Understanding NFTs: What to Know Before You Buy

An NFT essentially allows its buyer to say they own the original copy of a digital file, in the same way you might own the original copy of a piece of physical art.

Source: https://www.nerdwallet.com/article/investing/nfts

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  1. How do NFTs work?
  2. What are NFTs used for?
  3. What gives NFTs value?

If you thought navigating the thousands of available cryptocurrencies was confusing, prepare to have your mind blown by NFTs. These one-of-a-kind digital assets number in the millions, offering their buyers ownership of digital content such as images, videos and music.

NFTs — short for nonfungible tokens — have in some cases fetched staggering sums. One piece by the artist Beeple sold for $69 million in March 2021. Other creators have earned hundreds of thousands selling sports photos, online gaming items and even pixelated images of punk rockers.

Why would anyone spend hard-earned money on something that exists only online? As interest in NFTs grows, it helps to understand how these digital assets work, what gives them value and some risk factors to consider if you’re thinking of buying one.

How do NFTs work?

An NFT essentially allows its buyer to say that they own the original copy of a digital file, in the same way you might own the original copy of a piece of physical art or the master file of a music recording.

To grasp how NFTs function, you need to understand what it means for something to be “fungible.” If an asset is fungible, it can be swapped for another item within a category without changing its value. For instance, if you trade one dollar bill for another dollar bill, you still have a dollar.

Understanding NFTs also requires at least a baseline understanding of how blockchain technology works.

While blockchain networks support both NFTs and cryptocurrencies, the fundamental difference is that cryptocurrencies are fungible. One Bitcoin is essentially the same as another. Because NFTs are nonfungible, each one is different.

Content creators can make NFTs through a process known as “minting,” in which they generate a representation of their file on a blockchain network. These distributed networks can keep immutable records tracking every time an asset is bought and sold, and who currently owns it.

The dominant network used for NFTs is Ethereum, though others including Solana and Cardano are also commonly used.

Once an NFT is minted, it can be bought, sold or traded. And even if someone makes a copy of the underlying file, the record of ownership can’t be changed without the permission of its current owner. The technology is complex, but broadly speaking the records are secured by the same mechanism that gives cryptocurrencies value by ensuring that a single token can’t be duplicated and used in multiple transactions at the same time.

» Keep learning: How to buy Bitcoin

What is an example of an NFT?

Ownership can convey different rights depending on the specifics of an NFT. In some cases, an owner might be able to control how a file is used, and under what circumstances it can be reproduced. But the exclusivity conveyed by NFT ownership can often seem theoretical.

For instance, an NFT of a short music video by the artist Grimes sold on the online marketplace Nifty Gateway in February 2021, fetching about $389,000. You can still watch the video if you want. It’s right there, on the website where it sold.

But only one owner can possess the actual NFT of the video, known as “Death of the Old.” It’s analogous, in a way, to physical art. You might be able to look at a digital image of the “Mona Lisa,” or even a faithful real-world reproduction. But there’s one version that’s commonly accepted to be the true copy, and that’s at the Louvre in Paris.

The difference with NFTs is that even the original copy is digital. When people buy NFTs, the scarcity of original versions is a big part of what they’re paying for.

What are NFTs used for?

NFTs can theoretically be attached to pretty much any intellectual property, but activity so far has focused on a few sectors.

Art and music: The most highly publicized examples of NFTs have been in visual art, especially videos and still images that have sold for millions of dollars.

Some owners, for instance, use their NFTs as social media profile pictures, place them in online galleries or even use them as video conferencing backgrounds.

Collectibles: NFT technology has also proved a fit for digital versions of other collectibles, such as trading cards. Sports leagues including the NFL, MLB and NBA have all created digital collections memorializing things such as notable statistics and outstanding plays.

Gaming and virtual reality: NFTs can be attached to some unique video game items such as weapons, outfits or special characters — many of which have long been sold and traded in in-game marketplaces. NFTs could potentially make the sales of such items easier to execute, and less dependent on central authorities such as the makers of games.

Longer-term, NFTs could play a role in the creation of a realm of virtual spaces known colloquially as the metaverse. Some forecasters project that people in coming years will spend more time immersed in virtual reality spaces they’ve created. And in these spaces, exclusive NFTs could take on a new level of status.

» Find out more: Investing in other alternative assets

What gives NFTs value?

