Alternative Investments: Understanding Non-Fungible Tokens (NFTs)
‘Charlie Bit My Finger’ is a little piece of internet history, and one of the original viral videos; now the much-loved clip of baby Charlie gnawing on his brother Harry’s finger will be taken off YouTube after it was sold for £538,000 as a non-fungible token or NFT – writes Christian Leeming.
NFTs (pronounced by some as ‘niftys’) have exploded on to the scene this year featuring anything from art and music to tacos and toilet paper; some are changing hands for millions of pounds – or more often dollars as the US is leading the charge – causing some to draw parallels with the 17th-century Dutch tulips ‘bubble’.
So are NFTs worth the money; are they another bubble that’s set to burst (The Stock Market Almanac: Bubbleomics) or, as some believe, here to stay, and set to change investing forever.
What Is an NFT?
An NFT is a digital asset that represents real-world objects like art, music, in-game items and videos; they are bought and sold online, frequently with cryptocurrency, and are generally encoded with the same underlying software as many of the digital tokens.
NFT have been around since 2014, but have more recently become a popular way to buy and sell digital artwork; $174 million has been spent on NFTs since November 2017.
NFTs are generally either one of a kind, or part of a very limited run, with unique identifying codes that create digital scarcity; this is in stark contrast to most digital creations, which are almost always infinite in supply.
The theory is that cutting supply should raise the value of a given asset, but many early NFTs have been digital creations that already exist in some form elsewhere, such as digital art to be found on Instagram.
An example of NFTs in action is the (relatively) well known ‘EVERYDAYS: The First 5000 Days’ by digital artist ‘Beeple’ which sold at Christies for a record-breaking $69.3 million.
Anyone can view the 5,000 individual images—or even the entire collage – online for free, so why would people spend millions on something they could easily screenshot or download?
An NFT allows the buyer to own the original item, with built-in authentication, which serves as proof of ownership; ‘digital bragging rights’ are prized more highly than the item itself.
‘F’ in Cryptocurrency?
NFTs are generally built using the same kind of programming as cryptocurrency, like Bitcoin or Ethereum, but differ in that regular money and cryptocurrencies are ‘fungible,’ meaning they can be traded or exchanged for one another.
Crypto’s fungibility makes it a trusted means of conducting transactions on the blockchain because they are equal in value. One dollar is always worth another dollar; one Bitcoin is always equal to another Bitcoin.
However, NFTs are different; each has a digital signature that makes it impossible for NFTs to be exchanged for or equal to one another – hence, non-fungible.
How Does an NFT Work?
NFTs exist on a blockchain, a distributed public ledger that records transactions, which is the underlying process that makes cryptocurrencies possible.
Specifically, NFTs are typically held on the Ethereum blockchain; an NFT is created, or ‘minted’ from digital objects that represent both tangible and intangible items, including:
- Videos and sports highlights
- Virtual avatars and video game skins
- Designer trainers
- Even tweets – Twitter co-founder Jack Dorsey sold his first ever tweet as an NFT for more than $2.9 million.
NFTs are like any physical collector’s items, only digital; instead of an oil painting for the wall, the buyer gets a digital file instead.
Where Bitcoin was the digital version of currency, NFTs are considered the digital answer to collectables. Typically, they are traded as online artwork, though they can also be anything digital with very few restrictions.
This can include trading cards, sports/game characters, music, tokenised real-world assets such as real estate or cars, video footage or even virtual land.
NFTs essentially allow buyers to own the original copy of these digital assets, as well as proof of their ownership – they get exclusive ownership rights. NFTs’ unique data makes it easy to verify ownership and transfer tokens between owners so that there can only be one at a time; the owner or creator can also store specific information inside – e.g. artists can sign their artwork by including their signature in an NFT’s metadata.
What Are NFTs Used For?
NFTs give artists and content creators a unique opportunity to monetize their wares – artists no longer have to rely on galleries or auction houses to sell their art, they can sell it directly to the consumer as an NFT and keep more of the profits. Artists can also program in royalties so for the first time they can receive a percentage of sales whenever their art is sold on.
As is often the case, much of the early running in NFTs has been made on the other side of the Pond; brands like Charmin and Taco Bell auctioned off themed NFT art, raising thousands of dollars for charity.
One of the first uses of the new standard was a game called ‘CryptoKitties’, which allowed traders to buy and sell virtual kittens; if you thought you loved kittens, one person paid over $170,000 for one.
Nyan Cat, a 2011-era GIF of a cat with a pop-tart body, sold for nearly $600,000 in February Chris Torres, who created the meme 10 years ago said ‘I’ve basically opened the door to a whole new meme economy in the crypto world’; NBA Top Shot generated more than $500 million in sales as of late March, with a single LeBron James highlight NFT fetching more than $200,000.
Celebrities like Snoop Dogg and Lindsay Lohan have also jumped on the NFT bandwagon, releasing unique memories, artwork and moments as securitized NFTs.
If you want to start an NFT collection, you’ll first need to get a digital wallet that allows you to store NFTs and cryptocurrencies.
Then, depending on what currencies your chosen NFT provider accepts, you’ll need to purchase some cryptocurrency, like Ether, and put it in your wallet; crypto can be bought using a credit card on platforms like Coinbase, Kraken, eToro and now even PayPal and Robinhood now.
