NFTs: How Do They Work?
By Sumi Maria Abraham, Research & Development Engineer, Kerala Blockchain Academy
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Non-Fungible Tokens, or NFTs, were popularized by the game Cryptokitties built on the Ethereum blockchain. Later, more and more use cases apart from games were explored, and NFTs grew from mere game entities to millions worth of industry. The Covid pandemic prevention measures increased internet relations and further contributed to the expansion of NFTs. This blog is intended to give an introduction to NFTs for beginners.
History of Collectibles
Let me take you back to the previous century. Collectible hobbies were common during childhood days. Children eagerly collected stamps, coins, toys or even discarded items like chocolate wraps, plant seeds, etc. But it was beyond a hobby for many. Some people built museums out of their collections and were ready to spend considerable money to buy rare collectibles. The actual price of the collectable was much higher than the price of a specific commodity.
Consumer brands further commercialized the collectible hobby. Free toys with snack packets urged more people to consume such items as they wished to grab the limited edition collectibles.
As the digital era progressed, collectibles also took a digital turn.
Digital collectibles refer to unique or limited edition virtual items- image/video/audio files that can be stored and transferred over electronic media.
But unlike physical assets, digital assets have several challenges.
Limitations of Digital Assets
Digital assets can be easily copied and circulated. With the increase in popularity of social media, millions of digital files are getting transmitted daily. But no authenticated method exists to identify the creator or a given file. This issue happens due to the non-regulated nature of the digital space. As a result, the original creator may not get recognition. Even if someone purchases a digital asset directly from the owner, they cannot claim exclusive ownership since there can be copies of the same asset being circulated.
NFTs offer a solution for these challenges faced by digital assets. NFTs provide strict measures to ensure proof of ownership and transparency of asset transfer details. Let’s break down NFT.
N ? F ? T?
NFT stands for Non-Fungible Tokens. Fungibility refers to a property of an asset which makes it identical in value to other assets of the same type. For example, a currency note can be exchanged with another currency note of the same denomination. The same is the case for cryptocurrency. The value per unit of a specific cryptocurrency remains the same irrespective of the wallet holder.
Non-fungibility refers to a property which makes assets unique such that they have different values and hence are non-interchangeable. For example, consider an original painting and its recreated version. No matter how perfect or identical the two works are, the paintings’ value will be different.
Do you remember Kim Kardashian attending Met Gala 2022, wearing Marilyn Monroe’s iconic dress? Have you ever wondered why Kim went for the old dress when she could have easily afforded a new one? Well, even if Kim recreates Marilyn’s dress, its value cannot match the original, which Marilyn Monroe owned. The difference in weight comes from the difference in ownership, which makes that dress a non-fungible asset. Thus Non- fungible assets have different values depending on the ownership.
We also possess various assets which are Non-fungible, like our house, car, passport, certificates and so on.
Though there can be identical ones, none is equivalent in value to another.
Tokens are a representation of value. Recharge coupons, cash vouchers, etc., are examples of tokens representing a monetary value we use daily.
Non Fungible tokens represent the ownership of an asset into a digital token on a blockchain.
What is a Blockchain?
Blockchain is a decentralized, distributed ledger technology. Before heading to the blockchain, let’s understand some basic concepts.
Many people record their daily activities in small pocket diaries, such as excel sheets or mobile notes. Such records of transactions are termed ledgers.
Most enterprises rely on centralized computer systems for ledger keeping. Even we use services like google drive, one drive etc., for data storage. An issue with such centralized systems is that they need more transparency. The users need to find out who can access their data. Even the data can be modified without the knowledge of users.
Many physical asset ownership records are issued and managed by such central entities. For example, if you intend to sell your car, the buyer will verify the registration documents to confirm that you are the legitimate owner. It is the certifying authority and the certificate that guarantees your ownership.
But centralized ledgers cannot be applied to digital assets since they can easily be copied and circulated. Even if someone claims a digital asset, copies of the same will be in the network, making proof of ownership challenging.
In contrast to centralized ledgers, decentralized ledgers are a network of computers (nodes/peers), each holding a copy of the ledger. Whenever data needs to be stored, it will be communicated to all in the network. All of them will keep a copy of the data. These peers may not know each other. Specific algorithms (consensus mechanisms) ensure that all the peers hold the replica of transactions and specific network protocols to approve or disapprove particular requests.
Blockchain is one such decentralized ledger-keeping mechanism where cryptographic methods secure transactions. The pages in the ledger book are termed blocks, and cryptographic attributes, link the adjacent blocks together, forming a chain. Each node in the network holds a copy of the blockchain.
Whenever data is stored, it will be available with all the nodes in the network.
