NFTs, or Non-Fungible Tokens, work through many of the same systems that dictate the value of other items. Before we explain how NFTs work via the blockchain, we need to explain the ideas that went into creating these tokens in the first place.
Many of your favorite cryptocurrencies are fungible. This means that a single asset is interchangeable and identical to another.
One Bitcoin isn’t unique from another Bitcoin, but Bitcoin as a currency holds its value because it was a proof of concept technology that also has a limited supply – 21 million.
That’s something you already know if you’re interested in cryptocurrencies. What NFTs do is take this a step further.
While scarcity often creates value in an untampered market, rarity can create assets that are much more valuable and appealing to collectors. If you’re new to the crypto space and have any trouble understanding this, forget digital assets and think about anything else somebody might buy.
So, a photograph, painting, or book might have some value to it. Assuming the asset in all three cases is a successful one, it gets replicated over and over so that it’s shared far and wide.
People will own copied images of Van Gogh's work that’s worth nothing when compared to the original painting. Photographs will be copied and shared and, once posted online, free for anybody to download.
Books will run cycles of printing that make the book easier to acquire, and so less scarce.
In those three cases, the most original possible asset is the most valuable. The original photograph, often signed by the photographer, is rare and unique.
We don’t need to explain how the original painting is much more valuable than copies or images of that painting, we’ve all seen how much those original artworks sell for. Similarly, with books, a first edition is worth more than the latest edition.
If the book is signed by the author too, even better. Taking it a step further, some collectors will even pay handsomely to acquire the pre-publication manuscripts written by successful authors.
NFTs work by bringing that kind of uniqueness to the digital space. As we said, anybody can download and print out a famous photograph, which is seen as a threat to artistic value by some.
The ability to literally copy and paste anything on the Internet means that it’s hard to secure unmistakable value to a digital asset. Then NFTs came along.
Like cryptocurrencies, NFTs work from the blockchain. The technology was pioneered using Ethereum’s cryptography, so as of right now most NFTs are limited to the Ethereum blockchain. Let’s go through what a blockchain is and how cryptography is important to NFTs.
The core concept behind blockchain technology is quite simple – a database with a public ledger that records transactions taking place. Blockchains are structured differently from a typical database, however.
Data is stored and preserved in groups called blocks that, when full, are linked to the previously filled blocks – hence blockchain. This ensures that you have a clear timeline of activity since the blocks are layered in correspondence with periods and timestamped when added to the chain.
Filled blocks are made concrete, it becomes incredibly difficult to tamper with them once they’re added to the timeline, providing security for the transactions taking place.
Bitcoin is perhaps the best example to show blockchain’s ability to be secure and decentralized. Bitcoin uses blockchain tech to store every Bitcoin transaction that takes place.
A blockchain isn’t relegated to one computing system, either. They use nodes, which are individual or grouped computers in different geographic locations that number in the thousands.
Every node has the full record of blockchain data without possessing the power to change any of the information stored by the network as a whole. There isn’t some dark warehouse full of servers that hold all of the Bitcoin information in the world.
While private blockchains exist, this ability to be completely decentralized makes blockchain technology attractive for cryptocurrency.
If somebody tries tampering with a decentralized blockchain, the other nodes can cross-reference, find the node with incorrect information, and correct the network. If all the nodes are in one place and run by the same person, then tampering is much, much easier.
It would take a majority of nodes to agree to informational changes, democratizing data storage.
A decentralized blockchain is the most secure, decentralized, and transparent means of data storage we have right now. The tech can (and will) be used for other things besides cryptocurrencies, like ID or legal documents.
Cryptography is simply where messages are coded so that they can only be read by the intended receiver. Anybody else will see meaningless strings of numbers or letters, which we call hashes. Every block in a blockchain is secured by a hash.
Those hashes are locked by two keys, one public and one private. The public key is used to transform messages into an unreadable hash while the private key is used by the receiver to decode it.
When used for a blockchain, cryptography ensures that transactions are authenticated and anonymized.
How These Work With NFTs
Blockchains can be used to store non-fungible assets along with fungible ones. Through storing these tokens on the blockchain, their presence is solidified and protected as being unique on that chain.
When you buy an NFT, you’re paying for the ability to send that token to one of your crypto wallets. That token uses your private key to be accessible, making it evident that the sent copy is the original. The public key is retained by the creator of the NFT.
People can have a digital copy of the asset depicted in an NFT but, without those keys, they don’t own the original.
How NFTS Came To Be
Knowing where NFTs came from may be helpful to understand how they work. They find their roots in video gaming, specifically a 2017 game called CryptoKitties. Players bought virtual cats that were only available during certain events and periods.
From there, developers liked the idea of securitized unlockable items for their video games, to be won as prizes by performing certain actions in those games.
By turning in-game assets into tokens, they could also be transferred between games or two different players playing the same game through a blockchain marketplace. They could be sold and they could be made unique when sold through a blockchain.
From there, the same technology has been used by celebrities and influencers to secure and monetize digital images, videos, prose, music, even real estate.
It’s providing content creators with another way of selling their work or celebrating moments dear to their fanbases by selling video or imagery related to the memory.
NFTs are mostly made using the ERC-721 standard for the Ethereum blockchain. This token type is different from the typical fungible tokens that are traded. The ERC-721 standard even allows for NFT creators to earn a percentage of all subsequent sales.
The NFT market should grow in the future as more and more digital information is deemed valuable, minted as NFTs to make them unique and secure, and then sold. Even without taking the marketplace into account, tokenizing unique information into NFTs and storing it on a secure blockchain is going to be the foreseeable future of data storage.
To recap on how NFTs work:
- Non-Fungible Tokens are unique digital items.