For the most part, the value of NFTs is determined simply by what the market will bear. If you buy one as an investment, you’re essentially betting that someone will eventually be willing to buy it from you for more than what you paid.

There are other ways that an NFT can carry value, however. Beyond the innovation of digital scarcity, some believe NFTs have the potential to change the relationship between creators and consumers of content.

Because NFTs are built on digital “smart contracts,” which execute automatically when certain conditions are met, an artist could create a provision giving them a cut of the proceeds if their NFT were to change hands again. On the other hand, a buyer who supports a struggling creator with an NFT purchase could potentially secure a share of future earnings from other projects.

Creators have experimented with building other value propositions into NFTs. For instance, entrepreneur Gary Vaynerchuk’s VeeFriends NFTs come with free passage into his VeeCon business conference.

Are NFTs a smart investment?

Because every NFT is unique, it’s impossible to make any kind of blanket judgment on their value. Some may rise in value. Others will surely fall, and some may never sell at all.

Generally, digital assets such as cryptocurrency are considered risky investments, which should comprise only a small portion of your portfolio. One common rule of thumb is no more than 10%.

Treyton DeVore, an investment advisor based in Kansas City, Missouri, who advises clients on digital assets, says you can consider NFTs an especially unpredictable part of your crypto portfolio.

He says even if you hope an NFT will rise in value, the most important thing is to buy things you like from creators you want to support. That way, you still have something you can enjoy if you don’t make money.

“People like collecting things and putting them on shelves in their house so they can show people,” he says. “But with NFTs, if that becomes like your digital collectible, that becomes so much more visible.”

» Learn more: What is cryptocurrency? Here’s what you should know

How do you buy NFTs?

The technology that’s used to power NFTs is similar to what’s used in cryptocurrency. So if you already understand that, you’re a step ahead. Otherwise, you may have to get up to speed on a few basics.

In general, if you want an NFT, you’re going to have to decide four things:

  1. Where to buy it.
  2. What to buy.
  3. How to pay for it.
  4. How to secure and store it.

Where to buy NFTs

NFTs are sold in many ways, including through private sales, traditional auction houses and online marketplaces.

For most beginners, DeVore says it’s a good idea to start with a reputable online marketplace. Some well-known examples for art include OpenSea and Nifty Gateway. But there may be others depending on what you’re looking to buy. NBA Top Shot, which makes licensed NFTs based on basketball games and players, has its own marketplace, for instance.

How to select an NFT

Online shops allow users to search for NFTs based on the kind of art, the creator, the price and other filters. If you’re interested in buying one that has some level of cache, you can look at famous collections such as CryptoPunks and Bored Ape Yacht Club.

But beware that in a fast-growing and loosely regulated space, imitators and scammers can crop up quickly. Platforms often have verified accounts for notable creators, which can help you choose.

For lesser-known creators (whose NFTs are likely to be far more affordable), DeVore suggests looking at information such as what they’ve sold previously and how many of a given type of NFT they intend to make. If they haven’t set up an external website to provide information about their art, for instance, that could be a red flag.

How to pay for NFTs

Some marketplaces accept payment in fiat currencies such as U.S. dollars, but in other cases, you can’t use cash or credit cards to pay directly for an NFT. Prices are often set in the cryptocurrency used by the network on which the NFTs are registered. If a creator minted your NFT on the Ethereum blockchain, for example, you’d use ETH to pay for it. If the blockchain is Solana, you’d use SOL.

How to store NFTs

Before you buy, you may have to set up a digital wallet, which can store crypto assets, and place enough cryptocurrency in it to pay the full price. MetaMask is one wallet commonly used to buy and store NFTs.

Before you buy anything, though, make sure you have access to a wallet (or multiple wallets) able to store both the currency that you’re using and the NFT you want to hold.

If you don’t already own cryptocurrency, you’ll have to select an exchange and buy some. Coinbase, a major crypto exchange, also has a wallet service that can be used for NFTs.

Some services, such as Nifty Gateway, will hold your NFT for you, which can simplify the process if you’re willing to entrust your purchase to a third party.

Whatever you decide, you’re not alone if you’re feeling unsure about how to value digital ownership. People have argued for centuries about how to place a monetary price on art. NFTs may be just another round in that debate.

“With art, it is subjective value,” DeVore says. Whatever someone would pay, he says, “that’s what the value is at that time.”

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