24 - Non-fungible
The Wall Street Journal (WSJ) recently reported that the “NFT market is collapsing.” The article goes on to talk about the decline in activity in the NFT space since the same time last year. One of the statistics the article cites is active wallets in the NFT market fell 88% from 119,000 in November 2021 to 14,000 at the end of March 2022. The article neglected to mention that total dollar value of trading volume actually remained somewhat constant from Q4 2021 to Q2 2022, only declining about 4%. What this indicates is that NFT’s with “actual value” are maintaining that value while those less valuable NFT’s are being forgotten. NFT’s exploded in notoriety during 2021, and despite what the WSJ article might portray, are still and will continue to be a major part of the blockchain space. So, what exactly is an NFT?
Fungible vs non-fungible
NFT stands for “non-fungible token.” In The power of standards, we touched on the concept of fungibility when describing the ERC20 token standard. Fungibility is a characteristic describing an object's ability to replace or be replaced by another identical item. The best physical world example of this is the US dollar or gold. Any dollar or bar of gold can be swapped for an identical dollar or bar, and the individuals doing the swapping will be none the worse or better. Fungibility not only applies to monetary institutions but also other types of physical objects. Disregarding color, iPhones have the same quality. Every iPhone 13 is the same as every other iPhone 13 when you take it out of the box.
In the crypto world, fungibility was the main quality shared by the tokens being issued during the 2017 initial coin offering (ICO) bubble . Companies, groups, or even individuals would issue a token using the ERC20 standard and market it as a “utility token.” The term utility token was used to imply that the token being issued was not a security but rather a product of utility in a platform that was going to be built in the future. It would be like Apple pre-selling vouchers that could be later redeemed for an iPhone in order to fund the development of the iPhone. In most cases the SEC disagreed with a product designation for these assets and charged many of the companies issuing tokens with securities fraud. These regulatory actions and some of the major frauds taking place during that time helped to usher in the collapse of that digital asset market.
At the same time the ICO bubble peaked in January 2018 when another Ethereum request for comment was proposed by a group of developers in the Ethereum community. ERC 721 was a proposal to create a standard for non-fungible tokens (NFT’s). Unlike the fungible tokens created using the ERC20 standard, non-fungible tokens were each individually unique. In the physical world, paintings and art in general are non-fungible. The Mona Lisa by Leonardo Da Vinci is one of a kind. Despite people’s best efforts, even if they were able to create an exact replica of the masterpiece, it would not garner the same attention and respect that the original work does. ERC721 took that same concept of individuality and gave the blockchain world a digital standard to bring it to life.
The standard itself required that anyone issuing a token use many of the same fields that are used in the ERC20 standard, with the addition of fields such as token ID and metadata. Unlike ERC20’s, each ERC721 token is going to have its own unique characteristics. These unique characteristics start with the token ID field which gives an ID number to each token issued from the ERC721 contract. Additionally, the metadata field allows the creator to input specific details about each token such as a link to a picture of an uninterested monkey.
Why the hype?
As we discussed at the beginning of this piece, 2021 was the year of massive mainstream adoption of NFT’s. Whether it was social icons like Snoop Dogg, superstar star athletes like Tom Brady, or large international accounting firms like KPMG, everyone was either buying or in some way getting into NFT’s. These are some big names, and they aren’t just dabbling in the space but actually investing real money here. There has been much speculation as to why NFTs and why now?
Some of the adoptions have to do with the hype around blockchain technology. The concept of a digital item being uniquely rare has massive implications. First, NFTs could serve as the deed to a house or as unique access cards to events or shows. Second, they could be used in video games to represent unique items or specific skills. These use cases are promising but still far away and do not explain why an industry saw an increase of 21,00% from 2020 to 2021 in dollars traded. The reason can be linked back to a few characteristics all modern NFT’s have. With the backdrop of massive long term value, these characteristics helped to spur the current hype cycle.
First, NFTs are visual. We learned a second ago about that extra field called “metadata” in the ERC721 token standard. That field is where the creator of an NFT can input a uniform resource locator (URL). The URL included is going to be the address of an image stored on the internet. That image is what most people associate with an NFT. When you go to an NFT gallery site such as opensea.io, you can see the many thousands of NFT collections that have been created. These images are very distinct such as in the case of the Bored Ape Yacht Club or Crypto Punk Collections. They make the item you are buying tangible, which, in turn, makes it easier for people to understand what they are buying
Second, NFTs are relatable. That visual aspect makes them easy to describe, explain, and interact with. When asked, “Why am I buying this image?,” An easy reply is, “The same reason you would buy a fine piece of art.” Compared to their ERC20 (fungible) token predecessor, the ERC721 (Non-fungible) tokens do not need to require a lengthy explanation about why they are valuable. Instead of tying the token's value to our broken traditional financial system or explaining that these things will eventually grant you access to some software platform that has not been built, you can link the image you see on the screen to a piece of art. That ape people are buying for millions is actually the next Starry Night.
Finally, NFTs can be tied to your identity. Whether it’s a sports car, expensive handbag, or brand new electronics, people buy items to show their social status. ERC20 tokens were created much like financial assets. They had a ticker symbol and a logo but not much else that could be publicly viewed. Similar to your stock portfolio, it isn’t cool to show off your crypto portfolio. ERC721’s however are cool. In fact, many of the NFT projects that are hot are so strict because they provide you social status. If you own a Bored Ape or Crypto Punk, it says something about who you are. Either that you were an early adopter or that you have serious money to spend on one of these images.
The takeaway
From a technical standpoint, both fungible and non-fungible tokens are created using simple digital standards (ERC20 and ERC721). Tokens and NFT’s are numbers organized in a standard way and stored on a blockchain. Moving beyond the technical, both these token standards have created massive expansions of digital asset adoption. ERC20’s helped to spur the ICO bubble of 2017, with ERC721’s being the foundation of what will most likely be known as the NFT bubble of 2021. Standards are incredibly important; and although they have caused incredible hype cycles in the short term, they have massive long term potential.