A Deep Dive Into NFTs

A Deep Dive Into NFTs

X
minute read time
Bryan Wilson
Bryan Wilson
Legal Engineer
Bryan Wilson
Published:
June 30, 2022
Last Updated:
October 6, 2022

This is part four in our four part series on the Taxonomy of Tokens. You can see the previous articles on Security/Utility Tokens here, our deep dive on Liquidity Provider Tokens, and our complete guide on Governance Tokens.

In 2021, the wide-reaching potential of NFTs (Non-Fungible Tokens) captured the attention of cryptoworld, as NFTs produced abundant intellectual properties in the modern creator economy. Per an analysis done by investment bank Jefferies, the total NFT market-cap is forecasted to exceed $35 billion in 2022 and to over $80 billion for 2025.

Understanding the unique proposition of NFTs

So, What Are NFTs?

The term NFT stands for Non-Fungible Token. Non-fungible means that a token  is unique and, according to the economics literature, items that are non-fungible may not be interchanged with other goods of assets of a similar type. The value of non-fungible items is always specific to the item because, at a fundamental level, there cannot be  another one like it. Examples of non-fungible items include interests in land, pieces of art, and access to certain clubs or groups. Unlike a bitcoin or a one dollar bill, which are functionally identical and interchangeable with one another, the value of non-fungible items derives from their scarcity and uniqueness. 

As a result of their inability to be duplicated, NFTs enable the creation of unique digital assets. Therefore, they are often used as a tool to identify  a piece of data, such as text, images, and other files in the same way that a passport identifies a non-fungible person. The unique features of an NFT that are able to demonstrate this uniqueness are encoded within smart contracts on a blockchain, making their ownership and details immutable. Most of the activity in web3 marketplaces today is on the Ethereum blockchain, but that is beginning to change and diversify.

Because of their reliance on unique identifiers, the token standards for NFTs mostly include basic primitives such as ownership, transfer, and simple access control. As an example, check out the ERC-721 standard. However, because these items can be used to represent different types of rights and interests, it is possible to build additional features on top of a basic standard for rich display inside of applications, including creators shares and royalty payments to the original creators for new works. By way of example, Lifeforms, an NFT-art project by Sarah Friend, requires Lifeform NFTs to be given away within 90 days of receiving the Lifeform.

Sarah Friend announces Lifeforms on Twitter in September of 2021.

Paying for digital-only content might seem ridiculous to some. Why not copy the content or just use ‘right-click, save as’? The art publication, rightclicksave.com explores the ongoing and historical importance of NFTs. However, if theoretical case for non-fungible tokens is not compelling enough, perhaps the economics of their market value might be. This report from 2022 estimates that there were 12 million digital-only content consumers in 2021. Consumer spending on digital assets has evolved over the years and is verging on mainstream acceptance. NFTs enable the ability to identify an ‘original asset’ among several copies of a digital asset.

The idea of NFTs began sometime around 2013, when colored coins were issued on the Bitcoin blockchain. It was not until 2017, however that NFTs started to really make a mark, thanks to projects like ‘Cryptopunks’ and ‘Cryptokitties’, two different projects that brought NFT use into the mainstream.

In 2019, the inception of two marketplaces, SuperRare and OpenSea, fueled the growth of the NFT market among the masses. In 2021, NFTs made news when "Beeple’s Everydays: The First 5000 Days" was sold for a whopping $69 million at a Christie’s auction in May. This was a watershed moment. NFTs were now in the public conscience.Though NFTs based on art garner most of the attention due to headline-grabbing sale prices, they only make up 10 percent of the market, with collectibles and games comprising more than 80 percent. The reality is that art-based NFTs have risen in sale price but decreased in the number of transactions. This means that the prices of art NFTs have risen, thus reducing the amount of people who are able or willing to transact in this category.

NFT Formats

NFTs exist in many different formats. They can be:

The Science journal Nature analysed data concerning 6.1 million trades of 4.7 million NFTs between June 23, 2017 and April 27, 2021, which underscored the changing diversity of NFT types and their transaction volume.

