In this second instalment of our Metaverse 101 blog series, we turn our attention to Non-Fungible Tokens (NFTs).

NFTs have exploded into public consciousness in recent years as a new means of tokenising, storing and attributing digital value. Up to now, NFTs have most commonly been used for certifying rights in digital artwork; verifying the authenticity of luxury goods; representing in-game assets; and granting rights to exclusive digital objects, collectibles and sports highlights.

NFTs are frequently traded on secondary marketplaces such as OpenSea, Rarible and LooksRare, with the most desirable and rare NFTs trading hands for eye-watering sums of money.

So – what exactly is a Non-Fungible Token?                                                                  

An NFT is a one-of-a-kind digital token created (or “minted”) and recorded on a digital ledger, called a blockchain (see Metaverse 101: Blockchain, Distributed Ledgers and Smart Contracts for an introduction to blockchain technology).

An NFT is “non-fungible” because it has unique, irreplaceable value and cannot be exchanged like-for-like another item (or NFT). This “non-fungibility” usually relates to the underlying data of the NFT itself – encoded on the blockchain – that distinguishes the NFT as unique or inimitable in some way.

Where an NFT represents a right (or licence) to a specific digital asset, the data of the NFT will typically include a URL link to where that unique asset or artwork can be found on the web (an “on-chain record of an off-chain asset”). In some cases, the digital asset may be entirely “on chain” (meaning it is created and stored entirely within the blockchain code).

The key piece of technology that sits behind an NFT is called a smart contract. A smart contract is essentially a piece of code which automatically pays-out royalties to the relevant parties (such as the original creator) each time an NFT is sold and transferred to a new buyer – acting as an effective mechanism to store and distribute the value attached to each NFT on the secondary market.

In short, an NFT acts like a certificate of ownership (or rights) to a digital asset, stored on the blockchain, evidencing the holder of the NFT as the unique owner (or rightsholder) to the work.

What problem do NFTs solve?

One of the great benefits of our modern-day internet is that it made the copying and sharing of information accessible on a mass scale, without any loss in quality in the original work. However, proving ownership over a digital asset became a real problem, especially when everyone else on the internet had a copy (the “right-click save” conundrum).

NFTs solve this problem. By acting as a certificate of ownership, the holder of the NFT can prove that they are the unique owner of rights in and to a digital asset (even if others have a copy), with immutable evidence stored on the blockchain. NFTs therefore introduce scarcity to the world of digital artwork and collectibles, which naturally drives value of the NFTs linked to the most in-demand assets.

The smart contract functionality of an NFT also revolutionises an original creator’s ability to profit from secondary sales of their work. As an NFT is sold from person to person, a percentage of each sale is typically passed back to the creator in the form of a royalty. This is likely to see NFTs find real utility in the world of music rights and event ticketing as the market continues to mature.

Key use cases in the market today

Since the digital asset linked to an NFT can be a digital piece of art, many people treat NFTs as the next evolution in fine art collecting. The most expensive NFT artwork sold to date was The Merge created by Pak, a collection of 312,686 units of mass combined together to form a single artwork, which sold for a staggering $91.8 million.

Other use cases for NFTs in the market today include use in relation to the world of gaming, digital collectibles (e.g. NBA Top Shot), exclusive digital products and avatars, tokens “or passes” which provide specific utility in the NFT world (e.g. the Proof Collective pass), and even skins / fashion drops in the Metaverse.

Buyer beware

Whilst NFTs represent an exciting new frontier for digital rights and value distribution in Web 3.0, anyone looking to enter the world of NFTs should proceed with caution.

The space is rife with fraud and scams at this nascent stage – particularly across Discord, Twitter and on secondary market platforms – with increasing reports of crypto assets being stolen from hacked crypto wallets and unassuming collectors falling victim to “rugpulls” (where a fraudulent NFT project takes in money with the promise of NFTs to come, only for the creators to abandon the project and make off with the cash).

Further, since NFTs do not constitute the asset itself (but instead act as the digital certificate of rights to the asset), this creates some practical issues:

• Often, copyright in the associated artwork will actually be retained by the original creator. The holder of an NFT will not “own” the underlying artwork, but will instead obtain a limited “licence” to use that artwork for personal, non-commercial use. Where this is the case, the NFT creator should always make licensing terms available to buyers at the point of sale (such as on OpenSea). In reality such terms are very rarely made available, which means the terms on which the NFT holder is being licensed the asset can be extremely unclear.
• For reasons related to file sizes and blockchain transaction costs, the underlying asset / artwork is rarely actually embedded into the NFT code (“on chain”), but is rather included by way of a URL link to where that unique asset or artwork can be found on the web. This creates the risk of something known as “link rot” - where the asset at the end of the link could be tampered with, edited, or removed completely by a website owner. If the artwork disappears from the relevant URL, a purchaser could end up holding an NFT that points to a blank or broken internet page!