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How do NFTs work?

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Non-fungible token. It was a term that took the world by storm in 2021, a technology that accounted for $25 billion in sales on digital goods marketplaces, and a way for people to capture their online identity on social media platforms.

But, if you’re like many people, you might have raised an eyebrow at this new technology. And, likely, you had some questions. For instance, some common ones we see every day at Rarity Sniper are:

  • What is an NFT?
  • What are some blockchains that support NFTs?
  • How do you store an NFT?
  • And the big one: How do NFTs work?

If you’ve had some of these questions and you’re looking to learn more about this sphere of Web3, you’ve come to the right place. In this article, we’ll answer all those and many more, building your knowledge about non-fungible tokens, the technology that has given them birth, and what they may mean for you.

Let’s start with the most basic: What is an NFT?

What is an NFT?
When most people think of a non-fungible token, they think of a Bored Ape or a Beeple (real name Mike Winkelmann) digital artwork. But is that really what NFTs are all about? Let’s start with a definition.

Investopedia lists NFTs as “cryptographic assets on a blockchain with unique identification codes and metadata that distinguish them from one another.”

In other words, NFTs are a type of technology rather than the numerous use cases that represent it. We’ll touch on three aspects of this technology in this section: the smart contract, digital assets, and unique identifiers.

First, NFTs are created through programs called smart contracts. Typically, a developer for a team creates this “contract,” which uses a specific type of code to create a predetermined number of tokens, each with its own unique identifier and metadata.

There are different types of smart contract languages, the most popular perhaps being Ethereum’s Solidity, but they have a number of shared characteristics. By design, they run actions based on predetermined parameters, creating these tokens, which are then stored on the blockchain.

That brings us to our second chunk of knowledge: Really, NFTs are digital assets created with this code. They aren’t physical or tangible, like a piece of real estate or a slice of turkey. Some might even say they lack utility, and certainly, the earliest forms of them struggled for use cases.

They differ from other cryptographic assets because they are non-fungible and can represent different uses — a profile pic and digital art being the two main examples. But the most important part to remember is that they are digital items, created with code, and function according to a set of rules as outlined in the smart contract.

Third and finally, NFTs are non-fungible because they contain unique identifiers and metadata that separate them from other types of digital assets. That’s why two non-fungible tokens can never be the same. Simply, the unique identifiers and metadata would prevent them from being so.

Even in large collections (the most common being the 10,000 NFT collection), the developers use a method to vary the traits of the artwork so that no two are alike. In the end, NFTs are a type of technology rather than a use case, one that functions on blockchains and smart contracts. Now that we’ve touched a bit on this distinction between what is technical and the use cases you see on the news, let’s go over some NFT characteristics.

What are some NFT characteristics?
In the cryptocurrency world, non-fungible tokens are a relatively new phenomenon. Although the genius Hal Finney dreamed them up in the early 1990s, around the time the first iteration of the internet was taking shape, users first created NFTs as we know them around 2015. Today, they make up a growing part of the Web3 economy, generating $25 billion in sales volume in 2021.

Non-fungible tokens separate themselves from traditional cryptocurrency because an individual NFT cannot be swapped, traded, or exchanged for something of direct equal value. This is the definition of non-fungibility. While 1 bitcoin will always equal 1 bitcoin (bitcoin being a fungible asset), and a trader can swap 1 for 1, the same is not true of an NFT.

NFTs are more like trading cards: No two are exactly alike. Even with mass-produced baseball cards of the same player and the same image, the serial numbers would be different. The same is true of NFTs.

1 Bored Ape does not equal the value of another Bored Ape or 1 CryptoPunk, a VeeFriends, or a Drifter Shoots NFT photograph. While fungibility is an essential part of an economy (think of how difficult it would be for the United States economy to function without the fungibility of dollar bills for financial transactions), non-fungibility brings a unique component to digital assets, making them scarce and giving them value. Non-fungibility creates the basis for investor demand in NFTs.

Non-fungible tokens also are different from some cryptocurrencies (though not all) in that they are tokens, not coins. When it comes to cryptocurrency, coins are the native asset used on the blockchain. For instance, bitcoin on the Bitcoin blockchain and ether on the Ethereum blockchain. Tokens are other assets that use blockchain technology (a kind of public, digital ledger) but are not the blockchain’s native asset.

The most common NFT token is the EIP-721, which runs on the Ethereum blockchain. It is known as “the standard” and creates the basis for what we know of NFTs today. But it is just one of many different tokens that utilize the Ethereum blockchain.

Because NFTs reside on the blockchain, they are trackable and traceable. You can find out which NFTs are in which wallets, which wallet holds that Bored Ape you’re looking for, and even an ownership history. As such, NFTs have proof of ownership. Because an NFT has an owner, it can be bought and sold. Ownership, or having an owner, is one of the characteristics of an NFT.

Now, while NFTs got their start on Ethereum, it is not the only blockchain that features NFTs. So: What are some of the others?

What are some blockchains that support NFTs?

