What are Non-Fungible Tokens (NFTs)?
Updated: Apr 15, 2021
Image Source - CryptoKitties
When I first heard about CryptoKitties, I was a bitcoin skeptic and I immediately thought to myself “This is why no one takes cryptocurrencies seriously”. Digital pets with unique digital DNA that can breed and pass on their characteristics to their progeny? Seriously? The only thing more ridiculous that I could think of was Plantoids- A metallic plant shaped piece of junk (ahem, I mean Art) that accepted donations and claimed to be a blockchain-based self-replicating life form.
It was months later that I understood the bigger picture- the technology behind these cute images, the impetus to crypto adoption that it gave, and the potential future uses of the technology.
Let’s start at the beginning....
What are Non-Fungible Tokens (NFT)?
To understand Non-Fungible Tokens, one must first understand Fungible Tokens. Fungible Tokens are tokens that are easily interchangeable. If I lend you a $1 coin, when you return the money to me, I just want a $1 back. You don’t need to return the exact same $1 coin. Why? Because every dollar has the same value. On the other hand, if I lend you a watch which happens to be a limited edition Rolex and you return a Swatch to me, I won’t be happy. The two are not interchangeable. They are unique. In other words, they are Non-Fungible.
Non-Fungible also means non-divisible. If you return 50 cents to me then half the debt is repaid but you returning a broken watch doesn’t repay half the debt.
Coming to the blockchain, Bitcoins, Ether, Link, Comp, etc are all fungible. It doesn’t matter when they were mined/minted or who owned them in the past. 1Bitcoin=1Bitcoin, 1Ether=1Ether, 1Link=1Link, 1Comp=1Comp.
Before delving further into NFTs, I’d want to spend a few minutes on what “Ownership of Digital Assets” means.
You might own a Twitter handle but if you leave twitter then you lose everything you’ve ever posted on twitter. You might own a Gmail id but if you leave Gmail because say you disagree with their privacy policies then you lose all the emails in your account. Owning a Netflix or Spotify Account means access to content only while you have a subscription. The point I’m trying to get at is that what we call ownership of digital assets is not ownership at all. It is rental of digital assets.
Blockchain makes actual ownership possible. Once you have an asset, it is truly yours. It cannot be taken away.
The Project that changed everything - CryptoKitties
Bringing Non-Fungible Assets to the blockchain was not that straightforward. CryptoKitties (which I originally found so silly) have been responsible for popularizing NFTs in the blockchain, expanding the depth of assets that can be created/bought/sold on the blockchain, and paving the way for tokenized versions of unique real-world assets like real estate, art, identities, academic credentials, warranties, etc.
With CryptoKitties, you can buy digital cats with unique cattributes. The digital DNA of 2 cats can be combined to create kittens who have say the mother’s eyes and the father’s skin tone. You can shower love on your kittens by buying things like scratch pads and treats for them. No 2 CryptoKitties are alike and hence each must be valued separately.
The popularity of CryptoKitties created network issues for Ethereum. The number of transactions clogged the network and pushed up gas prices. To convey the scale of the mania, I’d mention that the most expensive CryptoKitty sale was for US$170,000. Yes, someone dished out US$170,000 for a digital kitten.
The silliness of this project masks the ingenuity of Dapper Labs, the team behind CryptoKitties. Working within blockchain constraints, they made unique tokens possible using ERC721 standards, they coded a smart contract making on-chain breeding possible factoring in the genetic code of the parents and they pioneered the Dutch auction contract for NFT price discovery.
Fungible tokens work on the Ethereum Token standard called ERC20 which stores common characteristics like name, symbol, decimal places, balance and token supply. CryptoKitties use the standard ERC721 which allows for the storage of unique characteristics about an asset. An even more advanced standard called ERC1155 combines the benefits of ERC20 and ERC721 and allows storage of fungible and non-fungible characteristics together.
Other use cases
Digital Art - Digital art in the past has not commanded high value as it can be easily replicated and a large part of the value of art comes from its scarcity. With NFTs the ownership and scarcity of the art can be easily verified. There exist several marketplaces for blockchain-based digital art like SuperRare and MakersPlace. One of them could grow to become the blockchain world's Sotheby.
Trading cards - Trading card games like Gods Unchained allow for buying rare cards. NFTs are perfect for trading cards as they cannot be replicated, cannot be counterfeited, and their number and provenance are easily verified.
Video games - Video games allow gamers to buy unique skins and weapons which are ideal for NFTs. This market is worth billions in the non-blockchain world. Blockchains today enable NFTs that can move across games. For example, Enjin created an “Oindrasdain Axe” that can be used in their game as well as other games like in “Forgotten Artifacts”. So you don’t lose a weapon that you paid for just because you stop playing a particular game.
Virtual Lands - One can buy digital plots of land in virtual worlds like Decetraland and CryptoVoxel. Digital land can be used for advertising. And till you find someone to rent advertising space to, you can use these lands to show off NFTs like CryptoKitties and CyberPunk art that you own.
Real-World Assets- NFTs could be used for digital identity, birth certificates, warranties, licensing, certificates, event tickets, real-world art, and fractional ownership of items.
NFTs may not have reached the popularity of DeFi yet but there's already big money invested already. Check out below the volumes in different NFT platforms in the last 7 days.
Image Source - Non-Fungible data
Borrowing on DeFi
In the physical world, one can get a loan by providing gold or real estate as collateral. Currently in the DeFi space, one needs to provide cryptocurrencies as collateral to borrow a different cryptocurrency. Protocols like Tinlake are now allowing the use of NFTs as collateral to finance assets in stablecoins like Dai.
How to get exposure to this asset class?
While some non-fungible assets have sold for large sums, I don’t have an edge in identifying which particular CryptoKitty or Trading card might run-up in value. Hence, I would prefer to invest in the space through a protocol like Worldwide Asset Exchange (WAX) which is a marketplace for collectibles.