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As someone who prides themselves on being up to date with the latest technology and trends, dabbles in cryptocurrency, and has a solid grasp on how digital currency functions; NFTs have left me banging my head against a wall trying to comprehend exactly how they work. The basic concept is simple enough: NFTs or “Non-Fungible Tokens” essentially certify the token holder as the owner of an asset, usually digital content. 

However, I still found myself asking: How can ownership be secured for a non-physical asset? What gives these tokens value if most digital content can be downloaded or saved by anyone with an internet connection? And most importantly, what makes this any different than cryptocurrencies? To begin answering these questions, first we need to know what cryptocurrency and NFTs are, and how they work.

What is Cryptocurrency?

A cryptocurrency, also known as a “Fungible Token” is a digital form of currency, and contrary to popular belief, they’ve been around for some time. Over the past few years crypto has started to gain some traction, and you may have heard references to some of the more popular cryptocurrencies like Bitcoin, Ethereum or the infamous Dogecoin. Those are just a small sample of the digital economy however, as new coins are launched constantly, and others die out just as quickly. 

Given the speed at which they come and go, it’s difficult to say exactly how many there are at any given time. At the time of writing, there are estimated to be more than 23,000 different tokens.

In many ways, cryptocurrency works the same way as physical money. You can buy, sell, trade and even earn interest on it. Unlike paper money however, coins are identical with no distinguishable characteristics. Your Bitcoins are exactly the same as my Bitcoins. They have same value, the same properties, and they are nearly impossible to track individually.

What is an NFT?

“Non-Fungible Tokens” or NFTs are similar, except that they are embedded with unique ID codes, making it feasible to differentiate one from another, and track that particular asset’s history.

Investopedia defines NFTs as:

“…cryptographic assets on a blockchain with unique identification codes and metadata that distinguish them from each other. Unlike cryptocurrencies, they cannot be traded or exchanged at equivalency. This differs from fungible tokens like cryptocurrencies, which are identical to each other and, therefore, can be used as a medium for commercial transactions.”

To put this in slightly simpler terms, think of cryptocurrency as gold, and NFTs as limited edition comic books. Gold is gold. The more you have, the more it’s worth. Comic books, however, can’t be classified the same way. Just because you have 4 boxes full doesn’t mean your comic collection is going to come anywhere close to being as valuable as a first edition spiderman. NFTs work the same way, they just didn’t get a Marvel movie, so you’ve never heard of them.

That’s not so bad right? Good, because it’s about to get a lot more complicated.

What is a Blockchain?

A Blockchain is defined by Investopedia as:

“…a distributed database that is shared among the nodes of a computer network. As a database, a blockchain stores information electronically in digital format. Blockchains are best known for their crucial role in cryptocurrency systems, such as Bitcoin, for maintaining a secure and decentralized record of transactions. The innovation with a blockchain is that it guarantees the fidelity and security of a record of data and generates trust without the need for a trusted third party.”

So, continuing with our analogy, if an NFT is a comic book, then a blockchain is your proof of purchase. It acts as a digital ledger that can be used to track and record just about anything from medical data to financial transactions. 

Every time a transaction is added to the chain, a new block is created for the data. The block is made up of three elements:

Data: varies based on the type of data being stored, for financial transactions it might include: the sender, the receiver, and the amount of the transaction.

Hash Code: a unique ID code embedded in each block that identifies the block and its contents.

Hash Code of Previous Block: each block in the chain also contains the hash of the block before it, which is the appeal of a blockchain network as it makes it nearly impossible to alter previous transactions and offers trackable proof of ownership.

For additional security, blockchains also incorporate the use of “Proof of Work” (PoW) procedures that slow the creation of blocks. This means that even if someone was able to modify a block, they would need to modify every block that comes after it as well, and with the creation delay, this would be a nearly insurmountable task.

Blockchains function on a P2P (peer to peer) network which is one of the major advantages they offer. Utilizing a P2P network allows the blockchain to remain decentralized, meaning that the data isn’t stored in any one central location. Instead, it is distributed to every member of the network which are referred to as “nodes” or “validators” giving the blockchain the ability to regularly verify its data.

Once a block has been created and added to the chain, the network verifies the block with the other nodes to ensure the hash codes of the block are consistent. If so, the block is added to the chain. If not, the block is checked against as many nodes as possible. If more than half of them return errors, the block is removed. If the majority can verify the block, the inconsistent nodes are updated to reflect the new data and the block is added to the chain.

