Cryptocurrencies have been skyrocketing in recent years, but these digital assets have more to them than just rampant speculation. Blockchain -- the digital ledger technology that enables cryptos -- has actual, real-world use. Non-fungible tokens (NFTs) are one example. NFTs are tokens based on a blockchain that represent ownership of a digital asset. The recent craze in NFTs involves digital art and creation (for example, Twitter (NYSE:TWTR) CEO Jack Dorsey sold the first-ever published tweet for $2.9 million via an NFT).

Sound silly? Perhaps. But there's more to the discussion around NFTs than meets the eye.

What are non-fungible tokens (NFTs)?

Non-fungible tokens aren't actual cryptocurrencies in the same sense as Bitcoin (CRYPTO:BTC). Cryptocurrencies utilize blockchain for its ability to track financial transactions between parties and were designed as a type of digital currency for use on the internet and in a digital-first world.

NFTs are also built on a blockchain but instead are used to guarantee ownership of an asset. Think of it as a certificate such as an auto or real estate title stating the legal owner of a car or home, except that an NFT is proof of ownership in digital form. Most NFTs are based on the Ethereum (CRYPTO:ETH) blockchain network.

Someone looking at paintings in an art gallery.

Image source: Getty Images.

An NFT is a unique digital asset that is not directly replaceable with another digital asset (thus the name "non-fungible"). Many physical assets are also non-fungible. Real estate, for example, is non-fungible since each piece of property is unique from others.

A "fungible" token, by contrast, is one that is replaceable with another one identical to it. Ether is the fungible token that trades on the Ethereum network, meaning one Ether is identical to another. The same goes for Bitcoin. One Bitcoin can be exchanged for another Bitcoin because they have the same value. Physical currencies work this way, too. One physical dollar bill is the same as another dollar bill, and thus each are "fungible." But each NFT is unique; there isn't another one exactly like it out there, so they are non-fungible -- or unable to exactly replace another.

Code is written into this digital token and recorded using the blockchain network it's based on (again, usually on Ethereum) to prove a list of historical ownership and the current owner of a unique digital asset. An NFT can represent any digital creation -- art, music, videos, writing, etc.

How many NFTs are there?

At the end of October 2021, there were nearly 7,000 different types of cryptocurrencies worldwide. Most NFTs are built on Ethereum, but many of these tokens utilize a different blockchain or were built on a proprietary NFT platform. As a result, there are innumerable individual NFTs representing works of art, videos, video game content, music, and more. As more artists and creators make use of NFTs to secure and monetize their work, this number will only increase over time.

How do NFTs work?

How exactly are NFTs used? Digital art collections, for one. In March 2021, an NFT representing an image, "Everydays: The First 5,000 Days," by artist Beeple was auctioned by Christie's for $69 million. The purchaser of the NFT now has ownership of the digital art attached to it. Digital creators Larva Labs auctioned off individual CryptoPunks characters in 2017; some of the NFTs are now worth millions of dollars.

These are some extreme examples of ballooning NFT values. For common functionality, though, artists can use NFTs to sell their creations to collectors and other digital creators. An owner or creator of an NFT can also collect royalties for the art's copy or use online. NFTs hold promise as a way to enforce digital copyright and trademark law.

Real-world use cases abound, too. Nike (NYSE:NKE) owns a patent on NFTs to authenticate sneakers as unique items. But outside the realm of collectors' items (a form of modern fine art speculation), NFTs could have some practical, everyday value. Remember the aforementioned titling of physical assets such as cars or real estate? Blockchain-based tokens could be used to guarantee ownership of physical property and cut out expensive intermediaries who traditionally handle titling services and related legal documentation. It's still early days for NFTs, though, so more ideas could emerge in the years ahead.

Why are non-fungible tokens important?

