What are NFTs and How Do They Work?

What are NFTs and How Do They Work?

NFTs have been all over the crypto space in recent months. They have been among the hottest topics, and new NFT projects have been popping up left and right. Klondike gold rush fever has taken over, and some NFTs have been selling for astronomical prices — and everyone wants to participate. But what are NFTs exactly, how do they work, and why are some of them worth millions of dollars?

Non-Fungible Tokens vs. Cryptocurrencies

To get a better understanding of the exciting world around NFTs, first look at them from a technical perspective. NFT stands for non-fungible token. This means that each of these tokens is a one-of-a-kind and has unique properties. Therefore, it makes a difference what specific NFT you own as it differs from other NFTs, even within the same NFT project.

This stands in stark contrast to cryptocurrencies, where it doesn’t matter which unit of a currency you possess, as all coins have the same properties. If someone owns Bitcoin A or Bitcoin B, in most cases, this makes no difference for the owner. On the contrary, it can make a key difference with NFTs, even if they are from the same collection. Thus, NFTs fundamentally differ from cryptocurrencies and are considered their own asset class within the crypto investment space.

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When Were NFTs First Created?

NFTs were first introduced back in 2014. A single NFT named “Quantum” had been created by two Americans and was sold for $4 during a live demonstration. For the first time, a token was explicitly linked to a work of art via on-chain metadata, which had not been possible before.

In October 2015, the first NFT project named Etheria was launched on Ethereum, just three months after the launch of the Ethereum blockchain. Most of the 457 NFTs went unsold until the spring of 2021 when the rising interest in NFTs sparked a buying frenzy and all the Etheria NFTs were sold for 1 ETH per piece within 24 hours.

Fun fact: The price for one Etheria NFT was hardcoded to 1 ETH. When Etheria was launched in 2015, the price for 1 ETH was $0.43. In the spring of 2021, when people started buying the Etheria NFTs, the price for 1 ETH was $1,800.

A milestone for NFTs was the introduction of the NFT token standard ERC-721 on Ethereum in 2017, which coincided with the launch of the now highly popular NFT projects like CryptoPunks and Rare Pepe. The standard allowed for the simplified creation of NFTs by providing a customizable template for NFT tokens. Later in 2017, the online game CryptoKitties sold tradeable NFTs cats, and its success made NFTs known in the broader crypto space.

But only in 2020, the NFT market gained momentum and its overall market value tripled to $250 million. By the end of 2021, fueled by several high-profile NFT art auctions and sales as well as an overall crypto bull market, the NFT market had surpassed $40 billion in total valuation.

How Do NFTs Work?

In their most basic form, NFTs are smart contracts on a public blockchain. A smart contract is computer code that stores information in a transparent and immutable manner on top of a blockchain. Theoretically, each new NFT that is being created could be written into a smart contract specifically coded for this project. For simplification purposes, NFT token standards have been created, which let people reuse a specific smart contract designed to represent NFTs. Even though standardized, the standard still allows creators to customize the smart contracts according to their liking in many aspects. Typical NFT standards are ERC-721 and ERC-1155 (Ethereum), Metaplex (Solana), and BEP-721 (BNB Chain).

The unique information of an NFT is stored in its smart contract. Next to transaction details and ownership data, the creator of an NFT can decide what kind of information they would like to include in the contract. This can be secure links to external files or details about the creator’s identity. Additionally, specific rules about trading the NFTs can be implemented. This can, for example, include a percentage of the royalties the creator receives from every subsequent sale on secondary markets.

To summarize, we can say a smart contract defines the actual rights that are being sold through the NFT. Not each NFT transfers the same rights to the buyer. Thus, understanding the terms and conditions written in the smart contract of each NFT is vital before investing in an NFT.

Watch: How NFTs Are Changing the World

What Can NFTs Be Used For?

When listening to crypto enthusiasts, the use cases for NFTs seem limitless. NFTs not only allow for selling art or music, trading in-game assets, and owning property in metaverses, but they will be part of our everyday lives — at least that is how NFTs are promoted by their proponents. The key to understanding NFTs is the fact that they are exactly this — keys — or more precisely, a proof of ownership.

Whoever owns the key to a house has full access to it. NFTs can be used in the same way. As ownership in a specific NFT is easily verifiable and cannot be faked, they work very well as gatekeepers to restrict access to goods or services, granting access to a limited number of NFT owners. A current example is a Discord channel, which is only accessible for owners of Bored Ape Yacht Club NFTs.

Spinning this further, NFTs can be used as concert tickets, as proof of authenticity for luxury goods, and as prerequisites for participation in a blockchain game (e.g., Axie Infinity). NFTs can grant exclusive access to airdrops, reward early supporters of artists and musicians, function as reliable proofs for academic credentials, and could also enable digital self-sovereign identity (SSID) in the future.

Prerequisites for an NFT future to materialize are fully reliable, decentralized, and immutable public blockchains, which guarantee true ownership to the holders of NFTs. Further, it is important to notice that not all NFT projects have plausible use cases. Many NFTs are nothing more than unspectacular digital art securitized on a blockchain. As there are thousands of these projects, many are likely to become worthless, similar to the large number of projects that were founded during the ICO bubble in 2017 and disappeared into meaninglessness after the bubble burst and the hype died down.

Thus, before investing in NFT projects long term, make sure they have an active community that is building an ecosystem or a game around the respective NFT collection, giving these NFTs a (future) use case. Or, and this could be even more promising: Focus on NFTs that have a collector’s value due to their history or unique properties.

Where to Buy NFTs

NFTs can be purchased on NFT marketplaces. Most of the largest blockchains have one or two popular marketplaces to trade NFTs. Besides these, there are other players that sell and trade NFTs, such as blockchain games, virtual worlds, NFT projects, non-profit organizations, and smaller trading platforms, among many others.

Read the Guide: How to Buy and Value NFTs

Popular NFT marketplaces are:

Ethereum

Solana

Avalanche

BNB Chain

Terra

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