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What is NFT?

The year 2021 might be known in the history book of blockchain technology as the year when digital collectibles, digital art and virtual lands exploded. In March 2021, a crypto investor paid +$60 million for the digital painting “Everydays: The First 5,000 Days” during an auction organized by Christie’s. Later that year, a series of 10,000 illustrations of bored-looking monkeys, called the Bored Ape Yacht Club (BAYC), was released and quickly made a splash. Mainstream celebrities including Serena Williams, Justin Bieber, Mark Cuban, Jimmy Fallon, Paris Hilton, Eminem and Neymar purchased a piece, pushing the collective price of the set north of a billion dollars. Needless to say, by speculating on success stories like BAYC, thousands of investors made a fortune, attracting even more media interest and capital. 

The assets described above are classified as NFTs. An NFT stands for a non-fungible token. It represents a unique digital data (token) that acts as a proof of ownership of a specific item (a photo, a song, an object within a game, or access pass) that is stored on the blockchain.

A good example of the subclass is the Bored Ape below:

Source: Open Sea (a leading NFT Marketplace)

Looks interesting, but why does someone pay $140k for a JPEG when others can just screenshot, save and use the same JPEG? Apart from being integrated with leading social networks like Twitter, where the genuinity of the NFT set as a profile picture could be verified on the blockchain, NFTs may come with important and creative utilities such as:

 

Okay, but why token? Is it similar to Bitcoin or other crypto tokens? Let’s take a pause here to distinguish the differences between NFTs and traditional (fungible) crypto tokens such as dollars (stablecoins) or cryptocurrencies like BTC and ETH. Each one of the fungible tokens are indistinguishable from the other. Similarly to a dollar bill, an investor does not make a difference between two Bitcoins. The NFTs, on the other hand, are unique, and by so have item-specific characteristics/traits.

Although both NFTs above belong to the same Bored Ape Yacht Club NFT collection, each has different characteristics or traits (hat, background color, clothes, etc). And depending on the rarity of these traits and how they are combined, one NFT can be considered rarer (exclusive) compared to another (and by so, could have different market price). 

NFT Creation Process (Minting) and Primary Sale

The process of creating an NFT collection begins when an NFT studio or a digital artist creates several pieces of unique artwork and attributes for it (think about several prototype moods of the famous bored ape plus a variety of skins, clothings, background colors, and the eyes, and how this elements are combined). 

Next, the parameters of the collection are specified including how many unique items will be there in the collection (e.g. a 10,000 or 1,000 set), the probability of each trait (e.g. 5% of the apes would have have laser eyes; 2% would have a blindfold).

Once the original items are drawn and parameters are specified, the artists combine these elements using a standard JavaScript code that randomly mixes the traits to create the software-generated images.

Finally, the process of tokenizing these images into an NFT collection is called minting. This term refers to storage of the picture of a link to the picture and its metadata on the blockchain as well as the primary sale of the assets within the collection. 

Blockchain Storage 

The different characteristics or traits for each NFT, combined, are called the metadata (JSON files). This code contains the description of what the character in the image has or has not (e.g with or without a hat, background color, skin type). This information is important because it enables the platforms / marketplaces to visualize the NFTs as human-readable images. The image itself can be hosted on the blockchain or on external hosting (Amazon Web Services / IPFS). Below is an example of the “Mr. Playboy” NFT and its metadata

How it is: How we visualize it on Marketplaces:

 

The Public Mint  – The sale on primary markets

After the team or studio has uploaded the metadata and built an online community, and as soon the NFT is ready to sell, each community member can try to secure a spot to have access to the public sale (or public mint). The most common methods to participate in the primary sale are:

  • Via Whitelist: With a whitelist spot, a participant secures a spot some days before the original (public) mint. Sometimes, this list comes with other benefits such as a reduced mint price or specific gifts. This spots are designed to compensate early community or engaged members and to create initial demand    
  • Via Public sale: After the whitelist mint finishes, the public sale is open to the public, anyone can participate in it and buy directly from the Project web page

In both cases, NFT collectors interact with a smart contract that allows them change their ETH (or the cryptocurrency the project decide) for the NFT

NFT Trading

As any real-life collectible, the NFT price discovery happens when informed collectors are trading with each other on dedicated NFTs marketplaces such as OpenSea or LookRare. However, unlike traditional cryptocurrency exchange, where trades mostly occur on order book-based venues like Binance and FTX, NFTs are swapped on peer-to-peer auction platforms similar to eBay or OLX. As a result, the matchmaking is far from instant as counterparties are not readily present, resulting in a highly illiquid market structure.

There are 3 main types of transactions on the NFT marketplaces:

  • Direct purchases: A participant can immediately buy an NFT listed for sale by taking the ask price
  • Bidding: Participants can place bids for certain NFTs and it is the owner’s sole discretion of whether to accept any of the offers
  • Transfer: This may not involve an atomic payment transaction. An NFT owner can send it to another user (address) without receiving any financial benefits in any form

What is rarity and why does it affect the NFT value

When assessing the value of an NFT collection, several factors have to be taken into consideration: art quality, team experience, community strength/engagement and roadmap among others. However, when we are valuing a particular NFT within the set, one factor has always stood out: rarity.

All NFTs by definition are unique, and each one has a different combination of traits. However,  while the combination of traits is different in each NFT, one specific trait can be applied to many NFTs (think about Apes with brown background but different clothes). So, NFTs with uncommon (rare) traits are likely to have a higher rarity ranking.

Let’s consider the example below. The list on the right represents the different categories (traits or attributes) one NFT collection has. In this collection exists a total of 10 traits including background color, clothes type, eyes shapes, among others. Each category also has different types. In the example, there are 14 types of accessories and 10 types of backgrounds to mention some of them. Thus, each NFT is the combination of different types for each category that when combined leads to a specific NFT in particular. 

Given rarity has importance in NFT collections, and considering that the traits combinations are randomly generated, determining a rarity score can become a complex statistical problem. There are several frameworks aiming to standardize the rarity score process for each NFT (rarity sniper and rarity tools). For example, Rarity Tools calculate first a “trait rarity score”, by calculating and assigning a rare value to each treat category or trait

Rarity Score for a Trait = 1 / (Number of NFTs with that trait/ Total number of NFTs in collection)

And then the “overall rarity score” by summing all odds trait rarity scores. 

Overall Rarity Score =  Σ rarity score for trait i 

Further details on these scoring systems are provided in the reading material at the end of the document.

However, rarity is not the only factor determining the price of an NFT. There may also be community preferences which make certain characteristics or traits more desirable. Media coverage or the profile picture of a crypto influencer having a specific trait may influence the prices within a collection. Last but not least, there’re personal preferences that differ between investors. One may like an Ape with a golden skin while another prefers laser eyes. These differences lead to a discrepancy between rarity and actual trading prices.

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