What Are Non-Fungible Tokens (NFTs)?

Non-Fungible Tokens (NFTs) Explained

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Non-fungible tokens or NFTs are unique digital assets that are based on blockchain technology. Anything can become an NFT—a piece of art, sports memorabilia, or even a tweet. Unlike cryptocurrencies that also use the blockchain network for ownership verification, one NFT cannot be directly exchanged with another NFT.

NFTs have existed, in some form, for several years but gained a level of traction in 2020. According to research by NonFungible.com and L’Atelier BNP Paribas, in 2020, the total volume of NFTs traded in the U.S. was $250.85 million, up almost 300% from $62.86 million in 2019. 

And its not just the overall volume. Some NFTs are raking in big bucks. In March 2021, Christie’s auctioned off an NFT-based artwork by Mike Winkelman, now famously known as “Beeple,” for $69.3 million.

Here’s what to know about NFTs, including what they are and how they work, plus examples.

Definition and Examples of Non-Fungible Tokens (NFT) 

NFTs are tokens offering ownership of digital assets. This ownership is then verified through algorithms on the blockchain. Most NFTs use the Ethereum network for verification.

Some trace the origins of NFTs back to tokens called Colored Coins in 2012. Colored coins were essentially bitcoins that were “colored” to give them special properties in order to distinguish them from the rest of bitcoins and had value independent of the face value of the underlying bitcoin.

From there they evolved to CryptoPunks, digitally generated characters and the first NFT on the Ethereum network in 2017. But NFTs became popular a little later in 2017 with the advent of Cryptokitties, a digital gaming platform on the Ethereum network, that allowed buying, selling, and breeding of digital cats. The craze caught on soon enough and in 2018, a Cryptokitty sold for 600 Ethereum—the equivalent of $170,500. 

In March 2021, a CryptoPunk sold for 4,200 Ethereum or the equivalent of $7.57 million.

You may have seen NFTs in the news, such as artwork, valuable sports trading cards, or computer-generated avatars. Many artists and other creatives are producing original works for distribution as NFTs. 

In early March 2021, Twitter CEO Jack Dorsey put up his first ever tweet from 2006 for sale as an NFT. It sold for $2.9 million nearly 2.5 weeks later.

How Do Non-Fungible Tokens Work? 

You can think of a non-fungible token as the proof of ownership of an asset that is verified by the blockchain. Blockchain is like an electronic ledger of transactions that serves as a record of NFT ownership. Every transaction on the blockchain is verified by computers across the world by solving complicated math problems. 

The transaction history and data associated with an NFT are made public on the blockchain and cannot be changed once verification is complete. Not only can an NFT owner prove their claim without a doubt, it can also not be stolen.

This makes NFTs useful in a number of industries, and some have already begun to see their adoption.

Art 

NFTs may work well in industries such as art or other creative spaces that might otherwise be subject to unauthorized copies and fraud. NFTs have the potential to limit this type of fraud.

Sports

Sports memorabilia often has high collectible value and NFTs may not only offer fans a way to enhance the experience, but also provide a way to prove authenticity and ownership of the high-value memorabilia. For example, NBA Top Shot auctions NFTs of player moments during games. There may also be a use case for NFTs in the ticketing of sporting events.

Licensing or Smart Contracts

NFTs have applications in licensing contracts in connection with intellectual property. This may offer solid opportunities for owners of various types of intellectual property to license the use of these assets. The use of blockchain to store these contracts may help ensure that all users are aware of ownership and limitations on the use of these assets, such as the royalties paid on the use of music. For example, the original owners or creators of the EulerBeats Originals still earn an 8% royalty every time the NFT is sold on.

Real Estate

In the real estate world, an NFT can be the digital symbol of ownership on a blockchain network. For example, instead of a paper deed stating that you own a single-family house, you could have an NFT showing your ownership of that house. This can offer some advantages in terms of security and ease of access. 

