What is a Non-Fungible Token (NFT)? Definition and How it Works

Key Points

• NFTs are digital tokens linking to an asset coded on the blockchain.
• Most NFTs are built on the Ethereum network and purchased on marketplaces like OpenSea.
• NFTs are extremely volatile and susceptible to scams and hackers, so investors should be cautious.

What is a non-fungible token? In early 2021, non-fungible tokens (NFTs) became the latest asset to experience parabolic returns as pandemic-era investors flooded cash into these speculative digital assets. But of course, many of these same investors had no idea who they were buying these assets from or how they worked, leading to many scams, rug pulls or outright NFT theft. 

Many NFT projects crashed and burned as the easy money dried up, but legions of devoted investors still buy and sell these assets daily. By the time you've finished this article, you'll be able to answer questions that many of these early investors couldn't — what is an NFT and how does it work?

What is a Non-Fungible Token (NFT)?

What are non-fungible tokens (NFTs)? They're directions for authentication. One of the problems digital artists run into is the ease at which someone can copy their work. For example, if you see a picture you like on a website, you can right-click your mouse and save the image. Then you can use it as a screensaver, smartphone background or even print it out and frame it if you like. Unauthorized copying is just one of the many reasons why art is hard to evaluate compared to assets like stocks.

An asset like digital artwork is the basis of an NFT, whether a cartoon monkey, an NBA game highlight or a detailed masterpiece from an artist like Beeple. But contrary to popular perception, the NFT isn't a copy of a particular asset. Instead, it's a link coded into the blockchain that grants buyers limited ownership of an asset. When you buy an NFT, you're not purchasing a copy of a piece of art but a link directed to where that piece resides on the blockchain that verifies authenticity. Owning an NFT allows buying and selling speculative assets and membership to a collectors community where creators can provide special perks.

History of NFTs

NFTs have a more extended history than you may know. The first NFT was created in 2014 by a husband-and-wife artist team (Kevin and Jennifer McCoy), who called it Quantum. Digital art is hardly a new format, but the McCoys were the first to integrate their art into the blockchain. By putting their art on the blockchain, the couple could track, verify and authenticate ownership of the piece while also having a simple way to facilitate buying and selling.

However, the groundwork for today's version of NFTs came from the CryptoPunks, a collection of 10,000 unique digital characters created by Larva Labs in 2017. Despite looking like pixelated images you'd find in a video game from the 1990s, the CryptoPunks proved to be an enormous success. Available for free at release, the value of these NFTs soared during the 2021 bull run based on the rarity of certain traits assigned at minting. One of the rarest and most valuable was CryptoPunk #5822, which sold for $23.7 million in February 2022.

Today, the non-fungible tokens meaning has expanded into these various art collections designed for use as a profile avatar (known as a PFP). After CryptoPunks, more PFP projects were released, such as CryptoKitties, EtherRocks and the Bored Ape Yacht Club (BAYC). Naturally, the collectibles industry took notice. For example, Dapper Labs (founders of CryptoKitties) partnered with the NBA to create NBA TopShot, where basketball fans can buy and sell their favorite highlights like digital trading cards. But after the 2022 NFT and crypto crash, the future of this speculative asset class remains murky.

How NFTs Work

Now that we've answered the question "what is an NFT?" it's time to discuss how they work. We call NFTs non-fungible tokens because the token's data imprints onto an immutable digital ledger, such as the Ethereum blockchain. Anyone can copy a picture to their computer hard drive, but the NFT provides documentation that the asset and buyer's ownership claim are legitimate. 

So what is minting an NFT? The developers will release a mint count when a typical NFT project is announced. Some tokens link to a unique NFT like a CryptoPunk; others link to copies of the same item, like an NBA TopShot moment. Investors can preorder them on the developer's website or enter a random draw where numbers are assigned.

NFTs are usually purchased with the cryptocurrency they're built on, mainly ETH for NFTs on the Ethereum blockchain. For example, CryptoPunks are built on the Ethereum blockchain, so they're usually bought and sold with ETH, the native Ethereum token.

When NFTs are minted, each buyer will need a digital wallet to distribute the token. Remember, delivery isn't an actual asset but a token confirming ownership of an asset hosted elsewhere. Once minted, NFTs can be bought and sold on digital marketplaces like OpenSea or NiftyGateway. Price appreciation is the primary source of NFT owners' profits, although some pay types of "dividends" like early access to new NFT drops or merchandise and event access.

Where to Find NFTs

Here are a few places where NFTs can be purchased:

• OpenSea: OpenSea is the largest NFT marketplace in the world, with thousands of assets trading hands daily. Here's where you'll find many of the most popular PFP projects like Bored Ape Yacht Club and CryptoPunks. In addition, OpenSea hosts NFT drops and functions as a secondary marketplace where buyers and sellers can link up.
• NiftyGateway: Owned by the Gemini cryptocurrency exchange, NiftyGateway is an NFT marketplace focused on artists, such as Beeple or Pak. What is NFT art? Digital artwork can be tokenized into limited copies, with the NFT verifying the buyer's ownership. Some NFT art is a unique piece, while others can be minted for each buyer.
• Dapper Labs: Sports fans looking for new collectibles flocked to NBA TopShot in early 2021. TopShot functions as a minter and marketplace where collectors open "packs" like trading cards and claim NFTs featuring their favorite player highlights. Dapper Labs expanded into football with NFL AllDay and MMA with UFC Strike.
• Social media: NFTs tend to go viral on social media sites like Twitter and Instagram, which can drastically increase their value. NFT creators also use Discord channels to inform collectors and highlight new projects.

