Chapter 1: The Landscape of Non-Fungible Tokens (NFTs)
In simple terms, fungible items are items that can be exchanged for one another. Money is a great example. A $100 bill is worth the same as another $100 bill (or even two $50 bills). Despite some minor differences, such as serial numbers and issuance dates, banknotes are considered fungible because they can be interchanged and facilitate transactions in our daily lives.
On the other hand, vehicles, artworks, and real estate are examples of non-fungible items, which are unique and cannot be exchanged for one another. Think of two adjacent houses—they may be in the same neighborhood, share the same property developer, and even look identical from the outside, but they are technically not the same and cannot be exchanged. Their decorations and internal layouts may differ. One might be closer to a busy train station, making it slightly more valuable than the other. Simply put, unlike two $100 bills, these two houses do not have the same intrinsic value and therefore cannot be exchanged, making them non-fungible.
Fungible and non-fungible items are traditionally tangible items. As our world becomes increasingly digital, intangible items are becoming more common.
In recent years, we have seen the rise of intangible and fungible tokens like Bitcoin, Ethereum, and so on. These items are intangible because they exist in a physical form that cannot be felt or touched, just like your Instagram account exists only in digital form.
With the rise of smart contract platforms like Ethereum, there is now technology to create non-fungible tokens (NFTs). Examples of NFTs include avatars like CryptoPunks and Bored Apes, and even masterpieces from prominent artists like Tom Sachs and Damien Hirst.
The simplest way to understand NFTs is to imagine Pokémon trading cards. Each Pokémon trading card is unique, and no two cards are interchangeable because they may have different move combinations, rarity, and physical conditions. You wouldn’t want to trade a brand-new Holo Charizard card for a damaged Rattata card. Even though both cards are first editions, the Holo Charizard card is more sought after due to its rarity, abilities, and physical condition.
Essentially, NFTs are digital representations of such items stored on the blockchain. On the blockchain, we can distinguish and digitize Rattatas from Charizards. Moreover, NFTs allow us to easily prove whether our Pokémon cards are genuine, a common issue in physical trading cards and collectibles. Before we dive deeper into NFTs, let’s understand the difference between NFTs and fungible tokens like Bitcoin and Ethereum.
Fungible Tokens vs Non-Fungible Tokens
We’ve been hearing about NFTs, but what exactly are they? Simply put, an NFT is a token with a unique identifier and additional parameters that allow you to store certain information about it. This unique identifier makes the token non-fungible. The additional information can be anything, such as text, images, audio, and video files. Unlike fungible cryptocurrencies, NFTs are unique and non-interchangeable. Since each Bitcoin or Ether is uniform and indistinguishable from other coins, you can freely trade them on cryptocurrency exchanges.
However, you cannot easily trade NFTs because no two NFTs are the same. Each NFT has its unique identifier and characteristics, making each one different, even if they appear similar on the surface.
Additionally, NFTs cannot be divided into smaller parts like traditional cryptocurrencies. For example, a Bitcoin can be divided up to eight decimal places. Therefore, NFTs typically lack liquidity and are difficult to sell because they must be purchased in full.
That said, there are some projects that allow NFTs to be split into smaller fungible parts (discussed in Chapter 10).
This gives users the opportunity to own a part of an NFT rather than the whole, lowering the entry barrier for high-priced NFTs and increasing the liquidity of these NFTs.
Authenticity and Efficiency
Verifying authenticity and transaction efficiency is often a pain point for non-fungible goods. For example, if someone buys the Mona Lisa and then tries to sell it, it can be difficult to verify its authenticity without consulting an art expert. Forgers may create multiple replicas and sell them to different buyers.
With digital art, creating copies and claiming the work as one’s own is even easier; and unlike in the real world, there’s no way to verify which digital image is the original. This is where NFTs come into play, utilizing smart contract technology to store and record unique information on the blockchain, meaning that whenever an NFT is created, only one verifiable NFT exists. NFT creators can also encrypt details such as rich metadata or secure file links, allowing people to create various verifiable digital assets based on images, audio, and video files. These technologies allow everyone to verify the authenticity of digital assets and simplify the process of determining ownership. They also enable secure, efficient, and verifiable asset transfers.
