What is an NFT?

By The Hong Kong Economic Times

Introduction

When talking about one of the most popular investment themes in the past year, NFT, or non-fungible token, can never be neglected – even the Collins Dictionary chose it as the word of the year for 2021. As a kind of digital asset of value based on blockchain technology, NFT has a soaring popularity resulting in a trading value of more than US$17 billion in 2021, according to a report by NFT data company Nonfungible.com¹. The number represented a staggering surge of 21,000% compared to the US$82 million recorded in 2020.

The burgeoning market has attracted numerous investors in pursuit of new business opportunities worldwide. The buzz around NFT also made eye-catching headlines both at home and abroad. In March 2022, actor Shawn Yue’s Zombieclub Token grabbed all the attention when the NFT reached the top on marketplace OpenSea within three hours during a presale, setting a world record². The NFT rendition of viral meme Nyan Cat was sold for US$590,000 in February 2021.

Compared to decentralised finance, which was only popular among cryptocurrency investors, NFT has become a real hit with almost everyone, even those unfamiliar with financial investment or coding, has tried or heard of it. Though the majority of NFTs are still largely dominated by artworks and other collectables, there has been a trend to expand into other categories. Undoubtedly, the application of blockchain technology has once again gained attention. Will this new application become widespread in the future?

Definition and history

It is like a unique digital token that can be used to prove the uniqueness of the item and the sole ownership of the asset. From art, videos to music and game avatars, NFT can exist in digital formats and as physical objects.

How does NFT work? Traditionally, when a collector buys a piece of art, he will need to sign a contract with the original owner like a gallery to transfer the ownership. He will then receive a certificate to prove the authenticity of this piece. In the world of NFT, this is somewhat similar. When an NFT is put on the blockchain for sale, an irreplicable digital token will be created in the blockchain, which will also automatically track the entire transfer history of the ownership and prices. All potential buyers will be able to view such information and get information about when this NFT asset was created, who created it, when it has been bought or put on sale, and its price history.

With the ownership authenticated and stored on a blockchain, an NFT is a non-interchangeable digital asset that can be collected, bought and traded via online platforms in an encrypted format³.

An NFT is a non-interchangeable digital asset that can be collected, bought and traded via online platforms in an encrypted format

Since NFT is a distinctive and scarce on-chain digital asset, the transfer of its ownership is done through smart contracts, with the whole process recorded on the blockchain. Because blockchain has key features like distributed ledger (which means complete transparency), immutability and decentralisation, all trading records of an NFT can be traced and checked at any knot, which ensures the transparency of an NFT trade and also makes it difficult to be tampered with or replicated.

Some believe the first NFT can be dated back to Colored Coins, which, introduced in 2012, are made of small denominations of a bitcoin and can be as small as a single satoshi, the smallest unit of a bitcoin. Yet they could only represent specific values upon a shared agreement⁴.

Some may also argue that “Quantum”, created by digital artist Kevin McCoy in 2014, was the first NFT. The non-fungible, tradable blockchain marker was first minted on the Namecoin blockchain and later transferred to the Ethereum blockchain.

It was not until 2017, when a project called CryptoKitties launched on Ethereum, that the implementation of NFTs were widely-recognised⁵. CryptoKitties was the first project launched on the new ERC-721 standard for Ethereum, in which players were allowed to collect, breed and trade virtual kitties, while tracking a specific token. In short, the explosive popularity of the game helped promote NFT to go mainstream. NFT has gained widespread attention from the world since then, and continues to show unprecedented growth to this day.

ERC-721, ERC-1155 and ERC-998 are the three main token standards used in NFTs. ERC stands for “Ethereum Request for Comments”.

It is worth noting that NFT is different from cryptocurrency, which is fungible and completely interchangeable. For example, the value of one bitcoin is always equal to another bitcoin. Because of this, cryptocurrencies can be regarded as a secure medium of transaction in the digital economy.

On the other hand, it is impossible to make two NFTs equal because each token is distinct and irreplicable. NFTs are digital representations of assets. There are no two NFTs that are the same. They are like digital passports because they each have a unique and non-transferable identity. NFTs are also extensible so they can be merged together into a new and unique NFT⁶.

OpenSea, Rarible and Axie are the most sought-after NFT marketplaces on the Ethereum network.

OpenSea claims that it is the world’s first and largest Web 3.0 marketplace for NFTs and crypto collectables. Since it was launched in 2017, OpenSea has delivered more than 80 million NFTs to the market. It allows users to buy, sell and bid for NFTs in a peer-to-peer format. Initially offering Ethereum-based NFTs, it also evolved to offer Polygon- and Solana-based NFTs⁷.

Launched in 2019, Rarible was the first to distribute a crypto governance token in the NFT space. Connecting content creators with potential NFT buyers, the platform is governed by the native cryptocurrency token RARI. By the end of 2020, a total of 2.5 million RARI (about US$4.6 million) had been given away to creators and collectors. The monthly sales volume reached US$8.5 million⁸.

Axie Marketplace is an internal trading platform of the Axie Infinity game. Gamers can buy, sell or auction NFT game assets in the marketplace. AXS, the native token of Axie Infinity, rose 17,772% in price in 2021.

