CGU ACADEMY: The Reality of NFTs

Non-fungible tokens are one of the hottest things to come out of the blockchain space. Treated with equal parts excitement, cynicism and confusion, depending on who you ask, NFTs are establishing themselves as a vital part of the Web3 and metaverse space.

As with any new and fast-moving technology, the reality is more nuanced than any single enthusiast, critic or mainstream media commentator will suggest. There are, of course, strengths and weaknesses, opportunities and pitfalls in the NFT movement – and the best way to make good choices is to ensure you’re well informed.

1. What are NFTs?

Regular tokens that represent ETH, BTC, LINK and many other well-known digital assets typically have a supply of millions or billions, and it is possible to send or transact any fraction of them. For example, a user might exchange $1,000 for 0.524 ETH.

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By contrast, non-fungible tokens (NFTs) are single or limited-edition, indivisible blockchain tokens. They cannot be split into fractions, and only one (or a relatively small number) of tokens exist. Users own either a whole token, or none at all. 

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NFTs have come to global prominence in the last two years as a new and promising branch of blockchain technology that makes it possible to trade digital art, though they have many other use cases. The NFT movement has attracted celebrities, household brands, and high net-worth individuals, as well as large numbers of retail investors.

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While it’s relatively easy to establish ownership of a physical painting, digital art is more problematic. Digital images can be copied and shared by millions of people, so it’s impossible to say who an image truly belongs to. NFTs have been used to address this problem.

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When an artist creates a digital image, they generate a unique hash – a kind of cryptographic fingerprint – which is then linked to an NFT. Since there is only one NFT, it acts as a certificate of ownership. The digital image is hosted on the internet, and the record in the NFT points to the location in which it is stored (which is often on IPFS, the InterPlanetary File System – a decentralised file storage network that avoids some of the problems of centralised hosted storage). The images can still be copied, but there can only be one owner of a token, which can be transferred and traded.

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This is similar to the situation for a regular physical painting. Anyone can own a copy of a famous artwork, such as the Mona Lisa. However, everyone knows and understands that these copies are not the original no matter how well they have been copied. 

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These properties mean that NFTs have facilitated the rise of a huge market in digital art, with tens of billions of dollars of NFTs changing hands in 2021. While there were some huge, well-publicised sales (including Beeple’s $69 million artwork, Everydays, sold by Christies in March 2021), the majority of sales were less than $10,000, indicating that smaller retail traders were dipping their toes into an exclusive market that had previously been inaccessible to them.

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NFTs therefore make it possible to register and track ownership of digital goods, and trade them on global online markets that anyone with an internet connection can access. As well as artwork, examples of NFTs include music, video, video game characters, inventory and skins, and even less tangible items such as blockchain-hosted domain names. 

2. The History Of NFTs

The first use cases of NFTs have been digital art, and this is how the technology has risen to global attention.

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The earliest NFT is generally thought to be a piece of animated, octagon-shaped art called Quantum, created by Kevin McCoy. While most NFTs nowadays exist on the Ethereum blockchain, Quantum is notable because it was minted on the NameCoin blockchain back in 2014 – before Ethereum even existed. Quantum was later migrated to Ethereum, because the blockchain has much greater adoption. 

NFTs remained a niche interest area until 2016, when Larva Labs brought out the CryptoPunks collection – a run of 10,000 semi-generative, pixel art images. CryptoPunks were an experiment and could be claimed for free by any user, and the collection soon minted out. As one of the earliest series of NFTs, they have gained blue-chip status in the crypto world, and now change hands for hundreds of thousands or even millions of dollars.

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CryptoPunks – as a limited-edition run of artworks with different traits and ‘rarity’ scores – proved to be a popular template for later digital art projects. Because NFTs are blockchain tokens, and the records for all the images they represent can be transparently checked by any user, it is easy to score and compare images according to rarity. In this respect, trading NFTs is similar to trading rare baseball cards and other physical collectibles. The model has been replicated thousands of times, most successfully by the hugely popular Bored Ape Yacht Club (BAYC).

