An NFT Is Only the Envelope — But What’s Inside?

After reading this article you will have a more differentiated view on NFTs. I will more exactly describe what an NFT is, what it can represent and what the relation between NFT and represented item is. For this we take a more systematic approach that focuses on the nature of the represented item as the NFT itself is merely an evelope. Firstly, I describe what an NFT is in narrow sense by adopting a cryptographic angle. I then introduce an NFT taxonomy and typical life cycles. Lastly, I highlight what technological design decisions to pay attention to depending on business case and type of NFT.

Provenance

When googling NFTs you find that they can be art, music, fashion and just about everything you can think of. These wide-ranging possiblities of application are the reason why I think this use of blockchain, usually subsumed under Provenance, will have the greatest impact of all. This is clearly backed by the PwC “Time for trust” report: Provenance was identified as the biggest of top five uses of blockchain with an potential boost to global GDP by 2030 of US$962bn — more than twice the contribution of the second biggest use “Payments and Financial Instruments”.

The “just about everything” is very fuzzy and although the concrete use cases art, music and fashion make the topic more tangible, all this hides crucial aspects of NFTs that I’d like to draw attention to. A different view on NFTs is that they represent legal rights, ownership, intellectual propery, proof of origin or proof of creation. Every time an individual creates something, an asset of (varying) value, like a piece of art, is created. The very process of creation evokes the words authenticity, uniqueness, originality and genuineness. All these words are reflected by provenance and if an item’s provenance should be established we create an unbreakable link between the creator or owner and this very item.

Expressed in technological terms, by associating your blockchain address with a token ID you establish proof of ownership based on cryptography. This is an NFT in narrow sense. This happens through smart contract execution that effects a blockchain state change that is captured in a particular block at a certain point in time. This is why I always refer to a blockchain as digital notary that maintains a permanent property register. As we will see, the degree of how valuable this link for you as token holder is the more it will influence the decision how your token is technologically implemented.

Token Taxonomy

In previous discussion we ignored the nature of the items created by an individual. From balance sheet perspective, items that are assets of value can be tangible/material or intangible/immaterial or a mix thereof. Consequently, NFTs can represent purely digital items and physical items whereas for latter the word “phygital” has been coined as the physical object has a digital twin on the blockchain. This obviously implies a linkage and interaction between digital and real world. The mere fact that NFTs can potentially represent all kinds of digital and physical goods explains why their impact will be so substantial.

Digital & Phygital Items

There exits a taxonomy of fungible tokens that differentiates tokens based on utility, payment or security characteristics. Though, there are fungile tokens that carry multiple characteristics much like phygital NFTs. We can now extend this taxonomy by NFTs. This makes sense as NFTs can potentially also carry characteristics of fungible tokens. Fungile and non-fungible tokens can even be nested if fractional ownership is required.

Token Taxonomy

NFT Life Cycle

The life cycle of an NFT is not overly complicated and basically consists of two major stages.

The first stage is the tokenisation or creation through a smart contract. As already described previously, one part of tokenisation is the association of your blockchain address with a token ID. This creates an NFT in narrow but crucial sense as it establishes provenance and proves ownership. On technological level you merely associate your address with a number, the NFT’s ID. By this you create the envelope or carrier for your to-be-represented item. Adding a reference of the represented item to the token ID completes the NFT and gives it meaning. Now it’s clear who the owner is, what the NFT’s content is and possibly also what rights are bestowed on the owner. This is what I consider an NFT in broad or holistic sense with all crucial information included. In another article I describe an NFT’s anatomy as result of tokenisation.

The second stage is simply the use of an NFT and associated item. Ownership can be transferred from address to address. Take digital art as an example. Christie’s Beeple NFT was created and ownership was transferred to the highest bidder in the course of a primary market auction. Another ownership transfer happens if the current token holder decides to sell the NFT on the secondary market. The link between address, that is, token holder and token ID is very strong as it’s secured by cryptographic “forces”. As a consequence, the rights and claims that are bestowed on a token holder by this link can’t be repudiated. (Legal enforceability is a different topic.) That means that ownership of your NFT is easy to protect. The link between NFT and associated item, digital or physical, on the other hand lies on a spectrum from very tight to very loose depending on the technological implementation. This means the right to use your NFT might be challenging to protect. E.g. Beeple’s artwork can be downloaded just here (320 MB JPEG): https://ipfsgateway.makersplace.com/ipfs/QmXkxpwAHCtDXbbZHUwqtFucG1RMS6T87vi1CdvadfL7qA.

