A Guide to NFTs: Everything You Need to Know About Non-Fungible Tokens

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Aja McClanahan is a personal finance writer who has a story of getting out of over $120,000 in debt. She's been featured in Yahoo! Finance, MarketWatch, U.S. News and World Report, Kiplinger and has written for publications like Business Insider, Credit Karma, Inc., and many others. Aja writes about investing and personal finance for Wealthsimple. In her spare time, she manages her own investment portfolios for herself, husband, and two kids. Aja double majored in Spanish and Economics and holds a Bachelor of Arts degree from University of Illinois at Urbana-Champaign.

Investors are currently exploring options to hedge their portfolios against losses in today’s peculiar market conditions, whether they believe inflation is coming, currency devaluation is inevitable, or various markets could suddenly lose value. As a result, alternative investments like cryptocurrencies and, now, non-fungible tokens (NFTs) are becoming viable investments. This class of investments is still a pretty abstract concept for most, but they are only increasing in popularity.

If you’d like to know more about what the future may hold regarding digital assets and non-fungible tokens, this article is a starting point.

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Basic concepts that can help you understand NFTs

Here are some basic concepts that can help you understand how NFTs work.

Interchangeability

To understand what a non-fungible token is, we’ll start with the concept of interchangeability. An example of interchangeable assets is paper money and coins. For instance, if you have a $5 bill, it could be replaced with another $5 bill.

Someone could also give you five $1 bills or 20 quarters or any combination of paper money and coins that equal $5. Because you can exchange various amounts of dollar bills and coins to have the same amount of money, paper money and coins are fungible assets. That is, they can be replaced by another, similar object of equal value.

But let’s talk about rare coins. If you search for rare or collectible nickels on eBay, you can find various nickels minted in the early 20th century. These coins are selling for much more than $0.05 per nickel, even though we all know and pretty much agree that nickels are worth 5 cents.

These rare, collectible coins would not be considered fungible. You cannot replace these coins with other coins of the same denomination. The owner wouldn’t allow you to exchange a nickel minted, say in the 1990s, for one of their rare nickels.

Other examples of non-fungible assets might include other collector’s items, houses, or precious stones. These items have unique qualities that make them more or less valuable to the markets that ascribe value to unique features that help determine the items’ prices.

Tokenization

Tokenization involves creating a digital token that represents an asset either in part or in its entirety. The token itself doesn’t have any inherent value, but the asset it represents does. Tokenized assets can exist in the real world, like real estate, or on a digital platform, like a GIF file.

Blockchain technology

Finally, to understand non-fungible tokens or NFTs, you should become familiar with blockchain technology. In a nutshell, blockchain technology is records of data that exist on decentralized computer networks. This means that no one person or entity has control over data on these networks.

To record and validate transactions, a process called “mining“ occurs. Data recorded on the blockchain will exist on a “public ledger” that cannot be destroyed, altered, or hidden.

Because of these properties, blockchain enables significantly increased transparency for transactional activity. In other words, there’s an open, traceable record of transactions that are easily accessible and, ideally, easy to verify.

The ability to create verifiable, transparent data records have many promising applications like preventing identity theft or securing elections via blockchain protocols. Perhaps you are familiar with one application that is already in use today: cryptocurrency.

Cryptocurrency, like Bitcoin or Ethereum, is a digital form of money that can be used to buy goods and services like any other currency. Unlike government-issued money, such as paper dollars and coins, cryptocurrency can only exist in a digital wallet.

Also, unlike government-issued money, creators of these currencies have applied certain scarcity protocols. So there is a limited amount of each currency in circulation verified on the blockchain ledger. With NFTs, not only is scarcity a feature, but uniqueness is, too.

What makes an NFT valuable?

When we put all of these concepts together, we arrive at how non-fungible tokens or NFTs work and exactly why they have value as an asset. Non-fungible tokens are a digital representation of an underlying asset that is limited in supply, unique, subjectively valuable, and easily authenticated because of blockchain technology.

Here are a few examples of how NFTs are taking shape in real, highly-liquid marketplaces.

CryptoKitties

The CryptoKitties game is an example of a game that introduced the concept of NFTs to the general public. Developers created the game in 2017 as an attempt to teach users about how non-fungible tokens work.

