What are NFTs?
Non-fungible tokens (NFTs) are blockchain-based tokens with unique identification codes and metadata. Unlike fungible tokens, NFTs are not mutually interchangeable and can therefore not be replaced with another identical token of the same value. As every NFT has its individual TokenID, they can be used to prove ownership and to certify authenticity.
Contrary to crypto currencies, each NFT is unique and must therefore be valued individually. The price of an NFT is dependent on what the market is willing to pay for it. After an NFT is minted, it can be traded on secondary markets such as OpenSea or SuperRare.
NFTs’ journey into mainstream digital assets
The first NFT was created in 2014, however, the industry only gained momentum in 2017 when the ERC-721 token standard was proposed via Ethereum GitHub. NFTs became popular when CryptoKitties was launched in 2017, allowing users to collect, breed, and sell NFT kittens. The blockchain-based game was so successful that the transaction volume of CryptoKitties exceeded Ethereum’s maximum number of transactions per second resulting in network congestions.
2021 is often referred to as the “year of the NFT” due to the increase in NFT trading volume from 33 million to 13 billion between 2020 and 2021. Mainstream attention reached its first all-time-high when Beeple sold his digital artwork “Everydays: The first 5000 days” for $69 million in March 2021. Recent developments with the Bored Ape Yacht Club and Twitter integrating NFT profile pictures show that NFTs might be more than just a temporary trend.
NFTs from a technical standpoint
NFTs are minted by writing smart contracts that conform with NFT token standards such as ERC-721. Smart contracts are programmable contracts that can automatically verify, execute, document and accelerate a set of predefined actions in the contract’s code. Before an NFT is minted, the author must specify under which terms and conditions the contract executes.
3 step minting process:
- Minting a new block
- Validation of Information
- Information recorded on the blockchain
The minting process of an NFT is initiated by the author of a smart contract. First, a new block is minted by storing the NFT’s metadata and TokenID, as well as the creator’s wallet address. Secondly, the block containing that information can be recorded on the blockchain only after the minimum amount of validation from nodes is achieved. Finally, the information is recorded on the blockchain.
Once the transaction is validated, the information is interchangeable and publicly accessible. For example, it is possible to trace specific tokens issued on the Ethereum blockchain via Etherscan. This guarantees transparency and verifiability.
How is ownership guaranteed?
Each token minted receives a unique identifier that is linked to the public wallet address of the creator. Hence, the creator’s public key is a permanent part of the token’s history. It serves as a certificate of authenticity for that specific digital asset.
All transactions made on a blockchain are irreversibly stored and are publicly accessible . It is therefore possible to identify all transactions related to a specific token. Wallet addresses of past owners and the public key of the current owner can be viewed by searching for the token’s unique identifier in the block explorer of the respective blockchain. Besides verifying authenticity, ownership can be proved for precisely every non-fungible token.
Metadata specifies the characteristics of an NFT
Each NFT corresponds to a specific set of metadata describing the characteristics of that NFT. The metadata specifies the multimedia content that the NFT represents and certifies. In order to attach metadata to the token’s ID, a hash is generated and saved in the smart contract.
Hashings are used to access the token’s metadata in a storage space-efficient way. The hash is associated with the respective token in the form of an url link. Therefore, NFT smart contracts do not store the multimedia files themselves but only the links to the respective off-chain resources.
The metadata must have precise fields in order to be shown correctly on marketplaces such as OpenSea or SuperRare. The minimum data necessary to define an NFT is name, description and image. Additionally, references to external sites can be used to link more attributes to the token.
The 3 major NFT token standards
NFT token standards are evolving as rapidly as NFTs gain in popularity. As of today, the most common NFT token standards are on Ethereum. However, protocols like Flow are catching up by addressing the scalability issues of the Ethereum blockchain.
The ERC-721 token standard is the most popular and widely used NFT standard. ERC-721 tokens run on the Ethereum blockchain and are open source. Compared to ERC-20 tokens, each ERC-721 token minted is unique and can be priced independently from other tokens.
As each ERC-721 token requires its own unique identifier, separate smart contracts must be minted for every NFT token or collection. This places redundant bytecodes on the Ethereum blockchain and limits the functionality of ERC-721 tokens.
Decentralized applications can be used to convert the encoded identifier into the file that the NFT represents. The tokenID thus functions as the input that is used to generate the multimedia file of the NFT.
Similar to the ERC-721 token standard, the ERC-1155 token standard is open source and runs on the Ethereum blockchain. However, the ERC-1155 is a multi-asset token standard that allows users to register fungible and non-fungible tokens in the same smart contract. One TokenID can represent several configurable token types with their own attributes and metadata.
Additionally, the ERC-1155 token standard allows new functionalities like transferring multiple tokens. As there is no need to separately approve individual token contracts, trading volume is reduced leading to a reduction in transaction costs.
The ERC-1155 token standard is widely used in the gaming industry as it addresses multiple operational problems of blockchain games. For example, users can now buy in-game coins (fungible) and in-game items (non-fungible) by owning just one ERC-1155 token instead of multiple ERC-20 and ERC-721 tokens.
