Non-fungible tokens (NFTs) are the latest advancement in the ongoing evolution of the blockchain market. To help put this new phenomenon into context, the BakerHostetler Blockchain team has prepared a series of papers that examine NFTs from various perspectives. In the first paper in the series, we introduce NFTs from the technological and market perspectives. Forthcoming papers will rely on the concepts in this introduction as we analyze the multiple legal issues arising from this new technology.
What is an NFT?
An NFT is a digital collectible. An NFT is a cultural phenomenon. An NFT is digital art. An NFT is a digital signature on art. An NFT is a new asset class. There are, for better or worse, many, many ways to answer the question "What is an NFT?" Sometimes, the answer's simplicity is inversely proportional to its accuracy. But even the more jejune answers to the question "What is an NFT?" provide insight into what an NFT actually is.
An NFT is a digital collectible—something with no physical existence or intrinsic value, but with a value based on popularity. An NFT is a cultural phenomenon akin to a Rubik's Cube, Beanie Babies, Pokemon or Dogecoin. NFTs have a relationship to digital art and can indicate that an artist has blessed a certain copy of art—similar to a signature. And NFTs are clearly an emerging asset class—in 2021, at least $44.2 billion of cryptocurrency was transacted in the NFT market.1 But while these types of answers describe traits or aspects of an NFT, to get that deeper understanding, it is helpful to have a more technical understanding of "What is an NFT?"
NFT stands for non-fungible token. In brief, an NFT is a one-of-a-kind digital asset created, stored and transferred on a blockchain network, with ownership and transaction history recorded and verified on that network's blockchain (i.e., digital ledger). This means that the owner of an NFT can prove—without the need for a third-party intermediary—that they are the verified owner. Though typically used to display and transfer data referring and pointing to online digital media files, such as digital artwork, NFTs also have the potential to be used to represent actual ownership of any intellectual property associated with the digital files as well as physical items, such as real estate. While fungible assets, much like dollar bills, can be replaced or exchanged with other identical ones of the same value, NFTs are unique, meaning no two NFTs are the same.
An NFT is a "Token"
The "token" part of NFT means that like other "digital assets" such as bitcoin, ether, Ethereum Network tokens (e.g., ERC-20 tokens), and other "cryptocurrency" tokens, an NFT is essentially digital code that contains certain information and that is created, stored, and transferred on a blockchain network. From a technical perspective, NFTs that exist on the Ethereum Network, for example, are traditionally ERC-721 tokens.2 Like all other cryptographic assets, the "token" part of NFTs cannot be copied or counterfeited, and can exist only in one specific place at any given point in time on a blockchain.
A blockchain is a digital ledger. This ledger keeps track of a token's ownership and details of the token's transfer. Once a transaction is recorded on a blockchain, it cannot be changed. For example, ether is a cryptocurrency token that exists on the Ethereum Network, and therefore every transaction of ether can be viewed on the Ethereum blockchain. So if Bob sends Alice five ether on February 18, 2019, at 3:37pm CST, a timestamped record of that transfer will indelibly exist on the Ethereum blockchain.
Like the ether transaction, the creation and transfer of ownership of an NFT is recorded on the blockchain to which it belongs. If Bob buys an NFT from Alice on a given date, and that NFT was created on and exists on the Ethereum blockchain, a record of the transfer of that ERC-721 token (i.e., token that is native to the Ethereum protocol) will exist indelibly on the Ethereum blockchain. If an NFT is created on a different blockchain, for example, the Solana blockchain, and Bob buys an NFT from Alice on a given date, a record of that transfer will exist indelibly on that other blockchain, in this case the Solana blockchain. This means that at any given point in time, the owner of an NFT can point to the relevant blockchain and prove that they are the one and only owner of that NFT.
An NFT is "Non-fungible"
Every NFT is different from other NFTs, hence the "non-fungible" part of the name. Non-fungibility may best be understood by first looking at its antonym—fungibility. A dollar, for example, is fungible because one dollar is functionally the same as another dollar. If Bob borrows five dollars from Alice, Bob can repay Alice with any five dollars—he need not pay her back with the same exact five dollars Alice originally lent him. This is because dollars are fungible. In the same way, cryptocurrencies are fungible. If Bob borrows five ether from Alice, Bob can repay Alice with any five ether. This is because ether (like cryptocurrency in general) is fungible.
Not so with NFTs. Each NFT is distinct from every other NFT by virtue of a unique identification code and associated metadata that are embedded into the NFT in the moment that the NFT is created on its underlying blockchain. This is similar to any other type of unique identification number (UIN), such as a bar code on the back of an event ticket or a grocery store item. However, while traditional UINs can be altered by the third party that hosts the UIN database, the unique identification code and metadata of an NFT cannot be altered because they are recorded on the underlying blockchain. The unique identification code and associated metadata that are embedded into an NFT at creation are immutable and verifiable in the same way that the transactional history and record of ownership of blockchain "tokens" are immutable and publicly available for anyone to view and verify.
