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Academy Industry Analysis Article

Nonfungible tokens aren’t new, but their future looks brighter than ever

2020.10.26 Matthew Lam

An examination of the past, present and future of NFTs

In the cryptocurrency sphere, the development of decentralized finance has taken center stage in 2020. While the market hype surrounding DeFi and liquidity mining has cooled down since late September, nonfungible tokens — also known as NFTs — have regained much of the popularity they saw at the height of CryptoKitties' popularity in 2017. 

With nonfungible tokens on the rise, OKEx Insights revisits their use cases and examines the potential adoption of NFTs.

What are nonfungible tokens?

The differences between fungible and nonfungible tokens are not terribly complicated.

Fungible tokens are interchangeable and can be easily replaced by something identical. BTC is a good example of a fungible token — or, in this case, coin. If you lend out one coin to someone on the Bitcoin network, it would not matter if they didn't return the exact same one. This is because the value of one BTC is the same as any other coin on the network.

Before we look into NFTs, it is worthwhile to understand examples of nonfungible assets in the real world. Let's use airplane tickets as an example: While the size and shape of each ticket look identical, the information printed on the tickets — such as a passenger's details and destination — is different. You cannot replace a ticket to the United States with one to Japan. In a similar way, nonfungible tokens are digital representations of assets that are not interchangeable in the real world.

Why do blockchain-based NFTs matter?

Nonfungible digital assets have been around since the advent of the internet and range from domain names to e-tickets to account handles on social media networks. These assets possess their own characteristics and are not interchangeable. Furthermore, one user usually cannot easily transfer a rare item from an online game to another user, and there exists a lack of proof over the ownership of the particular item. 

This is where blockchain-based NFTs come into play. 

Four benefits of NFTs

The use of blockchain technology with NFTs brings the following features and benefits to digital assets:

  • An ERC-721 token standard
  • Proof of ownership
  • Increased transferability and liquidity
  • The mitigation of counterfeit risk

ERC-721 token standard

As first introduced by CryptoKitties in late 2017, ERC-721 is the most common token standard for nonfungible tokens. 

There are two main differences between ERC-721 and ERC-20 token standards.

Firstly, ERC-20 tokens are divisible, while ERC-721 tokens are not. For example, users can purchase 0.5 units of Ether (ETH) or UNI. However, under the design of the ERC-721 standard, users may only possess the whole unit of the token. Such indivisibility makes ERC-721 tokens consistent with the nature of nonfungible assets. For instance, users cannot own half a kitten in CryptoKitties or claim 30% ownership of a digital collectible card.

Proof of ownership

ERC-721 tokens are different from ERC-20 tokens in their ownership records. ERC-20 tokens only record the account balance of the address. On the contrary, ERC-721 tokens not only record account balances but also maintain records of the token ID for each transfer. This feature is crucial for enhancing the transparency of nonfungible asset transfers.

Each nonfungible token represents a unique asset and contains essential information, such as basic properties and ownership details. The ownership record of the asset is stored in the NFT, which is traceable on the blockchain. 

Transferability

NFTs allow their underlying assets to be transferred and traded easily across multiple ecosystems. Using in-game items as an example, blockchains remove any intermediaries and serve as unified platforms for users to trade their items. For game developers, they can incorporate sophisticated trading capabilities, such as eBay-style auctions and bidding, into smart contracts. This makes blockchains one-stop platforms for users to trade, auction and sell their NFTs.

Additionally, the tradeability of NFTs leads to higher liquidity, as they can be traded in open marketplaces. Marketplaces for nonfungible tokens offer greater exposure to digital assets for a wider pool of buyers. 

Counterfeit mitigation

The use of NFTs helps mitigate the risk of purchasing counterfeit goods. 

Art is one field where this is especially useful. Each art collectible is assigned its unique identification in the nonfungible token, which allows people to prove the scarcity of the artwork. The blockchain serves as a publicly trackable database to show the entirety of the artwork's life. This helps to prove the authenticity of the artwork, as only the original piece of art is tracked on the blockchain. 

History of NFTs, explained

While nonfungible tokens first garnered mainstream attention with the rise of CryptoKitties in 2017, Colored Coins was arguably the first project related to NFTs — dating back to 2012. Colored Coins was the first to build NFTs on the Bitcoin network, and they represented ownership of different assets, such as property and digital collectibles. 

