Non-Fungible Tokens (NFTs): The Ultimate Beginner’s Guide
Most of what you will read about NFTs focuses on how people with too much money are buying worthless things using NFTs.
Art that you can’t hang on your wall for $1.5m, the Nyan Cat meme for $590k, a video clip of LeBron James dunking for $200K, even Jack Dorsey’s first tweet for $10M!
Just like the discourse around Bitcoin, Blockchain, ICOs, and DeFi, the focus is almost always on the hype and not on substance.
Enabled by the technological breakthrough of blockchain technology, NFTs are an innovative solution to severe problems plaguing the music, art, and content creation industries.
So what the heck are NFTs? How do they work? And why should you care?
Stone or Plastic?!
What do you think of when you first hear ‘tokens’?!
Do you think of round pieces of metal or plastic?
Come with me to Yap islands, part of The Federated States of Micronesia, an island country in the western Pacific Ocean associated with the United States.
Up until the 20th century, native inhabitants of Yap islands used Yapese stone money.
Yapese stone money was made out of large stone disks called Rai, weighing over 8,000 pounds, and created from the limestone deposits of the nearby island of Palau.
Rai stones were not moved when spent but simply changed owners.
The small community kept track of the transactions orally, just like Arabs kept track of poetry, poets, and tribes.
One day a Rai stone sank into the ocean as it was being transferred on a canoe, but the community still used it as money even though no one could see it or had physical access.
The Rai was a token used as currency, and the community kept an oral ledger of its transactions.
It may sound ridiculous today. Stones, not to mention immovable ones, are not money!
Let’s say you were teleported to Vegas; you would think colourful casino chips are money.
Both the Rai stone and casino chips served as a visible and tangible representation of value, a token.
A token is a thing that serves as a visible or tangible representation of a fact, quality, feeling, etc. It can be a voucher you can exchange for goods or services, it can be a ticket that gives you access to certain privileges, or it can be a plastic disk you use to pay for games in an arcade.
We can say a token can be whatever you want it to be, as long as others agree with you on what the token is or what it represents.
The critical difference between a token coin and a currency or legal tender coin is a legal tender coin is issued by a governmental authority and is freely exchangeable for goods.
On the other hand, a token coin is limited in use and is often issued by a private company, group, association, or individual.
What is a digital token?
Until the last few decades, all tokens were physical tokens; however, we got digital tokens with the advent of technology.
A digital token is a unit of information exchanged between users or machines to facilitate and represent a real-world transaction. The transaction can be anything from an online money transfer to subscribing to a service.
What about crypto tokens?
With the introduction of bitcoin and the rise of blockchain technology, we got crypto tokens.
Crypto tokens are digital tokens created using cryptography and exchanged exclusively on blockchain networks.
Crypto tokens usually represent a particular fungible or non-fungible asset or utility.
You may be thinking, Wait, what? Cryptography! Blockchain!
Am I supposed just to know what these are?!
And what the hell does ‘fungible’ mean?
Ok, let’s break it down.
Fungible! What’s that?
Fungibility refers to the interchangeability of a good or asset. Put simply, when something is fungible, it means every other thing like it has the same value.
Fungibility is a core property or money.
Let’s say you have a 100 US dollar note. You probably don’t care if someone took it and gave you another 100 US dollar note in its place.
For you, it’s the same; it holds the same value.
One may be a little worn out, crumbled, or someone decided to use it as a temporary notepad. It’s still a 100 US dollar note, and it has the same value.
However, you wouldn’t feel the same if someone took your 100 US dollar note and gave you a Canadian 100 dollar note because they do not have the same value.
We can say US dollars are interchangeable and therefore fungible. However, US dollars and Canadian dollars are not interchangeable, therefore, not fungible.
On October 31, 2008, a link to a paper authored by Satoshi Nakamoto titled Bitcoin: A Peer-to-Peer Electronic Cash System was posted to a cryptography mailing list.
To many probably, this was just another attempt to suggest a solution to some of the technical challenges of using peer-to-peer distributed networks.
The paper described “a system for electronic transactions without relying on trust.”
A couple of months earlier, on August 18, 2008, the domain name bitcoin.org was registered.
The identity of Satoshi Nakamoto remains a mystery till today. A pseudonym used by the person or persons who developed bitcoin. After releasing the bitcoin white paper, he, she, or they created and deployed the bitcoin software on January 3, 2009.
