By Komal Motwani, CFP ®
Before we start talking more about non-fungible tokens also known as NFTs, let us first understand, what are these fungible and non-fungible assets?
Fungible means goods or assets that are not unique and can be exchanged / substituted for another identical asset of an equivalent value. Fungibility is not exactly same as a Barter. A barter is when goods and commodities can be exchanged for other products that can be incomparable in value. For example, a farmer may barter (exchange) units of rice for required quantities of apples from another farmer. But in fungibility the farmer will have to interchange with the same product that is rice, of same quality and same value. Fungibility is also not always equal to liquidity either. Liquidity is the ability to exchange an asset, such as a gold ring, directly for an agreed-upon amount of money. Fungibility, on the other hand, indicates an ability to exchange an asset for an equivalent or similar asset.
In the above case, what we call an asset can have both the qualities of fungibility and liquidity. Let’s take an example, if you loaned a $100 bill to a friend, now the friend can return the $100 in denominations of one $100 bill or two $50 or five $20 bills. The value you receive is the same, the form or type of asset is also identical
Now, let us look at another concept called “arbitrage”. An Arbitrage is a strategy used to benefit from the price difference of the same commodity trading on different platforms or exchanges. This difference in pricing may occur due to inefficient pricing or based on demand and supply figures. For example, if the XYZ company May 2022 futures contract is trading at $500 per unit on exchange 1 whereas it is trading at $550 per unit on exchange 2. Upon identifying this opportunity, the arbitrageur can buy the futures contract from exchange 1 and sell it as per the futures contract on exchange 2, thereby making a profit of $50 per unit. This would be an example of a fungible investment. In our day-to-day life we come cross many such fungibility examples.
Now that we understand fungibility, it gets easier to understand non-fungible assets. These assets are unique and one of a kind and requires complex valuations based on their unique attributes and scarcity and cannot be exchanged for another item. For example, diamonds are non-fungible assets due to their uniqueness in size, color, shape, and quality. Hence it is not possible to substitute exact same unit for same price. Another example is baseball cards, each card is assigned a unique value based on it attributes such as edition number, design, player, and rarity. Each card will be valued differently and therefore cannot be exchanged directly with another baseball player card.
That is a lot of information to process. But we still don’t get what are NFTs or Non-Fungible Tokens?
After understanding the basic difference between fungible and non-fungible assets, let’s talk about NFTs. NFTs are basically digital tokens or assets that can be used to represent ownership and value of unique items. NFTs are not cryptocurrencies but they are related and are often used in conjunction with each other. NFTs are frequently bought and sold with cryptocurrencies. No two NFTs are exactly alike. The concept is based on blockchain technology. If you need to understand what is a blockchain technology, then perhaps some technology journals may provide detailed information. But here is a simple explanation by Coinbase, “Cryptocurrencies like Bitcoin and Ethereum are powered by a technology called the blockchain. At its most basic, a blockchain is a list of transactions that anyone can view and verify. The Bitcoin blockchain, for example, contains a record of every time someone sent or received bitcoin. The list of transactions contained in the blockchain is fundamental for most cryptocurrencies because it enables secure payments to be made between people who don’t know each other without having to go through a third – party verifier like a bank”. In other terms, a blockchain is a digital ledger that stores any kind of data such as NFT ownerships, cryptocurrencies etc. The stored data is public or decentralized but encrypted to ensure privacy of the user is not compromised and data cannot be alerted.
A few examples of NFT’s are, artwork, music composition, gaming & family heirlooms.
Artworks such as paintings are valuable and are one of a kind. But digital files can be created easily and duplicated multiple times. NFTs can avoid those issues, non-fungible tokens assist to protect the artist’s artwork by creating tokens or digital certificates of ownership that can be bought and sold. These tokens are unique and not divisible. An Artist can even claim royalties for the future proceeds after his/her original artwork is sold. This process allows a profit percentage to be paid to the artwork’s creator every time the NFT is sold or changes ownership. NFT’s can have only one owner at a time. Say if you purchase an NFT of an artwork and the ownership of the unique token is transferred to your account. The token proves that the copy of digital file is original, and your private key is the proof of your ownership. The artist’s public key serves as a certificate of authenticity for that artwork, and he can be paid royalties each time the owner changes. This entire system benefits the creator, and it also provides authentic value to the buyer.
We are living in an ever evolving innovative, technological driven digital world. NFTs are providing a solution for digitalizing ownership and property and allowing proper storage of the precious and rare artefacts. However, NFTs are discretionary assets and are based on demand rather than fundamentals. The future of this entire market will depend on people’s interest and understanding of the blockchain technology.
With the advent and acceptance of cryptocurrency, NFT’s have gained immense popularity. However, whether they evolve and become a part of our daily lives or not, I believe they are here to stay.
About the Author
With over 10 years of experience in the fields of Investment and Financial Planning, Komal Motwani has worked and studies in institutions across globe, from India to Singapore and the US.
Komal Motwani, CFP ® is a senior investment analyst at Yanni & Associates Investment Advisors, LLC., a Pennsylvania-based registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein