Intro to NFTs

close up shot of gold bitcoin on wooden surface Photo by RODNAE Productions on Pexels.com

First

I wrote this piece for a friend who wanted to understand what NFTs were. I have considerably simplified many points and omitted many others to keep the explanation below (relatively) short. If you’re interested, you can read the following articles/sites as well as find links to more discussion on this topic from there.

  1. https://digiconomist.net/bitcoin-versus-gold
  2. https://rpr2.wordpress.com/tag/nft/
  3. https://blog.dshr.org/2022/02/ee380-talk.html (I left out talking about scammers – this post has great explanations and additional learning resources on this front)
  4. https://caesuramag.org/posts/laurie-rojas-why-no-good-nft-yet

Background info

What is an NFT?

To understand NFTs, we need to understand the ‘T’ first: tokens.

And to understand the Ts, we need to understand the reason they exist: the blockchain.

The blockchain is widely touted to be a ledger of transactions. But I – a person who has struggled to understand banking and finance terminologies – have found it more useful to understand this technology in terms of the fundamentally new thing it facilitates.

In ‘conventional’ banking, banks – state-owned and otherwise – validate financial transactions. If I transfer money from my wallet to yours online, the bank knows a) whether money has been deducted from my wallet, b) whether money has been credited to your wallet, and c) whether I, the wallet’s owner, performed the transaction in question.

The blockchain is a database that, together with a bunch of algorithms, offers a way to perform these tasks without requiring a centralised authority. Instead, it helps the people who are transacting with each other to ensure the security and integrity of their transactions.

Say 10 people have already been using a blockchain to validate their transactions. Each row in this database is called a block. When one of the 10 performs a new transaction, it is added as a new block in the database along with some data pertaining to the previous block. This bit of data is called a cryptographic hash. Using the hash, all the blocks in the database are linked together: every new block contains a cryptographic hash of the previous block, all the way back to the very first block. This chain of blocks is called the blockchain.

Every time a new transaction is performed, and a new block has to be added to the blockchain, some algorithms kick in to validate the transaction. Once it has been validated, the block is added, a timestamp is affixed to the operation, and a copy of the blockchain in that instance is shared with all the 10 people using it.

This validation process doesn’t happen in a vacuum. You need computing power to perform it, drawn from the machines owned and operated by some or all of the 10 people. To incentivise these people to donate their computing power, the blockchain releases some files at periodic intervals. These files denote value on the blockchain, and the people who get them can use them gainfully. These files are called tokens.

Different blockchains have different validation incentives. For example, the bitcoin blockchain releases its tokens, the bitcoins, as rewards to those who have provided computing power to validate new transactions.

The bitcoin protocol states that the number of bitcoins released drops by half for every 210,000 blocks added. In May 2020, this reward stood at 6.25 bitcoins per block. The blockchain will also stop releasing new bitcoins once it has released 21 million of them.

Technically speaking, both centralised and decentralised validation systems use blockchains. The one that uses a central authority is called a permissioned blockchain. The one without a centralised authority is called a permissionless blockchain.

This is useful to know if only to understand two things:

  1. The concept of blockchains has existed since the early 1980s in the form of permissioned systems, and
  2. Permissionless blockchains need tokens to incentivise users to share computing power whereas permissioned blockchains don’t need tokens

The demand for bitcoins has caused the price of each such token to rise to $43,925, or Rs 33.47 lakh, today (March 25, 2022, 9:06 am).

The tokens on a blockchain can be fungible or non-fungible. An example of a fungible token is bona fide currency: one one-rupee note can be replaced by another (equally legitimate) one-rupee note and not make any difference to a transaction. Bitcoins are also fungible tokens for the same reason. On the other hand, NFTs are tokens that can’t be interchanged. Each NFT is unique – it has to be because this characteristic defines NFTs. They are non-fungible tokens.

Bitcoins are basically files. You write an article and store it as a docx file. This file contains text. A bitcoin is a file that contains alphanumeric data and is stored in a certain way. You can save a docx file on your laptop’s hard-disk or on Google Drive, and you can only open it with software that can read docx files. Similarly, you can store bitcoins in wallets on the internet, and they can be ‘read’ only by special software that work with blockchains.

Similarly, NFTs are also files. The alphanumeric code they contain are linked in a unique way to another file. These other files can be pictures, videos, docx files, bits of text, anything at all that can be stored as digital data.

When one person transfers an NFT to another person over a blockchain, they are basically transferring ownsership of the file to which the NFT is linked. Put another way, NFTs facilitate the trade of goods and value that can’t directly be traded over blockchains by tokenising these goods/value. This is what NFTs fundamentally offer.