The bitcoin network became a reality when people started to download and run the bitcoin software on their computers, and the first block of data was added to the chain.
Known as the genesis block, it had a piece of text embedded in its coinbase transaction. The text was a headline from the times on that day “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
What is Blockchain
Blockchain is a technology that enables the creation of decentralized networks of computers (nodes) that can securely exchange transactions without the need for a centralized authority (server or group of servers).
In a network like PayPal, a centralized authority (server or group of servers managed by PayPal admins) regulates, validates, verifies, and keeps a record of all transactions in a centralized database.
PayPal executives or anyone in PayPal with the right admin access or power can choose to shut the services of PayPal at any moment, and you will lose access to any money you have in PayPal, in addition to the ability to perform transactions using PayPal.
You are also limited to sending and receiving transactions to the countries that PayPal is willing to serve and people approved to have a PayPal account.
You pay what PayPal decides you should pay for transactions and exchange rates.
PayPal holds all the power; you are just a customer.
In a blockchain network, every computer (node) regulates, validates, verifies, and keeps track of all transactions on the network in an unchangeable (immutable) record (ledger).
There is no central authority in a public blockchain network, no one can shut it down, and no one can prevent any node from joining from any part of the world.
You can send and receive transactions from anyone, anywhere in the world.
Just like the Internet is made possible through a set of technologies, protocols, and software coming together to enable you to make an Amazon purchase. Blockchain is made possible through a set of technologies, protocols, and software coming together to allow you to send a monetary transaction to someone without relying on the likes of PayPal.
Since each public blockchain is decentralized and not owned by any entity, each public blockchain network has its own currency used for transactions.
For the Bitcoin network, that currency is bitcoin; for the Ethereum blockchain, it’s ether.
Currencies used in blockchain networks are usually issued through a computational process called mining that involves running complex mathematical processes that require a lot of computing power.
Blockchain networks also have cryptography at almost every level, including creating their currencies; that’s why we call those currencies cryptocurrencies.
So what’s cryptography?
Cryptography is a method of protecting information and communications through codes so only the parties in that communication can read and process its information.
Cryptography in Bitcoin prevents any alteration or manipulation because it secures the transactions and blocks of data by complex mathematical algorithms that are extremely hard to break.
Simultaneously, cryptography makes it easy and fast to verify and validate Bitcoin transactions and blocks.
Blocks! Is that why we call it a “block” chain?
Yes. In a blockchain, data is stored in a chronicle ledger, where each entry (block) is linked directly to the previous entry (block) and all the other previous entries (blocks), forming a chain of blocks — a block chain.
Ledger-based data structures are nothing new; however, they are considered slow and wasteful because storage was limited.
In today’s world, storage is very affordable. A ledger-based system that keeps all the history of data changes can become essential compared to the current data structures that only maintain the latest data set.
What a blockchain architecture provides is immutability, i.e. prevention against fraud and attempts to manipulate the data.
With a blockchain-based system, any change to any data will change the whole blockchain due to the connection between the blocks.
How do we get crypto tokens?
Crypto tokens are created through tokenization, converting rights to an asset into a digital token protected by cryptography, tracked and exchanged on a blockchain network.
Tokenization and creating pieces of information that correspond to fractions of a real-world asset can be done without using a blockchain and without cryptography, using existing centralized networks.
After all, that’s what the stock market is. With every stock, you purchase you own a fraction of a company.
However, maintaining and running a stock market requires massive investment in technology infrastructure, partnering with intermediaries to handle the clearing and settlement. There is also a need for regulators to make sure everyone plays by the rules.
Assets like stocks can be tokenized using a blockchain-based system, eliminating the need for a central authority, intermediaries, or intermediaries to manage the exchange of those assets or stocks.
In a blockchain-based system, the rules can be built into the blockchain software; it applies to everyone eliminating the need for a regulating body.
Why do we need crypto tokens anyway?!
Let’s take a more in-depth look at why we should consider tokenizing assets.
Assets are the cornerstone of business and trade. They are the resources we use to create, deliver, and capture value.
Assets are classified into two major classes: tangible and intangible.
Tangible assets have a physical substance, such as currency, buildings, real estate, vehicles, inventories, equipment, art collections, precious metals, rare-earth metals, fossil fuel, and crops.
