How do they work? All you need to know about Non-Fungible Tokens…
NFT means Non-Fungible Token. These tokens are blockchain-based, programmable deeds of ownership to an asset. This digital deed gives its holder the exclusive ability to use, sell and transfer the asset’s ownership rights, as dictated by their private key signature.
These rights could pertain to resale, physical redemption, digital functions, financial benefits or other intangible rights. The NFT does not necessarily “contain” the asset but rather is a programmable record of ownership with an inbuilt pointer to the asset location.
Fungibility refers to the interchangeability of the asset. Bitcoin and fiat currencies are fungible because there’s no difference between each unit. Non-Fungible assets are unique and cannot be interchanged seamlessly — e.g. houses or rare art. Non-fungible tokens represent unique assets on the blockchain.
“Semi-fungibility” is a relatively new term and refers to interchangeability between specific classes of assets. For example, concert tickets can be interchangeable if they are for the same show and the same booth or seating area. Note that these types of assets can change in fungibility over their lifetime.
In which cases are NFTs being used?
By now, there are six popular categories of NFTs, Collectibles, Art, Metaverse, Sports, Gaming and Utility.
Collectables are a limited set of NFT art, items, or ‘cards’ with varying attributes and scarcity. Collectables are popular to trade partly due to standard attributes across a collection, enabling rarity valuation models.
NFT Art is generally digital content: images, music and videos. Sometimes there is a physical item accompanying the NFT, but this is not always necessary. The NFT may have some function or offer rights to the owner, such as participation in a future art piece or access to exclusive content. Art NFTs often have inbuilt royalties, which pay a percentage of all future sales back to the original artist/creator.
Metaverses are networks of virtual environments where people can interact with each other, digital objects and the physical world through their avatars. While most compare metaverses to virtual reality experiences like in The Matrix, metaverses are more related to ownership of digital assets and identity across cyberspace. NFTs enable this with blockchain ownership and immutability, enabling continuity of one’s avatar and digital items across platforms.
Sports NFTs are used to represent sports collectables, community participation rights and event ticketing. Many of the collectables represent highlight moments from games which users can trade, similar to physical sports trading cards.
Gaming NFTs represent in-game assets, such as items and property, which have functional uses in the virtual world. Players in blockchain game economies have the opportunity to generate revenue, innovate, create, and have a true stake in the game world. Applications are becoming increasingly sophisticated as in-game economies and “play-to-earn” monetization models mature.
Utility NFTs provide the owner with some functional or monetary rights, usually in a digital platform context. Domain names and insurance NFTs are two popular applications today
In the next article, we will talk, also, about enterprise use cases of NFTs.
Which are the Drawbacks and the Risks?
The NFT market is a highly volatile, illiquid, nascent market riddled with pricing inefficiencies and unregulated transactions, and it often appears to be driven by speculative mania more so than by value. Participation in NFT creation, trading or service provision, therefore, carries all the speculative risk associated with early-stage financial technology, and due diligence is required to avoid monetary losses and legal penalties. Price manipulation from insider trading, influencers and other deceptive practices are common.
Blockchains are still an emerging technology with many underlying risks of malfunction, hacks and exploits. Protocols such as Ethereum have been extensively developed over many years, with market exposure stress-testing the technology, but even recently, exploits have still occurred. In general, larger projects have more proof of stability than obscure and speculative technology.
Similarly, while some alternative chains have a record of extensive use over many years, a slew of new chains are emerging, that carry a higher relative technological risk. Beyond NFT infrastructure, the ecosystem stack itself poses technological risks. Platforms built on top of layer-one and layer-two scaling solutions and emerging ERC token protocols do not necessarily have the same level of testing as the underlying reliable blockchain. Marketplaces, DApps, storage solutions and DeFi smart contracts all carry technological risk.
One strategy for mitigating this risk is to choose the largest, longest-running and most reputable infrastructure providers when dealing with NFTs. Insurance options, centralized or decentralized, may prove to be another viable strategy for mitigating inherent technological risk.
Origination Problem and Fraud
The origination problem is the issue of fraudulent NFT creation and monetization, often by the imitation of an established creator. The pseudonymous cryptocurrency market and lack of legal regulation leave plenty of opportunity for malicious actors, with little consequence. This could involve downloading an artist’s digital works and reselling them as NFTs, or tokenizing an influencer’s tweets and auctioning them off as NFTs without the influencer’s knowledge.
Shill bidding is the artificial inflation of prices from colluding bidders who do not intend to actually win the auction. This could be collusion with the marketplace or with the NFT vendor directly. Shill bidding is a well-documented form of price manipulation for auctions outside the NFT market and the pseudonymous nature of cryptocurrency makes it even easier with NFTs.
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