What is a non-fungible token (NFT) and how do they work?

NFTs are shaking up the worlds of art, music and gaming, but what is a non-fungible token (NFTs), how do they work and who is using them? 

Non-fungible tokens (NFTs) are digital representations of a real-world object, bought by collectors and usually sold online. They are supported by blockchain technology – often the Ethereum blockchain – and contain built-in authentication, which serves as proof of ownership.

Like physical artwork or collectables, NFTs are unique, or have a limited run, which means the amount NFTS are worth is subjective – as demonstrated by a photo of a bin being sold for $252,000 in February 2022. 

And the market can be volatile. While billionaire Twitter founder Jack Dorsey sold his very first tweet as an NFT for $2.9m in 2021, an article by the Wall Street Journal a year later suggested that its value had dropped to less than $14,000.

How do NFTs work?

NFTs have existed since 2014, but are becoming increasingly popular, with Reuters estimating that sales of NFTs reached around $25bn in 2021. Individual items have sold for as much as $90m, though the average price for an NFT ranges from $100 to $1,000.

Adoption of NFTs varies significantly by country – the Philippines, Thailand, Malaysia and United Arab Emirates all have adult NFT ownership rates well over 20%. While at the other end of the scale, less than 3% of adults in the US, UK and Japan own an NFT – with 70% of US, 78% of UK and 90% of Japanese adult populations not knowing what an NFT is.

For a potential buyer, the key value of NFTs is that they codify the ownership of an object, such as a piece of art or music. For creators, NFTs offer a way to sell their work that’s more accessible than venues such as art galleries, or music streaming services, where users typically migrate to their favorite artists. It enables artists to sell directly to their supporters and they can also continue to earn royalties when their art is resold.

What is the difference between NFTs and Crypto?

Cryptocurrency and NFTs are both built on blockchain technology, use the same principles of online commerce, and may attract the same digital players, with cryptocurrency often used in NFT purchases. 

However, while the value of each bitcoin is equal, non-fungible tokens are unique, valued individually and can’t be traded for another of equal value. 

How are NFTs stored?

With an increase of interest in the digital art industry comes an increase of risk, as hackers look for more ways to infiltrate blockchain systems and steal data. Based on an analysis of data from Slowmist, $52 million was lost to NFT crime within the first four months of 2022 – a 667% increase on the total amount lost in 2021, which amounted to less than $7 million. To mitigate against the rising risk of NFT theft, a secure crypto wallet should be utilized.

Each NFT has a unique digital signature that is established during its minting, or creation, process. This signature, which is also the token that defines the asset’s type (digital art, song, gif, etc.), is stored on the blockchain and establishes the NFTs ownership. However, the attached file of the asset itself is stored on the NFT marketplace where it was bought (i.e. OpenSea, Axie Infinity, Mintable, etc.). 

Prior to buying or selling an NFT, a crypto wallet must be connected to the NFT marketplace in question. While NFTs are not stored in crypto wallets, the wallets provide access to the investments held on the blockchain through a private key. The two main types of crypto wallets are known as hardware wallets (cold storage) and software wallets (hot storage). While hardware wallets are offline, physical devices, software wallets are stored locally as an application on a computer’s hard drive. Due to their high security levels, hardware wallets are often the recommended storage choice for NFTs as hackers cannot gain access to offline devices. 

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Who is using and creating NFTs?

Major brands, such as Marvel and Coca-Cola, have launched their own NFTs, elevating them further into the mainstream of consumer consciousness.

Others are more ‘viral’ creations. For instance, famous digital artist Mike Winklemann – better known as ‘Beeple’ – crafted a composite of 5,000 daily drawings to create perhaps the most famous NFT of the moment. ‘Everydays: The First 5000 Days’ sold at Christie’s for $69m. The buyer, crypto investor Vignesh Sundaresan, said he would be happy if everyone had a free copy of the artwork. 

Governments are also exploring NFTs. The UK Treasury announced plans for the Royal Mint to create a national NFT for the summer of 2022, as part of a move to promote Britain as at the cutting edge of new technologies. 

Other uses of NFTs could include identity management – where a person’s identity is represented digitally with an NFT – to improve the ability to perform IDV checks. And smart contracts enforced through NFTs may foster more transparent and secure deal-making. 

Explore more about the evolving world of NFT money laundering in our new guide.

What NFT Regulations are in place?

The regulation of NFTs is still in its infancy, as regulators and international bodies explore how they are used, and how widespread adoption becomes.

The Financial Action Task Force (FATF) updated its virtual asset guidance in October 2021, commenting that NFTs are not defined as virtual assets. The guidance states the importance of considering the nature of an NFT in practice, and whether it may be covered by FATF standards, regardless of how the NFT firm defines them. This is especially pertinent if they are used for payment or investment purposes. 

In May 2022, as part of a review of economic crime legislation, the UK government is exploring the definition of crypto assets to identify emerging uses such as NFTs. In the US, while there is no direct regulatory guidance on NFTs, some states have created laws that could hold NFTs under their purview.

Learn more about Crypto and NFT Regulations 

As cryptocurrencies and NFTs become increasingly mainstream, regulators, the media and policymakers are paying more attention to their associated financial crime risks. But what are the biggest compliance challenges crypto and NFT firms face, and what does a best practice AML program look like? Learn more about what are NFTs and how they work in our guide to building an anti-money laundering program for crypto, which includes hands-on tips for firms globally and emerging use cases compliance teams should be aware of. Download now. 

Originally published June 20, 2022, updated June 21, 2022