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What are NFTs: Environmental Nightmare, Ponzi Scheme or the Future of DeFI?

BasedXeno

7 months ago ·

17 min read

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fungible

/ˈfʌn(d)ʒɪb(ə)l/

adjective

  1. (of goods contracted for without an individual specimen being specified) replaceable by another identical item; mutually interchangeable.

I first heard about NFTs in late 2017, during that halcyon crypto-Summer boom, when Ethereum was still finding its feet and Bitcoin was celebrating a rocket-fueled ascent onto Katy Perry's CrYpTo ClAws. Non-Fungible Tokens. The name doesn't exactly roll off the tongue, which is why nowadays you'll generally hear them referred to by their acronym - NFTs - or, as Mark Cuban likes to call them; "Nifties". Back then they sounded cool, and probably useful, but aside from a network-straining CryptoKitties fad the market wasn't quite ready. Back then, gas was cheaper, the Ethereum infrastructure was still being built out, and ICOs for techno-babble vaporscams were all the rage. An intrepid few with lurid visions of what could be put their heads down and continued to build, but largely the concept of NFTs drifted softly into the background of the crypto-landscape.

Time passed. Much happened.

Fast-forward to early 2021 and you'd have to be living under a Doge-branded rock on Mars not to have heard of NFTs. Elon's tweeted about them. CNN's put them on the front page. Saturday Night Live wrote a song about them. To give you a picture of how mainstream they've become, my mother got her very first mobile phone just last year and recently she asked me if we should turn some of her artworks into NFTs. I'm sure you get the picture, no pun intended - NFTs have arrived. But hold on - what exactly is an NFT? Why is it different to a Bitcoin? How do I prove I own one, and can't I just take a screenshot anyway?

All valid questions, anon-kun. In this article we'll investigate all of the above, and much more. By the end of it, I'm hoping you'll either be taking out a second-mortgage on your house to stock up on CryptoPunks, or protesting outside the Dapper Labs headquarters demanding they put an end to this world-burning scam. But first, let's take a little detour to France - and not to the future of France, this time, but the recent past..

Money Lisa

It's a calm, pleasant autumn day, and you & your partner stroll along the Rue de Rivoli towards a glass-draped polyhedron surrounded by chattering tourists. You line up, people-watching while you wait, then purchase a pair of tickets and make your way into the world's largest art museum: The Louvre.

Home to many of the world's great artworks, there's one piece in particular that everyone here is standing on their tippy-toes to see. You know the one. Quick - what's the most famous painting in the world? There's only one correct answer, that girl with the faint smile, the one captured so delicately on canvas by the polymath Leonardo in the first years of the 16th century. 500 years later, the Mona Lisa is insured for over $660 million, secured by armed guards, and reprinted endlessly on fifty-cent postcards (that will remain blank and unsent), cheap plastic keyrings, and kitsch tablecloths.

money-lisa.jpg

Why do millions of people stand in line for hours in order to see something that they can purchase on a keyring for $3 at a knockoff tourist trap? Well, of all the Mona Lisa's in the world, there's really only one that counts. The value is not just in the image, but in the history of the object - the fact that this particular painting - the original - was touched by Da Vinci himself, and has passed through many hands and esteemed manors, accruing value and prestige with every transaction. The fact is that value is based on some opaque mix of mutual-agreements, provenance, and human wants, and while anyone in the world can display a copy of the Mona Lisa in their home, there is only one true Mona Lisa; the one hanging in a gilded frame in a particular room below that glittering pyramid next to the Seine.

Scarcity combined with demand is the name of the game when it comes to value. The Mona Lisa is a perfect example of this, but it wasn't until the invention of Bitcoin in 2009 that scarcity could be applied to the digital world.

We're living in the early days of the revolution this innovation has ignited, and in the space of just over a decade cryptocurrency has bloomed from a curious toy into a multi-trillion dollar market. There will only ever be 21 million bitcoins, and they cannot be forged or copied, despite being digital information. Yet, each bitcoin, just like a dollar of fiat money, is fungible - you and I could swap our bitcoins and there would be no discernible difference in value - 1 bitcoin is worth exactly 1 bitcoin, and it doesn't matter "which" bitcoin you hold in your wallet, they're all the same.

