NFTs: the good, the bad, the regulation

The metaverse’s blurring of the boundaries between multi-faceted digital environments and the physical world will no doubt disrupt conventional legal notions, including that of ownership. Possession is king, but ownership in the digital world is not the same as ownership in the physical world, and without due care and attention stakeholders may come unstuck.

The metaverse – the “Internet 3.0” – offers tremendous opportunities for growth & creativity

The extraordinary rise of NFTs is hard to miss. From the likes of Tesla billionaire Elon Musk selling his song about NFTs as an NFT, to the most expensive NFT sold to date (at over $69 million) by the artist Beeple at Christie’s auction house, one thing is clear – NFTs cannot be ignored.

No NFTs are created equal

In short, an NFT, or “non-fungible token”, is a unit of information recorded on a blockchain that is not interchangeable.

In contrast to cryptocurrencies (such as Bitcoin and other altcoins, or any other currency for that matter) which are fungible, NFTs are “non-fungible” – they cannot be replicated, traded or exchanged equally. An NFT contains data that represents a specific good or service and is different to every other NFT; they are unique. Just like no two plane tickets are the same – a ticket has a specific seat on a flight, for a specific time, on a specific day.

What NFTs and cryptocurrencies have in common is that they use blockchain technology to record transactions. A blockchain records information (such as transaction data and a time stamp) in a distributed database and this information is organised in linked “blocks”. The allure of the blockchain is that it is resistant to modification because it is not possible to alter one block in the “chain” without altering all the other blocks. Other attractive features include the fact that the blockchain is decentralised and has instant traceability meaning it is reliable and trustworthy.

However, the key feature of NFTs is “tokenisation”. This makes the asset that the information relates to “tradable”, turning previously non-liquid assets into “quasi-liquid” assets.

The illusion of ownership

How do these features work in practice? The earliest use case of NFTs has been the buying and selling of art, which provides the most straightforward example of how to define “ownership” in the digital era.

In law, property is “the right to enjoy and dispose of things in the most absolute manner”, whereas intellectual property comprises the rules applicable to “intellectual” or “immaterial” creations and elevates these creations to “intangible property” that may be appropriated or “owned”. Importantly however, the law does not elevate data (such as information on a digital ledger) as being capable of “ownership”.

So, how does the law work when it comes to the buying and selling of artwork? In physical artworks, there are two kinds of property: the tangible property and the intellectual property. On the other hand, in digital artworks we end up with just one kind of property: the intellectual property. This means that in digital artworks, only one property exists, and that is the intellectual property of the creator. When someone buys a painting from a gallery, they buy the “tangible property” – the physical canvas and the paint – and not the intellectual property. When you buy an NFT associated with digital artwork, this is not a purchase of the canvas and paint; you are buying information, which cannot be owned in law.

Our experience shows that most NFTs sold today are providing a service (authentication of the artwork) or granting a licence (a limited permission to use and enjoy the digital art), and rarely is ownership passed to the purchaser. In short, this means purchasers of NFTs need to understand what they are buying, and sellers need to be careful how they advertise NFTs in order to achieve legal certainty in the transaction, including in relation to “ownership”. Where a transfer of ownership or rights is intended, this must be appropriately documented.

How are NFTs regulated?

There are currently no specific regulations governing NFTs. The law and regulators are often criticised for failing to keep up with the pace of technology. However, whilst the regulation of tomorrow is being drafted, the regulation of today should not be overlooked – NFTs are subject to exactly the same regulation as any other online asset.

Most notably, a key consideration is to determine whether an NFT qualifies as a security or other regulated instrument under applicable laws. This is primarily determined by the purpose for which the NFT is being created and sold. For example, if the purpose is to create investment returns for members of the public, this will likely be considered a security.

Additionally, NFTs offered to the public will be subject to local consumer laws that demand a high degree of transparency from sellers and affords consumer protection against unfair commercial practices. Meanwhile, when it comes to tax treatment, this will be dictated by the type of transaction, such as whether it is a sale or a licence, a national or an international transaction, and business-to-consumer (B2C) or business-to-business (B2B). This will also be different for the relevant stakeholder, whether you are a marketplace, seller, or purchaser. Given these considerations, it would be prudent to seek specialist advice early on in relation to any compliance issues to avoid any nasty legal surprises at a later stage.

Of course, as NFTs become commonplace there is no doubt that new and specific regulation will closely follow. Just look at the waves Bitcoin and other crypto-assets have made in recent times, triggering the European Commission to produce the draft Markets in Crypto-Assets Regulation (MiCA) back in September 2020, closely followed by the European Central Bank’s generally supportive opinion on the MiCA in February 2021.

So, are NFTs just a bit of fun or the future of digital assets? There are certainly early signs of NFTs permeating more widely into the world as we know it; NFTs have been used beyond the art world, for the likes of charitable giving, brand collaborations, and virtual experiences. Indeed, NFTs may facilitate a smooth transition to a digital world where creations can be easily monetised, but it must be understood they don’t come without their risks and limitations. Players with skin in the game (figuratively speaking for most, but quite literally for those with video game skin NFTs) need to understand the potential pitfalls attached to NFTs and approach digital assets with the same rigour and vetting process as any other asset.