Besides representing a way for digital artists and other creators to monetize their work, NFTs are imagined as the evolution of art investing and collecting and as part of a new cryptocurrency investment asset class. Since an NFT is unique, there's always a slim chance an NFT collection could balloon in value (like Beeple's digital artwork). If you're an art collector, NFTs are easy to buy and sell on an online marketplace such as OpenSea. Cryptocurrency trading app Binance is launching an NFT marketplace, and Coinbase Global (NASDAQ:COIN) might do the same (it has invested in several NFT marketplaces, including Rarible).

But, for the average investor, NFTs represent a highly speculative class of investment that should probably be avoided. NFTs don't gain in value because of their utility but are based on the value of the media they represent (digital art, video, music, etc.). Sticking a value on something like art is incredibly difficult and subjective and unlike valuing a share of stock, which represents an ownership stake in a business and a claim on future profits generated by the business.

Investors who want some indirect exposure to NFTs anyway might consider adding a little Ether to their portfolio since most NFTs utilize the Ethereum network's blockchain. Ether is also a highly speculative investment, although it could increase in value if Ethereum network use rises over time. (It's important to note there is no cap on how many tokens of Ether can exist, but a recent change to the way transactions are validated from proof of work to proof of stake should decrease the supply of Ethereum over time.)  

Even so, non-fungible tokens could be an important technological development. In a new digital era that blurs the lines between the physical and virtual worlds, a new way to track digital asset ownership and distribution online will be increasingly important. These blockchain-based tokens could also disrupt financial intermediaries and lower the cost of buying and selling big-ticket items such as autos and real estate. That doesn't necessarily mean you should invest in highly speculative NFTs, but, at the very least, their development is worth keeping an eye on.

Exclusive NFT Q&A with outside experts

Dr. Merav Ozair

The Motley Fool had the chance to connect with Dr. Merav Ozair, a FinTech faculty member at Rutgers Business School (RBS) and an expert on blockchain and cryptocurrency. She serves as research director of the RBS Blockchain Hub, as well as an advisor and researcher for the Rutgers Blockchain and FinTech Collaboratory.

Headshot of Dr. Merav Ozair, FinTech Faculty Member, Rutgers Business School

Dr. Merav Ozair, FinTech faculty member, Rutgers Business School

The Motley Fool: NFTs seem to be the new craze this past year, but do you anticipate this trend to continue or do you foresee NFTs being just another bubble? Why?

Dr. Ozair: Whether an asset's value is in a "bubble" or not is determined in hindsight. If you are purchasing an NFT as an investment, then the risks associated with it are the same as with any other investment -- whether that's stocks, collectibles or real estate. The NFT's value may go up or down, depending on market sentiment, conditions, or preferences. Anyone can guess at or believe what the future value will be.

NFTs might also have a personal or "emotional" value associated with them, like the one-of-kind "GRONK Career Highlight Refractor Card." This NFT is a collage of four illustrations comprising the other tokens in the collection and is digitally signed by (National Football League star) Rob Gronkowski. The token's purchaser received the opportunity to meet the NFL star, two tickets to attend one of his NFL games, and VIP tickets to Gronkowski's next beach party event. The "perks" associated with this NFT might be valued only on a personal or emotional level for the purchaser.

NFTs are here to stay because the possibilities and the opportunities of NFTs are boundless and go beyond art and celebrities' tweets or photos. The future of NFTs lies in business applications -- as the true power of NFTs is providing authentication and facilitating the transfer of ownership. Thus, you can tokenize a bottle of wine, a Gucci bag, a property, or any physical or digital asset that is deemed unique.

The Motley Fool: NFTs are often images or videos that anyone on the internet can view, but the owner of that NFT has the "original," meaning the value of that NFT is based solely on what someone is willing to pay for it. That said, do you think it's worth adding NFTs to your investment portfolio when the value is so subjective?

Dr. Ozair: You can ask the same question about purchasing art or any collectible -- baseball cards, paintings, jewelry, or wine. It's the feelings of ownership and pride that incentivizes people to purchase a collectible.

Some may view [unique assets that they own] as investments. Unique assets like Picasso paintings or rare baseball cards may increase in value in the future, like the 1952 Mickey Mantle baseball card from Topps that sold for $5.2 million. In this tokenized world in which anything can be digitized, Twitter CEO Jack Dorsey sold his first tweet as an NFT for $2.9 million.