This is where NFTs come in - they allow us to take cryptocurrency one step further - to create digital objects that are truly unique, with an individual history that can be tracked & verified, much like the one true Mona Lisa that made its way from Leonardo's studio in Florence, through the hands of royalty and noblemen, and came to rest in the Louvre.

Things will never be the same: How ERC-721 changed everything

A "regular" Ethereum token, such as SNX (Synthetix) or UNI (Uniswap), is defined by the ERC-20 standard - a set of rules within a software contract interface that determine the values that a digital record can hold, and the ways it can be transferred between accounts. One of the salient properties of the ERC-20 token standard is that each token is entirely fungible - each coin is indistinguishable from any other of the same type, unlike the ERC-721 interface that underlies Ethereum NFTs - to paraphrase Tolstoy; "Fungible ERC-20s are all alike; every ERC-721 is non-fungible in its own way".

erc-20-erc-721.png

The ERC-721 standard was proposed by Dieter Shirley in late 2017 as a way to embed unique properties in an individual token, paving the way for tokens to represent and / or become collectible items, lottery tickets, concert seats, and anything else that is not intrinsically interchangeable. One of the keys to this functionality is the "tokenId" property, a globally unique id that can be paired with the token contract address to create a one-of-a-kind, unforgeable identifier. The release of the ERC-721 standard unleashed the natural next-step of smart-contracts - the ability to represent unique digital or physical items on the blockchain, backed by the security & tamper-resistance of the Ethereum network.

While Ethereum remains the dominant smart-contract network, with huge developer support and user mind-share, it's important to note that NFTs aren't restricted to Ethereum's ERC-721 standard - there are NFTs available with alternative implementations on other blockchains such as Avalanche or Solana. If you want to dive even deeper, you can also look into the ERC-1155 and ERC-998 standards, which build on the non-fungible concept while enabling additional functionality and flexibility.

Encoding Scarcity

One of the most impactful innovations of blockchain technology is that we have access to a decentralized, immutable record of balances & transactions without relying on human bean-counters to keep the score (or fudge the numbers). In Ethereum's case, by connecting the globally unique tokenId / contract-address pair of an ERC-721 smart contract with a user's account, people can now purchase unique digital items, prove their authenticity & provenance, and trade them freely without the need for an intermediary. This is kind of a big deal. Once the standard for NFTs was defined, it triggered a groundswell of creative projects experimenting with the format.

The most attention-grabbing of these early projects was CryptoKitties, a game involving uncanny collectible cats that can be "bred" to combine attributes and create endless permutations of quirky digital felines. When CryptoKitties was first launched by an innovation studio known as Axiom Zen in December, 2017 they caused such a stir that for several weeks they were actually responsible for literally slowing down the entire Ethereum network, taking up huge amounts of transaction space while raking in millions of dollars as enthusiasts rushed to mint & breed kittens.

crypto-kitties.png

While CryptoKitties had captured attention and made a splash, they weren't the first to experiment with the format - several months earlier John Watkinson and Matt Hall of Larva Labs had released a set of 10,000 pixel-art portraits they called CryptoPunks, with a similar underlying concept of "attributes" that ensured each CryptoPunk had an idiosyncratic look, running the gamut from tophat-wearing apes through to pipe-smoking, aqua-skinned aliens.

cryptopunks.png

Watkinson and Hall offered the punks essentially for free, with users only having to shell out a few cents to pay for the transaction fees, and less than 30 punks were collected in the first few days, illustrating the relative lack of interest from the crypto community at the time. It wasn't until an article in Mashable was released in June, 2017 that the idea took hold, with demand suddenly exploding. The remaining punks were collected within hours, with some users alone snagging dozens and even hundreds of punks. As of April, 2021, the highest price paid for a single CryptoPunk is $7.58 million, with the cheapest punks selling for no less than $65,000.

