What Is an NFT and How Does It Work?

  • NFT
  • Cam 
what is an nft

Most things in the world are non-fungible: your laptop, the table it sits on, and even your coffee mug. An item’s non-fungibility refers to its uniqueness. No two physical items are perfectly identical.

A non-fungible token (NFT) is a unique and tradable digital token that verifies ownership of an asset. Token ownership can represent assets like digital art, images, videos, music, gaming items, event tickets, and thousands of other items.

The owner of an NFT has a proverbial ‘bill of sale’ that enables them to prove that they own it—and that they are the only person who owns it.

Digital assets aren’t new. The first .com domain names were registered in 1985. Tickets to events are digital. Gamers spend billions on in-game skins for virtual avatars. Even Twitter and Instagram usernames are digital assets.

So what’s the difference between these digital assets that we’ve known for decades and NFTs?

The short answer is that NFTs operate more like real-world assets. You can freely trade them, sell them, and even insure them. You can’t do that with an in-game character skin in Fortnite–those transactions are all one-way.

The long answer is what I’ll cover in this post. To get there, I’ll explain the basics of what a blockchain is, then get into how a blockchain’s interoperability, immutability, composability, and censorship resistance take digital assets to the next level.

That may sound like a giant word salad now, but it’ll make more sense if you keep reading.

What is a blockchain?

A blockchain is a widely distributed database that keeps data secure and safe amongst a huge network of computers. Blockchains have many applications, but they’re most used for keeping a record of how much cryptocurrency the people who use the network have.

Blockchains are peer-to-peer networks, meaning that users can transact with each other without any third-party involvement. The most important part? The legitimacy of that transfer can’t be challenged and anyone can verify that a transfer took place by viewing the public ledger.

To paint a clearer picture, imagine the blockchain is an enormous public Excel sheet. In this example, thousands of computers have an identical copy of the sheet stored on their hard drive. The sheet can be viewed publicly for free, but anyone who wants to write in a new cell has to pay a fee to do so. There are two rules for writing a new cell: 1. Each computer with a copy of the sheet must update their sheet to match the others. 2. It’s virtually impossible to change a cell after the initial entry.

Since blockchains deal with important data (money), it is essential that all actors on the network play fairly and that the data stays secure forever. The “proof-of-work” consensus mechanism is an essential ingredient that enables this.

What the heck is proof-of-work?

All right, I’m going to get into the weeds for the people who nerd out about this stuff (like I do), but understand that this is still an oversimplified explanation. If you don’t care about this stuff, go ahead and skip to the next part.

Oversimplified proof-of-work explanation: nodes on the network pick up new transactions and place them in a pool, then “miners” compile a group of transactions and place them in a block. To validate a new block, all miners across the network work to solve a difficult hashing algorithm. The miner that solves the algorithm first, adds a new block to the chain and wins a reward for their effort. This reward is paid in the blockchain’s native token. For example, miners on the Bitcoin network are paid in bitcoin.

proof of work

The only way to attack the network is to acquire 51% of the network’s compute power. Bitcoin has been around for 13 years and it’s never been attacked. The combination of Bitcoin’s “difficulty adjustment” and mining infrastructure costs make an attack economically unsound. As of today, it’d cost more than $33B to get the proper equipment to attack Bitcoin, plus you need to account for land, mining facilities, electricity and time it would take to get things running. (YouTuber, 3Blue1Brown, has an amazing graphic explainer on how Bitcoin works technically, if you want to learn more.)

Many crypto believers argue that proof-of-work is vital for protecting Bitcoin, which has aspirations to be the next global reserve currency. But the electricity costs to run proof-of-work networks is intense. It’s estimated that Bitcoin uses more energy per year than countries like Sweden, Netherlands, Finland, Chile, and Denmark.

Newer blockchains, like Solana (and Ethereum soon), use a more environmentally friendly proof-of-stake mechanism instead of proof-of-work. Instead of providing the network with computing power, validators lock their funds (stake) into a contract and validate transactions in exchange for a reward. Validators are incentivized to act honestly because if they don’t, some of their stake is taken away (slashed). To modify the state of the blockchain against consensus, an attacker would need to own 51% of the network’s currency. (For Ethereum, an attacker needs close to 60M Ether, which is ~$90B in today’s USD value.)