Recent estimates place the current value of all real-world assets at around $256 trillion globally.
Intangible assets lack physical substance and usually are very hard to evaluate. They include patents, copyrights, franchises & licenses, music, digital art, goodwill, trademarks, and trade names.
Despite a turbulent 2020, global intangible value is now at an all-time high of US$ 65.7 trillion.
Tangible and intangible assets each face unique challenges when it comes to trading them:
- Tangible assets are costly to move and transfer.
- Intangible assets, while easier to move and transfer, are difficult to subdivide.
Depending on the asset, trades may have to go through extensive regulatory processes, require high fees, and take too much time.
Trading these assets also suffers from the challenges of doing business using centralized systems, the need for trusted intermediaries, the high costs, the lack of efficiency, and security and privacy vulnerabilities.
These challenges make markets highly illiquid and not within reach of most people.
When an asset is tokenized, it becomes much easier to trade, and it can be made accessible from anywhere in the world. Tokens, after all, are pieces of information that can be transmitted on the internet and tracked using a distributed ledger (a blockchain).
Why should I care? What’s in it for me?
Tokenizing assets is one of the most transformative aspects of the new blockchain world we are living in today.
For the first time, everyday people can build wealth through fractional ownership of assets that appreciate with time.
Suddenly, building generational wealth through homeownership, which is becoming more and more out of reach, is now within reach.
By tokenizing real estate, anyone can own fractions of properties in several key markets, like Vancouver, for example, where property prices are ridiculously high.
Why work all your life to own one property?!
It’s an asset that is highly illiquid. You are centralizing your risk in one asset in one location when you can use the same investment to diversify your portfolio by owning fractions of properties in the best cities in the world.
And because of the decentralized, trustless, immutable qualities of blockchain, we can democratize access to such assets by reducing entry barriers, lowering the costs, increasing transparency, significantly increasing efficiency, and enabling innovation.
What are the different types of tokens?
Before we jump into NFTs, we need to explore the different types of crypto tokens.
Payment Tokens (Cryptocurrencies)
These are native cryptographic assets of a particular blockchain network, intended to fulfil the functions of a currency, mainly as a medium of exchange and store of value.Some of the well-known Cryptocurrencies are:
- Bitcoin Cash
Platform tokens are usually associated with blockchain platforms that provide the ability to build decentralized applications — Dapps.Some of the well-known platform tokens are:
- Ether (ETH) by Ethereum, a blockchain platform with smart contract capabilities
- EOS by EOS.IO, a blockchain platform with smart contract capabilities.
- ADA by Cardano, a blockchain platform with a research-first driven approach
- Lumens by Stellar, a blockchain platform focused on cross-border and multi-currency transactions
Utility tokens are intended to give holders perks such as access to the network, application, or service, or voting rights.Some of the well-known utility tokens are:
- BAT — Basic Attention Token (on the Ethereum Blockchain): can be exchanged between publishers, advertisers, and users on a browser called ‘Brave.’ Brave is designed to increase privacy via blocking third-party ad trackers while monetizing user attention and rewarding content creators/publishers accordingly.
- GNT-Golem Network Token (on the Ethereum Blockchain): is used to provide everyone with access to the necessary distributed computational energy at a low cost on the Golem marketplace.
- FUN-FunFairToken (on the Ethereum Blockchain): issued by FunFair Technologies so players can use it to play casino games.
- FILECOIN: issued by the Filecoin project to give access to a decentralized storage system.
Security tokens qualify as “investment contracts“ or securities and therefore are subject to securities registration requirements.These tokens are classified as securities in the US-based on the Howey Test, which the US Supreme Court created for determining whether something qualifies as security:
- It is an investment of money.
- There is an expectation of profits.
- The investment of money is in a common enterprise.
- Any profit comes from the efforts of a promoter or third party.
Security tokens are usually the ones resulting from tokenizing tangible or intangible assets.
Natural Asset Tokens
Natural asset tokens represent natural assets such as gold, oil, natural gas, base metals, carbon credits, and energy.
Examples of natural asset tokens:
POWR-Power Ledger Token lets users buy and sell electricity using Power Ledger, a blockchain-based, peer-to-peer energy platform.
