NFTs have attracted a lot of media attention in recent months.

Bored Apes, CryptoPunks, CryptoKitties and Reece Witherspoon's forays into the marketplace have made NFTs almost inescapable in popular culture. 

To some, NFTs are a must-have investment. To others, they're nothing more than name-a-star vouchers for nerds. But what are NFTs? How do they work, and why are they so controversial?

What Are NFTs?

NFT stands for non-fungible token. An NFT is a type of tradable digital asset stored on a blockchain. These digital assets can be bought, sold and traded between cryptocurrency wallets. 

Some NFTs are treated like traditional works of art, with one Beeple NFT selling for almost $29 million at Christie's.

The Anatomy of a Non-Fungible Token

To understand NFTs, first you need to understand how the blockchain and cryptocurrencies work. 

Today, there are thousands of cryptocurrencies and they can be divided into two classes: crypto coins and tokens.

Crypto Coins vs. Tokens

Perhaps the most well-known crypto coin is Bitcoin. The pseudonymous inventor Satoshi Nakamoto described Bitcoin as a “purely peer-to-peer version of electronic cash" in the Bitcoin introductory paper

Bitcoin is created through a proof-of-work system that operates on its own blockchain. A bitcoin is a digital asset in and of itself, which represents the underlying value.

In theory, bitcoin and other similar coins are fungible. One bitcoin or satoshi (a fractional unit of a Bitcoin) has the same worth as another. 

In practice, things aren't so simple. As John Carvalho, former product designer for Bitrefill explained, "Each satoshi is its ledger history just as much as a unit of account, and none of them can be interchanged with another as they all have distinctive histories, permanently."

This traceability means coins of an unknown history could be seen as less valuable than those that are "freshly mined" and have never been moved. 

"Consider that many Bitcoin companies and federal agencies already monitor blacklisted coins and employ blockchain analytics companies,” said Carvalho.

Tokens are different in that they don't have their own blockchain. Rather, they operate on top of an existing blockchain, such as Ethereum. When a user spends a token, it moves from one address to another. 

Some tokens are bought and sold just like crypto coins and operate as a currency. These tokens are treated as fungible. Others, however, are considered non-fungible.

Related Article: 2022 Blockchain and Cryptocurrency Reality Check

Non-Fungible Tokens

When it comes to crypto coins, it doesn’t matter which coin you possess — just that you have one. Non-fungible tokens, on the other hand, are individually special. 

The most well-known NFTs currently exist on the Ethereum Blockchain, but they're represented in different ways than coins, using the ERC-721 standard, which states:  

"A non-fungible token (NFT) is used to identify something or someone in a unique way. This type of token is perfect to be used on platforms that offer collectible items, access keys, lottery tickets, numbered seats for concerts and sports matches, etc."

Each NFT has its own identifier and can have a limited supply. A person or organization could mint a single token to represent a unique work of art, or 100 tokens to represent tickets to a show. Tickets can then be transferred from one address to another.

One particularly interesting thing about NFTs on the Ethereum system is that it's possible to add extra functionality to them in the form of smart contracts. With this capability, developers can add options for royalties.

For example, if an NFT was to represent a piece of art, the artist could set up a smart contract with the buyer so that, whenever the NFT changes hands, the artist receives a percentage of the sale value in royalties.

What Are NFTs Currently Used For?

The technology surrounding NFTs is still in its infancy, and most projects on the market focus on digital collectibles.

NFTs made it into the public eye in 2021 with the sudden popularity of art collections such as the Bored Ape Yacht Club. However, the concept has been around for a lot longer than that.

Virtual Pet Games

The CryptoKitties game, for example, launched in 2017 and was one of the first uses of the ERC-721 standard. 

CryptoKitties Marketplace
CryptoKitties Marketplace

The game, which allows users to breed and trade virtual kittens, was so popular that the volume of cats being traded congested the Ethereum network, according to Garrick Hileman, tech researcher and visiting fellow at the University of Cambridge.

"Some people are concerned that a frivolous game is now going to be crowding out more serious, significant-seeming business uses," Hileman added.