Hong Kong showcase

In Hong Kong, auction house Sotheby’s made a rare collaboration in October 2021 with award-winning film director Wong Kar Wai to introduce the first Asian film NFT ever offered in an international auction house. Wong’s NFT, created with then unreleased footage from the romance film In the Mood for Love, was eventually sold at about US$550,000.

Moreover, Sotheby’s was also the first auction house to launch its own dedicated NFT marketplace, dubbed “The Metaverse”. The platform is backed by a number of celebrities and digital artists, providing a platform of high-end NFT art for digital art collectors.

Commenting on the burgeoning market of NFT, Max Moore, Sotheby’s head of contemporary art sales in Asia and co-head of digital art sales worldwide, said artists are bridging physical and digital experiences, reimagining the way NFTs can be used⁹.

Around the city, K11 MUSEA in Tsim Sha Tsui exhibited over 200 pieces of NFT art by emerging and established artists from across the world. Hysan Place in Causeway Bay has a gallery that occasionally features NFT art and even held seminars there to provide free NFT and art appreciation training for secondary school students, helping them auction their artworks on a NFT marketplace.

In general, Hong Kong ranked 8^th in 20 countries in terms of NFT ownership, with over 20% of people saying they either own NFTs or plan to acquire some, a survey by research firm Finder showed in November 2021. The Philippines topped the list, with 32% of people being NFT owners.

With this background, Hong Kong hosted Artaverse, one of Asia’s largest outdoor NFT art exhibitions in June 2022, which was participated by over 100 exhibitors, including local game software company Animoca Brands. The blockchain game developer has reached a valuation of US$2.2 billion in October 2021 amid the global NFT mania.

Hong Kong gamers were also among the world’s most enthusiastic ones out of 26 countries and regions in terms of adopting NFT games, coming only after India according to another survey published by Finder. Nearly 30% of respondents in Hong Kong said they had played NFT-based “play-to-earn” games, while only 55% of people surveyed said they had no idea of what a “play-to-earn” game is, the survey found¹⁰.

Behind NFT

To better understand what an NFT is, one has to get a better knowledge of blockchain first. Blockchain is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network. Here, the asset can either be tangible, like a house, or intangible, like patents. Trading on a blockchain network helps reduce risk and costs¹¹.

As the bottom infrastructure of NFT, blockchain has multiple layers, namely data, network, consensus, incentive, contract and application layers¹². The first three layers are essential for a blockchain while the remaining three are not.

The Ethereum blockchain is by far the most popular chain when it comes to NFTs, generating more than 97% of the market sales¹³. But there are other blockchains like Solana, Cardano and BNB vying for the NFT market. Normally, transaction fees in each platform’s native token will be required. Ethereum’s native token is ETH, which currently trades at US$1666.71 as at 5 August 2022.

Ether, the cryptocurrency of the Ethereum network

NFT has a close relationship with Web 3.0 (or Web3), an expression invented in 2014 by Gavin Wood, founder of blockchain infrastructure company Parity Technologies, to envision the future of the internet. According to his idea, Web3 is a truly decentralised and a more democratic version of the current internet.

“Web3 is really sort of an alternative vision of the web, where the services that we use are not hosted by a single service provider company, but rather they’re sort of purely algorithmic things that are, in some sense, hosted by everybody. So it’s like, it’s very peer to peer, right? ... The idea being that all participants sort of contribute a small slice of the ultimate service,” Wood said¹⁴.

In a decentralised internet space, users no longer need to keep their personal information, usage data and browsing history through major companies such as Google, Facebook and Amazon. The ownership of these data will be returned to the users and the whole internet will turn into a massive database. Blockchain, together with big data, virtual reality and artificial intelligence, are all key technologies that enable the Web3 ecosystem.

Because Web3 is still a very complicated concept that requires more advanced technologies, many people need to rely on middlemen like NFT marketplaces to interact and make use of blockchain. Yet to professionals like engineers, this poses great opportunities as more companies are seeking a presence or gaining bigger yields in the virtual world.

Job postings for cryptocurrency, blockchain and NFTs jumped 804% between April 2020 and April 2022, according to a report by job listings portal Indeed. This number represented a 15 times increase when compared with April 2019. Application developer was the top job role in the field, followed by data engineer and full-stack developer¹⁵.

Noting that NFT capabilities were something that had never existed before, Raj Kapoor, chief advisor at aCryptoverse, said employers are working hard to attract innovative talents. “The growth in this sector has just begun and we will see a major uptick in the hiring space as NFTs move beyond the realms of digital art into the mainstream,” he said¹⁶.

An economic bubble or a source of future growth?
In 1995, IT research firm Gartner introduced the Hype Cycle, which has been used for years to chart emerging technologies. According to the concept, an emerging technology usually needs to go through five key phases to reach maturity, which are innovation trigger, peak of inflated expectations, trough of disillusionment, slope of enlightenment, and plateau of productivity¹⁷.