Emergent facts

This background info leads to some implications:

  • Bitcoins have been exploding in value because a) their supply is limited, b) investors in bitcoins and/or blockchain technology have built hype around this technology, and c) taken together, the rising value of each bitcoin has encouraged the rise of many Ponzi schemes that require more people to get in on cryptocurrencies, forcing demand to rise, which further pushes up the coin value, allowing investors to buy low and sell high.
  • The demand for bitcoins, and other cryptocurrencies more broadly, has obscured the fact that a) permissionless blockchains need tokens to exist, b) these tokens in turn need to be convertable to bona fide currencies, and c) there needs to be speculative valuation of these tokens in order for their value over time to increase. Otherwise, the tokens hold no value – especially to pay for the real-world costs of computing power.
  • This computing power is very costly. It is highly energy-intensive – if it weren’t, anybody could validate any transaction and add it to the blockchain. In fact, one of the purposes of the compute cost is to prevent a hack called the Sybil attack. A copy of the blockchain is shared with all members participating in the chain. Say my copy gets corrupted for some reason; when the system encounters it, it will check it against the copy that exists on the majority of computers on the network. When it doesn’t match, I will have forked out of the blockchain and no longer be a part of it. A Sybil attack happens when multiple users work together to modify their copies of the blockchain (to, say, give themselves more money), confusing the system into believing the corrupted version is the actual version. A high computing power demand would ensure that the cost of mounting a Sybil attack is higher than the benefits it will reap. This power is also what leads to the cryptocurrencies’ enormous carbon footprint.
  • If you provide more computing power to the pool of power available to validate transactions, you have provided the system with proof of work. Another way to validate transactions is through proof of stake: the more value you have transacted using the blockchain, the more stake you are said to have in its proper operation, and therefore the likelier it will be for your transactions to be validated. Proof of stake is less energy-intensive, but its flaw is that it’s a ‘rich get richer’ paradigm. From a social justice point of view, both proof of work and proof of stake have the same outcome: wealth inequality. Indeed, a principal failing of the ethereum and bitcoin blockchains today is that a very small number of individuals around the world own more than half of all the computing power available to these networks – a fact that directly undermines the existential purpose of these networks: decentralisation.
  • NFTs differ in their uniqueness, but other than that, they also require the use of blockchains and thus inherit all of the problems of permissionless blockchains.
  • NFTs also have two problems that are specific to their character: a) they have to be scarce in order to be valuable, and this scarcity is artificially imposed – by investors but more broadly by tech-bros and their capitalist culture, in order to keep NFTs exclusive and valuable; b) the items that NFTs currently tokenise are simple crap made with conventional software. For example, the user named Metakovan purchased last year an NFT associated with a big collage by an artist named Tweeple for 500 ether ($69 million). This collage was just a collage, nothing special, made with Photoshop (or similar). Now, if I uploaded an image on a server and linked it to an NFT, and one day the server goes down, the NFT will exist but it will point to nothing, and thus be useless. This vacuity at the heart of NFTs – that they contain no value of their own and that whatever value they contain is often rooted in conventional systems – is emblematic of a bigger issue with cryptocurrencies: they have no known application. They are a solution in search of a problem.
  • For example, Metakovan said last year that using cryptocurrencies to trade in art was a way to use the anonymity afforded by cryptocurrencies to evade the gatekeepers of the art world, who, in his words, had thus far kept out the non-white, non-rich from owning the masters’ paintings. But many, many art critics have ridiculed this. I like to quote Laurie Rojas: “Even with all the financial speculation around NFTs, the point that Art’s value is determined within the parameters of a society in which commodification is the dominant form of social relations (i.e., capitalism) has too easily been abandoned for poorly defined neologisms. … NFTs are the latest phenomenon to express this.”
  • NFTs’ newfound association with artistic works is something for NFTs to do, otherwise they have no purpose. In addition, small-time and/or indie artists have criticised NFTs because they don’t solve the more fundamental problem of people not funding artists like them or protecting their work from copyright violations in the first place – much less because potential funders don’t have the requisite technologies. This criticism also speaks to the criticism of the bitcoin network itself: to quote Alex De Vries, “One bitcoin transaction requires … several thousands of times more than what’s required by traditional payment systems” to perform a transaction of the same value. Therefore it can’t be a functional substitute for the world’s existing banking system either. And we’ve seen in a previous point that they’re not decentralised either.

Two last issues – one about a new way in which blockchain tech is trying to find relevance and one about a pernicious justification to allow this technology to persist.

  • The first is what has come to be called “web3”. The current iteration of our web is known as web2, supposed to have begun around the mid-2000s. Web1 was the first iteration, when the web was full of websites that offered content for us to consume. Web2 was about content production – social media, blogs, news sites, etc. Web3 is supposed to be about participation – based on Metakovan’s logic. In this paradigm, web3 is to be powered by blockchains. This is a stupid idea for all the reasons permissionless blockchains and NFTs are stupid ideas, and others besides.
  • Second, some entrepreneurs have started to buy carbon credits from various parts of the world and offer them for a price to blockchain entrepreneurs, to help ‘neutralise’ the carbon footprint of the latter’s efforts. This is wrong and evil because it’s a wasteful use of carbon credits that diverts them away from more socially responsible uses. It’s also evil because, in this paradigm, cryptocurrencies and NFTs foster two paths towards greater inequality. First, as mentioned before, they impose a prohibitive energy cost to use them. Second, developed countries need to cut down on their carbon emissions right away – but many developing countries and most under-developed countries (in the economic sense) still have room to emit some more before they can peak. Carbon credits, the demand for which cryptocurrencies are increasing, reverse these outcomes – allowing the former to keep emitting while purchasing ‘room to emit’ from less developed nations, and thus lowering the latter’s emissions ceiling.
  • Finally, a fundamental flaw of the carbon credits system is that it assumes that emissions over one part of the world can be compensated by supporting forests in another. So carbon credits may in fact make the problem worse by allowing cryptocurrency folks to keep kicking the can down the road.