Explainer: Just what are Non-Fungible Tokens (NFTs)?

Twitter CEO, Jack Dorsey, has confirmed that the proceeds from the sale of his first tweet as a Non Fungible Token (NFT) will be given to charity across Africa, to lift families out of poverty. The NFT tweet has so far attracted a bid of Sh250 million.

A highlight clip of basketball great LeBron James just fetched $208,000 on NBA Top Shot, a platform for selling digital collectibles. In fact, the platform sold more than $150 million in such clips in the last week of February alone, according to CNBC. Think of them like digital sports cards.

But what exactly are NFTs?

Well, “Non-fungible” means that it’s unique and can’t be replaced with something else. For example, a Bitcoin is fungible — trade one for another bitcoin, and you’ll have exactly the same thing. A one-of-a-kind trading card, however, is non-fungible. If you traded it for a different card, you’d have something completely different.

Music group Kings of Leon issued its recent album via an NFT that entitles users to download the album and related artwork.

“It can’t be traded with another one, like a dollar can be traded for another dollar,” says Dr. Richard Smith, CEO of The Foundation for the Study of Cycles.

How do NFTs work?

NFTs are built on the same kind of infrastructure – blockchain – that cryptocurrencies are. Because they use blockchain, the transfer of an interest in NFTs is recorded on the blockchain, putting ownership on a permanent record, making it impossible (or at least very hard) to falsify.

At a very high level, most NFTs are part of the Ethereum blockchain. Ethereum is a cryptocurrency, like Bitcoin or Dogecoin, but its blockchain also supports these NFTs, which store extra information that makes them work differently from, say, an ETH coin. It is worth noting that other blockchains can implement their own versions of NFTs.

“Each time an exchange on the blockchain occurs, whether that’s buying and selling an NFT or transacting in Bitcoin, the transaction is made public on the blockchain and marked with a unique digital signature,” says Aubrey Strobel, head of communications at Lolli, a Bitcoin rewards app. “This distinct signature verifies the transfer of ownership of an NFT.”

But would-be buyers should be clear what they’re getting here. An NFT is not a royalty and does not give you an economic interest in, for example, the broadcast of a sports clip. Rather, it’s more akin to a piece of digital art or a digital sports card. Or in the case of an album NFT, it gives you the right to a certain asset, which you can then use and enjoy.

So, what’s worth picking up at the NFT supermarket?

NFTs can really be anything digital (such as drawings, music, your brain downloaded and turned into an AI), but a lot of the current excitement is around using the tech to sell digital art. Your nice Facebook, Instagram or Twitter posts, memes can be NFTs.

Some businesses, such as those in the music industry, envision the NFT as a future way to track the interest in a specific asset and then quickly pay the artists responsible for it. Similarly, when owners sell the asset to someone else, the original producer may even be able to take a cut of the sales price. Blockchain tech enables the hard-to-falsify record of ownership.

Will this become like art collecting?

I’m sure some people really hope so — like whoever paid almost Sh40 million for a 50-second video by Grimes or the person who paid Sh700 million for a video by Beeple. It’s actually more about proof of original ownership of every digital collectible. For instance, you can access any song of Diamond Platnumz, but being able to prove that WCB Records owns the copyright for all songs by the artiste is what NFTs are trying to create.

Because NFTs are denominated in cryptocurrencies, their prices have surged as crypto prices have skyrocketed, explains Citrano.

Meanwhile, Salnikov points to the increasing interest in cryptocurrencies such as Bitcoin and Ethereum and the ease of getting started with them.

“It’s a whole new non-financial use case for people, not only geeks,” he says. The explosion in interest is also another step in the “analog” world becoming more “digital.”

“The pandemic has increased the amount of time that people are spending online, making digitally native products like NFTs more attractive, as we’re living digitally now more than ever before,” says Strobel.

What are the risks of NFTs?

But despite the surge in interest and price, NFTs are no sure investment. In fact, they look much more like a speculative furor. Again, the comparison with sports cards looks apt, though one could consider them like other speculative assets such as sneakers, handbags or art. They produce no cash flow, and conservative investors such as Warren Buffett won’t touch them.

Naturally, you could also view or digitally save a video clip online for free, but collectors are still paying serious money for the right to own the “authorized” version of the clip or art.

“There’s a lot of room for misunderstanding and mispricing here,” says Smith. “NFTs don’t give you any royalties, and there’s no guarantee how many of one sort are out there.”

Because NFTs don’t produce cash flow, the only way to make money is if someone else comes along and is willing to pay more for them, what’s called the “greater fool” strategy of investing. Smith says it’s “treacherous times” for those buying high-priced collectibles.

“There’s a lot of greater fool theory speculation driving the markets right now,” says Smith. “I’m excited about them, but I’m not pulling out my wallet to buy them.”

NFTs also suffer from liquidity risk: If no one wants to buy your NFT, you won’t be able to resell it soon or at all. That’s in sharp contrast to the stock market, which provides ready liquidity.

Salnikov also points to counterparty risk, where the original producer of the NFT may not have had rights to the sports clip, for example.

Still, many traders are turning to NFTs as a way to turn a quick profit. That kind of market usually turns out poorly for those who mistime when to enter and exit.

“I’d urge speculators to be very careful here, and, as with any speculative investment, only invest what you can afford to lose,” says Citrano. “I’m bullish on the space but – like any asset class – they will experience their highs and lows.”

“If you’re buying an NFT because you really like it and want to own it, there is very little risk because it will be yours forever, or for as long as you wish to own it,” says Citrano. “If you’re buying NFTs to speculate, that’s another story.”

In other ways, however, NFTs are relatively secure, even if they don’t make a good investment.

“NFTs actually have an advantage over physical art,” says Strobel. “Whereas a painting can be stolen from a museum in a heist, stealing an NFT would usually involve hacking an individual user’s private key – no easy feat if they’ve secured it offline like most people do or should.”

And NFTs have the other advantages of blockchain technology, says Salnikov: They’re instantly and verifiably transferable, and your ownership is borderless and independent of the platform.

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