Description of the NFT landscape. (a) Top 5 NFTs collections (by number of assets) organized by category. The size of each circle is proportional to the number of assets in each collection. (b) Daily volume (in USD) exchanged over time for each category and for all assets (see legend). Days with volume below 1000 USD are not shown. (c) Share of volume traded by category. (d) Share of transactions by category. Results in these panels are averaged over a rolling window of 30 days. Courtesy of nature.com

Though NFTs based on art garner most of the attention due to headline-grabbing sale prices, they only make up 10 percent of the market, with collectibles and games comprising more than 80 percent. The reality is that art-based NFTs have risen in sale price but decreased in the number of transactions. This means that the prices of art NFTs have risen, thus reducing the amount of people who are able or willing to transact in this category.

NFT Marketplace

Key to any functioning market is a robust marketplace - an arena for buyers and sellers to connect. In the primary market, creators list their NFT for sale and collectors buy it. Afterward, collectors can trade amongst each other on the secondary market. In exchange for a fee, the NFT marketplace will typically handle the transfer of an NFT from one party to the other. Each NFT marketplace has its own system for how it operates. The types of NFTs available, fees, payment options, permitted blockchains and other rules will depend on which one you use. Examples of robust marketplaces are OpenSea (general collectibles), AirNFTs (gaming), NBA Top Shot (sports collectibles), and SuperRare (digital art).

The NFT market is based on peer-to-peer activity and thus is heavily dependent on secondary sales. The more popular an NFT is, the higher the demand and willingness to bid to claim ownership. Temporal patterns of secondary sales are unique for each collection and traders’ activity is highly heterogeneous.

Courtesy of ChainAnalysis

The Value of NFTs

Not to be overlooked in the value of NFTs is what they bring to the table for creators. For example, an artist that sells their work in a gallery, in the traditional sense, only will ever earn revenue for their work on that one sale. Any sales of that work, between two collectors in the future, will never be shared with the artist. NFTs change this.

NFTs enable artists to bypass third parties like top galleries, auction houses, music studios or streaming apps and grant artists direct access to their customers. It allows artists or creators to receive royalty, a percentage of all secondary sales of their creation, in a completely automated way, which is otherwise not an option in the traditional art world. So, when their work is sold between two collectors, they will receive a % of the sale price. Their earnings for their work continue on in perpetuity.

NFTs have real world value as well - the digital artworks can be displayed in physical or virtual art galleries, in-game purchases can be used as collaterals, trading cards can be used to earn tokens, in-game characters can be leased, etc. Since NFTs are simply digital representation of ownership, there might still be several unexplored value creation opportunities.

Use Cases of NFTs

Apart from digital collectibles, there are several unconventional use cases for NFTs like identity authentication assets, tickets or coupons, certifications or credentials, fuel consumption tracking, patents, etc. Here are a few of the current use cases:

  • Membership: Gated communities can provide memberships in the form of NFTs to create scarcity, as well as demand, through gated access. Example: Proof Collective.
  • Ticketing: NFT ticketing provides more secure secondary market and allows connections to be built between artists, event organisers, and their audience. Example: Ivy.Cash
  • NFT-as-a-service: NFTs used to outsource non-core tasks based on price with work conditions, time limits and other criteria set in the smart contract.
  • Physically-backed NFTs: Similar to “SuperGucci” NFTs which also came with a physical ceramic figurine. Or NFTs can be attached to physical items to provide traceability and transparency. Example: F.or Y.our R.eal E.ntertainment Painting
  • Real Estate: Ownership and titles are in the future, but currently held back by entrenched laws. But, NFT-based fractionalized investments and loyalty programs are already happening in the real estate sector. Example: OXO Living in Bali
  • Logistics: Tracing the movement of goods in the supply chain can help to understand expiry date, confirm uniqueness of the product, provide visibility into materials and components, etc. Example: Circulor

NFT Ecosystem

The NFT landscape has evolved into a multi-chain ecosystem with several layers consisting of specific characteristics, goals and functions.

Digital assets enable an internet-native economy, accomplished by NFTs that has distinctive characteristics like uniqueness, authenticity, rarity, ownership, transferability, transparency and trust. 