The cryptocurrency landscape has changed a lot since then, and several other NFT games have launched. NFT game Aavegotchi, for example, has a lot of similarities to the classic Tamagotchi game of the 1990s. Players breed virtual "frens," can play mini-games with them and earn GHST tokens for their efforts.

Play-to-Earn Games

Another popular NFT-based game is Axie Infinity. It’s similar to Pokémon in that players build teams of Axies and use them to battle other players, and each Axie is a unique tradable NFT.

Axie Infinity is widely known as a play-to-earn game, although the barriers to entry can be quite high. 

Finance journalist Shaurya Malwa explained, "New players need at least three Axies — costing over $1,000 to acquire — to begin playing. Players earn smooth love potion (SLP) tokens as rewards, which can then be redeemed for in-game features such as breeding new Axies."

This high barrier to entry means that many well-off players offer Axie scholarships. These richer players, known as "whales," loan out their Axies to people who have the time and motivation to play but lack the financial resources to do so. In return, the whales take a percentage of that player's earnings. 

Malwa added, "The lucrative earnings from SLP have created a so-called ‘economy’ over the past two years and has even become the main source of income for some communities in the Philippines."

The earning potential of Axie Infinity depends on new players coming into the ecosystem and spending money. The scholarship system and high SLP payouts caused a steady drop in the value of SLP.

While developers attempted to rebalance the economy in the Season 20 update, games journalist Phil Hall questioned whether the changes will have the desired effect, saying "Without the ability to earn easy, daily SLP, I wonder if we'll see significant changes in active player retention and scholarship programs? I imagine it would certainly discourage many bots and click-farms, as PvE content is much easier to automate."

Art Collections

Outside of video games, a primary use of NFTs is for trading digital art. Some collections that have attracted media attention include:

  • Bored Ape Yacht Club
  • CryptoPunks
  • Flower Girls NFT

Each of these collections includes hundreds (or thousands) of images. When users purchase an NFT, what they're buying isn't so much the image as membership to an exclusive club.

This phenomena is particularly apparent with the Bored Ape Yacht Club, where buyers receive a QR code that lets them attend exclusive parties. 

Journalist Adlan Jackson gate-crashed a Bored Ape Yacht Club party in an attempt to better understand the group. 

He said, "When you can't afford one anyway, it's much more tempting to see the technology as a gimmick, the scene's adoptions of language like ‘democratization’ as half-hearted cosplay for assets available mainly to the very rich and the whole enterprise as a scam by people too rich to get in trouble for scamming."

Jackson added that NFTs "look like the kind of thing that in the past might have earned you a modest following on DeviantArt — but these things are getting sold at Sotheby's." 

The journalist’s visit to the Bored Ape party revealed that the NFT scene wasn’t primarily tech people. Rather, it was “full of young, eager-eyed bros, happy to strike up conversation about their own pet NFT projects. It was more like a real-life version of those Twitter spam bots that promise that a certain cryptocurrency is ‘going to the moon' because NFTs are fundamentally about hype.”

Related Article: NFTs: A Digital Generation Defines Its Cultural Artifacts

Learning Opportunities

NFTs: More Receipt Than Work of Art

One reason many tech workers are skeptical of NFTs? They’re often advertised as a permanent feature of the blockchain, when that isn’t usually the case.

NFTs on Ethereum and Solana, for example, are merely tokens that contain a JSON document that points to a URL.

If that URL points to a traditional web server, the image could be changed by the owner of the server. It could even vanish if the server owner stops paying the hosting bill. 

If the URL points to a decentralized server, such as IPFS, the image could stil disappear if people decide to stop hosting it. It’s similar to a torrent file dying when interest cools down and people stop seeding.

An NFT Value Test

Creator of the Signal messenger software, Moxie Marlinspike, made an NFT that would look like one image on OpenSea, another image on Rarible and the poo emoji within a buyer’s wallet. 

Marlinspike said that, once the trick was discovered, OpenSea banned the NFT.  Then, it disappeared from his wallet. 

"It doesn't functionally matter that my NFT is indelibly on the blockchain somewhere,” Marlinspike explained, “because the wallet (and increasingly everything else in the ecosystem) is just using the OpenSea API to display NFTs."

None of this matters to speculators who are happy to buy NFT artwork in the hopes of reselling it for a higher price. Nor does it matter to those who view buying NFTs as membership to an exclusive club.