With NFTs, you can digitally prove the authenticity of an asset, while artists can easily prove that a piece is original. Furthermore, you can verify the provenance of a digital asset through the blockchain. For example, you can easily track when an asset was first created and subsequently sold. You can trace the list of past buyers and see how much each buyer paid for the asset.
NFTs mitigate issues like fraud and plagiarism, which are common problems faced by all non-fungible goods. We can use the blockchain to verify the authenticity of NFTs instead of hiring experts. Additionally, we can check if an NFT belongs to a larger collection by verifying if the contract address matches.
NFTs have disrupted many industries; for instance, artists no longer need intermediaries like galleries (which are often a necessary and highly demanding entry point) to promote and sell their work. Galleries often charge exorbitant commissions of up to 50%, reducing artists' net income. However, the emergence of NFTs allows artists to sell their work directly to buyers on NFT marketplaces like OpenSea.
NFTs Remove Intermediaries
Art is just one example of how NFTs disrupt intermediaries, with the key insight being that NFTs can tokenize anything and eliminate inefficiencies beyond authenticity.
Have you ever wondered why some key documents are still recorded on paper? This is because there’s no way to verify whether a digital copy is unique and trustworthy. NFTs will change this, paving the way for the creation of outstanding digital art, collectibles, in-game items, and even important documents like wills, passports, and land ownership.
An example of NFTs holding real-world assets is Centrifuge. Centrifuge collaborates with MakerDAO to use the Tinlake application to collateralize non-digital assets. Tinlake turns real-world assets, like mortgages, into NFTs and attaches all necessary legal documents. On April 21, 2021, the company successfully executed the first MakerDAO loan using a house as collateral, amounting to $181,000, effectively creating one of the first blockchain-based mortgages. Imagine if governments and other companies started using NFTs to handle their documents and processes. How efficient would it be when everything is tokenized? The possibilities are endless, and global adoption is just a matter of time!
History of NFTs
In 2014, New York artist Kevin McCoy launched an NFT on the Namecoin blockchain, which is often considered the first NFT in history. However, while it is one of the oldest NFTs, it is technically not the first NFT that exists today.
Quantum NFT
The first NFT can be traced back to Colored Coins, which were designed on the Bitcoin network as early as 2012. Colored Coins were an experimental project aimed at exploring the idea of non-fungible tokens.
Several white papers analyzed its capabilities and praised it as an achievement that distinguished it from regular Bitcoin transactions. However, since it was created on the Bitcoin network, there were technical limitations due to the need for complete consensus on its value.
"For example, if three people agree that 100 colored coins represent 100 shares of a company, if one participant decides no longer to equate colored coins with representing company stock, the entire system collapses."
Nevertheless, Colored Coins sparked further innovation and laid the groundwork for the emergence of NFTs. Subsequent projects, such as Counterparty (asset creators and decentralized exchanges), reaffirmed the potential of putting real-world assets onto distributed ledgers. However, it became clear that developers needed a more versatile blockchain to showcase the full potential of NFTs.
When the Ethereum network launched in July 2015 and introduced programmable code through smart contracts, developers finally had a platform to develop NFT projects. One of the first NFTs on the Ethereum network was Ethereum itself, a virtual isometric world where players could own tiles, farm plots, and build things. This project was created in 2015 and became part of Ethereum's history as a collectible.
Fast forward to 2017, many projects emerged, such as CryptoPunks, MoonCats, and CryptoKitties, which are now widely known.
Source: HarryBTC (this list is meant to be illustrative and non-exhaustive as there are other NFTs that have not been listed here)
It was also around this time that proper NFT development standards began to take shape. Prior to this, most fungible tokens on Ethereum used the ERC-20 standard (ERC stands for Ethereum Request for Comment). The ERC-20 standard was effective for many functions used to build fungible tokens on Ethereum, but it did not have the conditions to create non-fungible tokens.
In September 2017, GitHub contributor Dieter Shirley proposed ERC-721 to standardize the token standard for unique tokens. The purpose of this proposal was to improve upon past iterations, such as gas efficiency, allowing the blockchain to recognize non-fungible tokens.
It was in this proposal that the term "NFT" was first introduced. This new standard was later adopted by CryptoKitties, which was the first project to implement ERC-721. Since then, many NFT projects have followed suit and adopted the ERC-721 standard.
