What are NFTs and how do they work?

In recent years, a new digital file format has promised to revolutionize how things can be owned, bought and sold over the internet: “non-fungible tokens” or NFTs for short. As interest in NFTs—essentially receipts or signatures for digital assets—continues to increase worldwide, artists and publishers have begun experimenting with the technology.

Want to know more about NFTs? We’ve got you covered.

What are NFTs?

To understand NFTs, it is helpful to understand their underlying technology: the blockchain.

Blockchains are computer protocols designed to get many computers to agree on the same sequence of transactions without trusting each other. Instead of using third parties to verify transactions, blockchains rely on financial incentives and cryptography to make forging a transaction expensive and easy to detect. This setup is intended to allow computer networks to maintain databases in a decentralized, redundant, and public manner.

Blockchains’ exhaustive record-keeping means that apps built on top of them can create pieces of code that can be tracked as distinct entities and passed from user to user. These “tokens” can be made “non-fungible”, where one cannot be exchanged for another.

The idea is that NFTs create scarcity for digital objects, enabling a new type of traceable digital ownership. In principle, a digital asset, such as an image or a video, may appear many times on the internet, but only a few instances of it – or perhaps only one – will have the origin of an NFT. (The Walt Disney Company, majority owner of National Geographic Media, sells NFTs. National Geographic Media has partnered with NFT platform Snowcrash to do the same.)

Importantly, NFTs do not necessarily hold the data for the asset itself (although some do), nor do they necessarily transfer copyright. Most often, an NFT contains a URL that links to the asset, which is stored on a separate computer network.

Over the past two years, NFTs have gained attention for the huge sums of money they have attracted: as collectibles, as speculative investments, and as displays of wealth. In March 2021, digital artist Beeple sold an NFT for $69 million at auction to an investment firm that wanted to promote digital art. Bored Ape Yacht Club, an NFT collection featuring a series of 10,000 cartoon primates, shot up in value in early 2022 after a series of celebrity promotions. These NFTs now sell for tens of thousands of dollars.

By the end of 2022, this year’s NFT sales had totaled more than $11 billion – but over this period the market was extremely volatile. In dollar terms, sales volume for NFT marketplace OpenSea fell by more than 95 percent from January 2022 to November 2022, according to data compiled by firm Dune Analytics. The broader market for NFTs and related assets known as cryptocurrencies (digital “coins” that blockchains make scarce and therefore tradable) hit $2 trillion in July 2022 after rising to $3 trillion eight months earlier.

How can NFTs be used?

Proponents argue that NFTs provide a new revenue model for artists by allowing them to sell photos, videos and other digital assets such as collectibles or art. They can also act as fundraising tools, with Ukraine raising tens of millions of dollars in NFT auctions last year to support its war effort against Russia.

Unlike standard digital files, NFTs can contain tiny computer programs called “smart contracts,” which can sometimes issue royalties to an NFT’s original artist when the NFT is resold. Because NFTs are unique and transferable, they can also act as tickets, membership credentials or even records for carbon credits. Blockchain-based video games, such as Axie Infinity, use NFTs as in-game characters and items that players can own (and even pay other players to earn).

Some artists hope that NFTs – and the art scene they’ve created – can shake up the creative industry’s traditional business models, giving artists more lucrative and fair opportunities. Already, artists are using NFTs to organize collectives of fans and patrons called decentralized autonomous organizations, or DAOs for short (rhymes with “wows”).

At their most bullish, NFT advocates argue that the technology can underpin people’s identities within a “metaverse”. According to this vision, people will use virtual “avatars” to work and play within many interoperable digital spaces. Just as we own unique objects in the real world, proponents imagine that NFTs will function as deeds for their metaverse equivalents.

Beyond digital ownership, the decentralized nature of NFTs means they can be used to protect digital files from tampering or to track a file’s chain of custody. In June, Starling Lab, a research group founded by Stanford and the USC Shoah Foundation, submitted a case to the International Criminal Court that used NFTs and related technologies to archive records of Russian military attacks on Ukrainian schools.

What are some of the criticisms of NFTs?

Just as NFTs have attracted an ardent community of supporters, they have also received considerable criticism.

First, many proposed uses of NFTs either do not require NFTs to function (eg club membership) or have not yet been realized. As a result, some critics see NFT’s proliferation as little more than a “gold rush” that has little to do with the underlying technology.

There are also technical concerns. Whether one of NFT’s most bullish use cases, an interoperable “metaverse,” is even technically possible is a matter of debate. And if you’ve ever clicked on a broken website link, you know it’s hard to keep a digital asset online. NFTs typically do not contain digital assets themselves, so often a given NFT will only be as stable as the computer (or network) that stores the asset’s file. Even if the computer that stores the asset is properly maintained, it is difficult to prevent “bit rot”, or that data tends to deteriorate over time. In response, developers are finding ways to store files in a decentralized, redundant format.

Like other technology start-ups, NFTs have also lured in many bad actors. Grifters have inflated the prices of NFTs via “gold brick” scams, and have minted and sold a number of NFTs based on stolen art. With alarming regularity, NFT projects pop up, promise buyers an exciting long-term vision, then close and run away with the buyers’ money. The arrangement is so common that there is a term for it: “carpet pulling.”

Fraudsters have had some help from the blockchain itself. NFT thieves regularly use phishing attacks and other methods to trick people into emptying their digital wallet. In 2022 alone, more than $100 million worth of NFTs were stolen. However, because NFT transactions are decentralized by design, illegal transfers cannot be reversed by a third party.

In addition, NFTs have been criticized for their carbon footprint. Most directly or indirectly rely on the Ethereum blockchain, which was an energy hog until recently. On one day in January 2022, for example, one Ethereum emissions estimate exceeded 300 pounds of CO2 for an average transaction. It’s like putting more than 16 liters of petrol on fire.

However, in September 2022, Ethereum switched to a “proof of stake” architecture, which reduced energy use and CO2 emissions by more than 99.9 percent. The The Crypto Carbon Ratings Institute, a German research firm, estimates that the electricity for one Ethereum transaction now shakes out to 0.0063 kilowatt-hours – or about 3 grams of CO2, the emissions of driving an average passenger car in the US about 40 feet.