Non-fungible Tokens (NFTs)

This article is partially based on texts that have already been published in my book Token Economy and my blog post from a few years ago on NFTs.

Why unique tokens with more attributes will unlock the Token Economy

Recently, I have been contacted by a number of media outlets asking me to give interviews or write about NFTs. The wording is always: “NFTs seem to be the new hot shit.” NFTs are definitely not new, but due to some recent events in the art world and beyond, mainstream media is finally moving past Bitcoin price reporting to the wide array of more interesting things we can represent with tokens — and in this particular case — with NFTs. But why the sudden hype? Here s brief summary of recent events:

  • Jack Dorsey, co-founder and CEO of Twitter registered his first tweet on CENT — a decentralized application that allows you to register an “autographed versions” of any tweet on the Ethereum network, thereby creating a unique token that has been digitally signed (also referred to as NFT or non-fungible token). His tokenized tweed sold for 2.5 million USD (1630.5 ETH).
  • The Nyan Cat meme— a popular GIF from 2011 — was remastered for its 10-year anniversary by the original artist and registered as an NFT who the ran a 24-hour auction on the crypto art platform Foundation and sold the digitally signed Meme for about 590,000 USD(300 ETH).
  • A group of 34 digital collectible pieces of art issued as NFTs that were signed on a blockchain network by their creators, called CryptoPunks, sold for over 1 million USD (557.5 ETH).
  • Beeple — a digital artist with over 2 million followers on Instagram — sold an NFT art collection for over 3.5 million USD back in October 2020. One of the NFTs from his collection was recently resold on Christie’s for 69 million USD.
  • Kings of Leon released their Album (When You See Yourselfas NFTs. Their tokens represent a series of access rights and ownership rights. They can unlock special perks such as a limited-edition vinyl, front row seats to future concerts or exclusive audiovisual art.
  • Banksy’s 2006 screenprint titled “Morons”which criticized the art market was bought for $95,000 by Injective Protocol (a group of crypto-savvy artists) who the burned the print and registered the recording of the performance as an NFT which sold for 380,000 USD (228.69 ETH) on OpenSea — an NFT trading platform.
  • The Museum of Crypto Art — launched in 2020 within Somnium Space — isa virtual space built on the Ethereum network. The Museum displays tokenized art collection (NFTs that were bought by the collectors who contribute to the virtual musem).

Is this just a Hype?

Web3 tokens allow artists to sign a specific digital file (artistic content) with their private key, thereby creating uniqueness for that file. The client-server architecture upon which the current Internet operates does not allow us to distinguish original files from their copies. A data packet is a data packet. You can only use DRM to limit access to that data packet and use legislation to enforce your property rights and sanction pirating of files or IP.

Web3 tokens allow us to create a hash of an original file and sign it with the private key of the content creator, which means that the hash of this file can be collectively managed by a blockchain network. Uniqueness of digital art and the fact that files can be copied for free does not necessarily have to exclude each other. Creating a digital signature allows us to build complex behaviour into the token contract that could create interesting new dynamics in the art world and beyond.

Wether or not it makes sense to create artificial scarcity for a digital file is probably a matter of taste and subject to specific use cases. I personally don’t see an added value in paying 2,5 million USD for a digitally signed tweet by Jack Dorsey or paying 69 million USD for a an Instagram picture by Beeple. Other seem to think different. But there are many other NFT use cases that I find interesting and which we will discuss in a bit, but first let’s try and answer following question:

What makes NFTs different from let’s say Bitcoin?

As opposed to Bitcoin and similar crypto assets, Non-fungible tokens (NFTs) are unique in nature, with varying properties that allow us to distinguish one token from another. NFTs can represent digital, unique, and thus scarce assets, such as art, other collectibles or even real estate. NFTs can also represent identities and anything that is tied to a physical identity such as voting rights, access rights and management rights: Examples are certificates, such as licenses, degrees, keys, passes, voting rights, tickets, loyalty tokens, copyrights, proof of authorship (of books, scientific papers and any kind of audio-visual content) as well as warranties, software licenses, medical data, wills (the transfer of assets), and certificates of any kind, such as supply chain or art certificates.

Source: Shermin Voshmgir, https://token.kitchen, adapted from a graphic in the book Token Economy

Web3 tokens are programmable rights management tools that can have much more complex properties than fungible currency tokens. They can represent any asset, access right, voting right or management right. Here is a broad overview of the different range of properties a token can have: (i) technical perspective; (ii) rights perspective; (iii) fungibility perspective; (iv) transferability perspective; (v) durability perspective; (vi) regulatory perspective; (vii) incentive perspective; (viii) supply perspective; and (ix) token flow perspective, (x) privacy perspective.

Source: Shermin Voshmgir, https://token.kitchen, adapted from a graphic in the book Token Economy

In my book Token Economy I described all the above mentioned perspectives, in this post, however, i would like to focus only on the fungibility perspective.

Fungibility Perspective

From an asset perspective, fungibility refers to the interchangeability of a unit of an asset with other units of the same asset. Examples thereof could be any durable goods, such as precious metals or currencies. Fungible assets have two key properties: (i) Only quantity matters, which means that units of fungible assets of the same kind are indistinguishable. (ii) Any amount can be merged or divided into a larger or smaller amount of it, making it indistinguishable from the rest. If you were to lend 10 EUR to someone, for example, it would not matter if that person returns the exact same 10 EUR bill or another one, or various bills and coins that amount to the value of 10 EUR. The same applies to one barrel of crude oil. Flour is another example of a fungible asset, and is also one of the reasons why it was used as a commodity currency in the past. Fungibility is an important property of any currency or commodity to serve as a store of value, medium of exchange, and a unit of account.

