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August 18, 2021

The Key Characteristics of Non-Fungible Tokens

NFTs are special types of tokens that reside on a distributed ledger and hold a digital asset, such as a document, picture or movie. There has recently been an explosion in their popularity, most notably in sports, art and music. We explore their key characteristics and benefits, which stem from leveraging the properties of Digital Ledger Technology, such as immutability, digital scarcity and dropping the need for a trusted intermediary.

Introduction

Non-Fungible tokens, or NFTs, are tokens that reside on a distributed ledger, just like a bitcoin (BTC) or an Ether (ETH) token. One of the key characteristics of NFTs is that they are not fungible. Fungibility means that a BTC token can be exchanged with another BTC token, as they are indistinguishable in terms of value. This is a property also shared by fiat currencies, as one dollar bill has the same value as any other dollar bill. However, a non-fungible token is unique or of limited supply because it can act as proof of ownership for music, drawings, tweets, or any other item. As two NFT tokens are proof of ownership of to two different assets, they can differ in value.

 

Currently NFTs are found primarily in the Ethereum blockchain, using the ERC-721 token standard, although other ledgers have also created their own NFTs, such as Solana. They are bought and sold in NFT marketplaces, such as OpenSea, Rarible, SuperRare, Nifty Gateway and NBA Top Shot. The digital assets that are sold are artwork, domain names, sports collectibles, and trading cards, as well as videos of memorable NBA moments.

 

An example of the physical world equivalent of an NFT is a trading card or a painting. A painting is unique in the sense that even if it is replicated, one can recognise which copy is the original, whereas two different paintings have in principle different values so they cannot be exchanged.

 

Why is a Picasso painting worth millions, whereas an exact copy is worth almost nothing, even though it is indistinguishable to everyone except for a few experts? The answer is that some people find it valuable to own the original, rather than the copy, partly due to the social status this holds. Moreover, as there can only be one original there is scarcity, so there is no danger of eroding its value by increasing its supply.

Scarcity

NFTs leverage digital scarcity, the main characteristic of tokens that are created within a distributed ledger. Once generated, a token cannot be copied or replicated, whereas the person who bought it can prove they are the owner, without relying on the validation of an external intermediary. This means that once an NFT is created, or minted, referencing a digital asset, such as a digital painting, everyone can see that this token is the “original” token. At the same time, anyone can get the digital information and copy it onto their own hard disk. But this would be a copy and, in the same way some people would be willing to pay a lot of money to be the verifiable owners of an original Picasso painting, others are willing to pay a lot to be the verifiable owners of an original digital painting, such as the NFT of Beeple that sold for $69 million.1 A digital asset can also be linked and referenced by more than one NFT, thus replicating the physical world equivalent of trading cards that are issued in limited supply.2

Intermediaries and Ownership

The ownership of NFTs, as with any other token, is irrefutable and immutable. Moreover, it does not depend on any trusted intermediaries or owners of the network. To understand the significance of this, note that a digital song bought at Apple Music cannot be transferred to any other music service; it can only be played by Apple’s software. If Apple defaults, the songs might disappear as well. The “owner” of a song cannot sell it and they can only use the services that Apple has approved. In other words, there are many restrictions which put into question whether this can be called ownership. On the contrary, an NFT can be bought and sold without any restrictions. In principle, a user interface or service can ask the owner’s permission to display or play the digital assets that an NFT references, without putting further restrictions on how the digital asset is used. Finally, the NFT “lives” for as long as the distributed ledger is maintained by the numerous ledger validators, so its existence is not tied to the financial health of any company or platform which a company might wind down.

Royalties and Resales

Another advantage of NFTs is that they enable resale and royalty models that were not possible before. For example, smart contracts enable the original creator of the digital asset to get a percentage of the price, every time an NFT is resold. This means that an artist can benefit by the gradual appreciation of their art. As they become more famous, their early works of art sell at higher prices and they can capture some of the increase in value. This also means that fans can support early-stage artists by buying their NFTs, which may enable the artist to be less dependent on record labels and publishers. If the artist succeeds, then anyone who supported them early can benefit, as the NFTs will appreciate. Smart contracts can also enable new functionalities. For example, an NFT can directly donate money to a specific charity when sold, or unlock special perks that are connected to the physical world, such as front row seats.3 If there are multiple contributors to a digital asset, an NFT can split royalties every time the song or the movie is played, helping automate royalty distributions. Regular events tickets can also be issued as NFTs and a smart contract can even set a maximum price, to disincentivise those who buy them just to resell them at very high prices.

New Business Models

The functionality of NFTs and the fact that the intermediary is dropped may lead to a more direct relationship between the creator and their consumers, generating new business models. For example, in music the prevalent model requires a new band to sign a multi-record deal with a record company, so that that the company provides the initial investment but reaps most of the benefits if the band succeeds. Through NFTs, a band can now crowdsource the initial investment through their early fans and essentially make them co-investors, so that everyone benefits financially if the band succeeds. On the consumer side, we may go back to an ownership-based model, where listeners own their records, rather than the subscription-based model that we have now.

Conclusion

Although NFTs are relatively new, their usage has recently exploded. Still, there is a lot of growth potential, as mainstream users become more familiar with NFTs and the technology becomes more accessible. Moreover, NFTs are not constrained to digital art and music. In principle, any type of intellectual property can be embedded, licensed and sold using NFTs, so the potential uses are unlimited.

Footnotes

1 For more details, see https://www.theverge.com/2021/3/11/22325054/beeple-christies-nft-sale-cost-everydays-69-million.
2 However, it is important to note that originality can only be claimed within a particular blockchain, for example Ethereum. That is, the same digital asset could be loaded onto an NFT of another blockchain.
3 Kings of Leon released an album as an NFT which included unique perks such as front row seats and a variety of VIP experiences. For more information, see https://www.rollingstone.com/pro/news/kings-of-leon-when-you-see-yourself-album-nft-crypto-1135192/.

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