Understanding Non-Fungible Tokens (NFTs)

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Non-fungible tokens (NFTs) first hurtled to the attention of most of the world when artist Grimes sold several in March 2021, netting herself a cool $6 million in the process. There was a further flurry of interest when one of her NFTs was resold in November that year for considerably less than its purchase price, losing its owner some 70% of their original investment.

But what actually are NFTs? And are they worth buying? This page explores the nature of NFTs, and discusses when you might consider buying—and when you might not.

Defining NFTs

NFTs are digital assets that use blockchain to make them unique and identifiable.

Most NFTs use Ethereum, although some other blockchain providers have similar alternatives.

Some definitions of NFTs

“Non-fungible tokens (NFTs) are cryptographic assets on a blockchain with unique identification codes and metadata that distinguish them from each other.” Investopedia

“NFTs are tokens that we can use to represent ownership of unique items. They can only have one official owner at a time and they're secured by the Ethereum blockchain.” Ethereum.com

“A non-fungible token (NFT) is a financial security consisting of digital data stored in a blockchain, a form of distributed ledger.” Wikipedia

Non-fungible means non-exchangeable or non-equivalent.

These assets are therefore unique, unlike (say) money, where any single dollar has the same value as any other. Bitcoins and other cryptocurrencies may also be secured using blockchain, but one bitcoin is exactly like another. They are therefore fungible tokens.

NFTs often refer to digital files such as artwork, photographs or videos. Another common type of NFT is the digital assets in games, such as the players or characters that users build and create themselves. The difficulty with any NFT is that (unlike a fungible token such as bitcoin), it has no intrinsic or equivalent value. The value of any NFT is therefore what someone is prepared to pay for it.

Ethereum’s vision

The main blockchain on which NFTs are secured is Ethereum. The company’s website contains an interesting vision of an ‘NFT internet’ compared with the current internet.

In an NFT internet, for example, all digital assets are unique, and files cannot be replicated. All NFTs are owned, and their ownership is recorded in a public record, and therefore easily verified. Anything that uses an NFT can be traded in a digital marketplace, for anything else that uses an NFT. Content creators can therefore sell their content anywhere, across a global market, without having to use particular platforms. They can also retain copyright and claim royalties. You might even be able to use digital artwork as security for a loan.

Source: ethereum.org/en/nft/

The nature of NFTs

What is interesting about NFTs is that the NFT itself is unique.

They cannot be reproduced. An NFT proves ownership of something, and the ownership can transfer.

However, the artwork to which the NFT refers can itself be reproduced.

For example, you can, if you wish, download some of the images whose NFTs were sold by Grimes in March 2021. You can use them as your digital wallpaper, or print them off and hang them on your physical walls—but you still won’t own the original digital file.

NFTs therefore confer exclusive ownership, but not necessarily exclusive use. It’s a bit like the difference between a print of Van Gogh’s Sunflowers and the real thing—except that it is almost impossible to create an exactly identical reproduction of Van Gogh’s Sunflowers, whereas a digital artwork can actually be replicated entirely and completely.

If you find it hard to see the attraction of this, you are not completely alone. The jury is still very much out on whether NFTs are a one-hit wonder, or if they have some genuine uses.

The market for NFTs

The main market for NFTs is currently around artwork and collectibles.

Many of the early NFTs were issued by celebrities, including a token representing the first tweet ever made by Jack Dorsey, Twitter’s CEO. The other main use for NFTs is in games such as Cryptokitties.

Why would anyone buy an NFT?

There are three main reasons. The first is to be able to say that they own it. The second is to support the artist, or the cause for which the NFT is being sold. The third reason is as a speculative investment: because you think that the NFT will increase in value after you buy it (see box).

NFTs: who are the winners and losers?

The biggest winners from NFTs are undoubtedly the early creators of NFTs—and to an extent, existing creators, provided the market holds up. They have been able to create something for relatively little, and sell it on for money—often quite large sums. There is no question that NFTs help artists to hold onto the copyright for their work, and sell direct to customers, without paying agents’ fees. They can also allow for royalties to be paid each time the NFT changes hands.

There have also been cases where NFTs have been sold to raise money for ‘good causes’. In these cases, the charities or causes are also winners. The Football Association, for example, has sought a partner to create NFTs from digital assets such as videos. It sees this as a way to generate a long-term income stream that will support grassroots football in the UK.

What about the losers? The biggest losers so far are people who bought NFTs as an investment. The market remains positive, but many celebrity-linked NFTs have lost 70%–80% of their value since first being sold.

However, there are other uses for NFTs that may perhaps prove more promising in the longer term.

For example, NFTs can be used to prove ownership of real-world assets like property, a bit like a physical deed in the non-digital world. The use of blockchain means that every transaction is recorded, so it is very hard to fake.

This is similar to the way that many central banks have created digital versions of real-world currencies that are traded alongside the real thing (and see our page Understanding Digital and Cryptocurrencies for more information).

This use of NFTs is likely to grow over time, because it is a useful way to secure something digitally. As the need grows to secure assets digitally, blockchain looks like the best way to do so—and NFTs the most obvious use of blockchain.

The bottom line

Should you spend your money on NFTs? Go ahead, if you want to, and if you can afford to do so. After all, there is no harm in collecting things, if that is what you want to do.

Should you use NFTs to secure your physical assets? There doesn’t seem to be any reason why not, although you probably want to ensure that you also secure them in the physical world too. Indeed, this is probably the most promising use of NFTs to date.

Should you consider money spent on NFTs as an investment?

The jury is still out, but the verdict is looking more and more like no. NFTs are, at best, a highly risky investment. Instead, they are probably best seen as a purchase or an expense—with the bonus that the purchase may allow you to support a favourite good cause.