Non-fungible tokens (NFTs) have become a recurring topic of conversation in the crypto space. Some incredible amounts of money have been invested in NFTs, including a recent $69 million purchase for digital artist Beeple’s piece. Following a similar trajectory to cryptocurrencies, NFTs crossed the threshold into the mainstream when popular influencers became involved in the subject and amplified the hype surrounding this product.
Most people who are aware of NFTs heard about them for the first time through one of these influencers. But did they introduce it correctly? NFTs are often presented as unique digital tokens that cannot be replaced or duplicated, giving the owner sole ownership of that token. However, stories usually revolve around examples of particularly pricey NFTs, such as a video of Lebron James dunking selling for $208,000.
The initial reaction of the public to NFTs is usually twofold. On the one hand are the people who question the main purpose of NFTs. “Why would anyone pay such a huge amount of money for something that you can watch on YouTube?”, you hear them say. On the other hand, some think that NFTs are the key to implementing the basics of private property in a coming digital era. “You will be able to issue NFTs that prove the ownership of all your assets – both digital and physical”, they point out.
But are NFTs more than the Emperor’s new clothes? This is a question that Nick Ayton has been pondering. Nick is the founder and CEO of Chainstarter Ventures. He is heavily involved in artificial intelligence (AI) and quantum computing, and has been a prominent blockchain thought-leader. Nick is also a board advisor and strategist for the blockchain protocol token, Zenotta AG, which has been in development for seven years. He explained to us the most pressing vulnerabilities of NFTs, possible issues with third party involvement, and why, with the help of smart data, non-fungible assets (NFAs) should replace non-fungible tokens.
NFT transactions are a relatively recent phenomenon. As such, many people engaged in these activities do not themselves understand the possible risk they take when purchasing the tokens. The hype around NFTs seems to rest on a general misconception about the notion of non-fungibility. NFTs are not themselves a digital asset. NFTs can be thought of as digital certificates, a verification of ownership of a given digital asset. NFTs and the digital asset they certify are two distinct items, not inherently linked but associated by the certification role NFTs play.
“A token is a proxy,” Nick argues. “It’s not a store of value. It doesn’t represent any value at all. A token is just a means of exchange. When you buy an NFT, you are only buying a token; the asset that is linked to it is on another chain. Any exchange is separated with a different transaction from the miner back to the individual, so it’s not peer to peer. And that’s the fundamental issue with NFTs.”
The problem that Nick points out is that purchasing an NFT is not a peer to peer transaction. Rather, it is a wallet to miner and miner to wallet transaction. What does this exactly mean?
Let’s assume that I have 20 bitcoins and would like to send you 10. When I send you 10 bitcoins, what happens is that actually I send all 20 of my bitcoins to the network. A miner processes it, send you 10 bitcoin, and records it as a transaction. It also gives me back 10 and records it as a separate transaction, updating my UTXO (unspent balance). This is effectively a wallet (user) to miner or miner to wallet (user) transaction, which is distinct from real peer-to-peer transactions. In the case of bitcoin, the two different transactions are recorded as two operate ledger entries, but at least they are recorded on the same ledger on the same chain. It is not so in the case of NFTs.
“An NFT token issue will be on one ledger, and the item the token was apparently exchanged for resides on a different chain. Is not immediately reconciled,” Nick explains. “The fact that I’ve given you some tokens is written onto a ledger. But there is no discussion about what those tokens were exchanged for. And you’re relying on a notary and a custodian, and maybe another chain, who will help create the other part of the transaction, the double-entry side. But there’s no atomic relationship between the two.”
In a slightly different context, this issue was explored in a recent Bloomberg story reporting that “fake” Apple and Tesla shares have started trading on blockchains. These shares should be real representations of the actual assets and therefore sold for the actual AAPL or TSLA stock price. But there is no link between the real shares and their synthetic blockchain counterparts.
“All a trading account on an exchange will show is a “pink slip” of token movement, showing what was paid for the digital representation of the share. Recorded on a one-sided ledger entry, there is no corresponding binding of the exchange of value. Bob sends ten tokens to the exchange to buy a Tesla share. The exchange confirms the trade. But there is no direct link to the asset, which should either be held in inventory to be settled or held off change to be settled later.”
An underlying issue with both NFTs and synthetic shares – and much of the uncharted waters of decentralized finance in general – is that customer protection principles are harder to enforce. The traditional regulations that apply for the stock market and conventional finance either do not extend to the realm of blockchain or are harder to be upheld in this market space.
“The acrid test is if somebody gets ripped off and pissed off,” Nick points out. “Does it stand up in a court of law as their evidence of payment? That hasn’t been tested yet.
“Blockchain is excellent if you do it within the same stack. But as soon as you start doing all this other stuff [transactions that involve other chains], the wheels fall off. You get vulnerabilities, and there is no regulation here. There is no rule of law. It’s the Wild West, and there are a lot of bad actors who see this as a money-making opportunity. A lot of NFT activity is only about money-making, and some innocent people will get hurt. It’s inevitable, but the early adopters tend to be the early victims as well.”
Byzantine Faults are everywhere. It’s clunky, expensive and not at all safe.
The fact that NFT transactions are in fact wallet to miner and miner to wallet transactions that occur on different chains exposes the purchaser of the NFT to further vulnerabilities, namely the involvement of third parties.