Notable NFT Transactions

It seems like a new NFT pops up every day. In February 2021, a highlight clip of a memorable dunk by NBA star LeBron James sold for $208,000. The band Kings of Leon released an album in NFT format in March 2021. The types of assets that can be digitized as an NFT seem limited only by what the minds of creatives and businesses can think of. 

Non-Fungible Tokens vs. Cryptocurrency 

NFTs often get lumped in with cryptocurrencies like Bitcoin. Both utilize a blockchain network, but there are many differences.

The biggest difference between the two is fungibility. Cryptocurrencies are fungible tokens which means that they can be interchanged. NFTs, as the name suggests, are non-fungible and therefore cannot be interchanged.

“One bitcoin in a digital wallet is interchangeable for another bitcoin in a different wallet because each bitcoin has the same value and use,” a group of lawyers from Latham & Watkins LLP wrote in a blog post in March 2021. “NFTs, on the other hand, are coded to have unique IDs and other metadata that no other token can replicate. This gives NFTs the attributes of originality and scarcity that make them so attractive when coupled with digital media.”

Non-Fungible Tokens (NFTs) Cryptocurrencies
Each NFT is unique and cannot readily be exchanged for a similar token Bitcoin or other cryptocurrencies can be exchanged for cryptocurrencies of the same value
NFTs are sold on but not traded like securities on digital exchanges Cryptocurrencies can be traded much like securities
NFTs are not a medium of exchange for purchases Many types of cryptocurrencies can be used to make purchases of physical items like cars

Pros and Cons of NFTs 

Pros
    • Unique identifying digital tags make it difficult to counterfeit NFTs
    • A means for creatives to realize value from their work online
    • Online purchase and storage of NFTs may alleviate some concerns connected to physical collectibles
Cons
    • Gained popularity in 2020 and 2021, with prices driven higher by speculators
    • Online security may be an issue
    • May be confusing for buyers and sellers who are unfamiliar with blockchain and related technology


What It Means for Individual Investors 

For starters, ask yourself why you’d want to buy an NFT. Do you want an NFT as a collectible or as an investment?

This could help you understand how much money you’re willing to spend and how much risk you’re willing to take on. 

Given that the value of the NFT depends on scarcity and what you’re willing to pay for it, NFT prices are extremely volatile. For example, according to NonFungible.com, the average asset price of an NFT dropped from $3,932 in February 2021 to $1,426 in late March. That's a decline of nearly 64%.

Another aspect to keep in mind while thinking of buying an NFT is the gas fee. All transactions need to be verified by the network. The gas fee is required to conduct this verification and can simply be put as a measure of computational effort necessary for the process. Gas fees can add to your cost of buying the NFT, though, and can be substantial.

Investors should also be aware of fraudsters and scams involving NFTs. These could be in the form of replica stores that impersonate legitimate websites, counterfeit NFTs, and even giveaways.

Given that NFTs themselves are still fairly new, the regulatory framework for them also remains unclear, though it is beginning to evolve.

There’s also the question of whether or not NFTs are securities. The Securities and Exchange Commission (SEC) does not treat all digital assets as securities. According to Latham & Watkins LLP, NFTs that constitute art and collectibles should not be considered securities, but that needs to be evaluated on a case-by-case basis. There’s also the prospect that this could change as the use of NFTs evolves over time. 

It always pays to do your homework before jumping into a new investment so that you can avoid a nasty financial surprise. The same thing goes for anyone interested in physical collectibles or risky investments—do you research and only use money you can afford to lose.  

Key Takeaways

  • Non-fungible tokens (NFTs) are digital assets verified on a blockchain. They could be anything—art, collectibles, videos, or a host of other digital assets.
  • NFTs differ from cryptocurrencies in that they are unique and cannot be exchanged for another NFT in the way cryptocurrencies can be exchanged. Both utilize blockchain networks.
  • There are still many legal and regulatory issues surrounding NFTs that have yet to be defined.
  • NFTs gained popularity in 2020 and 2021, which makes them ripe for speculators and even fraud.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.