If zany characters and breedable animals could be captured in an NFT and traded, then what about real-life moments? That question was answered by the same team that created the original Crypto Kitties, Vancouver-based Dapper Labs (a division of Axiom Zen). Dapper Labs entered into a partnership with the US National Basketball Association (NBA) in 2019 and developed NBA Topshot, a product that packages NBA highlights into collectible NFTs that can be bought in packs, much like physical trading cards, and then traded on the NBA Topshot marketplace.

nba-topshots.png

Although the numbered highlights can be purchased in packs ranging in price from $9 - $230, it didn't take long before the market heated up, catching a perfect wave with the NFT hype of the early 20's and minting a fresh batch of crypto millionaires.

The highlights came with some lowlights, however - the promise of quick riches brought intense media coverage and waves of speculators, leading to such intense growth that Dapper Labs began restricting withdrawals of funds from the platform. This type of centralized control over user's funds is a cause for concern and highlights an important detail about Dapper Lab's product - it runs on a proprietary blockchain called Flow that is not truly decentralized, unlike Ethereum...

The $69,000,000 JPEG

Mike Winkelmann is an American digital artist, a kind of modern Warhol digesting the relentless stream of modern pop culture and regurgitating it into warped & vivid renderings he posts onto his blog and social media accounts every day. Literally _everyday _- better known online by his nom de guerre "Beeple", Winkelmann has made a piece of art every single day for over 5000 days in a row, starting on May 1st, 2007. On March 11, 2021, Beeple's NFT of 5000 of those pieces of art was sold by the centuries-old auction house Christies for $69,346,250.

beeples-everydays.jpg

The sale made Beeple one of the world's top 3 most valuable living artists, and marks the moment that non-fungible tokens broke the barrier from nerdy collectible to respected medium on art society's grandest stage. It grabbed the media's attention, and brought to the fore some pressing, and very important questions about NFTs; what exactly did the bidder buy when they won that auction, and what is the real cost of linking something in the real-world to something in the digital world?

What's really in an NFT?

“A person's worth is measured by the worth of what he values.”

― Marcus Aurelius

“Anything that just costs money is cheap.”

― John Steinbeck

We know now that an NFT is really a smart contract - a digital record, secured and encoded on a blockchain, and owned by an account. The NFT is unique because of its one-of-a-kind combination of id & contract-address, and the ownership of that NFT is verifiable and unforgeable.

There is, however, still something important that we're overlooking: On the Ethereum blockchain, computations and storage are expensive - storage is so prohibitively expensive that (as of April, 2021, and an ETH price of ~$2500) it would cost approximately $4000 to store a 50 kilobyte jpeg on the network. In the case of Beeple's $69 million NFT, the JPEG image file itself is not actually stored in the NFT - the NFT has a set of metadata properties, including a "uri'' property that points to an external URL, which is where the actual image data is stored.

what-people-think.png

So, an NFT is actually just a pointer, and the "real thing" that it references is always stored elsewhere, on a hard drive outside of the blockchain. And if that file is removed from that server? Well, your NFT now points at a HTTP 404 error page. That should be concerning, considering that the average lifespan of a web page on the internet is around 100 days, and companies become insolvent and disappear constantly. This means that for a lot of the media-based NFTs that are being bought for thousands of dollars and more, the actual artwork may no longer be where the NFT thinks it is.

tweet-jonty.png

An additional consequence of this is that often an NFT is not really as decentralized and immutable as people believe. If the images are stored in an AWS S3 storage bucket, for example, then whoever controls that bucket controls the image; a concept completely antithetical to the decentralized aims of the Ethereum blockchain, and a blow to the idea of true, sovereign ownership.

Some potential solutions to this involve storing the image file off-chain on a genuinely decentralized file storage system such as IPFS or Filecoin, but even these don't promise data permanence by default; in order to ensure that a file is not "garbage collected" an IPFS user must "pin" a file to keep it around; this is in itself such a chore that services such as NFT Storage and Pinata have emerged to make the "pinning" of files easier to manage, and still that doesn't completely solve the problem of files disappearing. IPFS files need to be hosted by nodes, and in many cases the larger companies participating in the NFT space such as Nifty Gateway are hosting files on IPFS via their own private gateways, meaning that there is still some reliance on a centralized organization to remain solvent and online.

