’s top-rated Starbucks Rewards offering with NFT collectibles.
- Everydays: the First 5000 Days: A discussion of top NFT examples is incomplete without this work of digital art by Mike Winkelmann. He worked on a different project – from start to finish – for 5000 days and then stitched it all together into an NFT collage that sold for over $69 million.
- Death Row Session Vol. 2: This is a music album that was released entirely as a non-fungible token. The album by Snoop Dog also includes several embedded collectibles that music buyers can reclaim for a reward later on.
- Candao for identity and access management: NFTs can provide an alternative to traditional role-based access control, as illustrated by the example of Candao. It provides users with a unique digital identity as an NFT, and every user activity will be recorded thereon.
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Non-fungible tokens (NFT) are the next step in the evolution of digital rights management. It allows users to own a digital asset and ascribe value to intangible items like virtual real estate or digital art. As the metaverse becomes the new destination for internet users, NFTs have the potential to generate and support an entire economy – complete with self-sustained operations, innovative job roles, and niche digital skill sets.
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