It’s 2021 — and crypto is back. Bitcoin is trading over $50,000. PayPal has started accepting Bitcoin, Litecoin, Ethereum, and Bitcoin Cash. And a new type of blockchain asset — the non-fungible token, or NFT — is selling for as much as $69 million at auction.
If you read financial news or follow financial social media, you’ve no doubt heard about the NFT craze that has swept up many investors in the aftermath of digital artist Mike Winkelmann's aka Beeple’s record-breaking NFT art sale at Christie’s. And if you’ve read into it, you probably have more questions than answers.
What is an NFT anyway? How does it work? What are its use cases, outside of ridiculously expensive digital art sales? Are we in an NFT bubble or should I invest? And how?
In this report, we’re going to answer all of these questions and more. But to understand what an NFT actually is, we have to start with an understanding of blockchain technology. To that end, the next few paragraphs may be somewhat of a review for seasoned cryptocurrency investors.
How Blockchains and Cryptocurrencies Work — and How NFTs Are Different
Blockchains are decentralized computer databases — electronic record-keeping systems that store information in a network of many computers. In the case of cryptocurrency blockchains, this information concerns the ownership and transaction history of digital coins.
The Ethereum blockchain, for instance, keeps track of who owns Ether coins. Whenever someone sends Ether to someone else, a piece of data is added to the blockchain saying, “This person was the owner of this Ether coin, and then they sent it to that person, so now that person owns it.”
No one can alter or manipulate a cryptocurrency blockchain; the only data that can be added to it is transaction data that is cryptographically validated by the other computers in the network.
This means that each piece of transaction data is submitted to the blockchain in an encrypted form, and other computers on the network must attempt to decrypt it using a blockchain-specific password in order to verify its validity. These other computers are compensated for their time and electricity with small amounts of the cryptocurrency in question, a process known as mining.
This self-checking process of encryption and decryption makes blockchains far more secure than just about any other type of computer system, with many computer scientists calling them “unhackable.”
The most well-known application of blockchain technology is to create fraud-proof, tamper-proof, inflation-proof currencies like Bitcoin. But many blockchains — including the Ethereum blockchain — can handle much more than currency.
You see, most blockchain cryptocurrencies, including Ether, are limited in supply, fungible (i.e., exchangeable for an identical item — one Ether coin is identical to another), and divisible into smaller units by a group of owners.
But recently, the Ethereum blockchain and a few others have started to store data on a different kind of tamper-proof token that is unlimited in supply, indivisible, and non-fungible — hence “non-fungible token.”
So What Exactly Are NFTs and How Do They Work?
Like a cryptocurrency, an NFT’s transaction history and ownership are “set in stone” by its blockchain — making it effectively fraud-proof, theft-proof, and hacker-proof.
But unlike a cryptocurrency, an NFT is completely unique, it can’t be broken into smaller units, and its creators can release as many or as few as they want into the market.
And perhaps more importantly, NFTs differ from cryptocurrencies in that they do not have value in and of themselves. They are attached to a digital asset, like a file, a video, a set of credentials — or a piece of art.
NFTs are currently making the biggest splash in the art collection world, where they serve as blockchain-backed proof of ownership of an original piece of valuable art. They are seen by many investors and art collectors as superior to the current paper title system of art ownership, which is largely built on trust and is thus extremely vulnerable to manipulation and fraud.
Now here’s where things get a little tricky to understand. You might reasonably assume, based on the description above, that an NFT for a piece of art would give you exclusive access or at least copyright over the work in question. But it doesn’t.
The image above is one of the paintings from Beeple’s Everydays: The First 5,000 Days series, which sold for more than $69 million at Christie’s in March. But it cost you $0 to look at it, and it cost us $0 to reprint it here.
And Beeple could even create another NFT of the same work and sell it to someone else. The person who paid $69 million for it doesn’t even get an assurance that they own the only Beeple Everydays NFT.
So what exactly do these tokens do?
Again, they simply determine who owns an original copy of a piece of digital art in a completely immutable way. Let’s explain it through an analogy…
The Mona Lisa Analogy
Suppose I could create an exact — and I mean exact — copy of Leonardo da Vinci’s Mona Lisa.
Suppose that this copy doesn’t just look identical; its frame is made from wood cut from the same tree as the original; the exact mix of pigments is reproduced perfectly; each of da Vinci's brushstrokes is reproduced perfectly. Suppose that the painting is completely identical to the Mona Lisa down to the molecular level.
It still wouldn’t be the Mona Lisa, would it?
I couldn’t take it to the Louvre, point to the one on the wall, and say, “These are two of the same item. Let’s swap them — what’s the difference?” And I certainly couldn’t sell it for $850 million, the estimated value of the original painting this year.
That’s because the value of da Vinci's original Mona Lisa isn’t the fact that it’s hard to see or under some kind of copyright or access control. Once again, we can post a digital reproduction of it below for $0. (Fun fact: Depending on the size of your computer screen, this image is likely larger and higher-resolution than the original, which is only about the size of an iPad.)
Rather, the value of the Mona Lisa is derived from the fact that da Vinci himself painted it — and that for centuries, people have cherished and coveted it (and, at one point in 1911, stolen it).
Now, suppose that grave robbers in Italy break open a Renaissance-era aristocrat’s coffin and find that the aristocrat’s skeletal hands are clutching a previously undiscovered second original Mona Lisa painted by da Vinci himself.