There do exist some NFT platforms that have taken all of the above issues into account and made concerted efforts to address all of them - InfiNFT offers on-chain image storage using a combination of IPFS and the Arweave blockchain, which has built something called the "permaweb", a collectively-owned hard drive promising true data permanency. The lesson remains - NFTs aren't always what they appear to be, and many will disappear over time, leaving users with some very expensive metadata in their wallets.

in many cases they’re simply buying that particular NFT, and not the artwork it represents

The issues with who owns what doesn't end with file storage. There still exists confusion among people who are purchasing these NFTs about what they're getting for their money - often they believe that they're buying the legal rights to the underlying artwork, yet actually in many cases they're simply buying that particular NFT, and not the artwork it represents - unless it's specified explicitly in the sale, the copyright and royalties still belong to the original artist. With this new technology, purchasing a piece of art is no longer as simple as taking ownership of a physical item, and this results in some murky waters to be navigated.

If you're in the market to purchase media-based NFTs, and are preparing to drop a pretty penny, make sure that you know what you're really getting by asking these questions:

  • Is this NFT being sold with the knowledge of the original artist?
  • Who owns the copyright to the underlying media?
  • Does the vendor have the right to convey these rights?
  • Where is the media being stored? Is the storage centralized? Is it persistent?
  • Is resale permitted?
  • How are resale proceeds distributed?

Once you've gone through that checklist, there's just one last thing to do before you click the buy button: make sure that your new virtual status symbol isn't responsible for triggering the apocalypse.

Are NFTs destroying the planet?

It didn't take long after the NFT boom of early '21 had begun for the accusations of environmental destruction and energy waste to start making the rounds. When a cartoon kitten you've just added to your collection of digital art is called a "goddam ecological nightmare pyramid scheme", it probably pays to take pause and find out where these claims are coming from. How can a digital file pointing to another digital file be responsible for "speedrunning the climate apocalypse"?

Let's not beat around the bush; the current implementation of the Ethereum blockchain does use a surprisingly large amount of energy in order to run. This implementation is based on something called the Proof of Work (PoW) consensus mechanism. Let's do Proof of Work in 100 words:

Ethereum (and Bitcoin) are decentralized networks of computers that secure the system by checking & agreeing that transactions are valid and no-one tried to cheat. This involves some complex cryptography in order to ensure validity. To incentivize each of these computers to process the incoming transactions and tell the truth about the results, each computer works to find a very specific, random number. The computer that finds that number wins a prize (Ethereum tokens). When a computer finds the number, it tells the other computers in the network, who can quickly check that number and verify the transactions are valid.

What this means is that the current Ethereum PoW consensus mechanism involves lots of computers (miners) working constantly to win tokens and publish transactions in consecutive groups called blocks (hence blockchain). The combined energy usage of all of these computers working 24/7 to secure the Ethereum network is currently estimated at around 39.2 terawatt hours of electricity per year, which is almost exactly the power consumption of New Zealand, a lovely little country of 4.9 million people. That's quite a lot, and in the wake of our growing acknowledgement of the imminent climate change crisis, it's also unsustainable.

Luckily, the Ethereum network is currently in the process of switching to an alternate consensus mechanism known as Proof of Stake (PoS), which vastly reduces the energy required to secure the network. By 2022 at the latest, Ethereum will be running on this new mechanism and using orders of magnitude less energy.

mining.jpg

The argument against NFTs in particular also bears a further look. When people make the accusation that an NFT is responsible for X amount of energy use, it's not entirely the case - the real energy use lies in the underlying PoW consensus mechanism, which is entirely neutral as to what type of transaction is being processed. It's kind of like an all-you-can-eat restaurant offering a 2-hour buffet; the cost ends up being the same regardless of whether you have 1 plate of food or 10. The minting of an NFT or the trading of a token are all just transactions that will be bundled into a block and processed by the network miners. Blaming an individual NFT isn't accurate, although criticism of the PoW mechanism certainly is.

