NFTs for Beginners: What Are They & How Do They Work?

Finance and technology are constantly evolving. In recent years, the two have been merging in new and exciting ways, including the invention of blockchain technology and the rise of cryptocurrencies as an alternative to traditional money.

At Addition Financial, we’ve been getting a lot of questions about everything related to blockchain and cryptocurrency, including this one:

What are NFTs and how do they work?

Because NFTs have been getting so much attention, we think it’s important to keep our members up to date. With that in mind, we’ve created this guide to NFT for beginners to help you understand what they are, how they work, and whether you should buy them.

What Are NFTs?

Since this is a guide to NFT for beginners, let’s start with the fundamentals. What is an NFT?

An NFT is a non-fungible token. Currency, including the United States dollar and any other national currency, is fungible. That means that you can take any US dollar and exchange it for another dollar without changing your net worth. Fungibility is also a characteristic of cryptocurrencies such as Bitcoin, Litecoin, and Solana.

A non-fungible token cannot be swapped in a life-kind exchange. In other words, one NFT may be worth significantly more or less than another. Each NFT is unique.

Another way of looking at an NFT is that it is a token of ownership. Many NFTs are minted for digital media, including things like digital artwork and music. The NFT represents the owner’s exclusive right to use whatever data is contained in it.

Like cryptocurrency transactions, NFTs are minted and cataloged in a blockchain, which is a decentralized digital ledger – in other words, an online database where information is stored across multiple computers and servers instead of in a centralized location. New information may be added to the blockchain by consensus.

You can make an NFT for anything that can be stored digitally and has value. Here are some of the things that may be minted, bought and sold as NFTs.

  • Digital artwork
  • Music
  • Game characters and cards
  • Digital collectible items

Keep in mind that the value of NFT art is determined by demand in the same way that the value of artwork is determined. People pay millions of dollars for Van Gogh’s paintings because we have collectively decided that his artwork is valuable, and the same process is used to determine the value of NFTs.

Why Would Anyone Buy an NFT?

Now that you understand the basics of what an NFT is, let’s talk about why somebody might want to buy one. 

We can start by thinking about why someone who had the money to do so might spend money for a piece of original artwork. 

Let’s look at an example. In 2017, an NFT collection known as the Crypto Punk Collection was released. The prices varied, with rare designs selling for far more than the more common options. One such NFT, which depicts a pixelated man wearing 3D glasses, sold to Canadian software developer Richerd for $86,000 in March of 2017. When he bought it, he stated that he would not sell it at any price.

Someone decided to call what they thought was a bluff and offered him 2,500 Ether, which at the time equated to $9.5 million, for the NFT. He refused. 

In Richerd’s case, he bought the digital art because he liked it, wanted it and had the money to afford it. If he had bought it as an investment, it would have been foolish to refuse the $9.5 million offer, which would have represented an 11,000% return on his initial investment.

People might also purchase NFT art for the following reasons.

  • They think that its value will increase, so they see it as an investment.
  • They want to support the NFT artist or creator.
  • They see the NFT itself as a status symbol.

We will talk more about the idea of buying NFTs as an investment later in this post.

What is the NFT Marketplace?

An NFT marketplace is an online marketplace where NFTs can be minted, purchased and sold. The original marketplace for NFTs was the Ethereum blockchain but since its inception, many others have joined the fray. 

  • Algorand
  • Binance Smart Chain
  • Cosmos
  • EOS
  • Flow (by Dapper Labs)
  • Hedera Hashgraph
  • Polkadot
  • Solana
  • Tezos
  • Tron
  • WAX

Some of the above blockchains are interoperable, which means you can buy an NFT on one and sell or trade it on another. An example would be Ethereum blockchain-based NFTs, which can be purchased with a variety of coins, including USDT, BNB, DAI and others. Others are closed, such as Flow, meaning that you can buy Flow-based NFTs only with FLOW coins.