Crypto-Fiat Currencies and Stablecoins
Unlike Bitcoin, Litecoin, and other cryptocurrencies and tokens that experience high price volatility, stablecoins are designed to maintain a relatively stable value.A stable coin is tied or ‘pegged’ to an underlying asset or currency, including:
- Fiat currencies. A crypto-asset can be related to one or more fiat currencies.
- Real-world assets such as securities, commodities, real estate, and financial assets.
Stable coins can also be algorithmically controlled to mimic monetary policy and adjust the supply of tokens to match demand to keep the price stable.
There are two categories of stable coins:
Centralized custodial stablecoins: a centralized custodian holds the underlying asset(s).
- USDT by Tether, USD Coin (USDC) by Coinbase, and Paxos (PAX)
- Digix Gold Token (DGX), Tether Gold (XAUT)
- Libra by Facebook
Financial institutions use these stablecoins to facilitate fast and low-cost cross-border transfers.
Decentralized non-custodial stablecoins: managed in a decentralized fashion, usually operated through smart contracts, that have reserves in cryptocurrency rather than fiat.
Dai is a stablecoin cryptocurrency that aims to keep its value as close to one United States dollar as possible through automated smart contracts on the Ethereum blockchain called MakerDAO.
What about NFTs?
The challenge with the discourse around NFT is this constant comparison between the real world and the digital/virtual world and the very simplistic statement of “buying art you can’t hang on your wall!” alluding to the ridiculousness of such a thing.
So let’s break it down and dispel the misconceptions.
First of all, WTF are NFTs?
Crypto Collectibles or Non-Fungible Tokens (NFTs) are crypto tokens.
However, unlike fungible crypto tokens, each NFT is unique, different, distinguished from another NFT, and cannot be duplicated.
CryptoKitties is an excellent example of an NFT.
The first game of its kind built on the Ethereum blockchain, CryptoKitties is a product of Dapper Labs, which valued at $2 billion at the time of writing this article,
CryptoKitties was started by a DJ from Vancouver, Canada, who loves cats.
Each CryptoKitties token represents a unique virtual cat that people can purchase, trade, raise, and even breed with other CryptoKitties.
Think of them as digital trading cards that people can get to mate with each other :)
In reality, an NFT is just a unique number, an ID. We then attach information to make it mean whatever we want it to mean.
When it comes to CryptoKitties, the ID points to a unique digital cat with specific characteristics (colour, eyes, shape, attitude, breed… etc.)
We can attach those IDs to any physical or digital asset or thing and make it so that the ownership of that ID means the ownership of the physical or digital asset.
So when you own an NFT, you get all the benefits from that ownership of the physical or digital asset it represents.
So a Non-Fungible Token is:
- Proof of ownership of a real or digital asset
- A unique ID number
- All the identifiable characteristics of the asset
- All the rights and privileges that come with ownership
- Coded, packaged, encrypted using cryptography.
- Recorded and tracked on a blockchain
What’s possible with NFTs?
Many will live their life without the prospect of seeing a Picasso in real life, but with tokenization, it is possible to change that.
Picasso’s masterpieces are in short supply and cost a fortune. The cheapest drawings are worth hundreds of thousands of dollars, and the most expensive was sold for $179 million.
So if we want to make a Picasso masterpiece available for many to own and enjoy the return on their investment, we must tokenize it.
That’s one way, but if the owner of the Picasso is not willing to share its ownership, they can still:
- Sell the rights to 100 high-end prints in real size; each can be represented by an NFT called PicassoReal.
- Sell the rights to 500 high-end prints in a smaller size; each can be represented by an NFT called PicassoSmall.
- Sell the digital right to own a digital version of the painting that can be represented by an NFT called PicassoDigital.
If you decide to own a high-end print, say print 34/100, you also receive an NFT called PicassoReal proving that you are the owner of that print.
You can verify that the owner didn’t issue more than 100 PicassoReal tokens and find out how many were sold.
You can choose to hang on the print and sell it later for a higher price. When you do, you also transfer the ownership of the NFT to the person who bought the print to prove they are now the rightful owner of the print.
However, if someone got the print illegally or created a fake print, they can’t prove the ownership since they do not have the NFT representing that print.
Why are creators and artists excited?
Imagine you are Picasso in your early years, you are still unknown, and to earn some income, you sell your paintings and artworks for whatever people are willing to pay you.