NFTs are one of the additions to the Gartner Hype Cycle for Emerging Technologies in 2021, which highlighted 25 breakthrough technologies that will have the biggest impact on business and society over the next two to ten years. The report showed that NFTs are now at the stage of peak of inflated expectations, with a number of success stories, as well as failures, gaining early publicity. At this stage, some companies may take action, but many do not. The advisory said it expected NFTs to reach the plateau status in two to five years¹⁸.

Shiv Sakhuja, co-founder of Magik Invest and former software engineer at Google, wrote on Twitter in July that he suspected NFTs were somewhere around the trough of disillusionment, where early projects fail to deliver on their promises and the public loses interest.

Sakhuja’s speculation has its reasons. While there are jaw-dropping stories like a US$69 million NFT sold at Christie’s last year, data showed that the NFT trading activities of both buyers and sellers returned to the range in the summer of 2021. There was a steady increase, between 2019 and early 2020, in wallets that have owned an NFT. Then, a parabolic growth was recorded, with the number of wallets rising from one to nearly three million at the end of 2021¹⁹.

Finder’s study also showed the worldwide average adoption rate for ETH declined to 24.4% in December 2021, compared with 28.2% in October.

Everydays: the First 5000 Days (an NFT artwork by Mike Winkelmann, better known as Beeple) was sold for US$69.3 million at Christie’s in 2021

NFTs are more than art collections or gaming items. NFTs solve some existing problems in the internet world today, especially in a world where everything tends to become more digital.

For example, NFT technology can provide an effective solution to copyright protection by utilising blockchain features like decentralised, encrypted and tamper-proof to generate a unique digital certificate of ownership.

With the wider adoption of Internet of Things (IoT), NFT can play a role in identification and authorisation as the unique token can store and manage people’s personal information. This may help realise automatic authentication among various devices.

Kristin Kostick Quenet, Assistant Professor at the Center for Medical Ethics and Health Policy at the Baylor College of Medicine in the United States, argued that NFTs or NFT-like frameworks can help incentivise a more democratised, transparent and efficient system for health information exchange, in which patients can participate in decisions about how and with whom their personal health information is shared²⁰.

Currently, NFT still focuses on the digitalisation of assets such as artworks through blockchain. It is predictable that financial assets such as stocks, equity and trusts will become NFTs. In the long run, traditional physical assets can also be transformed into NFTs and can be traded on the blockchain.

What comes after the hype?
Though NFT helps address the challenges of ownership identification and created favourable conditions for the exchange of virtual commodities, there are also new issues generated along with the emerging technology. If a product is counterfeited before being created as an NFT, it is almost impossible for buyers to notice. In 2021, NFT collector Pranksy spent ETH97.67, worth US$341,500, on a fake NFT artwork on OpenSea after seeing a fake NFT auction information on artist Banksy’s website, which was breached by hackers²¹.

Hong Kong’s Securities and Futures Commission (SFC) reminded investors in June 2022 of the risks associated with investing in NFTs. In a statement, the securities watchdog said NFTs are exposed to heightened risks including illiquid secondary markets, volatility, opaque pricing, hacking and fraud. It said some NFTs cross the boundary between a collectable and a financial asset as they are fractionalised or structured in a way similar to securities or interests in a “collective investment scheme”. Thus, marketing or distributing such NFTs may constitute a “regulated activity” and require a licence from the SFC²².

Therefore, like traditional trading, NFT also faces problems of who the real creator of the artwork is, and how to verify that, because it can only prove the authenticity of the token but not the artwork itself. Some artists may find their artworks being minted as NFTs without their acknowledgement.

As this technology involves virtual assets, buyers need to have a better understanding of it before being able to make a decision. Other applications like blockchain and smart contracts will affect the value of NFT. The influx of pouring amount of capital could not only create an industry bubble, but also bring regulatory challenges. As the hype cools down and the entire ecosystem continues to improve, some NFT projects will become obsolete, resulting in the depreciation in value of certain NFTs related to these projects.

Safety has always been a critical issue for emerging technologies, and NFT investors are exposed to similar online threats, like phishing, malware infections, and cyberattack, despite the relatively stronger security of the blockchain. 

NFT investors are exposed to online threats despite the relatively stronger security of the blockchain

Engineers can play a significant role in helping address these technical risks of NFTs by enhancing the safety of NFT wallets and exploring diverse NFT applications to make this technology more practical in real-life scenarios. 

The blockchain system has attracted an increasing number of safety attacks due to its rising popularity, yet there is no effective safety evaluation method or warning system to prevent these attacks, let alone a comprehensive recovery plan.

A decentralised platform may increase democracy but a unanimous system can also increase the risk of fraud, making it difficult to track down attackers and certain users when they conduct illegal activities on the blockchain. Once an attack succeeds, users will suffer irreversible losses because transactions cannot be cancelled or modified on tamperproof blockchain, even if they are illegal.

Considering the huge potential of NFT applications, all stakeholders should work together to improve the ecosystem for the long-term development of this technology. Regardless of the investment craze, it is high time for engineers to make use of their talent to solve the pain points in the industry, making contributions to the formation of a stable and pragmatic NFT ecosystem by enhancing the NFT infrastructure, categorisation, safety, and applications. 

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