Unlike ERC-721 and ERC-1155 tokens, Flow (FLOW) tokens do not run on the Ethereum protocol but on the Flow blockchain. Developers created the Flow blockchain as a response to the congestion on the Ethereum network after the launch of CryptoKitties in 2017. By inventing Flow, the developers of CryptoKitties solved the scalability issues of Ethereum.
Flow is specifically designed for massive crypto games and digital collectibles, and therefore built to scale more efficiently. Additionally, Flow tokens are created by minting “upgradable smart contracts” allowing authors to update and improve the smart contract over time. Once all involved parties are satisfied, the smart contract is finalized and becomes immutable.
Although most NFTs run on Ethereum, Flow’s network is growing as famous NFT collections like CryptoKitties and NBA Top Shots are represented by Flow tokens. Moreover, Flow differentiates from general-purpose blockchains like Ethereum by specializing in the gaming and collectibles industry.
NFT Applications and Use Cases
The development and success of NFTs is highly dependent on whether applications bring essential improvements to businesses’ products and processes. In the end, it comes down to whether NFT use cases drive customer value.
As smart contracts offer great flexibility, NFTs allow optimization in a notable amount of industries ranging from digital content to blockchain domains. Here are the five most interesting use cases that have great potential to remain sustainable.
Encoding digital content in smart contracts helps to solve the long-standing copyrights issues that content creators are facing. Due to the immutable nature and uniqueness of NFTs, it is possible to capture ownership rights of a piece of artwork or song. Therefore, NFTs created a market for digital content that previously did not exist.
Additionally, NFTs can be programmed to pay content creators a royalty fee whenever their NFT is sold. This ensures that artists profit from value increases of their work even after the initial sale. As smart contracts are self-executory, earning royalties from NFT trades allows creators to automatically benefit from passive income streams.
Recent sales of overwhelmingly expensive NFTs show that the digital art market gained remarkable significance and adoption. In December 2021, Pak’s artwork “The Merge” was sold for $91.8 million exceeding the price of Beeple’s collection of “Everydays: the First 5000 Days” which was sold for $69.3 million in February 2021.
NFTs have the potential to disrupt the current gaming industry as “Play-to-Earn” gaming models gain in popularity. In 2021, around $60 bn were spent on in-game items and currencies that do not carry value outside of the game itself. By offering in-game items in the form of NFTs, users would own the items collected or purchased.
The implementation of NFT in-game items enables gamers to sell their items after losing interest in the game. Moreover, in-game items would therefore carry real world value, making blockchain-based games more attractive. Besides NFTs, fungible tokens or cryptocurrencies can be used to purchase NFTs representing the in-game items.
The most popular play-to-earn game is Axie Infinity, a Pokémon-style monster-battling game. The characters of Axie Infinity are Axie NFTs that must be purchased before being able to participate in the game. All Axie characters have different characteristics and strengths making them unique. Therefore, the NFTs have scarcity and utility and are tradable on secondary markets. By developing and breeding their Axie characters, gamers aim at generating value for secondary market sales.
Verifying authenticity of fashion items could potentially solve the fashion industry’s issues of counterfeit products and supply chain traceability. NFTs can be used as a tool of verification protecting customers from falling prey to fake product resellers. This could revolutionize the resale market of fashion products as the full record of the item is publicly accessible.
Additionally, NFTs would provide customers with complete supply chain traceability, revealing details about the place of manufacturer and previous owners. Customers will be able to base purchase-decisions not only on the quality of the product but also on the quality of the supply chain. Consequently, fashion labels would be able to demonstrate their sustainability credentials.
The luxury blockchain consortium Aura, founded by LVMH, Prada, and Cartier has already started to tokenize ownership of luxury goods planning to replace current certificates. Likewise, Hennessy just reported that they plan to integrate the Aura blockchain to provide transparency to their customers.
Events and Ticketing
Both, customers and artists, can benefit largely from blockchain-based ticketing. As smart contract execution is automated, revenues from tickets can be directly distributed to artists removing the need for intermediaries. Therefore, artists will be able to have more control over the resale market.
The NFT’s TokenID and metadata allow the creation of customized tickets. Seat, date of event and type of ticket can be defined in the meta description of the corresponding token. In addition, tickets can be viewed as digital collectibles once the event is over.
Blockchain domains primarily serve to simplify complex wallet addresses by setting up a web3.0 domain. Instead of having a wallet address with over 30 characters, users can own their personalized address as an NFT. Additionally, several cryptocurrency wallet addresses can be bundled and thus increase user friendliness.
Besides simplifying transactions, crypto domains add another layer of openness and transparency as all domains are held in a registry on publicly accessible blockchains. Web3 domains can also be used to verify identity by connecting domains to social media accounts.
Another application of web3 domains is that programs like decentralized websites can run on domains. As crypto domains are usually purchased and owned as an NFT, it is possible to trade them on secondary markets. For example, Unstoppable Domains sold “win.crypto” for $100 000 in March 2021.
