Non-fungible Tokens: what’s all the fuss?

Introduction

NFTs represent a new way for brands to directly engage with consumers in the digital age; a way for brands to create a sense of scarcity and therefore value around their digital collectibles, including photos, videos and audio files. They potentially represent the next (digital) generation of the Panini trading cards traded by children in school yards in the 80s and 90s. Also, because of the way NFTs are able to tokenise, store and hold rights in digital or physical assets, they are likely to have a wide application to sectors such as financial services.

But what are they, what do they represent and what are the legal and commercial issues to consider?

NFTs – what are they and what do they represent?

An NFT is a one-of-a-kind digital token created (or “minted”) and recorded on a digital ledger, called a blockchain. NFTs can be bought and sold like any other property, but they have no physical form. NFTs are “non-fungible” (i.e. unique and not interchangeable) because each token comprises unique data (e.g. code and other metadata) that distinguishes it from other NFTs relating to the relevant blockchain.

Blockchain solutions like the public Ethereum network, Polkadot, Cosmos and Flow can be used to create NFTs. The NFTs can then be bought and sold via an NFT marketplace website that is linked to the underlying blockchain solution (e.g. OpenSea). The blockchain solution represents the back-end technology that tracks the NFT and who owns it. The NFT marketplace represents the user-facing interface that token buyers use to trade NFTs.

Generally, NFTs fall into two categories:

• Category 1 NFTs: the token is linked to a physical asset (e.g. luxury goods or diamonds). A buyer buys the physical asset from the seller and the parties agree (in the sale contract) that the seller will issue to the buyer an NFT linked to the physical asset which will include (within it) a digital certificate of authenticity/proof of ownership (digital record) confirming the physical asset is genuine and the details of the buyer. This provides the buyer with an immutable, digital record of ownership of a genuine asset that it can then rely on if it wants to sell on the physical asset. This is a much better record than a paper-based one that can be lost or easily doctored. Each time the physical asset is sold the data included in the digital record will be updated, for example, to reflect the details of the new owner.
• Category 2 NFTs: the token represents a right to do something with a (licensed copy of a) digital asset. Here’s how it can work:
  • Unique data in the NFT includes a unique URL link which takes the token buyer to a web server hosting the relevant digital asset.
  • The digital asset is not included in the NFT as that would be too compute intensive.
  • If the digital asset comprises a media file (e.g. music file), typically, the NFT represents a right to download a copy and listen to the music, available via the URL link, for personal purposes.

Legal and commercial issues

Contract

It is important that there are underlying terms and conditions governing the sale of the NFT (initial sale once the NFT has been minted and further sales via the NFT marketplace) so there is clarity on what the token represents, what rights the token creator has and what rights the token buyer is acquiring.

IP will play an important role in relation to Category 2 NFTs where the token creator is providing a right to do something with a digital asset linked to the NFT. For example, is the token buyer buying a right to the IP in the linked digital asset or just a limited licence to do something with the linked digital asset? In relation to Category 2 NFTs, where the linked digital asset is a unique URL to a music file available for download, when the token buyer buys the NFT it is usually being granted a right to download and listen to the music file for personal purposes; it is not purchasing a right to own the music file (copyright in the music file is not being transferred to you). So, the token creator is free to create further copies of the song and market it.

Financial regulation rules

There is no specific regulatory framework for digital tokens, including NFTs. Therefore, a key question for any blockchain platforms and brands issuing NFTs to consider is whether the NFT is likely to constitute a type of regulated financial instrument, or whether it may be subject to anti-money laundering requirements.

Whether an NFT is a type of financial instrument such as a security will depend on the characteristics of the NFT and the rights given to a token buyer. The non-fungible character of the token will not itself affect the regulatory status of the NFT.

If the NFT merely represents ownership in an asset or copy then this is unlikely to be viewed as a security and is likely to be considered as a utility or exchange token if all it does is confer the ability to hold the asset and to buy and sell it.

However, if the NFT has characteristics that are similar to a security such as a share or a unit in a collective investment scheme, it could be considered to be a “security token”. This could also include, for example, fractionalised NFTs. Most NFTs are unlikely to be considered e-money tokens because the basic characteristic of e-money is its inherent fungibility.

Most NFTs have not hit these regulatory perimeters as they focus on rights to an asset or copy in sports, art or music but use cases are likely to expand very quickly.

There is a need to think about these issues because if a person or entity is carrying on business in this area they will need to be regulated in the same way as traditional financial service providers. For example, the issuer may need to be licensed or at least subject to anti-money laundering requirements and the same analysis would need to be applied to exchanges facilitating buying and selling of these NFTs and token custodians or wallet providers.

Also, in relation to NFTs that are characterised as utility tokens or exchange tokens, certain jurisdictions may have certain marketing restrictions or even prohibitions and these will need to be checked if NFTs are marketed or offered more widely.

Non-legal issues

As well as legal issues, there are technical practicalities to consider. For example, what if the web server hosting the digital asset goes down? An increasing number of developers are using hashes of IPFS URLs for their tokens. IPFS is a peer-to-peer file storage system that allows content to be hosted across multiple computers, such that the file is replicated in many different locations. This ensures that the digital asset is always available as long as there are nodes willing to host the data. Hosting the digital asset on a peer-to-peer file storage system can increase the value of an NFT.

Many brands are looking to further commercialise their IP via the creation of NFTs. Given these brands often lack the technical expertise to create the NFT and/or create and operate the NFT marketplace, they engage blockchain suppliers to perform these activities for them. The brand provides a licence to the blockchain supplier to host a copy of the relevant digital asset. The blockchain supplier then creates a unique URL linked to the hosted digital asset and incorporates it into an NFT they have minted. The brand may also provide a licence to the blockchain supplier to use its trademark (which is then incorporated into the NFT marketplace), so that token buyers that may want to buy the NFTs know they are official. In return for the licence to the digital asset and trademark, the brand usually receives a cut of any fees generated in connection with the sale of any NFTs made by the blockchain supplier. Such brands need to be careful that the blockchain supplier delivers the offering in accordance with local laws and provides an acceptable level of service to token buyers to avoid brand reputational issues. For example, if the NFT marketplace is always unavailable that will impact on the reputation of the brand associated with the NFTs. In addition, careful consideration should be given to what happens on termination of the contract between the brand and its blockchain supplier. For example, is the blockchain supplier no longer permitted to generate new NFTs but is permitted to allow NFTs that existed at the date of termination to be sold/re-sold (Existing NFTs)? To what extent can the brand then licence its relevant IP (to the extent such IP is not associated with any Existing NFTs) to a new blockchain supplier that can then create new NFTs for a new NFT marketplace that may compete with the previous blockchain supplier and its Existing NFTs?

Conclusion

NFTs represent an exciting new avenue for brands to connect with their customers and fans. Brands, token buyers and token creators should consider the issues at play behind the tokens – including liability, consumer protection, data protection, IP, financial regulation, technical practicalities and brand reputation – especially as the number, complexity and variety of NFTs is only likely to increase (and this will no doubt lead to more complicated issues to consider and resolve).