The Benefits and Use Cases of Non-Fungible Tokens

NFTs are tokens that reside on a distributed ledger and hold or reference an asset, for example an in-game item, a song, art, or even real estate. We explore their key benefits and use cases, which stem from leveraging the properties of Distributed Ledger Technology, such as immutability, digital scarcity and removing the requirement of a trusted intermediary.

Introduction

Non-Fungible Tokens, or NFTs, are tokens that reside on a distributed ledger, such as the Ethereum blockchain. The key difference from cryptocurrencies, such as bitcoin (BTC), is that they are not exchangeable. This means that one NFT may have a different value and price from another one, whereas one BTC will always be exchangeable with another BTC. In other words, NFTs are scarce and unique, as they are issued in limited quantities.1 Formally, an NFT is a smart contract which prevents digital duplication of the data it contains, predominantly ERC721 and ERC115 smart contracts.

Digital scarcity, however, is not something new. Before blockchains and Distributed Ledger Technology (DLT), scarcity in the digital world was achieved in closed and centralised systems, operated and controlled by trusted intermediaries, like a bank or other companies. For example, Spotify controls how many copies of a particular song can be played and to whom, thus generating digital scarcity within its own platform. Similarly, a bank controls how “digital dollars” are transferred within its network.

The innovation of DLT is that it achieves digital scarcity of tokens within an open and decentralised platform, like a blockchain, that is not owned or controlled by any single entity. This innovation is important for at least two reasons. First, it creates use cases that would not be possible if the platforms were centrally owned and controlled. Second, it shifts economic power from the platform owner, who in many cases acts as a rent-seeker, to content creators and users. This incentivises creators more and offers better value for money for buyers. We examine below the important use cases and benefits of NFTs. 

Collectibles

Currently, the biggest use case of NFTs in terms of transaction volume is collectibles. The first project that became famous was CryptoKitties in 2017, however several other projects have now surpassed it in terms of value, such as NBA Top Shots and CryptoPunks. Axie Infinity, an online game where players create and sell NFTs of furry creatures, is currently the most valuable in terms of generated sales of around $1.8 billion.2 Recently, large multinational companies and brands are increasingly experimenting with issuing their own NFTs, such as Coca-Cola, Taco Bell, and Dolce & Gabbana.

Collectible NFTs have seen tremendous growth over the past year, attracting thousands of users. It is notable, however, that the most successful projects are created by users themselves and small start-ups, as opposed to established companies that have large advertising budgets for customer acquisition. The reason is that projects for collectibles can become successful by creating and organically growing a large and active community. Each member is not just a passive consumer of the collectible NFTs, but also an owner and therefore an investor in the project, with an incentive to grow the community further. If the project is successful and gains popularity, this is reflected in the appreciation of the value of their NFTs.

Removing Intermediaries

NFTs enable content creators to remove rent-seeking middlemen. This allows for a much more intimate relationship between content creators and fans. For example, a digital artist can sell directly to consumers, without depositing her works in a centralised database. They can control the price and the number of copies that are available, as well as receiving royalties every time one of their NFTs is re-sold. The fans do not only purchase a work of art, but also support their favourite content creators and become investors who participate in their future success. This incentivises buyers to expand their portfolios to include work from content creators at an earlier stage than they otherwise would. This, in turn, fosters a greater number and variety of content creators.

Price Discrimination

Another example of how NFTs benefit content creators is price discrimination. Because NFTs are unique, they can command different prices, unlike different coins of the same cryptocurrency, which are interchangeable and therefore have the same price. This enables content creators to price discriminate, by issuing different NFTs at various prices. Price discrimination allows the seller to capture a bigger portion of the consumer surplus, by charging each user as close as possible to the full value that they gain from the NFT. This means that NFTs enable a transfer of market power from the platform owners to the content creators, thus also changing the economics of how new projects can be funded.

Intellectual Property

As NFTs can hold any type of digital data, intellectual property is an obvious use case. This can take the form of patents, royalties from a movie or a song, and even technical documents that describe a particular production process. Recently, IBM in collaboration with IPwe, announced plans to build infrastructure to represent patents as NFTs, enabling efficient blockchain-based trading.3

The immutability and transparency of distributed ledgers allows anyone to easily track NFT trading. If there are multiple owners, automatic payments can be processed through the ledger using smart contracts. Because the ledger is decentralised, the owner does not need to trust an intermediary, such as company, to be the custodian of their IP, or to rely on them for setting the terms and conditions of trades.

Metaverse and Interoperability

As we spend more and more of our time online, the virtual worlds that we visit increase in importance, which means that the virtual assets that are created there become more valuable. Online games have long created their own virtual worlds, and Facebook has even announced the launch of a virtual office environment.4 The metaverse usually refers to a collection of virtual worlds that are connected to each other. This means that someone’s digital identity, together with their digital assets and digital money, can be transferred seamlessly from one virtual world to another. Up to now, this has not been possible, as virtual worlds are isolated from each other. For example, an avatar created in an online game cannot be transferred to the virtual world of a game owned by a different company. The reason is centralization, as the digital assets created in a virtual world are effectively owned and ultimately controlled by the company that developed the game, not the players themselves. Decentralisation, for example, through the shared and open platform of Ethereum, enables the interoperability between virtual worlds. As the owner of a digital asset is the owner and ultimate controller of an NFT that is stored on Ethereum, it can be transferred across all virtual worlds that are created on the same platform, or even other platforms, given the required interoperability.5 This increases the value and use cases of NFTs, as they form part of the true property and identity of the owner, across different virtual worlds.

Computer Logic

A key differentiator of NFTs relative to content in the physical world is the ability to have built-in computer logic (programs). NFT functionality can be complex, for example NFT memorabilia from an NBA match can be programmed to allow for VIP back-stage passes; access to exclusive content e.g. live streams or further NFTs; or discounts, and be done in a dynamic and automated way.

This offers content creators new ways to interact with their fan base and monetise the value created for their fans, through greater customer self-differentiation (price discrimination).

Conclusion

Before the advent of NFTs, true ownership of digital assets was impossible, either because they could be replicated endlessly and at zero marginal cost, or because they were subject to restrictive terms and conditions by the platform owner on how they could be used, traded and moved. NFTs enable a type of ownership of digital assets that is more similar to how we view ownership of physical assets, with minimal restrictions by third parties. As more of our activity becomes virtual, their value and use cases will inevitably increase.

Footnotes

1 See https://www.coinscrum.com/the-key-characteristics-of-non-fungible-tokens/ for more information on the key characteristics of NFTs.

2 See https://cryptoslam.io for a list of the most successful NFT projects and their sales volumes.

3 See https://newsroom.ibm.com/2021-04-20-IPwe-and-IBM-Seek-to-Transform-Corporate-Patents-With-Next-Generation-NFTs-Using-IBM-Blockchain for more information.

4 See https://www.ft.com/content/9b73b3e4-6d68-4530-9879-58480b72335e for more information.

5 Note that unless stated otherwise in a legally binding contract, the intellectual property of an NFT remains with the content creator, just like with traditional creative content.

Aaro Capital is the trading name of Aaro Capital Limited (“Aaro”), a private limited company, registered in England and Wales with number 11419585, whose registered office is at 5th Floor 14-16 Dowgate Hill, London, United Kingdom, EC4R 2SU. Aaro is not authorised or regulated by the Malta Financial Services Authority ("MFSA") or any other financial regulator.

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