What are NFTs and How Do They Work?

What are NFTs and How Do They Work?

Blockchain Knowledge

Crypto APIs Team

Feb 24, 2022 • 7 min

NFTs are a type of cryptographic token that represents ownership of unique items and gives proof of their authenticity. These items can either be fully digital assets, such as digital art, in-game accessories, jpeg, or other types of digital files or a tokenized representation of a real-world asset (RWA) such as a piece of real estate. 

Although NFTs have multiple industry uses, such as medical data, food safety tracking, and supply chain management, they have really come into their own within the creative industries. Digital art, avatar collectibles, in-game items, and music NFTs are dominating the market. 

The Cryptopunks collection is one of the earliest examples of NFTs on the Ethereum blockchain. This collection consists of 10,000 “punks”, unique characters all with proof of ownership. The average sale price of one of these algorithmically generated characters is 56.78 ETH ($139,395.01 USD)

According to DappRadar’s Industry Report, NFT sales hit $23 billion during 2021 and the market doesn’t look like it’s slowing down anytime soon. 

The numbers can be surprising especially when you realize that an NFT is not the actual asset. An NFT is more like a digital certificate pertaining to the asset's uniqueness and acts as a guarantee of its authenticity.

For example, let’s say the Mona Lisa is for sale. You purchase it, but you don’t get to walk away with the painting or hang it on your wall. It stays in the Louvre. What you do get is proof of ownership. 

NFTs work in the same way.

What’s the Difference Between NFTs and Crypto Coins 

NFTs are built on the blockchain, the same distributed public ledger technology that is the foundation of cryptocurrencies, such as Bitcoin and Ethereum. In fact, most NFTs are built on the Ethereum blockchain.

Although NFTs and cryptocurrency both run on the blockchain and use similar software and principles (immutable, verifiable, and public) they are not the same thing. 

Where they differ is in their “fungibility”. NFTs stands for “non-fungible tokens”, whereas cryptocurrency is fungible. 

What’s the difference?

The Difference Between Non-Fungible and Fungible

Fungibility is an economic term used to describe the ability of an asset to be interchanged with another asset of the same type. To be “fungible” individual assets must be indistinguishable from each other. For example, fiat currency is fungible because a $5 bill is indistinguishable in value from any other $5 bill. 

In the same way, cryptocurrency is also fungible. 1 ETH (the currency on the Ethereum blockchain) can be exchanged for 1 ETH. They are identical. They have the exact same value and can be freely exchanged, one for the other.

Non-fungible tokens, on the other hand, are unique, they even have unique identification codes that render them distinguishable. They cannot be exchanged as equal values because no two NFTs are the same. 

How are NFTs Created?

The process of creating an NFT is called minting. The concept of it is similar to how physical coins are minted, in the sense that once minted, they become a tamper-proof and immutable asset. Just like a dime coin can never be changed into a paper $5 bill, the digital asset represented by the NFT can never be altered. 

However, they can be purchased, traded, and digitally tracked every time it is resold on the blockchain. This is enabled by smart contracts, software code that stores information that enables the verification of creator, ownership, and transfers ownership. 

Minting an NFT is actually quite straightforward. There are many NFT marketplaces where you can create, buy and sell without any knowledge of code or even of the blockchain. There are many marketplaces to choose from, such as OpenSea, Rarible, and Mintable, and each marketplace will have its own minting process.

Generally, you can expect to follow these steps when creating your own NFT:

  • Choose your NFT marketplace and create an account
  • Create a crypto wallet and connect it to your marketplace profile
  • Add some funds to your crypto wallet (ETH if you’re using an Ethereum based marketplace)
  • Uploading your digital art from any multimedia file
  • Select the file or collection you wish to mint and input the stats, properties, and any details you wish to store in the field boxes provided. 
  • Hit Create, and that’s it. It’s an NFT. You can choose to sell or keep it on display. 

Why are NFTs So Valuable?

The value of NFTs comes down to four things: uniqueness, scarcity, authenticity, and ownership. 

To explain, let’s use a real-world art valuation.

Say you have a Picasso painting. It’s also non-fungible— one of a kind and irreplaceable. There is a sense of scarcity since Picasso is no longer with us the number of original paintings existing in the world is limited. 

Sure, there are countless copies but there can be only one original painting. Its provenance (its traceable history of ownership) is what helps authenticate it as being unique and therefore helps determine its value. 

You could say that ownership creates value.

For example, in February 2021 digital artist Mike Winkelmann, better known as Beeple created an artwork entitled Everydays: The First 5000 Days, which sold for $69million as an NFT via Christie’s.

The digital image is a collage made up of 5000 of Beeple’s previously shared artwork. You can go through his Instagram feed and screenshot any of the individual images and have a copy for free. You can even do the same for The First 5000 Days. 

But the original digital artwork’s certification of authenticity, the NFT, can have just one owner at a time. 

If someone was to try to pass off a copied image as an original on the blockchain, it would be impossible. NFT data is publicly visible on the blockchain and a newly minted NFT would have a completely different identifying number. 

NFTs are solving a problem for the creative industries.

The digital age has given the ability to make exact copies and distribute en masse making it extremely difficult for artists to prove originality, that they are the creator, or to prove the provenance of a piece of work. The concepts of uniqueness, scarcity, authenticity, and ownership have been almost impossible to establish. 

NFTs are changing that. 

How do NFTs Work? 

To understand how NFTs work, we need to look first at the blockchain and smart contracts. 

The blockchain uses cryptography to link blocks of data into a chain of records. Each block is secured by a cryptographic number or hash, that uniquely identifies that set of data. When a new block of data is added to the link, it stores the hash value of the previous block. It means you can’t change one block without changing all the previous blocks. It is immutable. 

A smart contract is a software program that runs on the blockchain. With a smart contract, a user can create rules much like a regular contract, and they will be automatically enforced at a code level. Any details or rules written into the smart contract can’t be deleted and any interactions (such as trading) are irreversible. 

Using these two technologies, creators can time-stamp their original artwork, include a digital signature to prove authenticity, create a verifiable record of provenance, and even stipulate royalties to be paid when resold.

The Benefits of NFTs

When an artist creates an NFT they can enable features with the smart contract that will allow them to be paid a percentage of all future sales, something that isn’t currently available with real-world art.

NFT marketplaces also help emerging artists, who can display and sell art that would otherwise be difficult to find a market for. 

With the ability to prove that they are the original creator, artists can now prevent unauthorized use of their work and monetize artworks that are easily copied.

Although we have focused on the digital art world in order to explain what NFTs are, they have many other industry use cases. NFTs can also be used in real estate to simplify, speed up and secure transactions.

In the medical field, NFTs can safely store a person’s medical records without compromising confidentiality. Or in supply chain management, NTFs give the ability to track products the whole way from source through to shipping and delivery.

Of course, like blockchain itself, NFTs are still very much in their infancy and there are developments happening daily. 

Watch this space.

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