Keep fees in mind as you research options; most exchanges charge at least a percentage of your transaction when you buy crypto.
Popular NFT Marketplaces
Once you’ve got your wallet set up and funded, there’s no shortage of NFT sites to shop. Currently, the largest NFT marketplaces are:
OpenSea.io: This peer-to-peer platform bills itself a purveyor of ‘rare digital items and collectibles.’ It is the first and largest marketplace for NFT trading and digital items such as collectables, gaming items, arts, domain names and other blockchain-backed assets. The company boasts over 700 projects and accepts multiple payment currencies, though the most popular is Ethereum. ‘Social tokens’ or ‘game currencies’ are also used for certain online communities or projects that use their own tokens. There is a 2.5% seller transaction fee on each successful sale; the creator may also choose to take an additional fee.
Create an account to browse NFT collections; sort pieces by sales volume to discover new artists.
Rarible: Similar to OpenSea, Rarible is a democratic, open marketplace that allows artists and creators to issue and sell NFTs. RARI tokens issued on the platform enable holders to weigh in on features like fees and community rules. It is a popular platform for buyers and sellers of digital artwork and memes, with thousands of users on the marketplace.
Nifty Gateway: A centralised USD based marketplace, offering fine art and collectables, known as Nifties; Canadian musician and artist, Grimes, auctioned her virtual artwork here, raising a total of around $6 million. Nifty Gateway teams up with top creators and brands to create limited-edition collections available exclusively on the platform. Each collection is opened at a specific time, known as a ‘drop’, and is available for a specified amount of time.
Foundation: Here, artists must receive ‘upvotes’ or an invitation from fellow creators to post their art. The community’s exclusivity and cost of entry—artists must also purchase ‘gas’ to mint NFTs—means it may boast higher-caliber artwork; Nyan Cat creator Chris Torres sold the NFT on the Foundation platform. It may also mean higher prices — not necessarily a bad thing for artists and collectors seeking to capitalize, assuming the demand for NFTs remains at current levels, or even increases over time.
These platforms and others host thousands of NFT creators and collectors, so do your research carefully before buying; some artists have fallen victim to impersonators who have listed and sold their work without their permission.
In addition, the verification processes for creators and NFT listings aren’t consistent across platforms — some are more stringent than others. OpenSea and Rarible, for example, do not require owner verification for NFT listings. Buyer protections appear to be sparse at best, so when shopping for NFTs, it may be best to keep the old adage ‘caveat emptor’ – buyer beware – in mind.
Should You Buy NFTs?
NFTs are risky because their future is uncertain; there isn’t a lot of history on which to judge their performance, so a modest initial investment may be a sensible way to try it out; investing in NFTs is a largely personal decision – if you have money to spare, it may be worth considering, particularly if a piece holds meaning for you.
Remember, an NFT’s value is based entirely on what someone else is willing to pay for it rather than fundamental, technical or economic indicators, which typically influence stock prices and generally form the basis for investor demand.
Therefore an NFT may resale for less than you paid for it. Or you may not be able to resell it at all if no one wants it.
NFTs also fall squarely into a tax black hole, with no published HMRC guidance considering their UK tax treatment, although it is a fairly safe bet to assume that they would be treated as a taxable asset for capital gains tax and inheritance tax purposes, as well as taxable in other ways.
The existing HMRC guidance is only stated to apply to exchange tokens such as bitcoin and does not consider how the tax treatment of a tokenised asset would differ. In fact, no tax authority in any jurisdiction has yet published guidance on NFTs or the tokenisation of assets.
The cryptocurrencies used to purchase the NFT may also be taxed if they’ve increased in value since you bought them, meaning you may want to check in with a tax professional when considering adding NFTs to your portfolio.
That said, approach NFTs just like you would any investment: Do your research, understand the risks—including that you might lose all of your investment—and if you decide to take the plunge, proceed with a healthy dose of caution.
Whilst NFT trading is rapidly gaining popularity, the concept is still very new and it may not suit everyone; things to consider:
- Secure – NFTs are created on secure blockchain networks, so their digital certificate cannot be tampered with or duplicated.
- Accessible– Anybody can buy or sell NFTs; they are also flexible in that sellers can ask for whatever currency or price they wish.
- Profit potential– Still heavily speculated, many collectors buy NFTs in the hope of a surge in value.
- Unique and exciting– A new, dynamic market that might appeal to crypto fans looking for something a bit different.
- Longevity– NFTs are based on digital file formats, such as jpg, png or mp3, which may deteriorate; they are not immune to technical issues or human error if, for example, someone forgets their wallet password.
- ‘Unique?’– Technically, every NFT is a unique token, but it is still possible to have multiple ‘unique’ copies of the same artwork (similar to a trading card).
- Wash trading– Wash trading occurs when someone who owns a significant amount of digital currency (‘crypto whale’) sells an NFT at a higher price than it’s worth, causing the price to artificially inflate.
- Environmental impacts– NFTs use the same blockchain technology as cryptocurrencies and therefore consume a lot of electricity; the concern of greenhouse gas emissions has led some artists to stop selling NFTs.