The game allows users to purchase and sell digital “cats” with Ethereum crypto-currency. Users can also breed cats and sell rare offspring at a profit. Each CryptoKitty is unique and possesses special “cattributes” that present based on the digital genome programmed into the game’s protocols.

This digital breeding process produces cats whose unique genetic traits have varying degrees of rarity, making each digital cat unique and non-fungible. The highest price fetched for a CryptoKitty so far? One user paid a whopping $170,000 for a seemingly average digital cat.

NBA Top Shot

Entities like the NBA are capitalizing on blockchain trading cards, or NFTs, as an additional income stream. If you head over to the NBA Top Shot beta website, you’ll see various sports highlight clips, known as NBA Top Shot moments, going for tens of thousands and even hundreds of thousands of dollars. This project is also spear-headed by Dapper Labs, the creators of the CryptoKitties game.

Each NBA Top Shot moment has a unique serial number that identifies it and proves its authenticity, plus other information tied to a blockchain record that, in theory, cannot be hacked, fraudulently replicated, or altered.

As a digital sports clip collector, you could watch LeBron James dunk over and over again by dropping a cool $250,000 to own one of his Top Shot moments. There are other clips and images that don’t cost as much.

The neat thing about this site is that there’s a record of completed, verified transactions on the platform. The records or sales and resale activity alone proves just how high prices can go in this marketplace.

Authenticity, scarcity, and subjective value of NFTs

Like real sports trading cards, NBA Top Shot NFTs derive their values from characteristics like scarcity and authenticity. These characteristics are somewhat artificial and, at times, arbitrarily created by the NBA and those who ultimately trade NFTs in this marketplace.

The NBA has built scarcity into the Top Shot market by limiting the unauthorized circulation of game video footage in real life (copyright permissions) and creating tiers on the Top Shot platform:

  • Common: 10,000+ available

  • Rare: 150-4,999 available

  • Legendary: 25-499 available

  • Platinum Ice Ultimate: 3 available

  • Genesis Ultimate: 1 available

If you think of these crypto-collectibles like sports trading cards, you can guess other characteristics that might add value to these NFTs. Highlights featuring high-performing players, remarkable plays, or iconic team match-ups will garner more money and have higher resale values. Rookie moments and certain serial numbers might also add value to a particular highlight.

How can NFTs generate income?

As an owner of an NBA Top Shot NFT or any other asset represented by an NFT, you are free to consume it at your leisure or hold on to it, hoping that it will appreciate. Because the NBA Top Shot website has a built-in marketplace, you can sell items in your collections for a short-term (or long-term) profit.

Other options for NFTs might include repurposing them for other uses like virtual or augmented reality. Either way, these NFTs are assets that you own and can use as you wish.

It’s worth noting that NBA players have a revenue-sharing agreement on NFT sales, so they also benefit as featured players in these clips. This brings us to another important aspect of NFTs: how stakeholders like creators, producers, or other parties with ownership rights can profit from selling their work, image, or likeness as an NFT.

NFTs for creators

One growing application for NFTs has been in the creative world. Artists like Mike Winklemann, of Wisconsin, aka Beeple, reports having sold $3.5 million of his NFT art in a single weekend. As of this writing, a collector has paid $69 million for one of Winklemann’s pieces at a Christie’s auction. According to the exclusive art dealer, this was the first auction that featured purely digital work and accepted cryptocurrency as payment for artwork.

Another recent example of artists profiting from NFTs sales is Tim Canter’s recent digital art exhibition. He’s the artist behind the cover art, stage designs, and videos for the world-famous band, Imagine Dragons. For his online art exhibition, can he created digital versions of select pieces, which he then converted into NFTs for sale on the Terra Virtual (TVK) platform.

One of the main reasons is that NFTs have simply made dealing in collectibles more practical.

With technology, NFTs can possess new properties that were not formerly available with traditional collectible items like:

  • An immutable record of authentication

  • Scarcity protocols

  • Ability to exist in a digital wallet with other digital assets

  • The potential to function across various digital platforms

  • Can be owned, sold, and purchased in multiple marketplaces

  • Programmability or addition of features and benefits associated with unique NFT serial numbers

These enhanced features are drawing the likes of creators, collectors, and investors in increasing numbers. What used to be an obscure, cumbersome, and somewhat exclusive process for creating, selling, and trading collectible assets like art has now become incredibly accessible, secure, and, thanks to many NFT marketplaces, extremely liquid.