Ownership details and transfer details of digital assets can be saved in blockchain networks. The decentralized distributed nature will ensure that the data remains tamperproof and the ledger entries are trustworthy as blockchain community-certified information.
Lifecycle of an NFT
Once you have a digital asset to be represented as NFT, this can be helped either by an NFT marketplace or by NFT communities supporting artists to convert their creations to an NFT. The artist may also need a blockchain identity handled by a wallet.
Wallets are applications which acts as account managers in blockchain. In a blockchain ecosystem, a user is identified by an account address, which is secured by a secret private key. This is similar to your email address and password. To know more on wallets, check out our blog on HD Wallets.
The conversion of asset ownership to a digital token is called minting. Minting is the process which generates the blockchain representation of an asset. Once the NFT is minted, it can be put on sale.
Minting an NFT incurs a cost called transaction fee which depends upon the blockchain which hosts that NFT. In some cases, user mints an NFT and puts it on sale and in some marketplaces the NFT is minted only when a buyer is willing to buy it. In that case, the transaction fee will be met by the buyer.
Buying an NFT from the original owner is termed a primary sale. Once received, the buyer may have the option to resell it, which is termed a secondary sale.
All the transfers occur via blockchain. Thus blockchain serves as a public ledger with the entire history of an NFT.
Who can benefit from NFTs?
Non-Fungible Tokens can represent any digital asset. It is of great help to digital content creators who can create unique representations of their work, which are digitally signed by the owner and certified by the blockchain community. Since NFTs can be transacted over blockchain networks, the creator can directly reach the audience without depending on or spending too much on third parties. It reduces the hindrances to entry into new markets where creators can monetize their creations like images, music, and artwork. It also minimizes the number of intermediaries involved, improving efficiency and decreasing overhead costs. NFTs are often described as a tool which has democratized art.
Is NFT only for content creators/artists?
No. There are many assets which can be added to the category of digital collectibles. For example, the certificates are non-fungible assets. There are services which issue certificates as NFTs. Instead of carrying a printed document or a PDF, how about using a wallet with all your certificates?
The NFT guarantees the document’s origin and the creator, which certifies that it is genuine. Certify.Social is a service that issues certificates as NFTs.
NFTs can also serve legal notices. Last year, LCX AG, a cryptocurrency exchange based in Liechtenstein, was subjected to a cyber attack in which it lost $8 million worth of digital assets. Apart from the address that holds the stolen assets, no other information is available about the attacker. Upon receiving the complaint from the New York court permitted, the exchange to serve the wallet address with an NFT containing a hyperlink to the required legal notice documents [news]. Though the personal identity of the attacker is unknown, the wallet address (a unique alphanumeric string) — used for the fraudulent transfer of assets is publicly available to everyone on the blockchain. The hyperlink embedded in an NFT ensures that the sender knows when the NFT is opened, indicating that the receiver viewed the court documents. This allows for a quick and easy way to alert the unknown party without risking the legal notice being lost during delivery or tampered with. Serving legal notice via NFTs was approved by some other courts also.
NFT Ticketing is an idea to issue tickets to events as NFT. Unlike classic tickets that lose value after an event, NFT tickets can be kept as digital purchases or resold for profit.
Is NFT Legal?
Many countries have special laws to deal with blockchain and cryptocurrency transactions. The rules are different in different countries. There are no laws which declare NFT illegal in India as of now. In India, NFT is considered a Virtual Digital Asset (VDA,) and the income generated from NFTs is taxed at 30%. Also, NFT transfer does not transfer the copyright of the underlying digital asset. If someone buys a painting as an NFT, they only get the copyright to re-use the image if it is explicitly mentioned in the terms and conditions.
Challenges of NFTs
Though NFT is a concept that can be expanded to various use cases, there still needs to be more awareness about this technology. A proper legal framework for NFTs also prevents enterprises from trying this technology.
There is a distinction between holding an NFT of an artwork and holding the copyright ownership of an artwork. NFTs are not subject to digital rights management and can be accessed by anybody and many users simultaneously.
NFTs are priced at a cryptocurrency, which is volatile. The usual ups and downs of cryptocurrency affect the NFT marketplaces also.
What will be the future?
With the high demand and participation in the digital space, NFTs are expected to thrive. NFTs are reported to lay the foundation for a brand’s digital transformation. Many well-known brands- Adidas, Gucci, Lamborghini and celebrities- Paris Hilton, and Amitabh Bachchan, are creating and endorsing NFT Collections.
Enterprises are more interested in the operational transparency and proof of ownership offered by NFT. As a result, various use cases to represent assets as NFTs are under research.
Though NFT marketplaces face demand fluctuations subjected to market trends, the technology and the idea are expected to grow and benefit our social life.
Image Courtesy: Flaticon