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Much like the altcoin bubble in the 2017 bitcoin market cycle, NFTs became a craze that saw enormous crypto adoption in the last bull run, with incredible hype around the most noteworthy projects and some almost unbelievable valuations for top artworks. 

While the hype, and valuations, have cooled since the peak of the market at the end of 2021, NFTs continue to see significant interest. Even if individual projects may have become overvalued, NFTs as a technology do offer significant advantages and address some of the problems of the conventional art market:

• Accessibility. The traditional art market is highly exclusive. It’s difficult for ordinary investors to become involved, unless they know the right people or have particular connections. Anyone can visit OpenSea or other NFT marketplaces and buy an NFT, or place a bid.
• Liquidity. Due to the exclusivity of the market, it can be hard to buy or sell physical art; there probably won’t be many buyers and sellers, except for the best-known paintings. Again, NFT marketplaces solve this problem.
• Security. It’s impossible to forge an NFT, because they’re secured by cryptography and stored immutably on the blockchain. 

However, NFTs have relevance for a growing list of use cases beyond digital art.

3. The Growing Utility Of NFTs

As blockchain-based assets, NFTs offer diverse benefits to creators and investors alike. They democratise the art space, making it possible for anyone to launch a collection or invest in art. They also offer new opportunities to users because, as software, they are programmable assets and can easily be plugged into additional blockchain functionality. Just some of the fast-growing list of functionalities and use cases include:

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NFTs as a source of income and recognition for artists

NFTs have become a popular way for artists and musicians to launch new collections. So long as they have an online following, they can sell directly to the community. Established musicians have used this as a way to access new markets, and unsigned indie musicians have been able to generate an income without the backing of a major record label. Unsigned artists can make more money this way than they would using a conventional platform like Spotify. Unsigned singer-songwriter Iman Europe, from California, made over 22 ETH (nearly $60,000) by selling five singles and a music video as NFTs. Artists can even crowdfund new music, as Daniel Allan did, selling 50 ETH of NFTs to make his EP Overstimulated. Artists can offer exclusive benefits to superfans, and even receive a percentage of royalties from future sales of their NFTs, giving them a long-term income.

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NFTs as a new asset class

Crypto is a new asset class, but within that, there are different types of asset – including BTC (digital gold), platform tokens like ETH and BNB, utility tokens (e.g. BAT), governance tokens (COMP, AAVE), and NFTs. 

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NFTs can be used to represent any rare or unusual item, whether digital or physical. Digital art is a major use case, but diamonds, classic cars and other real-world assets have been tokenised, as well as more unusual financial assets such as accounts receivables (outstanding invoices), enabling anyone to hold and trade these easily.

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NFTs as a signal of belonging to a specific community 

One of the less tangible but hugely significant uses for digital art NFTs is that they are widely used as profile pictures (PFPs) on social media, signifying affiliation to a particular community. The most noteworthy examples of this are Bored Apes and CryptoPunks, since these high-value NFTs have become status symbols, indicating ‘OG’ or early adopter status in the crypto world.

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NFTs in the gaming world

One of the biggest use cases for NFTs outside of digital art is in the blockchain gaming sector. NFTs are used to represent in-game characters and items, with the most famous example being Axie Infinity. This means players can develop their characters by gaining experience and succeeding in battles, then sell them to other players at a profit – with the most valuable Axies trading for thousands or even tens of thousands of dollars – as well as earning currency tokens (SLP) along the way. This model has been replicated across many other play-to-earn (P2E) games.