  • Respresenting uniquness: Fungible Web3 tokens can therefore represent any physical or digital assets that are identical to each other and can therefore be easily replaced. They are not unique and are therefore exchangeable with other tokens of the same type. Non-fungible (unique) tokens can represent ID cards, the ownership of a house, tenant rights, a car, a piece of art, or a gym membership. Non-fungible tokens can be transferable or not, depending on the use case.
  • Shapeshifting uniqueness & fungibility: Unique tokens can become fungible, if you fractionalize parts of the token into fungible equals. Example: The tokenized representation of property rights of a an apartment is unique in nature, because that apartment has different properties than any other apartment. But when you issues fractions of that NFT representing your apartment, these fractions can be fungible within your NFT token set. On the other hand, non-fungible assets such as securities could become fungible if you attach more complex properties (such as special voting rights, not transferability clauses etc.) to them which might not have been as feasible before.
  • Divisibility & liquidity in the case of asset tokens: The more easily divisible an asset is, the more fungible it is. Divisibility refers to the fact that you can exchange a fraction of that asset with someone else. In the real world, many assets cannot be divided, which makes them less easily transferable. Cryptographically signed tokens can represent unique assets — such as art and real estate— that were not easily divisible before can now be fractionalized at lower transaction costs than with established systems.

NFT Use Cases

There is a wide range of use cases for NFTs:

  • Digital assets that are unique in nature can be tokenized, such as crypto-collectibles (art and other collectibles), crypto-games, but also books, music, movies, or scientific papers. Examples for NFT Marketplaces for cryptoart are: Foundation, MakersPlace, Nifty Gateway, SuperRare, Opensea, Rarible, KnownOrigin, or Zora. Other types of digital assets have other markets that are slowly emerging.
  • Real assets that are unique in nature: NFTs allow the tokenization of unique investments tied to a physical assets, like unique artwork, real estate, investment in a SME (Small and medium sized company). One could tokenize a building, where some tokens could grant simple ownership titles of a fraction of the real estate, while other tokens could grant special privileges like access rights. NFTs can grant token holders different rights and levels of control over their assets. The management of the fractionalized investment rights in these assets is much cheaper and could create new market dynamics by making certain markets more liquid than they are today.
  • Identity Tokens, Certificates, & Reputation: Anything that uniquely represents a person could be represented as a non-fungible token: any type of ID or certificate like school transcripts, university degrees, or software licenses that are tied to the existence of one single person. A diploma could be issued and collectively managed by a distributed ledger with no need to be translated, manually notarized, or verified. Wallet-like software could manage all personal data without the need for centralized institutions storing our data. The token would represent a container for identity information related to a specific person without giving information about what is identified. Certification claims can be associated with the token, which would be issued by the trusted entities that issue these certifications. If properly designed, reputation tokens could be attached to identities and resolve challenges like “fake news.”
  • Access Tokens: NFT could be used to manage any type of access right that is tied to a special person, a special property, or a special event. By using public key cryptography, distributed ledgers can offer more secure and decentrally verified access-rights management than centrally managed digital access-rights management solutions.NFTs in combination with other Web3 protocols can be used to replace physical keys, state of the art digital keys, and passwords.
  • Asset Transfer Tokens: When someone passes away today, the assets of that person often needs to be split between multiple heirs, which can produce considerable bureaucratic overhead and coordination costs to split the value of these assets specified in a notarized will. While fractional ownership is possible today, NFT based asset transfer tokens managed by a distributed ledger would make the transfer of assets in the case of wills much more frictionless.

While some of these use cases are slowly showing some traction, they are not new. NFTs haven been around the crypto scene for a while, but we are still in the early stages of figuring out appropriate standards and similar patterns for pervasive use cases.

History of Web3 Tokens

The first Web3 tokens were the native tokens of public and permissionless blockchain networks. In 2013, “Colored Coins” was one of the first projects that attempted to attach unique properties to a token. The idea was to use Bitcoin tokens to represent real-world assets like stocks, bonds, commodities, or the deed for a house. “Counterparty” was another project that built on this idea, but went one step further. It enabled users to create their own virtual assets on top of the Bitcoin network.

With the advent of Ethereum, tokens have moved up the technology stack and can now be issued on the application layer. Such application tokens can have simple or complex behaviors attached to them. As opposed to Counterparty and colored Coines, Ethereum made it particularly easy to issue tokens with a few lines of code. Standardized smart contracts like the “ERC-20” standard define a common list of rules for Ethereum tokens, including how the tokens are transferred from one Ethereum address to another and how data within each token is accessed. These token contracts manage the logic and maintain a list of all issued tokens, and can represent any asset that has features of a fungible commodity. A majority of early tokens issued on the Ethereum network were ERC-20 compliant fungible tokens.

Over the last years, however, more complex token standards have emerged that can represent any asset or access rights with special properties, including identities and voting rights. “ERC-721” introduced a free and open standard that describes how to issue so-called “non-fungible tokens” on the Ethereum network and introduced the era of building more complex features into tokens.

From a tech perspective, the ERC-721 token standard allows for more detailed attributes that make a token special, beyond the attributes that can be found in ERC-20 tokens. It allows the inclusion of metadata about an asset and information about ownership. When validated, such additional information can add value, guaranteeing the provenance of art, collectibles, or along the supply chain of other goods and services.

Ethereum based NFTs started to attract attention in 2017 when the ERC-721 token standard was introduced, especially following the success of “Crypto Kitties,” a game on the Ethereum network where players can collect and breed digital cats, and where each cat’s unique digital “genetic code” is stored on Ethereum’s ledger.

However many more complex token standards have emerged that allow us to attach more complex attributes and behaviours to a token. The success of ERC-721 also triggered many other blockchain networks to develop their own non-fungible token standards.