A real estate property could be an NFT, with its investment value tied to the real estate's property value. In fact, [tokenizing] a real estate property would actually increase its value by adding liquidity.

The Motley Fool: What are some things investors should consider when looking to purchase an NFT (e.g., capital gains taxes, use of cryptocurrency, valuation, etc.)?

Dr. Ozair: If you are considering an NFT as an investor, not as a collector, then you should approach it like any investment. Who is the creator of the NFT? Does it have the potential to increase in value due to the reputation of the creator, its rarity, or [history of] ownership? On which auction platform is the NFT auctioned? Is it tradeable or liquid?

NFTs are not regulated yet. But regulators, especially in Europe, have already put forward some proposals. The U.S. has yet to follow suit. Regulation for NFTs may have implications on how they are classified and where and if they can be traded.

NFT creators pay income tax, while NFT investors are subject to [the standard] capital gain rules.

Most -- if not all -- NFT platforms use cryptocurrency to trade NFTs. Since the value of an NFT is quoted in cryptocurrency, the risk includes exposure to the fluctuation of the cryptocurrency's value, [in addition to the risk that the] NFT as an asset will lose value.

A few new platforms, like Circle and Rarible, will soon provide the ability to purchase NFTs with fiat money. This would eliminate, or at least decrease, the exposure to cryptocurrency value fluctuations. [These platforms can also] facilitate NFT transactions, which makes NFTs more appealing to the mainstream and likely can increase NFTs' liquidity and value.

Dr. Will Cong

Dr. Cong is faculty director of the FinTech Initiative, as well as the Rudd Family Professor of Management and an associate professor of Finance at Cornell University. Because of his expertise in financial technology, innovation, and investments, we reached out to ask him a few questions about NFTs.

Dr. Will Cong, Faculty Director of the Fintech Initiative, Cornell University

Dr. Will Cong, faculty director of the FinTech Initiative, Cornell University

The Motley Fool: NFTs seem to be the new craze this past year, but do you anticipate this trend to continue or do you foresee NFTs being just another bubble? Why? 

Dr. Cong: It is hard to predict if NFTs will continue attracting as much attention as they have in the past year, but I do not view [the past year] as a bubble. NFTs are an innovation that have attracted a lot of speculation. There are several reasons why NFTs are interesting:

  1. Non-digital art -- and even some digital arts -- face difficulties of authentication, which reduces ownership utility because it's hard to know if a piece [that an investor owns] is fake or authentic. Blockchain technology addresses this authentication issue, [and because of that] value from ownership could be enhanced.
  1. Tokenization also expands ownership possibilities. Instead of one person owning an artwork, 500 people could own it, each deriving some ownership utility. The total ownership utility may not be 500 times bigger because exclusivity of ownership is reduced and so is the prestige, but the [total ownership utility] is still bigger than one person's utility of ownership. So, again, total value of ownership could improve using NFTs. This is not [yet] what we see in practice, but NFT technology is ripe [for this to occur].
  1. By making [asset] ownership divisible and, thus, more tradable, there is a liquidity improvement and potential risk reduction. Tokenization also boosts [an asset's] value due to the crowd-based nature of the transaction. [As with] crowdfunding, there can be learning and herding with crowds, so [an asset's] overall valuation could become inflated due to investors' behaviors. For the liquidity improvement, consider that traditional art pieces are hard to trade, so even if someone values an artwork more than the current owner, the high transaction costs and [associated] effort [negate the value of] a transaction. Ownership can be easily divided and traded [using NFTs] and [fund managers] can rebundle that ownership into digital art ETFs, for which they can issue new NFTs. This allows for diversification [and lowers] the risks associated with the fluctuation of asset prices. Rebundling can also lead to opacity and create problems similar to [those underlying] the subprime [mortgage] crisis.
  1. Crypto tokens overall have been gaining value. Because crypto tokens and digital currencies are gaining momentum, investors are more open to owning tokens and are speculating about NFTs. Overall sentiment is positive and there is limited shorting of NFTs, which further adds to the higher market valuation of non-fungible tokens.
  1. So far, little attention has been paid to the viewership utility of digital art pieces. Depending on how the digital art is stored, fragmented ownership may preclude people from viewing the whole piece of art. The NFT industry may come up with additional arrangements to grant or rent the viewership right, especially for art pieces with high viewership utility. 
  1. Another issue with the tokenization of art pieces [relates to energy usage]. If tokenization leads to more proof-of-work-based mining, then [the rise of NFTs] could lead to greater environmental damage and electricity costs.