We could also cover the emergence of the bizarre YOLO culture that assigns random, arbitrary values to digital objects like memes, viral video or GIFS.

The wholly unpredictable and cultlike nature of memefication and virality, when thrown into the mix of attributes that determine how popular and valuable a digital asset could become, can make NFTs even more puzzling. See the 8-bit Nyan Cat GIF sold in an online auction in early 2021 for almost $600,000.

The rise of blockchain technology

One obstacle of NFT adoption is a lack of understanding regarding the underlying technology. Today, more people are not only familiar with blockchain technology and cryptocurrencies but are also actively participating in these markets. The general public’s understanding of cryptocurrency and crypto collectibles is increasing and spurring more participation in these markets.

Prevailing market conditions

In uncertain market conditions, like the ones we see today, investors may look to alternative assets, like NFTs, as a hedge. So far, the NFT concept is proving fairly successful: There are efficient marketplaces that demonstrate an impressive amount of liquidity where there was little to none before. It’s giving hesitant art investors and collectors more confidence while giving rise to another asset class that can readily appreciate and sell at reasonable prices.

Adoption

Another factor that might explain the increasing popularity of NFTs is that mainstream corporations, like the NBA, have adopted blockchain technology for its digital goods with undeniable success. At present, NBA Top Shot reports $400 million in sales, 300,000 users on the platform, and 2.5 million completed transactions on their platform.

Also jumping on the NFT adoption bandwagon are sophisticated art dealers, venture capitalists, institutional money, and creators themselves converting their work into NFTs for sale and resale.

How can I buy NFTs?

There are several different marketplaces where you can purchase NFTs. Here are some examples:

  • OpenSea

  • Rariable

  • Mintable

  • SuperRare

  • Decentraland

Plus, dozens of others that are specific to asset categories like sports, artwork, music, etc.

How can I create an NFT?

Many of the platforms mentioned have an interface that allows creators to convert their creations into NFTs. For instance, Open Sea gives creators a digital storefront. As long as you have a digital wallet, digital content to sell, and money to cover transaction fees, you can upload your work for sale on this digital storefront.

Some platforms even allow you to assign specific attributes to your work. For instance, you can indicate how many copies of your work are for sale and maybe even set a royalty on each resale.

Once you set up a profile and upload your work, the only thing left to do is wait for someone to buy your NFT creations. The smart contracts that govern these transactions automatically collect and distribute money to you, much like other traditional online marketplaces.

How can I sell my NFT?

Once you create a profile on any one of several NFT marketplaces, you can set a price for your digital goods. And as long as you have access to a crypto wallet, you should have no problem selling your work on these platforms.

What are some limitations of NFTs?

While NFTs might sound like the wave of the future, there are still some limitations to the technology. Although adoption is increasing, most people still don’t know much about NFTs and are not participating in these marketplaces.

Another issue is that NFTs don’t fully solve the authenticity issue. For example, NBA Top Shot moments can still be downloaded and copied without ownership of an official NBA Top Shot moment. This applies to other NFT assets, too.

The downside of some blockchain transactions is that they can be a cover for illegal activity. These transactions can be anonymous, which, some experts fear, could give rise to fraudulent, black market activity like money laundering or trafficking.

Another limitation of NFTs is that there are many standards and marketplaces that do not yet communicate or operate with one another. NFT collectors want their assets to reside and interact in digital spaces that are platform or marketplace agnostic.

Some critics of blockchain technology say it’s far too inefficient to net a real benefit to users as a whole. There are some reported issues regarding the environmental strain caused by the computing resources needed to mine blockchain data, which some argue is not a worthy means to achieve the end of blockchain assets.

NFTs as investments in your portfolio

NFT assets are not perfect investments by any means. But they are an increasingly viable alternative investment gaining more traction by the minute. If you’d like to purchase NFTs as part of your investment portfolio, treat them like any other investment. Research, test and evaluate your outcomes. If it makes sense, buy, sell, or hold accordingly.

Last Updated April 29, 2021

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