CryptoPunks, meanwhile, was the first Ethereum-based token in early 2017. It created 10,000 unique and collectible characters with the proof of ownership stored on the Ethereum blockchain.

2017: The rise of CryptoKitties

Launched in late 2017 at the ETH Waterloo Hackathon, CryptoKitties is an Ethereum-based game that allows users to collect and breed their own digital cats. The tokens of CryptoKitties are nonfungible, as each token represents a unique digital cat on the blockchain. The attribute of each cat is determined by an on-chain breeding algorithm written in a closed-source smart contract. The kitties can be sold via Dutch auctions and secondary markets — and the rarer the cat's characteristics, the higher price it could be sold for.

CryptoKitties went viral due to its breeding and trading mechanisms. Users first bought a couple of cats and bred them to make rarer cats, which they could then sell for a profit. More users then rushed to breed their own kitties to profit from. The surging demand for CryptoKitties led to the number of daily transactions on the Ethereum network reaching an all-time high (1.349 million) in January 2018 — a record that was just recently surpassed in September 2020 amid the liquidity-mining craze spurred on by Uniswap (1.4 million).

Daily transactions on the Ethereum network hit their previous peak during the CrypoKitties craze. Source: Etherscan, OKEx Insights

On the flip side, the CryptoKitties fever exposed Ethereum's lack of scalability. The growing number of users who were breeding and trading their cats led to a huge increase in transactions that needed to be executed on the Ethereum network. Because Ethereum can only handle approximately 15 transactions per second, most of the CryptoKitties transactions fell into the pool of pending transactions. The daily average of pending transactions rose from 1,500 to 11,000 during this time. In order to promptly execute their transactions, users were willing to pay higher gas fees. This led to high levels of congestion on the Ethereum network, with the average transaction fee reaching over $2. 

The congestion on the Ethereum network popped the CryptoKitties bubble in early 2018. Despite this, CryptoKitties was the first NFT to attract mainstream attention. It also pioneered a Dutch auction contract, which then became one of the primary price-discovery mechanisms for NFTs.

2018: Interest in NFT investing grows

Despite interest in nonfungible tokens cooling down after CryptoKitties, the fundamentals of the NFT ecosystem have been growing since 2018 in two primary ways:

  • Layer 2 games on CryptoKitties
  • Investment from crypto funds and venture capitalists

Layer 2 games emerged in the NFT ecosystem in 2018 and refer to games that were built on top of CryptoKitties by third-party developers unaffiliated with the original game's team. For instance, Kitty Race allows CryptoKitties to race against each other to win ETH. KittyHats enables users to accessorize their CryptoKitties, while Wrapped Kitties lets users convert their CryptoKitties into fungible ERC-20 tokens to be traded on decentralized exchanges. As described by Dapper Labs, the creator of CryptoKitties, the Layer 2 games built on CryptoKitties' smart contracts have expanded the game's ecosystem, also known as the KittyVerse.

2018 also witnessed an increasing interest in NFT investment from crypto funds and venture capitalists. Following the hype of CryptoKitties, Dapper Labs received two rounds of funding, which together brought in $27 million, from notable investors such as Andreessen Horowitz and Samsung Next. Additionally, Mythical Games raised $19 million in a funding round for its flagship Blankos Block Party game on EOS. Investment funds are also being launched to support this nascent space, such as Ripple's $100 million contribution to a fund managed by blockchain gaming company Forte.

2019: NFTs and intellectual property 

To protect intellectual property, traditional firms started to use nonfungible tokens in 2019 to issue their digital collectibles. The auto racing giant Formula One, for instance, partnered with Animoca Brands in May 2019 to develop a blockchain-based racing game called F1 Delta Time. On May 24, the game issued its first one-of-a-kind virtual F1 sports car, the "1-1-1." After a four-day auction, the digital collectible was sold for 415.9 Wrapped Ether (worth $113,000 at the time), making it the highest NFT token sale of 2019. 

Following the success of F1 Delta Time, Animoca Brands and Dapper Labs have recently secured a licensing agreement with MotoGP and plan to issue another blockchain-based racing game in the near future.

Apart from racing giants, trading card giant Panini America entered the NFT market in January 2019 with the launch of blockchain-based sports trading cards for major professional leagues and associations. Star Trek was also on the NFT scene in June 2019 when blockchain-game developer Lucid Sight introduced the iconic starships and other collectibles onto the blockchain.