The Motley Fool: NFTs are often images or videos that anyone on the internet can view, but the owner of that NFT has the "original," meaning the value of that NFT is based solely on what someone is willing to pay for it. That said, do you think it's worth adding NFTs to your investment portfolio when the value is so subjective?

Dr. Cong: With traditional art, some owners never display an art piece [and never] profit from others viewing it. The ownership itself is delivering utility to the owner. NFTs for images or videos can be treated similarly. Investors who want to include some art pieces in their portfolios without deriving profits from exhibiting them may as well [own] some NFTs. There are many speculative assets with subjective valuations, and NFTs fall into that category. 

It could be interesting to see how the NFT industry evolves. Once offline and off-blockchain, [assets] such as real estate or a physical piece of art can be linked to NFTs, then NFTs can verify ownership of items beyond images and videos. [Real estate and physical art] are not easily duplicated and viewed like [images and videos].

The Motley Fool: What are some things investors should consider when looking to purchase an NFT (i.e. capital gains taxes, use of cryptocurrency, valuation, etc.)?

Dr. Cong: Investors should think carefully, whether they are seeking capital gains or deriving ownership utility, when they purchase NFTs. Taxes are important to consider, as well as the fundamental valuations of crypto tokens. User adoption of a platform and the token supply policy also play a role. NFTs that are linked to physical art pieces or properties [are safer investments] than NFTs of someone's tweets.

Dr. Jimmie Lenz

As the director of Duke University's Master of Engineering in FinTech and Master of Engineering in Cybersecurity, Dr. Lenz has taught about blockchain, cybersecurity, financial technology, and other related topics. The Motley Fool had a few questions about NFTs for Dr. Lenz.

Dr. Jimmie Lenz, Director, Master of Engineering in FinTech, Duke University

Dr. Jimmie Lenz, director, Master of Engineering in FinTech, Duke University

The Motley Fool: NFTs seem to be the new craze this past year, but do you anticipate this trend to continue or do you foresee NFTs being just another bubble? Why? 

Dr. Lenz: The inverse of a bubble, I see that the surface of NFT usage is just being scratched. The opportunity to use the NFT format for other types of offerings is just now being analyzed. People are thinking about NFTs as a product rather than a software that can facilitate much more than a specific product offering.

This idea of "NFTs as software" is very important. The generic use [potential] of the NFT is not only very broad but also subject to interpretation.

The Motley Fool: NFTs are often images or videos that anyone on the internet can view, but the owner of that NFT has the "original," meaning the value of that NFT is based solely on what someone is willing to pay for it. That said, do you think it's worth adding NFTs to your investment portfolio when the value is so subjective?

Dr. Lenz: Thinking about NFTs as just a specific product is inaccurate. But in terms of specific [digital] images [with NFT ownership], a similar asset type might be a famous painting that is often copied.

The Motley Fool: What are some things investors should consider when looking to purchase an NFT (e.g., capital gains taxes, use of cryptocurrency, valuation, etc.)?

Dr. Lenz: Investors in NFTs that represent certain images should take into account all of the factors that would be considered [for any investment] in a similar asset type. Liquidity is of course very different for NFTs than most other image assets.

There is very little doubt that NFTs will proliferate as an avenue to [purchasing] other types of offerings. NFTs [could provide] a new way to view "pay per view," perhaps.