As NFT marketplaces are the gateway of digital assets trading, they have gained significantly in relevance since NFT trading volume increased. The tremendous development of NFT trading platforms shows that investors see long-term potential in unique tokens.
Recent developments confirm the noteworthiness of the NFT trend. For example, Coinbase, the third-largest crypto currency exchange by trading volume, announced that they are working on launching an NFT marketplace. However, is this trend only temporary or will it last?
Top NFT trading platforms
OpenSea, founded in 2017, is the first and leading marketplace for NFT sales. The platform is a decentralized peer-to-peer marketplace for buying, selling and trading NFTs running on the Ethereum blockchain supporting ERC-721 tokens. Furthermore, OpenSea launched a layer-2 scaling solution for Polygon to trade the Ethereum virtual machine (EVM) compatible ERC-721 token at lower gas fees.
It is possible to sell NFTs on OpenSea directly at fixed prices or through auctions. Either way, OpenSea takes 2,5% commission for every transaction happening on the platform. OpenSea also features a tool to mint tokens and accepts over 150 crypto currencies as payment tokens which underlines the platform’s common acceptance in the crypto ecosystem.
Nifty Gateway specialized on expensive, famous and celebrity NFT sales hosted on the Ethereum blockchain. The most expensive NFT, Pax’s “The Merger”, was sold on Nifty Gateway. In comparison to OpenSea, Nifty Gateway is a curated platform that is centrally controlled. Artists must apply at Nifty Gateway in advance which guarantees high-quality offerings.
Nifty Gateway has four different NFT sale methods: online silent auction, global offers, open editions and drawings. For both, online silent auctions and global offers, collectors make a bid or submit an offer, and are then informed whether the bid or offer was accepted.
Open editions means that an unlimited number of NFTs are created for a limited period of time. After the time limit is reached, no more NFTs are issued which leads to scarcity and a stronger market in secondary sales. Drawings can be compared to the concept of entering a lottery as collectors have to win the rights of purchasing an NFT.
Besides accepting common crypto currencies as payment methods, Nifty Gateway offers collectors to pay with credit cards. In addition, Nifty Gateway takes a 5% commission for each transaction, charging artists twice as much as market leader OpenSea.
SuperRare pursues a similar business model than Nifty Gateway as the platform has the intention to create a high-end art gallery focusing on exclusive art. All NFTs offered on SuperRare run on the Ethereum blockchain and comply with the ERC-721 token standard.
According to SuperRare, the marketplace only accepts 1% of the artists applying, hence, SuperRare is a curated platform with central authority. Moreover, artists are permissioned to mint only one of their origins, generating scarcity and rarity.
SuperRare charges 15% gallery fees which is comparably high to other NFT market places. However, considering that ordinary art galleries often charge up to 30% or 50%, SuperRare has a competitive fee.
NFTs in DeFi
The term Decentralized Finance (DeFi) refers to marketplaces that are not controlled by a central authority. Decentralized applications (dApps) work to replace the role of traditional financial intermediaries . As dApps remove the need for intermediaries, transactions are solely executed by smart contracts. Examples for dApps are peer-to-peer borrowing and lending networks as well as decentralized exchanges (e.g Uniswap).
DeFi networks run on public and permissionless blockchains like Ethereum. Thus, DeFi is commonly referred to as “open finance” as no user verification is necessary. Although dApps can increase the speed and efficiency of transactions, users may face several risks such as default loans.
To reduce the risk of default loans, borrowers are required to deposit a collateral which serves as a guarantee to the lender. Usually, coins are deposited as a collateral excluding illiquide borrowers from DeFi lending opportunities. However, if borrowers lack liquidity but own rare NFTs, they can then use the NFT as a collateral. If the borrower defaults, the same rules apply and the borrower’s NFT is sent to the lender as a collateral.
Fractional ownership allows NFT creators to split their tokens into smaller “shares”. Fractionalized NFTs can then be traded on decentralized exchanges or NFT marketplaces. Hence, investors are given the opportunity to buy highly valuable NFTs without having to buy the entire token. This reduces the risk of potential investors being priced out from owning NFTs.
Progress of NFT technology, use cases and trading platforms show that NFTs are not only gaining mainstream attention but also awareness from developers and investors. 2021 will be remembered as “the year of the NFTs” due to the explosion in adoption and awareness that the NFT ecosystem gained. These developments stress the importance of NFTs today and in the future.
Taking the whole crypto industry’s history into consideration, we can’t help but wonder whether these recent developments in the NFT market are just a hype. Is the NFT trend a bubble that will eventually burst, similarly to the ICO bubble of 2018 or do NFTs bring long-lasting value that will enable further growth and adoption of this technology?
As we summarized in this article, there are multiple high potential use cases for NFTs. From gaming to digital art, fashion to copyright, NFTs are undoubtedly revolutionizing different industries by bringing significant efficiencies to their processes. This trend seems to be sustainable and an increasing number of players aim at benefiting from the novel and innovative NFT industry.