Non-fungible tokens (NFTs) make headlines for the jaw-dropping prices they can command. There’s the collage by the digital artist Beeple that sold for $69 million, CryptoPunks (pixelated art images) that change hands for millions of dollars, and many others that sell for thousands every day. But what exactly are people buying, and how do NFTs work?

The answers may surprise you. NFTs create scarcity and a way to establish ownership of digital assets. And one day, we might use the technology in the physical world as a fast and secure form of verification.  However, within current legal systems, the “ownership” they establish may be limited and investors need to beware of the potential flaws in the systems.

What is an NFT?

An NFT is a non-fungible token, or a unique cryptographic token that can represent ownership of something such as a real-world or digital asset.

NFTs are distinguished from fungible tokens, such as Bitcoin and other cryptocurrencies, and fiat currency. When something is fungible, it’s easily interchangeable because each unit has the same value. For example, every $20 bill or Bitcoin has the same value, even if the specific bills or tokens have unique identifiers.

However, when someone buys an NFT, they’re purchasing a unique claim to an asset. These aren’t fungible because each NFT can’t be copied. Today, people primarily use NFTs to indicate ownership of digital artwork, such as images, graphics, and video clips. The artists may sell one NFT as a unique one-of-a-kind offer. Or, like limited-edition prints or rare trading cards, they may create and sell a set.

NFTs are mostly used to buy and sell collectible digital art, but the technology could have other use cases. Companies could use NFTs to track and verify ownership of assets within video games or metaverses, virtual worlds with realistic environments. In the real world, a luxury retailer or events company might use NFTs to fight counterfeiting and scalping. Some organizations in India and Singapore are already testing the use of NFTs to verify whether someone earned a diploma or certification.

How do NFTs work?

NFTs rely on the same blockchain technology that underpins cryptocurrencies, and people create NFTs with an existing blockchain—the Ethereum blockchain is a popular option.

Blockchains are public databases whose copies are stored and helped to run by computers around the world. New information is grouped together into a block and then added to the existing chain. Once it’s added, the existing information can’t be changed.

Some blockchains focus on tracking transactions and the balance in each digital wallet, where crypto owners store coins. Others, like the Ethereum blockchain, work more like supercomputers, allowing developers to build and run programs (called smart contracts) using the power of the network.

When someone creates (or “mints”) an NFT, they add a new token to a blockchain and the ledger shows it’s tied to their NFT-compatible crypto wallet; only one entity can own an NFT at a time. If they sell it, the transaction is added to the blockchain for everyone to see and verify.

The digital assets represented by NFTs generally aren’t part of the blockchain because of the costly storage space they’d require. Instead, the NFT has a pointer (such as a URL) where someone can find the digital asset.

Although details depend on the terms of the sale, with digital artwork NFTs, the buyer often doesn’t receive the copyright or other legal claims to the underlying work. That’s not necessarily different from owning physical artwork, as the owner of a print of a famous painting doesn’t necessarily own the copyright, have the right to display it publicly, and can’t prevent others from printing copies of the original.

However, in addition to potentially receiving limited legal rights, the NFT buyer (and, in some cases, the seller) won’t necessarily have control of the URL or server where the digital asset is stored. Someone may be able to change what’s at the other end, or the digital asset could be completely lost if the servers fail.

Some NFTs use a decentralized network, such as the InterPlanetary File System (IPFS), to host the digital assets, which can help minimize risks. And high-value NFTs may use several systems as a backup. But similar to owning real-world art, buyers may need to put some effort into maintenance.

How to buy or sell an NFT

Investors can buy and sell NFTs on different trading platforms and exchanges. Some popular NFT marketplaces where NFTs can be bought and sold include:

• OpenSea
• Rarible
• Larva Labs
• Rarible
  

The buying and selling process can vary depending on the platform and listing. For instance, an NFT may have a set price, an option to make an offer, or be part of a limited-time auction. Prices are often listed in cryptocurrencies, and buyers may need a crypto wallet that’s compatible with the marketplace.

Some listings and marketplaces support different types of cryptos. If a buyer doesn’t have the specific crypto already, they may need to purchase it or pay a fee for the marketplace to convert their crypto to the appropriate currency.

Royalties and fees

Sellers may have to pay an account setup or service fee to the marketplace and royalties to the NFT creator. Or, if they’re the creator, they can sell the NFT with royalties and automatically receive payment whenever it’s sold in the future.

There may be so-called gas fees (transaction charges) for NFT sales based on the type of cryptocurrency, current supply, and demand on that blockchain. Whether the seller or buyer has to pay the fee varies by transaction type and marketplace.

Creating NFTs

Investors, artists, and others may want to create their own NFTs or NFT collections.

For established artists or well-known professionals, NFTs could present an interesting new revenue stream. They may be able to create NFTs of their physical work, or create new digital work and sell NFTs of the images. Some artists and art collectors have gone a step further by creating NFTs of images or videos of physical artwork, then burning the artwork. (Famously, this happened with a $33,000 Banksy print.) The idea is that the NFT could be worth more if the original artwork no longer exists.

Some popular NFT exchanges can help with the creation process. There may be a prompt to upload a digital file, which will then be “tokenized,” and to add details before minting the NFT.

Some NFT marketplaces only list NFTs from high-profile creators. Christie’s and Sotheby’s, two well-known auction houses, have managed the high-profile auctions of certain NFTs. Other NFT marketplaces are linked to specific games or organizations, such as Axie Infinity’s Axie Marketplace and the NBA’s Top Shot marketplace.

Potential advantages and risks of owning NFTs

NFTs garner a lot of attention from individual and institutional investors. But before purchasing an NFT, investors should consider the potential upsides and downsides.  

Potential advantages of owning NFTS

The primary upsides of purchasing NFTs come from the bragging rights of being a sole owner and the potential to earn money.

1. To purchase a collectible.

   NFTs create and verify uniqueness and scarcity in the digital realm. While others might create a copy of the digital asset, someone who buys an NFT may be the only verifiable owner, which creates an opportunity for collectors.

2. To potentially make money.

   As with other collectibles, some NFTs could wind up being worth a lot of money. However, as with art collecting, their value may depend on the original artist’s reputation or whether the NFT (or its collection) has made headlines.

3. To support an artist.

   Buying an NFT could be an interesting way to support an artist or creator.

Potential downsides of owning NFTs

As with any investment, there are risks to consider. NFTs may have additional risks because they’re part of an evolving cryptocurrency ecosystem.

1. Value depends on the system.

   The value of an NFT that represents ownership of digital artwork can depend largely on what others are willing to pay. (In contrast, the value of a stock could depend on the company’s future earnings, or the value of a bond can depend on its yield.)

2. Storage could become an issue.

   The excitement around NFTs means organizations and individuals are putting real effort into creating safe storage for the digital assets the NFTs point to. But it could become an issue if an investor’s NFT points to something different from the original asset, or nothing at all.

3. Scams proliferate.

   NFT scams could catch potential investors off guard. Individuals or organizations might hype the value of an NFT project, then disappear with buyers’ money. Or, scammers might sell NFTs of stolen work.

The bottom line

Anyone can buy a print of a famous work of art, but only one person owns the original. Similarly, non-fungible tokens represent ownership of digital assets. While anyone can copy and paste an image, an NFT lets someone lay claim to the original.

Investors may be able to make money from buying and selling NFTs if enthusiasm for this new type of art and approach to ownership increases. However, getting caught in a bubble or falling for a scam could be ever-present dangers when buying technology-based collectibles. As with any investment, due diligence is important.