A typical NFT tech stack and its components:

As discussed above, NFTs can be seen as digital representation of ownership or digital reflection of our physical life. There are various types of “experiential” NFTs that highlight these physical experiences and affiliations:

  • Collectible NFTs: Digital-scarce items that can be collected, traded, traced and shown to others. It is based on our affinity to collect items even in the physical world.
  • Credential NFTs: Basically our physical records that allows us to limit the sharing of our achievements, and if shared, trace this across an ecosystem in verifiable ways.
  • Programmable NFTs: NFTs coded to behave in a dynamic way and not just track ownership.
  • Fractional NFTs: a single NFT that is co-owned by a large number of owners to help; often used to help with the financing and maintenance of an NFT project.

Collectible NFTs

Collectibles are the most popular form of NFTs. According to NonFungible.com, collectibles represent a larger share in the NFTs markets with nearly 80% of the total volume traded. They were the major drive behind the NFT boom in 2021. Collectible NFTs are very similar to physical collectibles like action figures, toys, game items, souvenirs, paintings, etc. but in a digital form. 

Curio Cards (30 unique art collectible cards from seven different artists) were the first major NFT collectibles ever launched after which several other collectibles like Cryptopunks, CryptoKitties (first ERC-721 tokens), MoonCats, Bored Ape Yacht Club, Gods Unchained Collectibles, etc. have taken off. Even global brands joined in the trend to launch NFT collectibles like Lamborghini, Coca-Cola, Adidas, TIME Magazine, NBA Top Shot,etc. Depending on their rarity, utility, and other factors, NFT collectibles can gain value beyond economics just like any other physical collectible.

Collectible NFT Examples:

Bored Ape Yacht Club
One of the most popular NFT art collections, known for its rich and detailed features is the ‘Bored Ape Yacht Club’. BAYC consists of 10,000 different ape avatars, each unique as they are randomly generated from more than 170 possible traits like expressions, clothing, headgear, laser beams, accessories, etc.

Launched in April 2021, the ape avatar as profile pic has become a popular trend now and is considered a prestige symbol, all thanks to its celebrity owners. BAYC sales are governed by the creators and the most popular secondary marketplace is “OpenSea”.

The members are offered additional perks like access to “THE BATHROOM”, a communal graffiti board, access to the BAYC Discord, access to additional NFT collectibles such as Bored Ape Kennel Club dogs (for free) and also other future benefits yet to be unlocked. Coinbase is set to produce an animated Bored Ape Film Trilogy along with creators of BAYC, Yuga Labs.

Nike Cryptokicks
Nike CryptoKicks is a digital sneakers collection of 20,000 NFTs, launched with RTFKT, a studio that has already sold millions of dollars in virtual sneakers. A pair of sneakers was sold for $130K. Launched in April 2022 with their iconic swoosh mark, these NFTs came with Skin Vials that allow users to customize the virtual sneaker NFTs according to their preference. 

In February 2022, RTFKT released 20,000 NFTs of a mysterious box called MNLTH, with the Nike Swoosh and RTFKT’s lightning bolt logo. About 8,100 people who owned an NFT from one of RTFKT’s earlier collections received a MNLTH for no additional cost. Others could buy on OpenSea, starting around 5 Ether (about $15,000 at the time), although no one knew, at that time, what was inside.

Owners were randomly assigned one of eight skins, ranging from the most common, “Human,” with its fuchsia and black colorway, to the rarest, “Alien,” in purple and green. Users are hoping to wear these shoes in online games and metaverse.

Axies
Axie Infinity, a popular play-to-earn game has nearly 2 million daily active players (DAU) and $5.5 billion in virtual assets. In this play-to-earn model, players can earn by winning a battle or re-selling their ‘Axies’ in the marketplace. Axies are characters in the game, where the Axies themselves and the land they inhabit are actually NFTs. One of its rare NFT costs about $800,000. It is also possible to breed more Axies from existing ones, at a small token cost. The newly bred Axies, in most cases, more powerful, can be sold in the marketplace but there is a limit to the number of Axies bred.

Axies can be sold in exchange for Ethereum as NFTs, using the Axie Infinity Marketplace. Also, its “play-to-earn” approach rewards with crypto tokens that can be exchanged for money. Axie owners can also loan their NFTs to other players to use and earn with. Axie Infinity had already hit a total NFT sales of $4 billion.

Axie was launched by its parent company Sky Mavis in May 2018 but didn’t pick up steam until the second half of 2021. Axie Infinity’s Origin update on April 7, 2022, included a set of free starter Axie NFTs in an attempt to onboard new players.

