Non Fungible Tokens

June 2018

In December 2017, the Ethereum network became heavily congested.The reason for this was the release of a new application that dramatically increased transaction volumes on the network. The application allows users to own, breed and sell digital cats that exist on Ethereum. It is calledCryptoKitties. While this may sound like a bizarre gimmick, it represents something incredibly powerful that will have profound effects on how assets are created, shared and exchanged online. Digital cats are just the start. This new type of digital asset, termed a “non-fungible token” (abbreviated to NFT), can represent ownership of all kinds of asset from physical ones like houses and artwork, to digital assets and memes. Crucially, it is now possible to build market places for exchanging digital ownership of unique assets.

 

An important feature of currency today is that it is fungible. This means that a USD10 note in my wallet holds the same value and is interchangeable with a USD10 note in your wallet. Most digital assets today strive to achieve this property of fungibility. It is important for one bitcoin in my digital wallet to be worth the same amount as one bitcoin in your digital wallet, as we can then use bitcoin as a means of exchange, unit of account and store of value. But most assets in the world are not fungible. For example, my house is unique and is unlikely to be interchangeable with your house. A Picasso is valued differently from a Mondrian. These assets are non-fungible owing to the fact that they are unique. Blockchain technology offers the ability to digitize both fungible assets, like a bitcoin, and non-fungible assets, like a unique CryptoKitty.

To understand how this works from a technical perspective it helps to understand how tokens are created on Ethereum. A custom token of any type in Ethereum is part of a “token contract”, which is a small database that states who owns what token. A single token is a single entry into the token contract that states ownership. For example, an entry might state:

 

0xMyWallet = 1,000 tokens

 

The Ethereum blockchain has different standards for the types of tokens that can be created and stored on the platform. The two main standards being used today are ERC-20 (fungible tokens) and ERC-721 (NFTs)[1]. These two standards give their tokens different functionality and from a technical perspective the token contracts respond to a different set of commands. ERC-20 is an extremely simple type of token that is used for money-like tokens. It can be written in about 20 lines of code and allows for the creation and transfer of a type of token. ERC-20 tokens are often divisible into numerous decimal places and are interchangeable with each other. ERC-721is a more advanced specification of a token contract as each token created is completely unique and is non-interchangeable with other tokens. For example, we could create an ERC-721 token called the “PET token”, with one token representing my dog and another token representing your cat. The cat and dog token are both a type of PET token, but they are not interchangeable as your cat does not equal my dog.

There are numerous use cases for NFTs that are starting to be explored. Physical assets represented in a digital form:

  • Collectables like artwork, classic cars, watches and fine wine
  • Real estate

 

Digital assets that have no physical embodiment:

  • Goods that exist inside video games
  • Collectibles that have never existed before such as CryptoKitties[2]
  • Virtual land where users can build virtual properties such as a virtual casino

 

Some of these use cases have obvious applications. For example, it is costly and time-consuming handling the legal and administrative work that goes into selling a house. In the future, a house may be represented by an NFT which will include all of the attributes of the house in a digital format; blueprints, land titles, history of ownership. Selling a house might no longer require lawyers and accountants, but simply the exchange of a token between digital wallets. Another example that is getting a lot of attention are goods inside video games. In game assets are a multi-billion USD market today. At the moment, World of Warcraft gamers do not actually own the swords and shields that they buy in the game. There is a database run by the gaming company that keeps track of who owns what. It is envisaged that in the future gamers will hold their own digital goods outside of the control of the gaming company. When a gamer buys a sword, it is held in their digital wallet, where they have total control. They may even be able to transport that sword into a different game.

 

Some of the implications of NFTs are less obvious. On Ethereum, it is possible to see all NFTs that are in existence as the network is public. A consequence of this is that a buyer is able to signal that they would like to buy an item that may not be for sale. While the owner may have no intention of selling an asset, this will not stop bidders from bidding meaning that we will have price discovery of items that are not for sale. A potential seller will know that offers are legitimate as they will have been signed by the bidder’s private key meaning that the potential seller just needs to accept the offer and the item will move between wallets.

 

Another possibility is that if an item is particularly valuable, the owner may opt to offer fractional ownership of the asset. Going back to our example of a house, a homeowner may want to raise money by selling just a portion of their house and so they may split their house token into 100 tokens and sell just 5 of them, representing 5% of the property. In this way, the notion of collateralized lending can be dramatically extended as it is possible to turn any physical object into an NFT. A sailor could sell fractional ownership of their speedboat, a farmer could borrow against the value of a tractor, a celebrity could sell a unique social media post and an Uber driver could pay a split of proceeds to each of the owners of the car being driven. NFTs allow entirely new business models and concepts to be created.

 

AtCMCC we have been conducting due diligence on a number of platforms looking to implement NFTs into their offering. In particular, we are looking into a number of computer gaming platforms in Asia. We believe that the first mass market adoption of NFTs is likely to be by gamers, who will intrinsically understand why an NFT differs from traditional centralized digital assets. In the future, we foresee computer gamers refusing to buy assets that are not NFTs as they will understand that these are not provably scarce and cannot be verified on a public blockchain. We are excited by the transformative applications of NFTs and look forward to investing in the best teams operating in the NFT ecosystem.


[1] ERC stands for Ethereum Request for Comments. An ERC is authored by Ethereum community developers and if approved by the core developers and community it then becomes an Ethereum standard.

[2] Some people have likened CryptoKitties to trading cards. It is interesting to note that in 2016 a Topps Mickey Mantle trading card from 1952, graded PSA NM-MT+ 8.5, sold for USD1m

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