Ethereum is the No. 1 blockchain for NFTs, and it’s easy to see why. With its decentralized nature and enhanced security, trading is easy. The blockchain is also home to some of the most popular NFT collections, including Bored Ape Yacht Club and CryptoPunks. But Ethereum comes with a big downside: Because it uses a Proof-of-Work consensus mechanism, it requires a lot of energy to process transactions. As such, it has a large carbon footprint.

Fortunately, for those looking to trade NFTs but don’t want to use Ethereum for whatever reason, there are other blockchains to choose from. Here are three.

Solana. Once dubbed the “Ethereum killer,” the Solana blockchain uses a combined Proof-of-History and Proof-of-Stake consensus mechanisms to process transactions quickly and for a minimal cost. It is home to some top NFT collections, including Solana Monkey Business and Degenerate Ape Academy.
Tezos. The blockchain most known for alternative art marketplaces, Tezos has made a name for itself as the “Green blockchain” due to its environmental friendliness. Here, you won’t find many 10,000-NFT collections or big hitters. Instead, you can peruse its marketplaces for edgy, strange, and sometimes brilliant digital art.
Flow. A Dapper Labs creation, the Flow blockchain uses a Proof-of-Stake consensus mechanism to achieve low transaction costs and high speeds. It is home to various NFT collections, including Ballerz, but its claim to fame is NBA Top Shot, which is said to have onboarded most of today’s NFT collectors into the space.
Those are the four main blockchains where you can find NFTs. Now, let’s move to another burning topic: Some examples of non-fungible tokens.

What are some examples of NFTs?
While non-fungible tokens are a technology, there are certain examples of them that may shed more light on how they are being used today. Here are four examples of NFTs that have sprung up since 2017 that continue to enthrall and inspire.

NBA Top Shot moments. The product of a partnership between Dapper Labs and the National Basketball Association, NBA Top Shot utilizes moments that are short video clips of action on the hardwood. They can be of a three-pointer, dunk, block, steal, or more. NBA Top Shot is widely credited for starting the interest in NFTs during the 2021 bull run.
CryptoPunks. This 10,000-NFT collection from Larva Labs in 2017 set the trend for most large NFT collections after it. Using an algorithm, the creators used a pre-defined series of traits to create the collection, in which no two NFTs are alike. CryptoPunks also introduced the concept of rarity into NFTs, which gave more value to some NFTs in a collection than others.
Drifter Shoots. This photography collection from Drifter shows the former military serviceman scaling high buildings without equipment. The photos detail incredible city landscapes from a vantage point that few have attempted to reach, and as such, they command a high value in Web3.
Jenkins the Valet. Created using an NFT from the Bored Ape Yacht Club collection, Jenkins the Valet is a character the creators use as a story-telling device. The first product the team delivered was a “tell-all” book about the Yacht Club featuring Apes in the collection. In a twist, it was the holders in the Jenkins collection NFTs who created the backstory for the characters.
You might recognize a theme here in these four collections: They fall under the branch of collectibles. That category of NFTs remains dominant into 2022, though there are already interesting projects sprouting up that create utility out of the technology rather than a simple digital collectible.

What are some use cases for NFTs?
NFT use cases differ slightly from examples of NFTs in that they are broader. While an example of an NFT might be confined to a product, a use case can encompass countless examples. Here are six worth watching out for, in the current market and in the future.

Profile Pictures. Ever since the dawn of the internet, people have cultivated a digital identity. Profile pictures or the small images that appear next to screen names on social media and in profiles are a large part of that cultivation. Profile picture NFTs signal to others who we are affiliated with, who we align ourselves with. They can also lead to digital bragging rights.

Art. The IRL art field is often difficult to crack into for artists and collectors. NFTs allow anyone to become an artist and sell artwork while making it easy to own and invest in art on the collectors’ side. It was the first use case for NFTs in 2015 and remains one of the most popular. There are even technological inventions that allow you to display your digital artwork on IRL physical devices. NFTs have added to the creator economy.

Royalties. NFTs allow for a distribution of royalties that may upend the traditional royalties world. While you can easily buy royalties to a song today, it often costs thousands of dollars. But in the NFT world, the cost is much cheaper and, due to the straightforward process of purchasing an NFT, much simpler. NFTs also allow artists to receive royalties on every subsequent sale of their artwork in perpetuity.

Licensing. Similar to royalties, NFTs may someday change the way we view licensing. The aforementioned Jenkins the Valet NFT project is a good example of this innovation. The team created 6,942 NFTs that acted as licensing tools for their products. When an NFT holder uses the NFT for licensing, they grant the team the license to use one of their avatars in exchange for royalties.

Real Estate. Some companies are experimenting with using NFTs to represent property deeds on the blockchain. In this way, the NFT can act as a placeholder that allows for the change of ownership of the deed without either party having to deal with the paperwork that accompanies selling and buying a property. And because the transaction is on the blockchain, it is immutable.