2020: When NFTs meet DeFi

2020 has been an explosive year for decentralized finance. While liquidity mining has cooled down after the release of Uniswap's governance token, UNI, yield farmers have turned their attention to NFTs.

The yield farming of NFTs has primarily been pioneered by Rarible, an NFT marketplace. Rarible released its governance token, RARI, in mid-July, which resulted in an 814% price growth. The trading volume of NFT marketplaces surpassed $7 million in September, of which Rarible accounted for 81%.  

Apart from Rarible, NFTs gained traction among the cryptocurrency community with the launch of the MEME token. MEME is an experimental protocol meant to integrate DeFi with crypto collectibles. Despite the project's slogan being "Don't buy MEME," it has gathered market hype and once reached a $48 million market capitalization. The MEME team has also collaborated with digital artists to allow users to stake their MEME in order to participate in NFT auctions of their artwork.

Despite the popularity of yield-farming NFTs, Ilya Abugov, lead analyst at DappRadar, believes that NFTs have not reached mass adoption levels of hype. He told OKEx Insights:

"The industry is still learning how the NFT concept can be applied. I think, given the currently limited reach, it is too early to measure the hype. It is more exciting during the exploratory phase. Art and games look to be the first to benefit from NFTs. However, we have already seen use cases, like tokenized insurance, that show how NFTs have a wide range of applications."

In the first half of 2020, the amount of USD transferred in the NFT ecosystem reached $233 million — up 52% from the entirety of 2019. 

The first half of 2020 has already seen record amounts of USD flow into NFTs. Source: NonFungible

NFTs and gaming: Putting in-game assets on the blockchain

NFTs are seen as having the huge potential to revolutionize the gaming industry. 

In traditional online gaming, users' in-game assets are owned by the centralized server. Game developers allow gamers to possess their in-game assets. However, users do not actually own them.

Blockchain technology enables true digital ownership over in-game assets. Those represented by nonfungible tokens store ownership records and asset details on the blockchain. The transfer of NFTs represents the transfer of ownership over the assets, which cannot be stopped by the game's developers. While a completely decentralized blockchain game could be slow and clunky for players, gaming companies considered using the technology to process gaming transactions while retaining the actual gaming mechanics on the centralized server.

Yat Siu, the founder of Animoca Brands, believes that gaming companies can now offer true economic benefits to games via NFTs. He told OKEx Insights:

"NFTs confer true digital ownership and make it possible to deliver real property rights to gamers. This means that traditional gaming companies can now offer real economic benefits to players — the concept of value can now be realized in the game. This is similar to offering trading and virtual banking services for your gaming assets."

Siu also believes that NFTs in gaming are being increasingly integrated into the DeFi ecosystem. He explained:

"Because NFTs are, in essence, real assets, you can start applying real-life principles — such as loaning or renting the assets. In F1 Delta Time, we allow for the staking of race cars, which can be rented to other players for use in the game."

Going into more detail, Siu added: 

"We also provide race rewards for the top players, calculated on the amount you stake, so we are combining yield farming with some fun. Everyone who stakes our REVV token can get a yield, but the best players get a better yield! We have seen players band together and form teams, with some providing financing and letting those who know how to play the game better to race and share profits."

Digital art

Before blockchain technology, the lack of adequate authentication for pieces of artwork has been a headache for artists. According to a 2014 report by the Fine Arts Expert Institute, over 50% of art is forged or not attributed to the correct artist. This is largely a result of improper documentation during art transactions. Artists and private collectors sometimes do not document art transfers with formal legal agreements. Additionally, buyers seldom conduct formal due diligence on the artwork they purchased.

The advent of blockchain technology brings the potential to address the lack of artwork provenance. Each transaction in an artwork's life creates a new block and appends to its previous block. Transactions are tamper-proof on the blockchain, and no parties can alter the artwork's details stored on the blockchain. This enhances the transparency of provenance and trust among buyers, sellers and collectors.

CryptoZR, a blockchain artist, told OKEx Insights that online provenance is the main difference between digital artwork and traditional artwork. She commented:

"The provenance of traditional artwork is conducted offline, which often requires the assistance of third parties. For instance, experienced artists, exhibitors and commentary experts can help to determine the authenticity of the artwork. On the contrary, blockchain enables the online creation of original artworks, and the provenance process is conducted online." 

