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Non-Fungible Token (NFT)

What Is An NFT?

A non-fungible token (NFT) is a unique virtual asset that has a variety of applications. While often mistaken for traditional cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH), non-fungible tokens feature an inherently unique functionality. Like conventional cryptos, NFTs are "tokens" that utilise blockchain technology, but that's where the similarities end. Beginning in early 2020, NFTs became a rapidly growing part of the cryptosphere and an asset class all of their own.

Fungibility Vs Non-Fungibility

According to the Merriam-Webster dictionary, fungibility means "being capable of mutual substitution."[1] As it pertains to finance, asset fungibility refers to goods that may be exchanged evenly on a one-for-one basis.

Examples of these types of assets are commodities, shares, or units of a domestic currency. For instance, one 42 gallon barrel of West Texas Intermediate (WTI) crude oil may be readily exchanged for another, and one U.S. dollar (USD) may be directly substituted for another USD.

Conversely, non-fungibility refers to the impossibility of equal exchange. Non-fungible assets are goods that are not interchangeable. They feature a collection of attributes that make their value inherently unique. Examples of non-fungible assets are baseball cards, artwork and diamonds. For instance, it is impossible to trade one Rembrandt painting for another; each piece is unique, carrying with it a distinct valuation.

Until recently, the world of tokens and blockchain technology was thought to fall within the realm of fungibility. Cryptocurrencies such as Bitcoin (BTC), Ethereum (ETH) or Ripple (XRP) functioned as modes of exchange, much like USDs, euros (EUR) or British pounds (GBP). However, with the 2020-21 rise of non-fungible tokens (NFTs), blockchain technology entered the worlds of collectible, virtual art.

What Defines An NFT?

A non-fungible token (NFT) is a crypto-token that may not be exchanged or traded for other "like" tokens on a standard 1-for-1 basis. In contrast to BTC and ETH, which may be directly swapped for other BTC and ETH, each NFT has a distinct valuation and is not interchangeable with other NFTs.

Created through the process of cryptography, each NFT is recorded separately on the blockchain. This functionality makes NFTs unable to be duplicated, much as cryptocurrencies are not prone to counterfeit. NFTs may be used to prove the authenticity of any physical or digital asset, making them the basis for contracts regarding ownership. Given this functionality, non-fungible tokens have become popular in the digital art and collectibles markets.

Technically, NFTs are ERC-721 tokens, which refers to the basic tenets of existing as a non-fungible token on the Ethereum blockchain.[2] However, as long as they have "smart contract capabilities," NFTs can also function on other networks such as EOS and NEO.[3]

How To Purchase An NFT

Purchasing NFTs is straightforward; all one needs to do is visit a market site such as OpenSea, SuperRare, Foundation, or VIV3.[4] However, when one buys an NFT, one is not buying the actual collectible―only the computer code identifying the asset. As put by founder of CoinFund Jake Brukhman: "You're not buying the picture. You're buying the property rights to the picture."[5]

Brief History Of NFTs

Although relatively new in the world of finance, NFTs were first marketed as Coloured Coins in 2012.[6] Five years later (2017), cartoon cats known as "CryptoKitties" became available to the public and were lauded as the first blockchain game built on the Ethereum network.[7] Players purchased and bred digital cats, each verified as a non-fungible token. Within a short time, CryptoKitties generated more than US$12 million in sales, with the rarest kitties selling for upwards of US$100,000 apiece.[8]

How Are NFTs Valued?

So, what gives non-fungible tokens value? Like many traditional luxury items, there are three major factors that drive the NFT market:[3]

  1. Scarcity: NFTs aren't mass produced and cannot be replicated. In fact, many NFTs are one-of-a-kind.
  2. Indivisible: While not technically impossible, NFTs typically cannot be broken into smaller parts. This functionality makes fractional ownership of the asset impossible.
  3. Unique: An NFT is authenticated by a "permanent information tab," which confirms that it is a unique asset.

At its core, an NFT's value is driven by supply and demand. Due to vastly limited supplies and their one-of-kind nature, a sudden increase in public interest can spike prices. Subsequently, the cryptocurrency boom of late-2020 and early-2021 took many NFT products to staggering heights.

Are NFTs A Passing Fad?

Since the initial success of CryptoKitties, many other assets have followed suit as NFTs. Throughout 2020 and 2021, a few high-profile examples illustrated the robust market value of select NFTs.

  • Christie's Auction House sold a piece of digital art named "Everydays: The First 5,000 Days" for US$69.3 million. The artwork was authenticated as a non-fungible token, the first such asset to be sold by Christie's in its 250-year history.[6]
  • Twitter CEO Jack Dorsey announced plans to sell his first, 15-year old tweet as an NFT. Bids quickly reached US$2.5 million.[9]
  • National Basketball Association digital trading cards known as "NBA Top Shot" generated millions of dollars worth of transactions in early-2021.[10]

The explosive growth of the non-fungible token asset class has prompted many skeptics to call it a market fad or bubble. According to UC Berkeley computer science professor Nicholas Weaver, the idea of paying large sums for an NFT is absurd[11]: "The ownership records themselves are the digital equivalent of Beanie Babies: cute little nothings that have no value beyond what someone else will buy them for."

On the other hand, Charles Stewart, the CEO of Sotheby's auctions took a much different stance toward non-fungible tokens[12]: "We've [Sotheby's] been following the NFT space for some time. This is new for all of us. But, there's a lot here that's really exciting and we think it has staying power."

Summary

Non-fungible tokens are created by the process of cryptography and recorded on the blockchain. They cannot be mass reproduced, counterfeited or divided into smaller parts. Accordingly, NFTs may be used for a wide variety of purposes, including validating ownership and as the basis for smart contracts. Valuations of NFTs vary wildly, but are related to each token's inherent scarcity and uniqueness.

The rise of NFTs during 2020 and early 2021 created an abundance of media hype and controversy. However, given the high valuations of certain non-fungible tokens, traditional auction houses such as Christie's and Sotheby's chose to enter the market. Although NFTs are not yet part of the financial mainstream, they are a budding asset class with an uncertain future.

Russell Shor

Russell Shor

Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…

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