These Collectible NFTs can be considered to have uncertain value because their worth is based on the mindset of masses.

Credential NFTs

These are non-transferable NFTs which have been under-explored so far. They go beyond the monetization of NFTs, making NFTs a digital representation of our physical self.

Credential NFTs could be personal identity, certifications, passport, medical reports, insurance claims or even self-sovereignty. These NFTs can be used for digital identification and verification.

Credential NFT examples:

0xcert
The first open protocol built to support the future of digital assets, powered by NFTs. Allows to create, own, and validate unique assets on the blockchain. The 0xcert protocol offers tools for building powerful dapps, aimed at easy authentication and management of digital or real-world tangible assets (such as ID, educational certificate, in-game item or a house) on the blockchain.

Oxcert was founded as early as 2018 with a starting point as non-fungible tokens, specifically the ERC-721 Ethereum standard. In addition to common functions for transferring and managing standard non-fungible tokens, the 0xcert protocol provides another layer of conventions for creating certified non-fungible tokens for unique assets. With 0xcert protocol, it is possible to validate a proof of existence, authenticity and ownership of digital assets without third-party involvement. It enables developers to focus on the application layer and quickly build applications for issuing university certificates, KYC applications, applications for loyalty programs, warranties, badges, credits or even a decentralized non-fungible exchange. It uses ZXC utility token to perform user requests on the blockchain. 

0xcert is building out a whole ecosystem of parties involved in the non-fungible space like specific application developers, companies from various verticals, researchers, organisations and communities.

Soul-Bound Tokens
Vitalik along with his peers E. Glen Weyl and Puja Ohlhaver introduced the idea and theory behind Soul-Bound Tokens (SBT), which are non-transferable. It represents commitments, credentials and affiliations of ‘Souls’ (self), the trust networks of the real economy to establish provenance and reputation. Education and on-chain resume projects like 101.xyz and Noox issue online credentials as Soulbound NFTs. For example, a university could be a Soul that issues SBTs to graduates. A stadium could be a Soul that issues SBTs to longtime Dodgers baseball fans. 

Soulbound tokens (SBT) are non-transferable, publicly-verifiable digital tokens that can act as a type of resume (CV) for web3 users. SBTs improve upon the NFT concept to serve as a way for users to prove who they are and what they do. Lack of Web 3-native identity and reputation forces NFT artists to often rely on centralized platforms like OpenSea and Twitter (TWTR) to commit to scarcity and initial provenance, and prevents less than fully collateralized forms of lending. SBTs could provide the missing link to bridge the trust gap in web3. With SBTs users can observe the immutable history of people before conducting business with them.

While there are several distinctive advantages of SBTs, they also pose few threats. They may reveal too much sensitive information about a person. Additionally, implementing the tokens can prove challenging. A community recovery method has been suggested in case an SBT is lost.

NFT COVID-19 vaccination passports
On July 1 2021, Principality of San Marino in partnership with VeChain pioneered digitised Covid-19 vaccine passports in the form of NFTs.  The vaccination passport contains a record of past infections, negative test results, and also provides a digital vaccination certificate. The digital vaccination certificate is issued upon request from approved facilities by San Marino health authorities. It is recorded on the VeChainThor public blockchain, by linking an enterprise non-fungible token (eNFT) to an individual’s Covid-related medical history.

The certificate contains two QR codes - first code is in compliance with European Union requirements and standards and can be verified by approved member states and entities, second QR can be scanned by “anyone anywhere” outside of the European Union and directs users to a web-based app where the blockchain based eNFT certificates can be verified.

There are limitations in the implementation of these credential NFTs. Apart from the technological issues, there are also trust issues like “shifting the mentality of trust” from centralized institutional trust to trusting networks. For example, would an academic certificate NFT be controlled by a centralized educational institution? If so, what is the point of storing these NFTs on a distributed ledger?

Programmable NFTs

These are configurable NFTs that can dynamically modify their appearance and functions based on triggers and inputs. Although NFTs are inherently programmable in nature, this feature has been heavily underutilized at the moment. Imagine an NFT that changes color based on the season, an in-game NFT that changes property based on your win or loss, a music NFT that plays track based on time of the day, a credibility NFT that blacks out when accessed by anyone other than the owner. All these are some basic use cases of Programmable NFTs.