Fundraising. For entrepreneurs, NFTs represent an opportunity to raise money quickly and start a community. For investors, buying the NFT is akin to buying an asset they can later sell when the entrepreneur’s project gets big. It’s a win-win for everyone involved, assuming the entrepreneur doesn’t simply run off with the money. And it’s not just entrepreneurs getting in on the action. Many NFT projects have raised funds for charity as well.

Can anyone create an NFT?
The answer is an unequivocal “Yes.” Here is exactly what you need to create an NFT.

First, you’ll need the basics: a computer and an internet connection. Because NFTs are digital assets, a computer is required. Because you’ll be accessing networks that run on the internet (decentralized networks that have nodes all over the world), you’ll need internet access.

Second, you’ll require the image, GIF, or file that the NFT will link to. You can almost consider this the final product of the NFT or what the end-consumer sees when they find your NFT in a marketplace. Really, any file can suffice. Make sure to store the file in a way that would prevent it from being lost, or else your customer will be left simply with the raw NFT.

Third, you’ll either want to write up your own smart contract, hire someone to do it for you, or use a smart contract on a marketplace. There are pros and cons to each method. While using the marketplace contracts is more convenient, especially for the less tech-savvy, you can learn a lot as a creator by drawing up your own.

Fourth and finally, you’ll need a way to pay for the minting process. The “minting” of an NFT is simply how an NFT is born on the blockchain. In general, it costs cryptocurrency. The specific coin will depend on which blockchain you use. For Ethereum, you’d need Ether, for Tezos, $XTZ, etc. Some marketplaces may employ a “lazy minting” strategy in which you’ll only pay for the mint if your NFT sells. Using this technique can save you money upfront.

Overall, it’s a relatively simple process that requires just a few items. For more information about creating an NFT, visit this Rarity Sniper guide.

How do you store an NFT?
Storing an NFT is a simple process and involves a digital wallet. Just like you have a wallet to store cash and cards in real life, there are crypto wallets for the storage of cryptocurrencies and non-fungible tokens. Some common ones you may have heard of are Metamask, the Coinbase Wallet, and Exodus.

Wallets tend to organize themselves into two categories: custodial and non-custodial. Custodial means that the wallet is controlled by an entity other than yourself. You’ll usually find these wallets on exchanges like Coinbase, Kraken, or Binance. A non-custodial wallet is one that only you have control over. No one, not even the provider, can access the wallet except for you.

Both, when it comes to the storage of NFTs, have their advantages and disadvantages. The advantage of a custodial wallet is that you don’t have to worry about being locked out of your wallet if you forget the password to your account and lose the seed phrase. The disadvantage is that you don’t have control over your assets, and your account can be shut down anytime.

The advantage of a non-custodial wallet is that you have complete control of your wallet and the assets inside of it. You can even input the seed phrase into another provider, and your wallet will pop up. The disadvantage is that if you forget your password and lose your seed phrase, you could lose your assets forever.

Who controls the private keys and seed phrases is the main difference between custodial and non-custodial wallets. With custodial wallets, the centralized entity has control of the keys, while you do with non-custodial wallets. There is a phrase in Web3 that goes, “Not your keys, not your wallet.” It shows the danger of keeping assets in a wallet where you don’t have control of the keys because you could lose access to the wallet at any time.

For more information about which wallets are the best in Web3, visit our top NFT wallets guide.

How do you invest in NFTs?
Although the subject of this article is “How do NFTs work?” or “How to Invest in NFTs,” most of the market today is based on price speculation. Therefore, we would be remiss not to include a section with some basic investment tips here. Although these tips can apply to numerous sectors of investment, they are specifically tailored for trading NFTs. Here are four:

Buy What You Like. The first guideline of NFT investing is to buy what you like. You may like an NFT because of the art, the utility, the community, the team, or another factor, but it always helps to invest your money in an asset in which you stand to gain something.
Invest no more than you can afford to lose. This guideline is important, especially in areas of investing where you can make a great deal of money quickly, which can lead to overinvesting and leveraging. Answer the question: “Would I be okay if I lost this money?” If the answer is “yes,” you may be in a good place.
Red Clipping. Red clipping is based on a technique where you buy one asset, watch it rise in value, sell it, then buy an asset of lower value. By repeating this process, you can amass a lot of liquidity quickly, which can enable you to make bigger bets on the collections you like.
HODL. A misspelling of the word “HOLD” from a Bitcoin forum years back, “HODL” is a way to ride out the highs and lows of the market while maintaining an even keel. It also holds to the theorem that markets tend to go up over time, and you’ll stand to gain money if you stay in the game rather than sell.
Those are four guidelines for investing in NFTs, and there are many more. Right now, the cost of entry into NFT investing is still relatively low. For a more detailed look at how to invest in this nascent space, visit our Rarity Sniper guide, “How to Invest in NFTs.”

Conclusion
NFTs can be many things, but at their heart, they are simply technology. The use cases for this technology are growing and growing fast, with more coming each day. Soon, many believe that the majority of the people in the world will interact with them in some fashion.

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