What Is a Non-Fungible Token (NFT)?
Non-fungible tokens (NFTs) are assets like a piece of art, digital content, or video that have been tokenized via a blockchain. Tokens are unique identification codes created from metadata via an encryption function. These tokens are then stored on a blockchain, while the assets themselves are stored in other places. The connection between the token and the asset is what makes them unique.
NFTs can be traded and exchanged for money, cryptocurrencies, or other NFTs—it all depends on the value the market and owners have placed on them. For instance, you could draw a smiley face on a banana, take a picture of it (which has metadata attached to it), and tokenize it on a blockchain. Whoever has the private keys to that token owns whatever rights you have assigned to it.
Cryptocurrencies are tokens as well; however, the key difference is that two cryptocurrencies from the same blockchain are interchangeable—they are fungible. Two NFTs from the same blockchain can look identical, but they are not interchangeable.
- NFTs (non-fungible tokens) are unique cryptographic tokens that exist on a blockchain and cannot be replicated.
- NFTs can represent digital or real-world items like artwork and real estate.
- "Tokenizing" these real-world tangible assets makes buying, selling, and trading them more efficient while reducing the probability of fraud.
- NFTs can represent individuals' identities, property rights, and more.
- Collectors and investors initially sought NFTs after the public became more aware of them, but their popularity has since waned.
NFTs were created long before they became popular in the mainstream. Reportedly, the first NFT sold was "Quantum," designed and tokenized by Kevin McKoy in 2014 on one blockchain (Namecoin), then minted on Ethereum and sold in 2021.1
NFTs are built following the ERC-721 (Ethereum Request for Comment #721) standard, which dictates how ownership is transferred, methods for confirming transactions, and how applications handle safe transfers (among other requirements).
NFTs are created through a process called minting, in which the asset's information is encrypted and recorded on a blockchain. At a high level, the minting process entails a new block being created, NFT information being validated by a validator, and the block being closed. This minting process often entails incorporating smart contracts that assign ownership and manage NFT transfers.
As tokens are minted, they are assigned a unique identifier directly linked to one blockchain address. Each token has an owner, and the ownership information (i.e., the address in which the minted token resides) is publicly available. Even if 5,000 NFTs of the same exact item are minted (similar to general admission tickets to a movie), each token has a unique identifier and can be distinguished from the others.
Many blockchains can create NFTs, but they might be called something different. For instance, on the Bitcoin blockchain, they are called Ordinals. Like an Ethereum-based NFT, a Bitcoin Ordinal can be bought, sold, and traded. The difference is Ethereum creates tokens for the asset, while Ordinals have serial numbers (called identifiers) assigned to satoshis—the smallest bitcoin denomination.7
Blockchain and Fungibility
Like physical money, cryptocurrencies are usually fungible from a financial perspective, meaning that they can be traded or exchanged, one for another. For example, one bitcoin is always equal in value to another bitcoin on a given exchange, similar to how every dollar bill of U.S. currency has an implicit exchange value of $1. This fungibility characteristic makes cryptocurrencies suitable as a secure medium of transaction in the digital economy.
For this reason, NFTs shift the crypto paradigm by making each token unique and irreplaceable, making it impossible for one non-fungible token to be "equal" to another. They are digital representations of assets and have been likened to digital passports because each token contains a unique, non-transferable identity to distinguish it from other tokens. They are also extensible, meaning you can combine one NFT with another to create a third, unique NFT—the cryptocurrency industry calls this "breeding."
Fungibility is the ability of a good or asset to be interchanged with other individual goods or assets of the same type.
Key Takeaways
- Fungibility is the ability of a good or asset to be readily interchanged for another of like kind.
- Goods and assets such as cars and houses that aren't interchangeable are non-fungible.
- Money is a prime example of a fungible asset because a $1 bill is easily convertible into four quarters or 10 dimes.
- Unique items such as cars, houses, or artwork are non-fungible.
- The line between fungibility and non-fungibility of some assets can be murky.
Fungible assets are of like kind, which makes them interchangeable. Non-fungible assets, on the other hand, have something unique about them that means one cannot be replaced by another.
Money is another example of a fungible asset. It doesn't matter to Person A if they're repaid with a different $50 bill if Person A lends Person B a $50 bill. It's mutually substitutable. Person A can be repaid with two $20 bills and one $10 bill and still be satisfied because the total equals $50.
Conversely, it's not acceptable for one person to borrow a car from another person and then return a different car, even if it is the same make and model as the original. This is an example of non-fungibility. Cars aren't fungible with respect to ownership, although the gasoline that powers the cars is. Other examples of non-fungible assets are:
- Diamonds: Individual diamonds have different cuts, colors, sizes, and grades, so they're not interchangeable.
- Baseball cards: Each card has unique qualities such as rarity that add or subtract from its value.
- Real estate: Each house experiences different levels of noise and traffic, is in varying states of repair, and has unique views of surrounding areas, even on a street of identical houses.
Much of the earlier market for NFTs was centered around digital art and collectibles, but it has evolved into much more. For instance, the popular NFT marketplace OpenSea has several NFT categories:
- Photography: Photographers can tokenize their work and offer total or partial ownership. For example, OpenSea user erubes1 has an "Ocean Intersection" collection of beautiful ocean and surfing photos with several sales and owners.
- Sports: Collections of digital art based on celebrities and sports personalities.
- Trading cards: Tokenized digital trading cards. Some are collectibles, while others can be traded in video games.
- Utility: NFTs that can represent membership or unlock benefits.
- Virtual worlds: Virtual world NFTs grant you ownership of anything from avatar wearables to digital property.
- Art: A generalized category of NFTs that includes everything from pixel to abstract art.
- Collectibles: Bored Ape Yacht Club, Crypto Punks, and Pudgy Panda are some examples of NFTs in this category.
- Domain names: NFTs that represent ownership of domain names for your website(s)
- Music: Artists can tokenize their music, granting buyers the rights the artist wants them to have.
Investing
NFTs can also be used to streamline investing. For example, consulting firm Ernst & Young developed an NFT solution for one of its fine wine investors—by storing wine in a secure environment and using NFTs to protect provenance