“My blockchain has the message of another blockchain,” Nick explains. “That’s the fundamentals of NFTs. So there’s a fault. If you’re on another chain, who owns that chain? How is their security? Are they good actors or bad actors?
“So, the problem with NFTs at the moment is that you’re dependent on lots of different parties, in different chains, in different economic models. If we add a third party, we put a T connection, a join, in the pipe. In the blockchain, that’s called a Byzantine fault.”
Another vulnerability that third party involvement poses to NFTs is centralization and transaction fees. Furthermore, the more parties are involved, the harder it is to monitor the transactions.
“And with NFTs, you rely on third parties, which often means you get another centralization effect where you’re relying on a custodian or a storage provider. And what happens if they don’t play ball? What happens if they go out of business, or if they’re owned by some people who have different moral compass? So therefore, it’s another thing that can go wrong. And if you wanted to audit the whole thing and take a look at the entire transaction portfolio, then your transaction costs will be quite high. Everyone who is storing a piece of information will charge you gas or transaction fees.
“The whole point of blockchain is that it’s meant to be more efficient – it’s meant to be able to cut out the centre, not create the centre. With NFTs you’re creating more centralisation, a notary of other storage providers. So this is your challenge. Now, the way to solve this is to forget about the token and make things as a non-fungible asset. And the only way you can do that is to make data smart.”
Creating smart data
Nick supports Zenotta AG in an advisory role. Zennota AG is a Zug (Switzerland) based company that aims to establish a peer-to-peer electronic trading system, by introducing smart data. Their concept of solution is that instead of using non-fungible tokens that are linked to certain assets (files), these assets themselves should be made non-fungible and scarce, by giving attributes to data.
“Data is created willy-nilly: it is copied, edited and pasted,” Nick thinks. “Thus, the internet destroys any value that any data ever had. And the reason why we can’t go to the Internet for value is because of that fundamental problem. It’s a data problem. You have to make data intelligent and unique. And of course, if you think about the whole basis of NFTs, it is about the non-fungibility and uniqueness of whatever you’re creating.”
The fundamental problem with NFTs today is that they only provide you a link, a URL, or a JPEG of what you, in theory, own. But this data (e.g. a picture of what you own) can be changed anytime, because a JPEG file is a piece of data that has no innate protection, no identity. To this fundamental problem provides smart data a real solution.
But how do you make data smart? Nick tries to explain the seemingly complicated process in simple words:
“So creating the smart data is that we pass it through a filter protocol, which adds different attributes to that data, so that data is a file with extra attributes. We know its state. So what you do is you pass all data through a protocol to create a new file format. This is an internet of files.”
Smart data gives various attributes to the file. For instance, it gives it a timestamp, a price, and validates ownership. It validates its previous ownership and the identity of the owner. This is what makes the data intelligent. You can also build into that the rights of information of that data. In other words, you can specify who can view it, who can sell it.
“It means that I send ten to you, and you’re going to send me the asset. And we do that in a dual double-entry in the same transaction, creating a file. And then the last piece of the structure is a governance legal layer. What that means is that when I do a deal with you, there’s instantaneously a true exchange of value. But there’s also a basis in law, which is important if there’s a dispute. If you, for instance, no longer want to go ahead with the deal, you have a formal basis of dispute.”
Smart data could solve the problem of real attributes of ownership. One of the most frequently cited possible use cases of NFAs, backed by smart data protocol, is applicable in the music industry. Artists are known to sign away their rights to music labels and get a fraction of the revenue that their songs generate for streaming services. Selling their songs as NFAs could provide a solution to the problem, Nick claims.
“When data is out on the internet, you can track and trace it natively. You know who’s viewing it, you know who’s got it, and you know who’s paid for it? You know who has permission and who doesn’t. With that being said, you can’t stop piracy. But I could tell if you’re holding a copy of my song that you haven’t paid for. So then I have some ability for recourse to track you down and say, “okay, you now owe me this. Or you have to prove to me you’ve destroyed it.”
Each copy of a song – or of a picture, for that matter – becomes an original but unique version of the artist’s work. The reason is that when the song is passed through the protocol, it is automatically given a different time and date stamp.
“If it is Beyonce’s new single, for instance, then she personally can sign every song with a digital signature. So we can say that Beyonce is selling a million copies – they got her signature and a unique time and date stamp on them. And each piece of content could actually have slightly different redemption rights. So she could sell her songs to a record label, who might have a right to package her songs with other songs in a unique album or playlist. The price of songs can also reflect supply and demand movements in a market automatically.”
Nick concluded by stressing that he is not against the idea of non-fungible tokens completely. He is, however, convinced that smart data will bring about a real breakthrough in blockchain technology and that NFAs could solve many of the problems currently associated with NFTs.
“Really we’re on the verge of non-fungible assets. Non-fungible token is a brilliant idea. And a lot of people give me a hard time and say, “Nick, you know, you’ve really got to stop bashing NFT’s.” I’m saying, “Well, I’m not.” What I’m saying is the current iteration of blockchain is not up to the job. And if you start using multiple chains, you’re creating all these commercial nightmares, these Byzantines faults.
“But there is a solution to this, the next evolution of digital trading markets where all data and assets become intelligent. A new commercial trading architecture unlike anything today is something I am working on. The world problem is identity based ownership of things, of assets, of creative output. Once you have this everyone can be included in trading and protecting their value.”
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