Each transaction in an NFT marketplace is logged on the blockchain, thus establishing a chain of ownership. In the world of artwork, this is known as provenance. 

How Can You Get Started Buying NFTs?

There are several things you’ll need if you want to get started buying NFTs.

Access to a Marketplace

The first thing you will need to buy an NFT is access to an NFT marketplace. You’ll need to choose a marketplace, keeping in mind whether the market you choose is interoperable or closed. Choosing an interoperable marketplace will give you more options for buying and selling NFTs.

You should make sure to choose a secure password for any account you create. While you’ll be purchasing NFTs with cryptocurrency, you’ll need to spend traditional money to fund your wallet, which we’ll talk about in the next step.

A Crypto Wallet

The next thing you will need is a crypto wallet, which is a place where you can store your cryptocurrency and NFTs. Make sure to choose a crypto wallet that’s compatible with whatever blockchain network supports the NFTs you will be buying.

For example, if you want to buy NFTs coined on the Ethereum blockchain, you’ll need a wallet that is Ethereum compatible. Examples include MetaMask, Trezor One and Ledger Nano S.

There are two basic types of wallet, hot and cold. A hot wallet is connected to the web and generally seen as less secure than a cold wallet, which is stored offline. You can choose from the following.

  • Software wallet. This type of wallet is generally in the cloud and may be hot or cold. If you store your wallet on a laptop that is never connected to the web, it will be a cold wallet.
  • Hardware wallet. Akin to a thumb drive, a hardware wallet is a physical device you can carry in your pocket or purse.
  • Paper wallet. A paper wallet is exactly what it sounds like. It consists of encrypted keys and QR codes printed on a piece of paper.

We recommend a cold wallet for optimal security.

Coins to Buy NFTs

Finally, you’ll need to fill your crypto wallet with crypto coins to purchase NFTs. Any marketplace you choose will require you to fund your wallet before you buy, list or mint an NFT. Here again, it is essential to learn which cryptocurrencies are supported by your chosen NFT market before you fund your wallet.

Are NFTs a Safe Investment?

Now, let’s talk about the question that’s one of our biggest concerns as a credit union. We want our members to go into any financial transaction or investment feeling well-informed and comfortable that they understand the benefits and risks of their decision.

First things first: the NFT itself is not an investment but the underlying asset it represents may be. If you purchase an NFT that represents the rights to a song by your favorite band, the NFT is merely a representation of the song itself.

Here are a few tips to help you protect yourself if you decide to explore NFT investing..

  1. Remember that NFTs are not an asset class in the same way that cash, stocks and real estate are. It’s a misconception that they are and part of the reason that the value of NFTs can be volatile and inflated.
  2. It’s very difficult to buy NFTs with a fiat currency such as the US dollar. As we noted above, you must fund a crypto wallet with a cryptocurrency that’s compatible with the blockchain marketplace you choose.
  3. Minting NFTs (like generating cryptocurrency) is an energy-intensive endeavor and there has been a lot of criticism for that reason. For the purposes of comparison, you should know that minting a single NFT can use as much electricity as would be used by a single family home in about a day and a half. You might think that a digital asset would be environmentally friendly, but the opposite is true.
  4. NFT prices and crypto prices are highly volatile. You might think you know what that means since the stock market is often described as volatile. NFTs are volatile at a level that far exceeds the typical volatility of stocks. It’s important to keep that in mind when buying crypto and NFTs.

It’s a good rule of thumb not to spend more on an NFT than you can afford to lose. There’s no real way to predict what will happen to the value of an NFT over time. It could appreciate and you could resell it at a considerable profit. Or, its value could tank and you could lose most of what you spent.

Conclusion

NFTs have become a hot commodity and you may want to buy some to see what it’s like and take ownership of something you want. If you decide to buy NFTs, keep in mind that you should only spend what you can afford to lose.

Do you need help choosing investments? Addition Financial can help! Click here to learn about our MEMBERS Financial Services Program.

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