NFTs ("Non-Fungible Tokens")

By now you must have heard of non-fungible tokens, or “NFTs” as they are often called. I had heard the term but didn’t really pay much attention to NFTs until the much-publicised sale at a Christies auction in early March of Everydays: The First 5,000 Days by artist Mike Winkelmann, known as Beeple. This digital

piece of work in the form of an NFT, illustrated here, sold for an amazing $69.3 million, which I understand to be the third largest amount ever paid for a piece of art.

Naturally, this new marketplace suddenly had visibility and momentum, drawing in other artists, musicians, sports celebrities and famous people:

• NFL player Rob Gronkowski – sold a series of NTFs under the moniker “Rob Gronkowski Championship Series NFTs”, generating $1.8 million,

• Elon Musk – developed an electronic music track about NFTs to be sold as an NFT but after receiving bids of over $1 million withdrew the item for sale,

• Twitter and Square founder Jack Dorsey – sold his first tweet as an NFT for $2.9 million,

• The Kings of Leon – released an album “When You See Yourself” as a limited edition NFT, generating around $2 million, and

• Snoop Dogg – released an NTF collection entitled “A Journey with the Dogg “ that included various memorabilia and an original song about NTFs.

It is hard to predict if NFTs are a fad or something that will stick, but they have drawn plenty of attention. Even The New York Times jumped on the NTF bandwagon, or rather allowed one of its journalists to do so. Kevin Roose, an author and technology columnist at NYT, minted an NFT of his column about NFTs.

Mr Roose wanted to see how the process of an NFT worked, so all proceeds – should any materialise – would be directed to a charity. Although expectations might have been modest initially, the auction had such strong momentum in its closing stages that the NTF of the column – which you can read here (for free) – sold for a remarkable $560,000 to a buyer apparently based in Dubai, @3fmusic. You can listen to how the sale of this NFT unfolded in a very interesting audio podcast in The Daily (April 13th, here, circa 33 minutes), in which Mr Roose walks through the process of minting and selling the NFT containing his article.

Although there are a variety of reference materials available about NFTs, I wanted to research and write about some of the more salient points of these new digital ownership vehicles in a concise article, a suggestion in fact from one of my subscribers. I have kept this article reasonably “high-level”, providing links to articles should you wish to dig deeper. Or better yet, if you really want to test the waters, why not create your own NFT? I am thinking about doing this for this very article, just to better understand how the process works. Have no fear because my expectations are low – in fact very low ­­– but by creating an NFT myself, I might be able to better understand how the process works as far as minting and selling an NFT.

What exactly is an NFT, or non-fungible token? NFTs are digital tokenised assets represented by unique digital files, which are placed in and transferred via a blockchain, usually Ethereum. Digital file formats can include JPGs, MP3s, GIFs and videos. You might have first heard of blockchain in the context of cryptocurrencies, like Bitcoin, which rely on blockchain technology because these currencies are only digital (i.e., they do not exist physically like fiat currencies). Blockchain, similar to a ledger, is a type of database in which blocks of data are connected together in chronological order digitally. Each block of data has a digital timestamp, in essence creating an irreversible timeline. These blocks are stored in a decentralised format, meaning that thousands of computers have records of the various blockchain transactions, making it nearly impossible to alter or forge as far as the historical record. Blockchain technology is best known in the context of cryptocurrencies, but the blockchain has much broader uses, one of which is for so-called “smart contracts”, an essential part of an NFT. An NFT contains not only the digital image, but also unique information about the file which is embedded via a smart contract. Should you want to learn more about the blockchain and how the blockchain actually works, Investopedia has a very comprehensive article – “Blockchain Explained” – that you might find interesting.

Ethereum, which again you have probably heard of in the context of the second most popular cryptocurrency (Ether), seems to be the blockchain of choice for NFTs. Ethereum is much more than a cryptocurrency blockchain, having from its inception in 2015 articulated its objective to “enable the deployment of smart contracts and decentralized applications to be built and run without any downtime, fraud, control or interference from a third party” (source: Investopedia here). The Ethereum website (here) has a very good article on how the Ethereum blockchain actually works with NFTs.

NFTs have a unique URL address in the form of a series of alphanumeric characters representing a unique piece of digital content. As the first two words of the acronym suggest, an NFT is non-fungible, meaning there is only one unique digital footprint of the item. NFTs are different from cryptocurrencies, which are fungible, meaning that one Bitcoin can be exchanged for another Bitcoin, but the Bitcoins are indistinguishable, i.e., they are fungible. The digital content of an NFT can be copied, just like a print can be made of a famous original painting. However, the additional information aside from the digital image (in the form of a smart contract) cannot be replicated, and this information – just like the artist’s signature on an original painting – is exclusively in the original NFT. This is in essence what provides the scarcity value, as with any unique piece of art.