Ultimately, if environmental sustainability is your priority, then currently Ethereum / PoW-based NFTs aren't something you can justifiably invest in - you're better off waiting until Ethereum transitions to Proof-of-Stake.

Market liquidity and fractional ownership

matrix.png

While market liquidity is a concern, just as it is in the traditional art market, there are signs that the NFT boom is not just the latest bubble preparing to pop. While there was certainly a mood of euphoria coinciding with the Beeple sale and CryptoPunks resurging in popularity, according to nonfungible.com there is still plenty of demand and volume in the market, and it may only just be beginning.

To satisfy the demand for NFTs, and also offer new ways to commoditize and trade them, several solutions have been released in the first few months of 2021. This includes NFT index funds, allowing users to gain exposure to the market without taking on the direct risk of selecting individual NFTs. Among the NFT index funds available, there are offerings from NFTX, and Indexed Finance's NFT Platform Index, which offers investors access to a basket of NFT platform tokens.

nftx.png

With NFT prices reaching into the hundreds of thousands and even millions, the idea of fractional ownership has also become popular, with tokens such as B20 by Metapurse representing shares in a collection of Beeple artworks. By holding these tokens, not only are users able to claim some level of ownership of previously unattainable NFTs, but they gain access to liquidity by being able to trade the fractional share tokens on exchanges like Uniswap and Sushiswap. Owners are also able to vote on things such as reserve price if the NFT goes to auction, and in the event of a sale are able to redeem their tokens on a pro-rata basis.

What does the future hold for NFTs?

It can be easy to forget that the entire concept of a cryptographically-secured decentralized peer-to-peer network has only been developed and constructed over the past 12 years, leading back to Satoshi's whitepaper, and the first release of the Bitcoin protocol in 2009. In that time we've seen the industry grow from 2 pizzas being purchased for 10,000 bitcoins, to self-paying loans, buy-in from billionaires, and automated-yield optimizers outperforming the stock-market. NFTs may have begun as a proposal for tokens to be able to represent art, or lottery tickets, but in hindsight their creation opened the door for tremendous innovation in decentralized finance and digital media ownership, nascent industries that are experiencing a Cambrian explosion of ingenuity.

financialization.png

In the realm of digital content, NFTs are being used by artists to disintermediate the traditional middlemen and deliver their products directly to fans, a phase-change in the topology of distribution akin to the way that Twitter enabled people to essentially become their own publishing companies.

The notoriously labyrinthine complexities of royalty payments are also transparently and verifiably handled by NFTs utilized by DeFi protocols - "creator fees" can be programmed into a piece of digital art, ensuring that the original creator will automatically receive a percentage of each resale.This attribution and automated royalty payments is not only applicable to the art world - the Planck protocol aims to utilize the proceeds of scientific study sales, with the revenue generated then funding a replication of the study.

NFTs can now also be used to secure collateralized loans, with marketplaces such as NFTfi enabling the owner of say, a CryptoPunk to put that ERC-721 token up for collateralization (held in the NFTfi smart contract), with the loan provided by another user. Users can reclaim their NFT when the loan is paid back, echoing the traditional banking markets where art-secured loans account for an estimated $20 - 24 billion. This genie isn't going back in the bottle.

And beyond that? Companies totally replacing stocks with NFTs that can be traded anywhere in the world, or tradeable equity in a company being offered in lieu of Christmas bonuses? How about NFTs that represent a person's mannerisms being rented in the MetaVerse? This is truly just the beginning.

Dive a little deeper

By now you should have a good understanding of what NFTs are, what they can be used for, and why the industry is worth keeping an eye on. If you'd like to learn more about the latest news in the industry and perhaps dip your toes into the waters, here's a collection of resources & platforms that you can use:

NFT Exchanges, Marketplaces & Analytics

NFT Social Platforms

NFT Social Accounts

BasedXeno

7 months ago ·

17 min read


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