- They’re unique because they’re transacted using blockchain and secured by two keys that prove originality.
- Since they are unique, they prove ownership of that digital item, whether that’s images, sounds, files, or some text.
- Buyers are attracted to the uniqueness and security of these digital assets, so they buy.
How Do NFTs Gain Value?
Even those who understand NFTs may struggle to explain how their value is dictated, especially now where many proof-of-concept transactions are going on that may not be feasible in the future.
Understanding value is something that goes above and beyond knowing what NFTs are or any digital assets that have no physical presence in the world.
The best way we can explain how they have value is by providing examples and explaining how the main drivers for valuation correspond to NFTs.
So, what has been made into an NFT?
- Virtual items, models, and video game skins
- Collectible Items
You can find an example of all of the above selling as an NFT, from prices in the five figures to eight figures. The most expensive to date came from the digital artist Beeple, who sold 5,000 pieces of artwork for $69.3 million.
It was the first time that Christie’s had auctioned and sold digital art. Twitter founder Jack Dorsey’s first published tweet was also sold for $2.9 million and, on the more humorous side, a GIF of the Nyan Cat meme from 2011 sold for $600,000.
The value depends on how many people, or how many wealthy people, are interested in owning the unique NFT. By buying the NFT, the interested party then becomes the exclusive owner of the asset.
So how is this value decided? The exact value depends on the nature of the NFTs since they can be different assets.
That said, investors can use four broad information categories to determine whether an NFT is valuable or not. They’re also things that those looking to make NFTs should have covered to guarantee that the NFT has an increased chance of becoming valuable.
- Utility – Of course, the surest way to make something valuable is to make it useful. NFTs originated from video games where they were first used as digital assets to be won and traded. Rare NFTs from these games have been sold for large amounts of cash, making game assets one of the more useful and valuable NFT examples.
If the asset is transferable to other games or programs, that increases the value as it has more applications than the standard NFT. It’s difficult to make an NFT interoperable, however.
Most NFTs that are used with games only play on that original game and, without some sort of standardization, future games that can use the same NFT are likely to come from the same developers.
As the NFT economy develops, we’re likely going to see much more expansive use cases.
There is also the possibility that businesses and other services can provide benefits to people who hold certain NFTs. Think of a discount that, to be eligible, checks if you’re the proud owner of the required NFT. If you are, then you’re able to access benefits that the typical customer can’t have.
- History – The identities tied to an NFT can go a long way in dictating its value. NFTs that are frequently traded are likely worth more and have made people profit in the past, hence why it’s had so many owners. Maybe the original issuer is an influencer or a celebrity, or a known artist. Influential people impart value into the things they create solely because there are people out there who want to get their hands on them.
Fortunately, blockchain tech allows transactions to be reliably recorded but discovering the previous owners can be difficult if that data isn’t harvested and displayed by marketplaces or third-party tracking interfaces.
OpenSea is an example of one of these interfaces that can track successful NFT investors and find high-value NFTs that they trade with.
- Appreciating Value – Like with any investment, a lot of the value may appreciate over time. Valuation is largely driven by speculation, especially with some newly emerging cryptocurrency assets. Rampant speculation is often regarded as a negative, and there are concerns, but the price inevitably corrects over time and sturdier assets with stronger use cases prevail.
While a lot of NFTs out there now may be based on menial and humorous things, they may sell for higher figures because they are proof of the NFT concept, of a digital asset that’s owned by one person.
NFTs aren’t a bubble but not every NFT is guaranteed, or even likely, to solidly appreciate in value over time.
Buying an NFT that takes off means you can cash it in for a massive profit. If a smaller influencer or artist offers an NFT that has the potential to grow in value over time, that may be a valid means of profiting off of the asset.
Speculative prices can be increased if future markets showcase NFTs that are growing in value so that investors can choose to buy and sell them.
An increasing cash flow can also contribute to the appreciation of NFT assets. Creators can program royalties into NFTs so that they earn a percentage whenever the NFT is traded. Companies can create future cash flow by leasing NFTs where they can be considered business assets.
- Liquidity Premium – The liquidity premium is why assets on blockchains have a higher value than tokens that are still off-chain. The ERC standard used for NFTs is much easier to trade on marketplaces with anybody who possesses ETH. As one of the larger cryptocurrencies on one of the most sophisticated blockchains, the number of potential buyers who use ETH is only growing.
A high trading volume is always a welcome sight to investors because it means there’s less risk when holding the asset. This is because there is always an audience who is willing to buy the NFT.
If you can’t buy and sell an NFT to somebody then you have no investment. If an NFT becomes instantly useless and irrelevant, and so its other value points are demolished, high liquidity can still save the investment because people will buy it.
NFTs that aren’t based on the Ethereum blockchain haven't got much liquidity right now. This should change in the future but, if you’re focusing on the liquidity premium, you want to consider NFTs that are available to a large consumer base with lots of people willing to buy the asset.
The prominence of NFTs is going to increase in popularity as we move further into the future. It’s going to be helped by companies adopting them and developing token economics that encourage the proliferation of NFTs through the market, driving engagement from more people.
As NFTs gain popularity, we’re likely to see all four of those value components become more obvious to the average person.
NFTs will become more useful, whether that’s for leisure purposes in video games or as companies adopt them as a usable asset.
As they trade, influencers will introduce more NFTs whose value comes from speculation based on the identities that made, bought, and traded the asset.
As the market speculates on these NFTs, creators can also earn royalties based on the trades.
Lastly, the increased buying audience for these assets also ensures that they maintain some value as long as people will seek to buy them.
All of these developments established and will continue to increase the value of successful NFTs.