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NFTs as an access pass

Because NFTs are unique blockchain tokens that can only be owned by a limited number of people, they can be used as entry passes into games, metaverses, and other applications. Axie Infinity is a good example of this, since players need three Axies to get started. Bored Ape NFTs allow access to the Bored Ape Yacht Club, including both online and in-person events. However, NFTs don’t need to represent digital art or gaming characters to have this use case. An NFT can be used as a password to a site, a subscription to a service, or premium features. When the user no longer wants or needs access, they can sell it on the secondary market. Many Discord communities have closed groups that can only be accessed by NFT holders.‍

NFTs as a global digital pass

The extension of this idea is that an NFT could be used to register for a wide range of Web3 sites. In the same way that users display prized NFTs as their PFPs across social media, so they could use them to access many different services, rather than dApps issuing their own NFTs to signify membership. This would make a user’s NFT a kind of global access pass for all of their online activities – without needing to track different usernames and passwords for dozens of different sites.

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4. The Potential Drawbacks Of NFTs

Like any new technology, NFTs have their pros and cons. They are not a panacea to all of the problems of Web2, and there are some pitfalls that users will need to avoid. 

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Illiquidity and volatility

Because NFTs have low supply, and it’s not possible to buy or sell fractions of them, liquidity can be very limited. That means that in a bull market, or when a project launches and there is lots of interest and confidence, it can be easy to buy an NFT – but when the hype cools, there may literally be no buyers. If you have to sell, you might end up being forced to settle for a price far below what you paid, or even far below the most recent price other NFTs in the same set have traded for. In short, be careful, and understand that while NFTs can be extremely valuable, you may end up with a token you can’t sell.

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Scams and ‘rug pulls’

The unregulated and often anonymous nature of the NFT space means that holders can end up losing money through fraud. NFT teams may collect money based only on a concept or on a small number of sample images, and then disappear when the project has minted out – something known as a ‘rug pull’. 

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NFT holders also need to be watchful for various types of hack and scam, particularly phishing attacks. Some of the most common tactics are taking over projects’ Discords to post fake websites that compromise user’s wallets or sell fake NFTs, or that install keyloggers or other malware on their computers. If you are in any doubt, use a ‘burner’ wallet for NFT mints – a newly-created address that only contains a small amount of ETH.

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Undelivered promises

Other rug pulls are less malicious but still costly. Sometimes, artists or teams are simply unable to deliver on the promises they made, perhaps because their vision was too ambitious, or because they didn’t collect enough funding. This means the project ultimately stalls, leaving the community holding useless tokens.

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Environmental harm

NFTs that exist on Ethereum have also come in for criticism due to the environmental impact of proof-of-work mining, which secures the Ethereum blockchain and involves thousands of energy-hungry computers. However, with the coming launch of Ethereum 2.0, the network will move to proof-of-stake, which will reduce its carbon footprint – currently equal to that of Switzerland – by 99.95%. 

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5. The Future Of NFTs

NFTs have a bright future as one of the core technologies of the metaverse and Web3. At present, they are best-known for their role in facilitating digital art markets, which has made them controversial and in many cases confusing to people, who (perhaps understandably) don’t always grasp their full significance.

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However, NFTs are far, far more than a way of registering digital art, or even in-game characters and other items. They are unique, cryptographically secure tokens that are owned by one and only one account, and that can be programmed with additional instructions and information. This will make them the keys to the decentralised web in all its forms.

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In the future, users will own NFTs that are linked to their online and offline identities. These will be used to access all kinds of services, from games and metaverse applications to social networks, workplaces and job opportunities, private groups and communities, and much more. These NFTs will likely replace the conventional Web2 approach of usernames and passwords, providing users with greater flexibility, security, and privacy. 

Meanwhile, use of NFTs to represent physical and digital assets will continue to grow, enabling the rise of new markets and providing liquidity for asset classes that are currently illiquid – real estate, cars, jewellery, account receivables, royalty streams for artists and more will be tokenised, enabling them to be plugged into the global decentralised finance system. Projects like MakerDAO are already pioneering these links between DeFi and TradFi, blurring the boundaries between them.

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In short, NFTs will not only be an intriguing feature of Web3; they will be embedded as a fundamental asset of the decentralised internet and the hybrid TradFi/DeFi system. Will you be one of the users to embrace the change and adopt the NFT-driven web, or will you hold onto Web2 for as long as possible?

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