CryptoZR added that a new artwork ecosystem has emerged from the advent of blockchain, explaining:

"Traditional artwork had a mature ecosystem for centuries — ranging from the artwork's creation and auction mechanisms to art exhibitions and galleries. The advent of blockchain led to the rise of a tokenized art market, decentralized art exchanges and virtual artwork exhibition, which brings a new ecosystem to the art industry." 

Artwork can be represented by a nonfungible token on the blockchain, and each token possesses unique characteristics — such as the origin, ownership and sales records. 

Additionally, while the art sales industry is perceived as a market for high net-worth individuals and angel investors, the tokenization of artwork opens up the market for retail buyers. The tokenization of artwork enables fractional ownership for retail investors that do not have access to huge capital.

Decentralized art exchanges

The tokenization of artwork has also led to the rise of decentralized art exchanges. 

Blockchain-based art exchanges save on the overhead costs of operating physical art galleries. Moreover, platforms such as the Blockchain Art Exchange and Ethereum-based platform DADA allow cryptocurrencies as a form of payment. Decentralized art exchanges are one key driver for the growth of online art sales platforms from an estimated $5.9 billion in 2020 to a forecasted $9.32 billion by 2024.

Apart from decentralized art exchanges, traditional art auction houses have begun to streamline their operations with blockchain technology. For instance, auction house Christie's first piloted the use of blockchain technology with Artory in November 2018. Both parties produced digital certificates for a $300 million art sale that included the works of Georgia O’Keeffe and Edward Hopper. On Oct. 8, Christie's launched its first auction in NFTs for the Bitcoin-inspired artwork "Block 21," which sold for $131,250.

Can NFTs go mainstream?

While NFTs have regained the community's attention once again since CryptoKitties in early 2018, there are still obstacles for NFTs to overcome before they go mainstream.

One such obstacle concerns regulation. While NFTs grant holders the ownership of the underlying asset, there is no legal consensus on the nature of NFTs — whether they are utility tokens, security tokens, currency tokens or belong to a new asset class. Henri Arslanian, PwC's global crypto leader, told OKEx Insights that regulators have not come to a consensus on whether securities regulations should be applied to NFTs. He explained:

"The jury is still out on whether NFTs should be, or even can be, regulated. Whilst most agree that there needs to be an oversight on the platforms where such NFTs are offered and traded, there is still no consensus on what type of NFTs should be regulated. Some believe that they should fall within the remit of securities regulations. Others argue that they are simply unique by their features and functions and including them within the securities sphere would not be appropriate."

User experience is another area currently lacking in the NFT space. Despite the recent market hype, the ecosystem remains nascent. Crypto communities, in general, often do not understand the mechanics of NFTs and struggle to mint their own NFTs. Moreover, there is a lack of well-established NFT marketplaces.

Ilya Abugov also stressed that education and user experience, apart from regulations, are the biggest hurdles facing NFTs and their push to go mainstream. He explained to OKEx Insights:

"Education and the user experience/interface will be the biggest hurdles. This is especially true for the gamers and collectibles segments. To achieve meaningful adoption for a game utilizing NFTs, publishers will need to design and properly market an interesting game. It won't be enough to just add an NFT tag and hope the economics take care of themselves. Moreover, the general public will need to be educated regarding the uses and functionality of the NFTs."

Arslanian at PwC shares a similar view with Abugov. He added in his comments:

"A lot of education and awareness still needs to take place on the topic of NFTs before we can see them go mainstream. That takes time."

Finally, wash trading is a concern in the NFT market, where traders may potentially engage in the creation of false demand for a particular token or intentionally mislead market participants. In a typical example of wash trading, the assets are exchanged between two wallet addresses frequently within a short time frame. When investors place the sell order, they will then place a buy order to fulfill their own sell order.

A typical example of wash trading, where the asset is exchanged six times in 24 hours. Source: NonFungible

Project teams and statistics platforms can help to mitigate the wash trading of NFTs. For project teams, they can impose higher market fees when designing reward structures. When the reward is less than the cost-of-attack, traders will be less likely to perform wash trades. On the other hand, statistics aggregators and platforms need to develop methods to detect wash trading and facilitate price discovery for NFTs.

While the NFT space is still in its early development and is facing multiple obstacles on its road to mainstream adoption, it has the exciting potential to revolutionize various industries. As stated by Arslanian:

"NFTs will allow users better ownership, traceability, interoperability and trading of 'digital' assets, from items brought in video games to new digital collectibles. Whilst it is not entirely a new asset class, the possibilities that NFTs unlock are novel and very exciting."


Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.


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Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

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