There is one subtle point that needs to be made as far as the rights of NFT owners. Ownership of the NFT does notconfer ownership of the copyright of the digital asset, which remains with the creator of the NFT unless otherwise specified. Therefore, the owner of the NFT cannot print or distribute the digital work without permission of the creator, a topic on which this article from media law firm Odin Law & Media focuses. As the article says very clearly: “The individual who purchases the NFT undoubtedly gets the ability to buy and sell that specific NFT. That’s all they get. An NFT ownership interest does not give any rights to any intellectual property. Instead, it gives interest in the literal digital file purchased. The digital file could be literally anything. It derives value from the file’s scarcity, not the image.”

Another interesting complication of an NFT is that the creator could theoretically make multiple copies of a nearly-similar digital asset and sell it over and over. For example, by altering the colour slightly of one pixel on a JPG file that contains millions of pixels, such a digital file would be hardly distinguishable from the “original”. Yes, the altered NTF would be unique, different than the first, but it would violate a morale principal of the market. The best I could take away from my research on this matter is that the creator of the work underlying the NFT is essentially on the honour system to not sell multiple copies, or near copies, of the same piece of work, unless this is clearly disclosed in cases where limited editions for example are minted and offered.

NFTs can represent about anything. Aside from the most popular digital assets – art or music – NFTs can also be drawings, sports cards, articles/written works, games, or even tweets, anything for that matter that can be converted to digital format. The special appeal to musicians and artists in particular is that the owner of the digital token representing the work is known through the blockchain, as are subsequent transfers of the NFT. As such, most creators of NFTs build in a royalty feature whereby the creator receives a royalty payment on future transfers of the digital asset. The royalty amount can be set by the creator at any level he or she wishes, but normally ranges from 5% to 20% on the incremental value of future transfers. The only drawback though is that the NFT has to usually be sold on the same platform on which the NFT was created, or the royalty will not necessarily be automatically deducted and paid. Still yet, the royalty mechanism enables the creator to receive compensation on subsequent transfers in most cases, which means collecting such payments is built in, not a feature of the physical art market today. Imagine a famous artist selling a physical painting for $250,000, which is later sold to another buyer for $5 million. The artist would not receive any remuneration on the subsequent sale, a loophole NFTs aim to close.

NFTs are not without criticism from an environmental perspective as the blockchain, which is the backbone for NFTs, consumes large amounts of energy and is not carbon neutral. Much of the environmental attention regarding carbon emissions and sustainability with respect to blockchain technology has been focused on cryptocurrencies, mostly Bitcoin, because mining the coins uses a tremendous amount of energy. However, running a blockchain is also not currently sustainable. Ethereum, the blockchain of choice for NFTs and most “smart contracts”, use a technology known as “Proof of Stake” that is considered much more efficient than older technologies used by Bitcoin and some other legacy cryptocurrencies. Still, it is a far from net carbon neutral. An article I read in “Artnet news” about blockchain sustainability (here) said the following: “…in 2018, Ethereum used more electric energy than Iceland, so it is still far from environmentally friendly.”

If you are wondering how to create and sell an NFT, the process is as follows:

1. “Minting” the NFT, meaning essentially registering the piece, verifying oneself as its maker, and confirming its status as either a unique or limited-edition digital asset. A URL address in the form of a series of unique alphanumeric characters is provided for the NFT, and this URL is often linked to another file that contains the actual digital asset.

2. The NFT is offered for sale through an intermediary, of which there are several, that provides an online marketplace platform. These include for example makersplace, Autogragh, OpenSea, MetaMask, Crypto.com, SuperRare, Enjin, KnownOrigin and Mintbase. This step also involves the creation of the terms of sale, represented as a “smart contract” on the blockchain.

3. The NFT is sold, the asset is transferred to the buyer, and the proceeds of the sale are transferred to the creator/artist, usually in the form of a cryptocurrency.

I suspect NFTs will continue to flourish because this interesting digital transfer mechanism relies on a technology – blockchain ­– that will certainly be gaining more traction, assuming it is not slowed or derailed by environmental concerns before it can improve its carbon footprint. NFTs will likely prove to be increasingly useful to a variety of artists, including painters, musicians, photographers, sports stars, gamers and others, involving any sort of creative asset that can be tokenised. From a buyer’s or investor’s perspective, NFTs provide strong protection against fraudulent works of art, enhancing the uniqueness and protecting the integrity of the work. However, I suspect that NFTs will encounter plenty of speed bumps along the way, similar to what we have seen in the cryptocurrency market, simply because the market is nascent. I also suspect that the market for NFTs will be highly volatile, subject to self-promotion and perhaps blatant manipulation to drive up prices. In this respect, the NFT market might not be terribly different from many of the bubbles we see from time to time in other asset classes, especially at the moment, driven by FOMO and unprecedented amounts of monetary and fiscal stimulus.

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