Shorthand for non-fungible tokens, NFTs represent a novel medium of asset ownership which has flourished into one of the killer applications of the blockchain. From first principles, the concept of fungibility refers to assets which are one-to-one interchangeable; for instance, one US Dollar is exactly equivalent to any other US Dollar, one bitcoin is exactly equal to any other bitcoin, and so on. In contrast, because NFTs are by definition non-fungible, each NFT is unique and theoretically commands its own value. Accordingly, NFTs cannot be directly exchanged for one another in the same way as US Dollars or bitcoins. NFTs confer ownership rights over physical or digital assets onto their holders, and their existence on an open, permissionless blockchain means they are protected from counterfeiting. In essence, you can think of the primary innovation of NFTs as being their ability to enable scarcity and uniqueness among easily-reproducible digital assets.
The following guide will introduce you to the constituents of the NFT ecosystem and direct you to articles where you can learn more about each. In particular, the following areas are covered:
In its most popular conception, the blockchain is a decentralized, immutable, and permissionless ledger which records transactions and tracks the provenance of assets, essentially providing a trail of breadcrumbs to audit an asset’s movements. The integrity of data stored on the blockchain is secured by way of a consensus protocol, the most popular implementation of which being known as Proof-of-Work (PoW). This mechanism relies on a network of miners who compete to solve cryptographic puzzles in exchange for cryptocurrency rewards. Other variations of this model for securing the network are being developed to allow for less energy-intensive block mining. Arguably the most popular alternative to PoW consensus is known as Proof-of-Stake (PoS).
To address the efficiency and scalability concerns inherent in permissionless blockchain designs, many networks have resorted to using Layer-2 (L2) solutions or sidechains. In essence, both L2s and sidechains can be viewed as auxiliary networks which allow for transactions to occur off-chain, meaning they do not have to uniformly be written to the main chain. Given this property, interim transactions on L2s and sidechains can avoid the lengthy processing requirements of transactions occurring directly on the main chain. By shifting some transactional burden off-chain, the main network becomes less congested and its scalability can be increased without altering its architecture. The fundamental difference between L2s and sidechains lies in the fact that the former inherit the main chain’s security guarantees, whereas the latter rely on security infrastructure that is distinct from that of the main chain.
In much the same way that cryptocurrency trading is facilitated through exchanges, NFT commerce is facilitated through marketplaces. Some marketplaces serve as aggregators, taking a universal approach to their listings by supporting the trade of NFTs from a wide range of projects. Naturally, this generalist approach means these marketplaces can cater to a larger audience and therefore capture a greater share of the total addressable market. Comparatively, some marketplaces take a more focused approach in their listings. For instance, art-oriented marketplaces concentrate on the listing and sale of tokenized high-end artwork. These platforms serve a similar function to real-world luxury auction houses, peddling higher-value, lower-volume NFTs. Art-centric marketplaces take a more exclusive approach to building their community of sellers, requiring prospective digital artists to pass some degree of vetting before being permitted to sell through the marketplace.
There also exist several other marketplaces with more niche objectives. For instance, some marketplaces are designed with the express purpose of enabling fractional ownership of high-value NFTs, significantly lowering price-related barriers to entry for investors. Other marketplaces were built to facilitate trading of physically-backed NFTs – that is, tangible assets that have been tokenized on a blockchain.
Naturally, to engage the broadest audience possible and attract users who may not be crypto-forward, the NFT ecosystem must include sleek user interfaces that allow investors to easily interact with their tokens as well as those of others. Such front-end interfaces include platforms for portfolio management, curation and exhibition of token collections, and even music-streaming.
One of the most popular use-cases for blockchains, DeFi represents the full suite of financial primitives – including lending, borrowing, and derivatives-trading among others – implemented through blockchain-based applications. This use-case has seen tremendous growth recently, with the total value locked in DeFi protocols at the time of writing having risen by 1,023% year-over-year to USD$82.09B.
DeFi applications have played an invaluable role in the NFT market. For instance, some applications have been developed to enable the use of NFTs as collateral for loans. Others allow for the creation of liquidity pools to facilitate other NFT-centric financial transactions. There also exist platforms for the appraisal & valuation of NFTs, as well as for the launch and issuance of new tokens.
Decentralized Applications (Non-DeFi)
Otherwise known as dApps, decentralized applications are largely comparable to traditional web-based applications aside from the fact they are built atop a blockchain infrastructure. At a high-level, they are constructed using smart contracts deployed to the blockchain as well as a front-end for enhanced user experience. The functionality of many dApps hinges on the usage of NFTs, which can serve an array of different functions including the representation of in-game avatars or virtual-world parcels of land.