Before the birth of the ERC-721 protocol, older NFTs like CryptoPunks were built on derivatives of ERC-20 and are now considered hybrids.
ERC-721 gradually became the most popular NFT standard, but in 2018, an alternative universal NFT standard called ERC-1155 emerged. The principle of ERC-1155 is simple: it aims to combine the functionalities of ERC-20 and ERC-721.
The functionalities of ERC-20 and ERC-721 are merged into a single NFT standard while addressing some inherent flaws of ERC-721, such as higher transaction fees.
As a result, ERC-1155 has lower transaction fees, especially for batch transactions. For example, it can handle 10 NFTs in a single transaction, while ERC-721 would require 10 separate transactions to handle 10 NFTs. However, overall, due to programming reasons, the ownership history of ERC-1155 tokens is harder to track.
Both standards have their advantages and disadvantages and are designed for different types of assets. Notably, because ERC-1155 allows smart contract interfaces to simultaneously embody and control both ERC-20 and ERC-721 type tokens, it is often seen as a semi-permanent standard. Nevertheless, the core principles remain the same, allowing non-fungible assets to be tokenized and authenticated on the blockchain.
NFTs on Other Blockchains
Blockchains are public playgrounds for decentralized applications. Anyone can create anything on a blockchain network, but this also means there are no requirements or standards to adhere to. For example, one person can make slides out of plastic, while another can make slides out of different materials like concrete. The key is that, due to its decentralized nature, there are no enforceable standards.
ERC-721 and ERC-1155 are clear examples of different NFT standards on Ethereum. However, we are now part of a multi-blockchain world, each with its own NFT technical specifications. Below is a (non-exhaustive) list of different NFT standards and NFT projects on other blockchains.
You may wonder if it is possible to connect and move your NFTs across various blockchains. For instance, bridging is currently possible on Ethereum, but it is in the experimental phase on the Rinkeby testnet. In the near future, you should be able to connect NFTs on Ethereum Virtual Machine (EVM) compatible chains that use similar ERC-721 token standards, such as Binance Smart Chain and Polygon. On the other hand, non-EVM compatible chains like Solana, which uses the SPLNFT standard, will require new infrastructure to be established before you can move your NFTs.
How Big is the NFT Industry?
The NFT industry is full of innovation. New use cases emerge every day, expanding our imagination of NFTs. However, it is challenging to categorize the industry correctly due to the many different interpretations. In this book, we focus on NFTs themselves, specifically the different use cases of NFTs, rather than the infrastructure or supplementary parts of NFTs.
Based on this approach, we can roughly divide the industry into eight segments:
- Art
- Music
- Collectibles
- Gaming
- Sports
- Metaverse
- Utility
- Finance
Collectibles are by far the largest segment, often featuring expensive sales. As of October 25, 2021, seven of the top ten NFTs in the crypto grand slam events were collectibles, with total sales exceeding $3 billion.
Source: CryptoSlam
One way to estimate the market size of NFTs is to calculate the total number of NFTs sold across each chain. As of October 25, 2021, the total sales of NFTs across all chains amounted to $12.3 billion.
Source: CryptoSlam
Ethereum's total sales exceeded $8 billion, far surpassing other chains. The second is Ronin, the sidechain of Axie Infinity. However, we are beginning to see more and more NFTs being minted and sold on other blockchains, such as Binance Smart Chain, Polygon, and Solana.
However, it is worth noting that the numbers above are just estimates, as some chains like Tezos have not been tracked by CryptoSlam, meaning the entire NFT industry could be much larger than it appears. Additionally, utility and financial NFTs have also not been tracked by CryptoSlam—this may be because they are less popular as speculative investments and represent a smaller share of the overall NFT market.
Aside from the availability of projects, one of the main reasons project owners and investors choose different blockchains to mint or invest in NFT projects is the on-chain costs. For example, if an NFT on Ethereum costs $50, the gas fees often exceed the cost of the artwork itself. Beyond costs, some blockchains are faster and more user-friendly than others.
Some popular non-Ethereum NFT projects include Zed Run, a horse racing game on Polygon, and Degen Ape Academy on Solana. Ultimately, Ethereum remains (for now) the market leader in this space, as it has the earliest projects and a first-mover advantage, along with its vibrant culture and large community. However, this may change as NFTs begin to be widely adopted on different chains.
