What is an NFT and why do they have value?

Non-fungible tokens (NFTs) are unique digital tokens that are typically connected to a piece of art.

They gained traction in 2017 through a virtual cat breeding game called CryptoKitties and a collection of 10,000 pixelated avatars called CryptoPunks. NFTs experienced another boom in 2021, bringing a Cambrian explosion in the type of metadata, use cases and purposes the technology can bring. 

An individual may purchase an NFT as a way to collect art, support a musician, aim to sell it at a profit, become a part of a community or gain an element within a game. An increasing number of companies, from Taco Bell to Tiffany to Spotify, have explored NFTs.

What is an NFT?

An NFT is a non-interchangeable unit of data stored on a digital ledger, typically a blockchain. It uses cryptographic techniques to provide a digital certificate of authenticity. Unlike cryptocurrencies such as bitcoin or ether, which are fungible and can be exchanged on a one-for-one basis, NFTs are cannot be exchanged on a like-for-like basis. For instance, you can trade one bitcoin for another, but you cannot necessarily trade one NFT for another. 

This uniqueness is what gives NFTs their value. Each token is associated with a specific digital or physical asset, which could range from digital art and music to virtual land. NFTs are most commonly built on the Ethereum blockchain using the ERC-721 token standard, but they can also be created on other blockchains that support smart contract functionality. These tokens have gained significant attention in various industries, particularly gaming and digital collectibles. 

While the NFT's ownership history is recorded on the blockchain, the metadata can be stored through a centralized server or decentralized storage platform such as InterPlanetary Protocol System (IPFS).

ERC-721 is perhaps the most popular token standard for NFTs, with ERC-1155 and ERC-20 following behind. However, there are other types of NFTs as well. Some can even be rented using the ERC-4907 token standard. 

Why does an NFT have value?

The inherent value of an NFT is derived from its distinctive characteristics and the value the market places on those elements. Individuality and scarcity often drive an NFT's value. For instance, digital artworks, rare virtual items in games and other unique digital assets can be tokenized as NFTs, and their value is determined by the demand and willingness of buyers to pay a certain price.

NFTs also possess a digital ownership record that verifies authenticity, adding another layer of value as it provides a proof of ownership. This is particularly important in industries such as fashion, digital art and collectibles, where provenance and authenticity significantly influence the value of an item.

It's worth noting that the value of NFTs is subjective and highly dependent on the demand and the perceived value of the digital asset it represents.

Use cases for NFTs

Today, the use of NFTs extends beyond art and gaming. They are being used to represent a variety of digital assets, including virtual real estate, digital identities and even tweets.

One of the most prominent types of NFTs is associated with the gaming industry. These tokens have revolutionized gaming by introducing in-game economies, where unique traits and accessories, such as weapons and skins, are tokenized. This allows for their transfer and usage across different games, thereby enhancing players' gaming experiences and the economic dynamics of the industry.

Another popular NFT use case is the metaverse, or the future vision of the internet that includes embodied interactions via avatars and virtual spaces. Virtual world platforms such as Decentraland and The Sandbox offer parcels of virtual land as NFTs — some of which have sold for over $1 million.

Musicians have also eyed NFTs as a way to bring blockchain-based verifiability to their work. NFTs augment how musicians receive royalties through their music, bypassing the middle management of record labels. 

Finally, non-digital assets have also become NFTs. A physical home in South Carolina sold for $175,000 as an NFT in October of 2o22. Tattoo artists can use a special tattoo machine that mints their design as an NFT, allowing them to earn royalties each time that design is used. Items with both physical and digital counterparts are called "phygitals" and often rely on NFTs to bridge the two. 

How tokenization works in NFTs

The tokenization process allows for the fractionalization of assets. A fractionalized NFT means that one NFT — say, a very expensive CryptoPunk — has been broken up into a set amount of portions, and those pieces are then sold on another marketplace.

This process has opened up new investment opportunities, particularly in industries like art, real estate and collectibles, where high entry costs have suppressed access.

Energy consumption and sustainability

NFTs are not without their environmental implications. The issue lies primarily in the energy-intensive process involved in creating and transacting NFTs, particularly those built on the Ethereum blockchain. For most of Ethereum's life, the blockchain used a consensus mechanism known as proof of work, which requires substantial computational power and, consequently, a large amount of energy. NFTs minted on Ethereum when it used a proof-of-work consensus system most likely had a large carbon footprint, though it was difficult to calculate the exact environmental toll of an NFT at the time. 

However, partly to ameliorate its environmental impacts, Ethereum switched to a proof-of-stake system in September of 2022. The move dramatically decreased the blockchain's energy consumption and thus carbon footprint. As a result, NFTs minted on the blockchain after the switch had their environmental impact reduced as well. Still, its unclear how the crypto industry should go about addressing the environmental impact of NFTs when minted on blockchains using a proof-of-work consensus system.