Would that cut the value of the Louvre original in half? Would it be just as valuable as my modern molecular-level copy?
Of course not.
The second original Mona Lisa would have its own inherent value derived from its origin story; from the fact that it is a 500-year-old da Vinci original that languished in a grave for centuries. It would likely fetch a lower price than the one in the Louvre — but that price wouldn’t alter that of the Louvre original, and it would be far higher than that of my molecular copy.
The point of this silly analogy is that an artwork’s pedigree and ownership history give it value, regardless of its reproducibility or original quantity. And NFTs store this essential pedigree data in an ironclad way.
What’s more, art trading is actually a fairly niche use case for NFTs. There are many other more economically productive applications for the technology that are starting to emerge — and that should really take off once the technology matures…
More General Use Cases for NFTs
NFTs are currently mainly used as proof of ownership for digital art — but there’s no reason they couldn’t be used as a titling system for other kinds of collectibles, including physical items.
In 2019, Nike (NYSE: NKE) won a patent for a blockchain-based system called “CryptoKicks” that would create an NFT for each individual pair of shoes. This NFT could be bought or sold along with — or instead of — the physical shoes. It could also be combined with other unique shoe NFTs to create “shoe offspring” that can then be ordered as a new physical pair of shoes.
The technology also has exciting implications for identity verification and credentials management.
Identity theft costs the U.S. economy nearly $50 billion per year, and dozens of people are arrested every year for unlicensed practice of law, medicine, and other licensed professions. Both problems could be considerably easier to deal with if people had unique digital tokens verifying their identity and ownership of important personal and professional information.
A third NFT use case that is already starting to appear in real life is ticketing. Several blockchain technology organizations, such as NFT.NYC, Token Summit, and Coin.Kred, have sold tickets to events in the form of NFTs.
According to e-commerce fraud-prevention firm Riskified, ticket fraud costs American event planners some $10 billion each year in lost revenue, largely through duplication and unauthorized “scalping” transactions.
Current ticketing technology tries to prevent this through barcodes and serial numbers, which aren’t bulletproof — especially to a fraudster with some basic Photoshop skills. But an NFT ticket would be mathematically impossible to duplicate or sell without the approval of the issuer.
In summary, even though NFTs are a somewhat heady and hard-to-explain concept, they have real value, both in the art world and in the broader economy. The question, given what’s going on in the art world now, is how much value NFTs intrinsically have.
So Was That Beeple NFT Worth $69 Million?
Absolutely not. Just about everyone — including artists and cryptocurrency evangelists — agrees that the NFT market is in a massive bubble right now.
If the $69 million Everydays auction wasn’t evidence enough, there have been several smaller-scale NFT transactions that have arguably been even more ridiculous. This past March, Brooklyn-based filmmaker Alex Ramirez-Mallis sold a 52-minute audio compilation of his own farts as an NFT for $85. The NFT appreciated to more than $420 shortly after being listed.
Even Beeple himself has explicitly called the current craze a bubble.
In a Fox News interview shortly after the Everydays auction, he said, “I absolutely think it’s a bubble, to be quite honest. I go back to the analogy of the beginning of the internet. There was a bubble. And the bubble burst, but it didn’t wipe out the internet. And so the technology itself is strong enough where I think it’s going to outlive that.”
The artist was referring to the dot-com bubble of the late 1990s and early 2000s, when a speculative mania around early internet companies — combined with a widespread ignorance of what the internet actually was or how it worked — pushed the Nasdaq Composite up to an unsustainable level, eventually leading to a huge sell-off.
As you can see above, the Nasdaq took decades to recover from the dot-com bubble — but it eventually did and today is far above it.
To that end, Beeple likely has a point. NFTs may be in a bubble today but, like the internet, there is real future potential to the technology, which should survive after the bursting of the bubble.
But how long will we have to wait to see that potential? And in the meantime, should you buy NFTs?
The Future of NFTs — and How to Invest
The first question is a complicated one with no easy answer. In some ways, NFTs are already solving important economic problems. The global collectibles market, although not exactly an essential industry for day-to-day life, was valued at $370 billion in 2020 — and had been moving toward digital ownership verification before the emergence of NFTs.
The second question is more straightforward to answer: No, it’s not yet time for people like you and me to buy NFTs. It’s not a mature enough technology to dive into headfirst — and NFTs aren’t especially useful assets for most investors unless they’re shopping for a piece of digital art that is only available in NFT form.
Rather, the reason why NFTs are worth paying attention to right now is because they provide a sort of proof-of-concept for sophisticated blockchains like Ethereum, which hosts the vast majority of NFT transactions today.
The emergence of a nonfinancial use case for Ethereum, bubbly as it may be, proves that Ether and similar cryptocurrencies have real value outside of speculation, black-market transactions, or technological novelty.
To that end, Ether has been minting new all-time highs throughout the NFT craze...
And based on its technical momentum as represented by Bollinger Bands, it looks like it’s nowhere near stopping.
One group of investors has been banking large returns from an Ethereum allocation for years already, guided by an expert who saw the blockchain platform’s potential years ago.
Technology and Opportunity subscribers are already up big on the cryptocurrency. Click here to learn how you can get in on editor Keith Kohl’s next pick.