Fungible or not, that is the question

Defining things by negations is a bit clumsy, but here we are: “non-fungible tokens” are first and foremost tokens that are not fungible (duh!). So, what is fungible? Fungibility is one of the properties an asset needs to possess – next to portable, durable, and divisible – to be a candidate for good money. Fungibility means the asset is of homogeneous texture and can be portioned in equally looking pieces. For example, your Dollar bill is as good/the same as my Dollar bill, they are fungible. However, the two bills are not identical, but clearly distinguishable because they have different serial numbers. Just, usually, nobody is tracking the serial numbers as it very hard to do in the analog world.

Despite much talk about pseudonymous and anonymous crypto currencies, it is essentially the same in crypto. For most practical purposes, your 0.1 ETH is the same as my 0.1 ETH – or any other fungible token on Ethereum. That is what the ERC20 token standard indeed represents. However, the equivalent of the serial number – the Ethereum (or Bitcoin) address – is very closely tracked on the blockchain, and it needs to because that is how we can track transfers without a bank. Traceability of crypto currencies (as addresses or unspent transaction outputs, etc.) and how to achieve/avoid it, is a large privacy topic of its own. If you like to dig deeper, we invite you to read the 4th edition of Themes on “Privacy in the era of cryptocurrencies”, which also looks at traceability and privacy implications of Central Bank issued Digital Currencies.

Coming back, a Non-Fungible Token (NFT) is a unique digital representation of a digital or analog item that contains its origin and history and, in most cases, also contains code governing its behavior, for example actions when it is transferred between holders. In that context, holding an NFT in a wallet is considered the equivalent of being the rightful owner of the underlying item.

How do you create an art NFT, for example? You first create the image (JPG file). Second, you define metadate (author, date, description, tokenURI, etc.). Third, you create the (copy/paste) the NFT smart contract or use an existing one. Fourth, you “mint” one or more of your tokens using the smart contract’s mint() function. Fifth, you make you new tokens available on a marketplace. Six, you wait for a solvent buyer taking an interest in you token(s).

Market structure

Typical NFT markets are much more akin to art markets: only one or few items exist that one or a few collectors want to own, which can lead to pricing that is subjective and potentially reach very high levels as “value lies in the eye of the beholder.”

Illustration 1 gives an overview of the NFT space, structured in layers. (1, 2) While Ethereum-based NFTs dominate the space, you can see that different Layer-1 platforms (and different Layer-2 solutions) are active in the space. Each chain maintains their own technical standards and platforms. In the case of Ethereum, most NFTs used to be ERC721 smart contracts, while today ERC1155 is considered the default contract type as it can handle multiple token types in one deployed contract (c.f. comparison).

(3) The punk/ape/kitty look of the artwork is defined in metadata that is not part of the contract, but resides elsewhere. An ERC1155 contract stores metadata by pointing to a web resource (“tokenURI”) that hosts all the colorful pixels. This raises the interesting question of how the availability of metadata is secured to always show the actual/correct artwork and how it is governed. Many storage solutions in use are web3 applications like IPFS for example.

(4) The largest and most dynamic layer is the application layer. NFTs are used across an ever expanding spectrum of application domains, ranging from digital items in games and virtual worlds (metaverse) like weapons or virtual land to domains that represent crypto addresses, to new royalty mechanisms for musicians, writers, and many more.

Here, the possibility to reliably remunerate creators in the secondary market is a key innovation for the art market – and a historical first. A smart contract can, for example, stipulate that the NFT creator receives a percentage of each transfer of the NFT on the secondary market. One way to implement royalty mechanisms in Ethereum-based contracts is defined in EIP-2981.

(5) Aggregator services on the next layer make NFTs created in these applications discoverable and tradable. For example, a NFT market place like OpenSea displays the metadata plus the NFT contract address in a searchable manner and thus facilitates trading. Aside from normal marketplaces, the “reverse” use case also exists. Fractionalization means that several owners share (fractions of) one particularly expensive NFT, thus democratizing access and ownership in a sense.

(6) Finally, tools are emerging that allow users to manage an entire portfolio of NFTs across different protocols and token types.