Linkages

Another potential NFT use case should be briefly mentioned here. In the field of Supply Chain Technology NFTs could be used to track and trace goods from origin to where it’s consumed. E.g. NFTs could represent batches of food. As the batch makes its way along the supply chain from producer to consumer, data is collected and captured in the NFT. The history of changes to this NFT form an audit trail. This is used for accountability reasons in the food industry and thus constitutes value. In the same sense could the history of ownership changes in the Beeple case be an additional factor that contributes to an NFT’s value apart from the value of the associated asset. Think of a celebrity being a previous owner.

Purely digital NFTs live exclusively in the digital world, governed by the cryptographic foundation of blockchains and smart contract logic. Phygital NFTs additionally have to establish and ensure the connection and synchronisation between physical item and digital counterpart. With regard to token economics both types of NFTs allow for a huge variety of use cases. But depending on the intended use case and nature of an NFT, purely digital or phygital, different approaches of technological implementation are required, especially if you want to control use of your NFT.

Digital Assets

Digital goods are quite suitable to be rendered as NFTs as both token and associated digital good reside in the digital world. Therefore, it’s natural that digital art, music, digital fashion and games are among the first use cases of NFTs. Also, distribution of digital goods is generally easier than that of physical goods.

Let’s examine music closer. You could argue that NFTs liberalise artists from record labels by giving them full control of both the rights to their art and distribution of their art. Drawing from our NFT life cycle, a composer can tokenise a piece of music by first establishing herself as originator and then associating the digital music file with the NFT. As I described in another article, associated files can either be stored in decentralised or centralised manner but usually these media files are in public domain and can therefore be freely distributed (see the previous Beeple example).

The NFT now enters the second stage of its life cycle. More specifically, the composer wants her music to be consumed and earn money from it. This is her business case and obviously requires access to the NFT’s associated music file. NFTs with the underlying smart contracts and blockchains form an infrastructure that streaming services such as Spotify can utilise to fuel their catalogs. The composer and Spotify can negotiate royalties for the songs played whereas payments are preferably automated by smart contracts.

So far so good, but consider this: An open-source Spotify can utilise the same open infrastructure as the commercial Spotify but without negotiating royalies. To continue previous discussion, the right to use an NFT, more specifically the associated music file, is hard to protect as there is no access restriction. This situation resembles quite closely the time when the MP3 codec dramatically simplified audio file distribution and Napster emerged. We all know how the story ended but it made clear that digital rights management (DRM) never fared well.

It is absolutely desirable that all kinds of artists can prove authenticity of their work by establishing the strong link between their blockchain address and token ID. However, depending on their business case they have to take great care of the link between token ID and associated asset. Beeple as an example benefited most from the auction. Possibly he also participates from secondary market sales. Therefore, he doesn’t necessarily have an incentive to earn royalties from his art being showcased in a digital arts frame. On the other hand, the composer wants to earn money from listeners of her music. Whereas Beeple mostly capitalises on the provenance aspects of his NFT, wants the composer to capitalise on her NFT’s use.

Commonly used plain vanilla NFT implementations only cater the cases of the likes of Beeple but they won’t work sufficiently in other cases. Therefore, more elaborated solutions are required to better protect an originator’s rights to control use of their art.

Summary & Outlook

This article touched upon a vast range of different NFT topics. It might be more an essay that reflects my current thoughts rather than a structured article. But the NFT topic is so huge that I could only touch on basic concepts and few real-world examples — there are many more. But I claim that the energetic public discussion clearly reflects that we yet have to grasp the topic whereas I try to promote understanding.

The differentiation between an NFT in narrow sense and broader sense certainly made you more aware of the two separate aspects of NFTs: Ownership and use. Whilst the first is easy to manage, does the second require deep reflection on your NFT’s business case. Do you capitalise more on the provenance linkage or on the use of your asset?

The token taxonomy certainly needs more elaboration with legal aspects being incorporated. This is especially required for tokens with overlapping characteristics.

Phygital assets came too short. The interaction between real and digital world require the employment of e.g. IoT technology whereas communication between the two worlds can be realised by Near Frequency Communication (NFC) and optical means such as QR codes. This topic in itself is so multifaceted that I decided to dedicate a separate article on this.

To sum up, establishing provenance and ownership with NFTs is certainly easier than before as no trusted entity such as a notary of some sort is required. But protecting rights and claims of asset holders wasn’t solved by NFTs. It’s interesting to elaborate technological means and software architectures in order to accommodate both non-repudiation of ownership and sensible control of asset use. This is what I would like to present in another article.

Driven Blockchain and FinTech entrepreneur and IT architect