Programmable NFT examples:

Async Art
Async.Art’s platform is specialized to support NFTs that have been tied to programmable artwork. Programmable art can be built with autonomous features, meaning that the art can change based on things like statistical data, geographic location, etc. It is possible to create a single piece of art with the potential to take on different forms.

They introduced ‘Async Music’ where NFT ownership privileges give their holders control over certain elements of the music piece: “they get to choose from a menu of options based on the composer’s intent,” which include elements such as tempo, timbre, and narrative. Users can create and then trade these 'Limited Editions' based on the piece’s musical layers at any given time.

Human One
A three-dimensional video sculpture by Beeple, would evolve over time. Beeple will have remote access to the artwork and continuously work on it, forever.

22 Racing Series
Developed by GOATi, 22 Racing Series is a racing game, where players can collect and combine individual, immutable components to create futuristic vehicles. These NFTs can then be traded or swapped for other constituent parts. The constituent parts remain the same, but the end product is the result of the player’s imagination. 

Since these NFTs are dynamic and programmable, their applications and abilities are rich and limitless.

Ecological Impact of NFTs

NFTs are at least partially responsible for the millions of tons of CO2 emissions generated by the cryptocurrencies used to buy and sell them. Minting a single NFT using the proof-of-work method uses the same amount of electricity as an average American household over almost nine days.

Digital artist Mike Winkelmann, famously known as ‘Beeple’, plans to make his artwork carbon “neutral” or “negative”, by investing in renewable energy, conservation projects, or technology that sucks CO2 out of the atmosphere. It costs an estimated $5,000 to offset the emissions from one of his collections.

As Ethereum transitions to a new architecture and it becomes less energy intensive to execute transactions throughout the web3 ecosystem, it is not unforeseeable that web3 applications will follow a similar trend to Moore's Law and go down over time.

The Future for NFTs

The explosion of interest and speculation in NFTs has led to a certain increase of awareness about the unique features of NFTs. . However, a lack of clarity around what is actually owned in NFTs (e.g., the ways the intellectual property rights of the code match up to the intellectual property rights of the marketplace the code is being issued on and the intellectual property rights of the NFT administrators) plagues the space. Just last month, Seth Green lost his Bored Ape that he built an entire TV Show around via a phishing attack and only after publicly haggling with the transferee of his Ape. So we are still in very early days in the space. However, as better design patterns emerge, better mechanisms of delivery are developed, and more safeguards are built up around NFTs, there is lots of interesting conceptual and commercial opportunities that will emerge.

This article does not constitute investment and/or legal advice, and is strictly for education purposes only. Upside is not an SEC registered investment advisor, practicing legal entity or any other type of licensed body that can legally provide investment and legal advice. Upside is not responsible for any errors or omissions in this article, due to the changing nature of laws, rules and regulations or otherwise, or for results obtained from use of the information it contains.

Why It's Hard To Launch A Token...and Why Its Worth It For Ambitious Businesses

Join Noah Thorp, founder and CEO of Upside, for a 40 minute overview of why businesses are moving into Web3; and the legal, technical and regulatory complexities involved in that move.
Watch The Presentation
The Ledger
More from the Upside Ledger
Nine Examples of Security Tokens in Web3
Nine Examples of Security Tokens in Web3
Security Tokens are cementing their place in the financial industry as a programmable vehicle for investment in any asset that already has value, like real estate, a car, or corporate stock.
The Complete Guide To Governance Tokens
The Complete Guide To Governance Tokens
Uniquely, compared with other types of tokens, Governance Tokens may actually take many forms. There are security tokens, utility tokens, and LP staking tokens, that each perform a governance function.
Everything You Need to Know About Liquidity Provider Tokens
Everything You Need to Know About Liquidity Provider Tokens
Liquidity Provider Tokens, or LP Tokens for short are a reward mechanism to help facilitate transactions between other different types of currencies. To understand Liquidity Provider Tokens better, it is helpful to...
The Complete Guide to Security Tokens vs. Utility Tokens
The Complete Guide to Security Tokens vs. Utility Tokens
Organizations from all types of markets and communities are looking to tokens as a way to deploy new types of businesses and projects.