Examples of NFTs

A few of the most common and expensive NFTs include: 

• CryptoPunks: CryptoPunks started the original NFT craze. CryptoPunks were minted in 2017 for free, but its value skyrocketed over the succeeding years when cryptocurrency markets turned bullish in mid-2020. Exactly 10,000 unique "punks" were created, each with its own features, traits and rarity scores.
• NBA TopShot: TopShot and its sister sites, NFL All Day and UFC Strike, are marketplaces for sports highlights in NFT format. Similar to digital trading cards, NFTs called "Moments" are dropped in packs and can be sold in an online marketplace. In August 2021, a Lebron James Series 1 NBA Finals moment sold for a record $230,023.
• Bored Ape Yacht Club: Like CryptoPunks, the Bored Ape Yacht Club was a 10,000-count NFT series where each digital image had various traits with different levels of scarcity. At its apex, the Bored Ape Yacht Club was one of the most successful PFP projects, with six different NFTs posting individual sales of more than $2 million.
• Digital art: Many artists have turned to digital media for pieces, which can be sold and resold on marketplaces like NiftyGateway or OpenSea. Beeple is the most renowned digital artist, and his Everydays series has been in high demand. "Everydays: The First 5000 Days" sold for $69.3 million at Christie's in 2021, the most expensive NFT sale.

Pros and Cons of Investing in NFTs

NFT investing is not for the risk-averse. Prices are volatile, the assets have questionable regulatory status and scammers have flocked to the space because of the irreversible nature of cryptocurrency transactions. Here are a few benefits and drawbacks when building an NFT portfolio.

Pros

Check out the benefits of investing in NFTs:

• Potential for outsized returns: While some investors genuinely believe in the technology underlying NFTs, most are in it for the money. In 2021, specific NFT projects like the Bored Ape Yacht Club created a lifetime of wealth if buyers timed the trade well. NFTs aren't a slow-and-steady race like stocks or bonds; purchasers aim to attain quick riches.
• Not correlated to non-crypto assets: Stocks tend to move in unison regardless of the industry or company. Some might perform better than others, but the direction is usually the same across the broader market. Since NFTs don't connect to real-world cash flows, they represent an asset class genuinely separated from the overall economy and stock market. 
• Collector communities: Like dividend-paying stocks, NFT owners get special perks, depending on the collection. Additionally, owners often get invited to the community Discord channel where like-minded investors can discuss trading ideas, future NFT plans or talk about life. Other assets rarely provide this type of diverse group setting.

Cons

Now, the downside of this investment option:

• Extreme volatility: Despite what project creators tell you, NFTs are a day- or swing-trading vehicle, not a sufficient long-term investment (at least not yet). Even NFT collections with large market caps can move like penny stocks, often advancing or declining 100% daily. So if market timing isn't your thing, NFTs aren't your ideal asset class.
• Scams and rug pulls: NFTs exist in the anonymous and unregulated world of cryptocurrency, which unfortunately brings scammers out of the woodwork like termites. A common scam is a "rug pull," where creators assemble an NFT project, lay out a roadmap, collect investor money, then disappear into the night with your funds. 
• Theft: NFTs "live" in digital wallets, which can be hacked or made vulnerable to theft. One practice involves sending malicious links through Discord channels which drain the NFT from the wallet of those who click on it. And once an NFT gets stolen, there's little recourse for getting it back.
• Lack of information: NFTs have no analyst coverage, earnings reports or stock price targets. Most information comes from social media; not all creators have the best intentions when promoting their NFT projects. Investors can find sales data on marketplaces like OpenSea, but due diligence is tricky when very little information is available.

Are NFTs Safe?

"Safe" is a relative term. No NFT is safe from drastic price swings — that's just the nature of an emerging asset class. However, buying and selling NFTs on reputable marketplaces like OpenSea or NBA TopShot is usually a safe venture.

What makes NFTs risky isn't just the price swings but the constant threat of scams and theft. If NFTs stay in a cold wallet (i.e., an offline piece of hardware not connected to the internet), they'll be safe. But hot wallets connected to a server or exchange can be hacked and drained if investors aren't careful about who they trust and what sites they visit.

Use Caution When Buying NFTs

The NFT bull market raged through 2021 like an unstoppable force. However, the bubble burst when interest rates began to rise, and risk assets lost favor in the market. Today, you can still make money buying NFTs, but the craze is over, and projects should be heavily vetted and understood before buying. NFTs differ from stocks, where a different strategy can be successful, like picking 52-week lows. Instead, you'll need time, research and a bit of luck to hit it big with NFTs.

FAQs

Here's a list of questions investors should ask regarding what non-fungible tokens are:

What are some examples of non-fungible tokens?

Some of the most popular NFTs include the Bored Ape Yacht Club PFP collection, CryptoPunks, digital art and sports highlights like NBA TopShow or NFL All Day.

What are non-fungible tokens?

NFTs are tokens representing an ownership claim in some form of digital asset. The token is used to verify the authenticity and can be bought or sold on the open market.

How do non-fungible tokens work?

NFTs contain data and timestamps imprinted onto a digital ledger like the Ethereum blockchain, which cannot alter or change once confirmed. Like digital bearer bonds, whoever possesses the NFT can claim ownership of the digital asset it represents.