Another technical feature of NFTs that contributes to their "non-fungible" character is that NFTs are, by operation of their technical code, non-divisible. Cryptocurrencies can be subdivided into decimal fractions. In contrast, NFTs exist on the underlying blockchain only as whole numbers.
An NFT Links to a Media File
The characteristics of NFTs, as described above, may lead to their adoption for enhanced record-keeping in the physical world, such as in product supply chains or property title registries. However, over the past two years in particular, NFTs have become most known for their ability to record ownership of digital media. This is accomplished by programming NFTs with code that provides a link to a digital image, song, video, tweet or other media that exists in digital form—for ease, we call this referenced asset the "NFT Media."
The NFT is separate from the NFT Media. While the NFT exists on its underlying blockchain, the NFT Media exists in a separate digital database—often a traditional centralized or cloud-based database or a decentralized database like the InterPlanetary File System (IPFS). By programming the digital location of the NFT Media into the NFT, the NFT is forever programmed to "point" to the location of the NFT Media. In this way, the NFT serves to verify that the NFT Media is the original, official or genuine version of the media file. This is incredibly important in a digital world, because a digital file can be copied an infinite number of times.
An NFT can make one version of the media file—the NFT Media— unique, and therefore more valuable, than other copies that are not attached to the NFT. In this sense, the NFT Media is similar to a photograph that is part of a series that was signed and numbered by the photographer. While many copies of a photograph exist or can be printed, there is only one version with a particular number, accompanied by that particular photographer's signature. Like the number and signature, an NFT is a unique identifier that adds value to the NFT Media. But whereas the photograph's numbering and signature physically exist on the photograph, the NFT is digital code pointing or linking to where that particular copy of the NFT Media is stored.
Where is the NFT Media?
Generally speaking, there are two predominant methods for storing the NFT Media that is referenced/linked in the metadata of the NFT. Each method has its own benefits and risks, and the pros/ cons, best practices and pitfalls of each method are still subjects of debate. One way is to store the NFT Media with a location-addressed URL that is directed to a private, centralized server. This can be a private server, but the more common approach is to use an account at a cloud provider, such as Amazon Web Services. The alternative approach is to store the NFT Media on a decentralized storage network, such as the IPFS. There are pros and cons to each approach. The key distinction between the two methods is that if the NFT Media is stored in a private cloud account, the NFT Media can be deleted or altered by the owner of the account. In contrast, NFT Media that is stored on IPFS generally cannot be altered or deleted.
NFT Marketplaces
NFT marketplaces are online platforms where NFTs can be stored, displayed, bought, sold and, in some cases, minted. Marketplaces vary in the types of NFTs they support, fees charged, services offered, terms of use, level of security provided and other factors. In order to fully utilize any particular marketplace, users first need to set up an account with that marketplace. They also need a cryptocurrency wallet that is compatible with the blockchain network on which the NFT is minted. For example, buyers and sellers of NFTs that reside on Ethereum, such as ECR-721 tokens, need a compatible Ethereum wallet, like MetaMask or MyEtherWallet. For Solana-native NFTs, users need a wallet such as Sollet. The wallet should be prefunded, as even listing and minting NFTs on a marketplace often incurs a network and/or marketplace fee to be paid in cryptocurrencies. The NFT's actual sale price is usually set in a cryptocurrency denomination, although some marketplaces will also accept fiat currency.
For NFT transactions, sellers select the NFT to sell from their wallet, list it for sale on the designated site within the marketplace and either set the NFT's price or sell the NFT through auction. Sellers can also usually set the duration of time that the NFT will be available for sale or auction. If the seller has not yet created an NFT and only has the NFT Media at this point, many marketplaces offer minting services for a fee. In this case, the creator/seller uploads the NFT Media onto the marketplace and follows certain prompts to create the NFT. Once the minting is done, the marketplace deducts the fees from, and transfers the NFT to, the creator/seller's wallet. In order to purchase the NFT, a buyer can search the NFTs listed for sale on that marketplace to find the one they want. Then, provided they have a compatible wallet and sufficient funds, the buyer can follow the marketplace's prompts to participate in the NFT's sale. If the sale is accepted, the marketplace facilitates the transaction by debiting the sale price, and the transaction fees, from the buyer's cryptocurrency wallet and transferring the NFT to the buyer's wallet.
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Footnotes
1. Report Preview: The 2021 NFT Market Explained.
2. ERC-721 refers to a certain token standard on the Ethereum Network, i.e., a set of rules that define how that type of token is created and can operate. There are also Ethereum Network tokens created under other standards, such as ERC-1155 tokens, that are used for NFTs.
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