The TL;DR

Bitcoin is a cryptocurrency (fungible token) that’s enabled by Bitcoin’s blockchain, while non-fungible tokens are a different type of asset that can sit on top of smart contract blockchains, like Ethereum and Solana.

Because of a blockchain’s guarantees, owning an NFT gives you irrevocable property rights to your token, and grants you the freedom to hold or transfer indefinitely. As long as the chain remains alive, so does your NFT.

Many blockchain skeptics argue that a centralized database with good security can protect digital assets just as well as a blockchain. While that may be true in some cases, let’s go over the other things that a blockchain brings to the table aside from strong security.

1. Standardization & Interoperability

To view a webpage on your device, a web browser utilizes at least four standardized protocols (TCP/IP, HTTP, & HTML/CSS).

Because these protocols are universal, a website will render in the same way on dozens of different web browsers and devices. For example, ebay.com will look similar on Firefox and Chrome.

SMTP is another protocol used for email. Whether you use Gmail or Yahoo for your email interface, you’ll use the SMTP protocol to send an email.

Before the invention of Bitcoin, in 2009, a protocol for transferring digital currencies peer-to-peer didn’t exist. Four years later, Ethereum took the blockchain concept and expanded its use case to programmable smart contracts. But it wasn’t until 2018 that the ERC-721 token standard was born on Ethereum, which became the accepted protocol for non-fungible tokens.

When you own an ERC-721 token, it’s viewable and transferable with any compatible digital wallet provider. And the token is sellable on any marketplace that can read ERC-721 tokens.

How is this different from previous versions of digital ownership?

Let’s say you have Red Sox tickets from Stubhub and you want to transfer them to a friend. Your friend will have to download the Stubhub app on their phone and provide you with their username. If your friend uses SeatGeek as their preferred ticketing app, they’re out of luck because these two apps aren’t interoperable.

Or let’s say you want to sell your tickets on the Stubhub marketplace. It’s free to list your tickets, but when the tickets sell, you owe 15% of the sale price to Stubhub. Stubhub provides a service, so you could argue that they deserve a cut, but because sellers can’t list tickets on other marketplaces, they hold the sellers hostage. Some may see the high marketplace fees as a way to reduce ticket scalping and price markup, while others see this as interfering with the free market.

If your tickets were in NFT form, you’d be free to list them on any ERC-721 compatible marketplace (OpenSea, LooksRare, etc). Because the NFT marketplaces compete on fees, they’re forced by the market to provide a superior service or reduce fees.

what are nfts

In the NFT world, the marketplace fees are 2.5% or lower. As more marketplaces come online, these fees will trend even lower.

Having one accepted standard for digital assets means that token holders have their choice of wallet providers and marketplaces. There’s no lock-in or penalty when you want to switch providers, which creates a great environment for users because wallet providers and marketplaces must compete to please users or they’ll lose them.

2. Provable Scarcity & Immutability

Most people agree that scarcity of digital assets is important. For example, Fenway Park has 38k seats, so selling 40k tickets for a single game wouldn’t make sense. 

The Red Sox closed ticketing database seems to work well because they’d face a lot of angry fans if they sold the same seat twice. We have to trust that the companies issuing digital assets are always acting in good faith and this system seems to work fine for event tickets.

So why does scarcity of digital assets need to be provable? Can’t we just trust the company that issues the asset to protect our interests?

NFTs are early in the adoption cycle because they’re a brand new asset class, but here are early NFT iterations where provable scarcity is important:

Digital art and photography. Previously, anyone could right-click and save digital art or photography to their computer. To get around this, artists need to jump through hoops like watermarking the art so that they can try to (hopefully) at least get credit if someone does that. NFTs solve the problem of ownership. Now, we can have an original owner and it opens new opportunities for creators.

Digital collectibles & in-game items. Previously, if a company created a limited edition digital collectible or gaming skin, the company could potentially edit the mint count in favor of more profits. Now, once scarcity is stated on a blockchain, it can’t be changed.