For others, however, this issue raises questions about the true value of NFTs. People are spending thousands of dollars (or more) on something that is little more than a receipt.

What Could the Future Hold for NFTs?

Blockchain enthusiasts believe NFTs can be used for more than just video games and digital collectibles. Prospective use cases include collecting royalties for musicians, managing ownership and supply chain issues and streamlining ticket sales with the goal of reducing scalping.

ConsenSys is currently working on the music royalties angle. Crypto reporter James Beck explained, "The MLC portal, largely built by ConsenSys, launched in January and is still evolving. There are already roughly 48 million songs, and 9,400 music publishers on it, and they just inherited $424 million in unpaid royalties (‘the so-called Black Box')." 

Several companies are working on the idea of tokenizing tickets for shows and plays. Developer Kasper Keunen suggested that NFTs could “make trust-less and friction-less ticket trading possible." He described creating an NFT that can generate a time-locked QR code that works as a ticket.

Keunen noted, "One of the downsides of static QR codes is the fact that they are still usable by their previous owners." Thus, the idea of a time restriction. By refreshing itself every few seconds, only the owner of the NFT ticket will be able to generate the correct QR code and enter the venue. 

The Problems Surrounding NFTs

NFTs offer a lot of promise to a variety of industries. But the innovation also comes with a few challenges.

Wash Trading 

Unlike traditional financial sectors, cryptocurrency markets are still mostly unregulated and are plagued by wash trading.  
A recent study published by Cornell University suggested that as much as 70% of the cryptocurrency trading volume on major exchanges is faked.

Journalist Jakob Steinschaden, of Trending Topics, reported that of the $9.5 billion in NFT transactions since LooksRare’s launch in early 2022, $8.3 billion  — around 87% — was wash trading.

CryptoSlam's Clay Coffman noted that LooksRare may have accidentally incentivized wash trading with its $LOOKS rewards. "$LOOKS are being awarded to both buyers and sellers on the marketplace proportionally based on the percentage of overall platform sales they represent in a 24-hour period.” This meant users could profit by buying and selling their own NFTs.

On Jan. 27, 2022, OpenSea decided to limit its "lazy minting" tool, saying, "We've recently seen misuse of this feature increase exponentially. Over 80% of the items created with this tool were plagiarized works, fake collections and spam."

Since NFTs are bought and sold using cryptocurrency wallets — and major platforms don't require traders to verify their identities — it's hard to have confidence that the prices of popular NFTs aren't artificially inflated by wash trading.

Environmental Impact

One final concern surrounding NFTs is their environmental impact. 

The Ethereum blockchain, a  major NFT player, consumes an estimated 104 terawatt hours per year, according to data collected by Statista.

Chart of Global Ethereum energy consumption from May 2017 to Jan. 10, 2022

The people and entities who secure this blockchain are miners, and they decide how and where they run their operations. Many miners operate in countries that use nonrenewable forms of energy.

University of Colorado Boulder's Natasha Smith explained the impact of mining operations on the environment: "The hardware used on mining farms has its own inevitable environmental impacts — between 8,000 to 12,000 tons of unrecyclable circuits, or e-waste, per year.”

On top of that, mining plants have large amounts of hardware that need to be cooled. According to Columbia Climate School, one plant in New York requires 139 million gallons of fresh water each day. Later, it discharges that water at much higher temperature, endangering local wildlife. 

The Ethereum Foundation is working on moving Ethereum to Proof of Stake — instead of Proof of Work — to consumer less energy.  However, the switch was already delayed several times, and a definite switchover date has not yet been announced.

Final Word: Are NFTs a Good Investment?

Deciding whether or not to invest in NFTs is a personal decision. Anyone can mint an NFT collection, and nobody can be sure what the market will decide a specific piece of art is worth in a year or two.

Today, the speculative market for NFTs is busy, and people are making a lot of money from buying and selling popular tokens. However, the money depends entirely on demand. Once someone is no longer willing to buy an NFT, the value plummets.

Individuals considering jumping into the NFT marketplace should keep this potential fluctuation in mind. Should the hype die down, you might be left holding a picture of a monkey that nobody wants to buy.