That was a lot of information, so let’s take a second to recap. Blockchains operate on a P2P network, so in order to alter a blockchain, you would need the approval of the majority of network nodes in order for the blockchain to accept the data. In other words, a person trying to modify a transaction would need to have access to the machines of more than half of the users on the network. Every time a new block is created it is verified by the blockchain against the network data to ensure consistency and validity before being added to the chain.

How Do Blockchains & NFTs Work Together?

So now that we have a general understanding of blockchains, we can begin to understand how NFTs utilize them to function. NFTs are traded on the Ethereum Network, and through use of smart contracts, ownership is assigned to assets.

 

“Ownership is managed through the unique ID and metadata that no other token can replicate. NFTs are minted through smart contracts that assign ownership and manage the transferability of the NFT’s. When someone creates or mints an NFT, they execute code stored in smart contracts that conform to different standards, such as ERC-721. This information is added to the blockchain where the NFT is being managed.”

 

– Ethereum.org

 

A smart contract is a self-executing program consisting of the terms of agreement between buyer & seller which upon completion of a transaction, distributes this data as code to the blockchain. The blockchain makes these transactions trackable and irreversible.

The Copy/Paste Argument

The most common argument against NFTs is the idea that you can download or screenshot the content of an NFT and negate its value. This one tripped me up for quite some time, but I think I’ve finally grasped the concept. Essentially, nothing has value until we assign value to it, and by having a certified original piece, it is inherently more valuable than a copy of said piece.

In addition to that, the NFT minted piece is logged and tracked on the blockchain so there is no dispute over legitimate ownership. The typical counter argument is that if someone took a picture of the Mona Lisa, is that picture just as valuable as the painting itself? Of course not, and while this argument makes sense, it is somewhat difficult to transfer that perspective to digital content. 

What Are NFTs Used For?

NFTs can theoretically be used for almost any tangible asset, but being in the early stages of development, currently they’re primarily used for digital content. Digital content can refer to any type of media in a digital format like videos, art, graphics, or music. NFTs benefit artists & creators by allowing them to collect funds from sales directly, without paying fees to a third party. They may also have the opportunity to collect royalties each time their content is sold due to the metadata embedded within.

Another common use of NFTs is in gaming, where players can purchase NFTs that grant them access to limited or exclusive in-game content, which can be held for personal use, or traded to another player. This lays the foundations for an in-game economy where items are subject to supply and demand, meaning you could potentially buy an NFT of a rare costume, then when you get tired of it, sell it to another player. Based on its value in the marketplace, you may even make a profit. Game developers can also benefit by receiving royalties each time an in-game item is traded or sold.

While NFTs are primarily used in the digital landscape right now, there is little doubt that this technology will be used more commonly in the future, potentially in place of property deeds, vehicle titles, and even loans.

How Do I Buy An NFT?

To purchase an NFT, you first need to get your hands on some Ether tokens as the majority (97.8%) of NFTs are bought & sold on the Ethereum network using the OpenSea marketplace. 

Next, you’ll want to log on to OpenSea and click the wallet icon in the top right corner, then select the applicable wallet you chose previously to link your wallet. Now you’re ready to buy. Search through the marketplace for something you like. If and when you find something, you’ll have 3 options: Buy Now, Make an Offer, or Place a Bid.

Buy Now will pay the current fixed price of the asset, but may incur transaction fees referred to as “Gas” which can fluctuate based on market conditions. The current status of “Gas” can be found here: Ethereum Gas Tracker | Etherscan.

Make an Offer lets you counter the asking price. If the seller accepts your offer, they will pay the “gas”.

Place a Bid will allow you to take part in an auction for the asset. The winning bid must be 5% higher than the previous bid and must meet the minimum bid requirement.

If an asset you want isn’t listed for sale, you can still make an offer to try and persuade the owner to sell.

TL;DR

An NFT is a digital certification of ownership. Currently they are in the very early stages of development, but it is highly likely that they will become an integral part of society as we become an increasingly digital world. It may not be long until the deed to your home is certified with an NFT, and with the Metaverse beginning to find its footing, the use of NFTs could become even more commonplace in digital transactions.

For further reading, I highly recommend checking out this Guide to NFTs on Ethereum.org.