A few years pass by, you gain some publicity, and now you have some galleries brokering the sales of your artwork. They are getting anywhere between 30–50% to do that.
Fast forward 10–20 years, and you are freaking Picasso; your paintings are selling for millions at auctions.
Awesome, right?! No.
You don’t see a penny of those millions because you do not own the art being sold, you don’t know who owns it, and you have no way of tracking it.
In yesterday’s world, artists and creators were beholden to industry, intermediaries, and platforms and had to adhere to their terms and conditions.
If Picasso was starting his artistic journey today, he could use NFTs to tokenize his artwork, be it physical or digital.
And as his name gains more recognition, he can keep track of all his artworks as they are being sold and traded. And through it all, he can earn royalties, sell directly without paying any commission to brokers or galleries, and he can enforce a specific usage for his work, so it can’t be displayed, sold, or traded without his permission.
Using NFTs, artists get paid, continue to get paid and maintain control over their work and creations.
Put simply, NFTs give the power back to artists and creators.
With proof of ownership, you can do quite a lot:
- Sell anything that someone else finds valuable — Jack Dorsey is auctioning his first tweet ever as an NFT, and at the time of this writing, it’s worth over $10 million!
- Earn royalties on what you own and what you create — All EulerBeats original owners will earn 8% of the revenues on each print sold of the original.
- Prove your ownership anywhere and everywhere as the value of the assets appreciates — CryptoPunks have sold for a cumulative $43 million.
- Celebrate with your customers and reward them - Taco Bell celebrated the return of potatoes to its menu with taco NFTs that sold out in minutes. Now, they’re reselling for thousands of dollars.
The NFT market
According to NonFungible.com, the largest database of blockchain gaming and crypto collectible markets, more than 128,226 sales took place with a staggering volume of over $185 million.
These include digital art, digital music, virtual real estate, VR wearables, gaming assets, blockchain domain names, luxury goods, and more.
There are many NFT creation (minting) marketplace platforms, exclusive membership-only platforms and do-it-yourself (DIY) platforms.
- Nifty Gateway teams up with Top artists and brands to create collections of limited edition, high-quality Nifties, exclusively available on their platform.
- SuperRare is a marketplace for digital works of art from leading artists and creators around the world.
- OpenSea is a peer-to-peer marketplace for the biggest collection of rare digital items and crypto collectibles.
- Rarible allows digital artists and creators to issue and sell NFTs. Rarible is also a marketplace.
Can history help us predict the future?
When we first got the internet, everyone predicted video conferencing. It took us 40 years and a global pandemic to get some decent video conferencing, and we are still not there!
What no one predicted is the rise of Facebook, TikTok, Uber, and Airbnb.
Innovations enabled by blockchain technology free the internet from the grip of centralized power-hungry corporations. It gives us the power to decide what matters to us, what we value, what we are willing to pay for, and how to pay for it.
Soon everyone will be collaborating to create infinite digital artwork like Beeple’s opus. Created over 5,000 days, the collage is the first purely digital artwork (NFT) ever offered at Christie’s.
Bands like Kings of Leon will release their albums as an NFT so their fans can unlock all kinds of special perks like limited-edition vinyl and front row seats to future concerts.
And creators who go viral for a meme like Nyan Cat can enjoy more than clout and followers and earn six figures for their work.
If you feel overwhelmed and do not get what the hype is all about, you are justified. Most of what I read out there just takes for granted that non-fungible tokens are the greatest thing since sliced bread because, you know, blockchain and stuff, artists are getting paid, and it will all work out; who cares if it’s just hype.
The problem is, as you can probably tell from the length of this article, it’s quite challenging unless you know everything we’ve discussed so far to fully explain what NFTs are and what’s their impact.
In a few years, people will be using NFTs without the need to understand how they work. Just think, out of all the people using email, how many understand how it works?!
Tokenizing assets may seem like the logical move that goes along with the progress and advancement of technology. However, considering the challenges of implementing a technology as complex as blockchain, still in its early stages of development, established markets require more than the “newer is better” argument.
Whether the NFT hype continues or goes away, they are here to stay as a vital component of the new blockchain world taking shape right in front of our eyes.
There may be opportunities to make money with NFTs. However, as an innovation that’s still in its infancy, there is much to explore in the coming years. Those who are willing to go beyond and invest in learning and education will probably be the new world’s biggest winners.
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