What is an NFT?

In 2021, the most expensive non-fungible token (NFT) to date sold for a whopping $91.8 million.¹ It helped amplify a craze for digital collectibles, which grabbed pop culture attention and led to more multi-million-dollar NFT sales.

More recently, there are signs the euphoria has faded. So are NFTs just hype, or is there more to the story? Let's take a look at how they work, and what should be taken into account if you are considering buying an NFT.

What does NFT stand for?

NFT is an acronym for non-fungible token. The word "fungible" means "interchangeable." Examples of fungible items include currency and stocks. They are interchangeable because they're essentially identical. There's no difference in value between a dollar bill and another dollar bill, or one share in a company and another share of the same company.

In contrast, a "non-fungible" item means there is a difference in value between each unit. Many collectibles fall under this category. For example, the first Michael Jordan rookie basketball card ever printed is likely worth significantly more than the 100th print of the same card. In other words, a non-fungible item is one of a kind.

NFTs are a lot like sports cards, except they're digital rather than physical. And like cryptocurrencies, they're created and stored on blockchains.

Currently, the most popular usage for NFTs is digital artwork, though other mediums including music, videos, and video game accessories are gaining popularity. NFTs can also be used to trade contracts that represent ownership of real-world items, such as property rights, tickets for football games and concerts, and other tokenized investments like wine or art.

How do NFTs work?

When a creator is ready to launch an NFT collection, they release it to the public through a process called minting. Returning to the trading card analogy, this is a lot like printing a card. Minting an NFT records its unique characteristics on a blockchain. This can include details like rarity, serial number, and other attributes relevant to the collection.

Most importantly, minting makes a record of who owns the NFT. When it comes to collecting digital art, you might wonder why someone would buy an image anyone can screenshot or download. Unlike traditional collectibles, who owns which NFT is tracked and updated on blockchains. The NFT market exists, to some extent, because a part of what collectors are paying for is the title of ownership recorded on a blockchain.

The most widely used platform for creating NFTs is currently the Ethereum network, though the Solana and Polygon blockchains are gaining traction as well. On the Ethereum blockchain, NFTs are minted using what's known as the ERC-721 token standard, which makes the underlying code for each NFT unique.

NFTs can also have additional features. They can have the ability to attach a real-world perk. For example, a musician can create a collection where anyone who owns an NFT with an even-numbered serial number gets free entry to every concert for life.

They can also allow the creator to receive royalties any time their NFT is traded. For example, creators can dictate that they receive 5% of every sale. This means that if owner A sells the NFT to owner B, the creator receives 5% of the transaction price. And if owner B sells it to owner C, the creator still receives 5% of the transaction price—and so on. Once an NFT has been minted, every subsequent sale is considered a sale on the "secondary market."

How do NFTs relate to crypto?

The key link with crypto is that NFTs use blockchain technology. Cryptocurrencies such as ethereum are also used to buy and sell NFTs, and crypto wallets are used to store them. And while there isn't a direct correlation between crypto prices and NFT valuations, crypto volatility can affect NFTs.

As with other crypto transactions, minting, buying, or selling NFTs involve charges known as "gas fees." These costs—which can fluctuate depending on the volume of activity happening on a blockchain—are paid to those who update (or "validate") the blockchain.

How to buy an NFT and what to consider before buying

The most common way to buy an NFT is through an online marketplace. The value of an NFT depends on many factors, including popularity and scarcity. While the hype witnessed in 2021 has since cooled, and many NFTs have decreased in value, some are still selling for millions of dollars.

Those considering buying NFTs should be aware that, like cryptocurrencies, NFTs may be more susceptible to market manipulation than other investments, such as stocks and bonds. The regulatory environment for digital assets is still developing, and NFTs don't benefit from the same protections as other investments. For example, they are not insured by the Federal Deposit Insurance Corporation or the Securities Investor Protection Corporation.

In light of this, if you are considering purchasing an NFT, only buy with an amount you're willing to lose.

What are the potential advantages of NFTs?

Proponents believe NFTs are a critical development for creators. Becoming an artist can be a difficult way of making a living. The ability to charge royalties on secondary NFT sales may provide a new avenue for artists to monetize their work.

NFTs also potentially offer a way to remove the need for third parties in several industries. Because ownership can be easily tracked and verified on a blockchain, NFTs can be used as tickets, property titles, voting tokens, and more. Traditionally, these functions often require third parties to manage. In contrast, NFTs may be able to offer instant verification.

What are the potential disadvantages of NFTs?

As previously mentioned, buying NFTs comes with risk. For instance, prices can be highly volatile. During 2021's boom in popularity, many NFT prices shot up in value, and several have since dropped significantly in value following 2022's crypto volatility.

There are also numerous examples of pump-and-dump schemes. Because anyone can launch an NFT collection, many buyers have fallen victim to so-called "rug pulls." This scheme typically involves creators raising funds for NFT projects, only to then vanish with investors' money.

NFT owners can also be vulnerable to hackers and phishing scams. Due to the high values of some NFTs, collectors are frequently targeted by cyber thieves. Crypto wallet holders should always protect their passwords and never share their seed or recovery phrase.