Assuming society collectively decides that certain items from this new asset class have value, it’s important that everyone can recognize that the assets are scarce and who owns them, not just via one company’s database.

3. Composability

Blockchains work as building blocks for third parties. Due to a blockchain’s public and open nature, it’s easy for third-parties to build services around NFT assets.

For example, because NBA Top Shot uses a blockchain rather than a database, analytic sites like LiveToken, Collective, Own the Moment, and Evaluate built businesses on top of Top Shot’s data. And they didn’t even have to get Top Shot’s permission to do this!

Not only are these companies able to build sustainable businesses off of Top Shot’s data, they simultaneously improve the experience for Top Shot users, which helps Top Shot’s business. Everyone wins.

Before blockchains, the only way to build a project off another company’s data is by applying to use their public API. But this is a risky proposition because companies can change their API or strip your access without notice. For example, in 2018, Twitter turned off its API which hurt a bunch of businesses, like Tweetbot, Twitterrific, Talon, and Tweetings, that relied on this data.

Blockchains provide incentives for new businesses to be built, which is great for providing NFTs owners with more applications and utility.

Another interesting aspect is that app makers or communities can tap in directly to certain communities. For example, if a coffee shop wants to give everyone who owns certain tokens 15% off their coffee, this is easily doable. The potential for partnerships and collaborations are endless when assets are on a public blockchain.

4. True Ownership & Censorship Resistant

Most crypto-natives argue that a blockchain’s most important feature is its censorship resistance, meaning that the right to hold or transfer your assets can’t be taken from you under any circumstance.

Many claim that censorship resistance is essential for protection against tyrannical governments, but for the sake of this post, let’s say governments don’t care about your NFTs. How else is this censorship resistance important?

Let’s say you spend $100 on the skin for Fortnite, but a few weeks later, you receive an email that you’ve been banned for violating the company’s code of conduct. What happens to your skin?

You don’t have much ground to stand on if you broke the rules that you agreed to. But what if the violation was a misinterpretation of the rules? Or maybe your account was wrongly flagged by their automated system.

Either way, you’ll likely at least temporarily lose access to your assets while you appeal your account’s status. In a blockchain-less world, a single keystroke inside a database from one company employee or automated system can be the difference between owning an asset and not.

It’s unlikely Fortnite or any gaming company would recklessly ban players and their assets because it’d hurt their brand, upset customers, and the company would lose money from previously paying customers.

But the fact there’s a .0001% possibility of losing your assets, brings up the question: what do you own when buying these gaming assets? You’re essentially renting assets from a single company’s database.

Other digital assets come with restrictions too. For example, if you own a coveted username on Twitter or Instagram, it’s against the terms of service to transfer or sell them to someone else.

Owning an asset-backed by a blockchain means you have irrevocable property rights to that token. The only way someone can take a crypto asset from you is if you give an attacker your seed phrase (a string of 12-24 words) or sign a malicious contract (we’ll cover NFT security and crypto’s confusing UX in a future post).

Whether you live in Uganda or the United States, you have digital property that’s not only recognized by everyone, but it cannot be seized by anyone on the internet.

And the wildest part? You can freely cross borders and store billions of dollars of digital assets in your mind (without a device), if you can memorize your 12-word seed phrase.

Wrap up

NFTs offer several benefits over non-blockchain digital assets without many sacrifices. A previous drawback to blockchains was that they didn’t scale well and were too cost-prohibitive to make sense for all applications, but this is no longer the case.

Developers in the Ethereum ecosystem are working on layer-two solutions that will radically decrease costs. And Ethereum side-chain options, like Polygon, already work well with near-zero transaction fees.

The bottom line? Because blockchains are becoming more efficient and cost-effective, companies will likely face criticism if their digital assets are on a closed-off database rather than a blockchain in the future. Blockchains will become table stakes.

If you found this post interesting and want to know why some people are valuing certain NFTs at crazy levels, check out the next post in this series.

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Cam

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I’ve been obsessed with gadgets since I was eight years old. I buy each device reviewed with MY money and don’t have insider access. I’m just like you, the everyman.