Evolving Legal Issues for NFTs
Introduction to NFTs
Throughout 2021 and 2022, Non-fungible tokens (NFTs) have increasingly grown into public awareness. People often hear about NFTs through collectible projects like Bored Ape Yacht Club, CryptoPunks, and World of Women. Usually, people then encounter the hype, interest, and indignation about what exactly NFTs are along with the corresponding potential use cases. Why have NFTs exploded into the zeitgeist? Namely, because NFTs have the potential to collapse the cost of verifying ownership of digital goods, create new revenue streams and markets for artists, and provide a sense of community built around user-defined identity. This article aims to clear up some of the obfuscation around NFTs, outline the evolving legal environment for NFTs, and explore their current and potential use cases.
NFTs are provably unique digital assets, cryptographically secured on a blockchain. Essentially, NFTs provide a potential mechanism to secure and verify ownership of digital assets without an intermediary. The ability to secure immutable ownership of one’s digital assets without a third-party has implications for cost and efficiency across industries and markets. Digital assets can also be user-defined, leading to many different and innovative use cases. The rapid development and iteration of NFT technology is a catalyst in the expansion and reinvention of many digital asset-based industries.
NFTs can take many different forms, including art, collectibles, video game assets, membership tokens, immutable government records, identity certifications, and digital representations of physical objects. NFTs are tokens represented on a blockchain through smart contracts, giving the token many unique properties and interoperability with other smart contracts and token types. Throughout this article, we will explore NFTs on the Ethereum blockchain. NFTs are also hosted on other blockchain ecosystems like Avalanche, Polygon and Solana. Before diving into the various use cases and projects utilizing NFTs, we will explore fungibility vs. non-fungibility.
What does it mean for a token or any item to be fungible vs. non-fungible? A fungible item is simply an item that is exactly like another. US Dollars, Ether tokens, Euros, and Yen, are all tokens (meaning here a symbolic representation of something; here representing value), that are all interchangeable with one another. 1 dollar is always equal to 1 dollar. NFTs are everything else that cannot be replicated 1 to 1. Any object that isn’t a 1 to 1 interchangeable replacement with another is considered “non-fungible.” Your couch, your dog, your house, real property, music, and art you create, all are non-fungible. The non-fungibility of objects in the world seems an almost quibbling definition over semantics, as this aspect of life is generally obvious and unnecessary for us to worry about. On the blockchain and particularly with digital assets, how to secure the representation of an object’s “non-fungibility” is all important.
Because computers and the internet make it trivial to cheaply create many copies of a digital asset, it becomes difficult to secure and demonstrate ownership of digital goods without a third-party in place to help steward ownership of the asset. The introduction of a third-party can eventually lead to many problems we encounter today with digital asset ownership. Such issues include users not owning their own data, property rights being arbitrarily revoked by the third parties that access, security issues when centralized servers are hacked, distribution fees when working with third parties to sell digital goods, and increased costs in having to pay intermediaries to verify ownership. NFTs were created first on the Ethereum blockchain in an attempt to solve these problems and provide decentralized, immutable ownership of digital assets. How exactly does decentralized ownership work in practice?
Simply defined, an NFT is a smart contract with metadata, representing a token, hosted on a blockchain. An NFT must have a certain set of properties, defined as a “token-standard” that allow the NFT to interact with other smart contracts and NFT marketplaces, like Opensea, Rarible, and LooksRare. NFTs also possess programmability, allowing different attributes to be customized by the creator. These attributes include verifiable randomness of traits, power levels of characters, and stats for in-game items. NFT traits are instantly viewable and verifiable on NFT marketplaces, which can seamlessly interact with the smart contracts the NFTs are created from. NFT marketplaces are essentially interfaces that use blockchain technology to allow any NFT to be bought and sold, without the marketplace having to hold or steward the assets. NFTs also have corresponding metadata which describe what the underlying asset is, often hosted on decentralized file hosting services like IPFS, FileCoin, and Arweave. The metadata underlying an NFT is key to how marketplaces are able to show aspects of the NFT to the user. What allows the interoperability of NFTs is the smart contracts they are built with.
NFTs are defined by the ERC-721 and ERC-1155 token standards. ERC-721 is a smart contract standard that represents unique ownership, while the ERC-1155 introduces aspects of fungibility. To not get too bogged down in the specifics, an ERC-1155 allows multiple, fungible versions of a unique asset to be created. This is very useful in the case of content creation and in virtual video game assets, release of a music album, or for making batched transactions more efficient. Each standard has been linked above for more information. Token standards provide the minimum functions a token requires to be considered an NFT. It is important to note that the standard implementation is often just the start, as these assets can be customized and created with different abilities according to user needs. Examples include programming an art-drop NFT with royalties for the creator, enabling air-drops to a community where the NFT is the access token, and allowing users to create derivatives of an NFT based on the metadata.
What types of NFTs are currently being created? NFTs are primarily being used for art and collectibles, such as collectible player profile pictures (PfPs), with many projects being developed for video game assets. However, collectibles and art aren’t the only forms NFTs can take. The high value transactions involving these digital assets obscure other benefits these types of NFTs bring to their owners: identity and ownership in a community. NFTs provide a sense of shared ownership and identity, and NFTs are programmable and allow communities to build their own type of organization. NFTs provide a unique opportunity for creators to eliminate third-party gatekeepers so that artists are able to directly control and monetize their own work.
Direct control and ownership of NFTs an individual created or buys is a subtle and important distinction, that is often misunderstood by many first exposed to NFTs. A common meme in the NFT space is that anyone can “right-click save” an NFT and have the same ownership of it that anyone else does. While amusing, it isn’t the “gotcha” many think it is. Anyone can take a picture of any piece of art hanging in any museum at any time. Having a copy of a piece of artwork gives no essential ownership rights over the original piece of artwork, just the copy they have created. NFTs provide unique, verifiable, and immutable proof of ownership of digitally created goods that are also programmable by the creator. Programmability allows artists to build-in royalties, oversee the distribution of their work, and benefit from decreased costs in having to secure their work with a third-party.
Now that we’ve defined different types of NFTs, we return to the “Why?” Besides speculative activity, users of NFTs often purchase them for a sense of belonging and identity in various communities, as mentioned above. As our digital lives increasingly intertwine with our physical lives, NFTs also allow users to own their own data on the internet. When we extend identity and personal data ownership to a community, big possibilities begin to open up in how communities are organized and owned by their members.
A crucial use of NFTs is in Decentralized Autonomous Organizations (DAOs), where they serve as an efficient and automated ticketing system for voting and membership. NFTs not only provide a membership token in the community, but they also serve as valuable pieces of culture that the community builds around. In DAOs where voting is commonplace for deciding upon activities, a membership NFT provides an immutable record of your vote on the blockchain. As these possibilities are only beginning to be explored, there are several other areas that could benefit from utilizing NFTs.
NFTs provide unique advantages in several different areas: content creation, data security, membership to communities, identity verification, and provenance for verifiably rare collectibles. This is far from an exhaustive list of the possibilities of the use of this new technology. NFTs have the potential to revolutionize how artists own and collect royalties for their work. Digital rights management can be included within the smart contract that effectuates the NFT. They can be made highly efficient for use in ticketing, couponing and other types of ways of how we use digital assets with utility. For video game communities, NFTs provide user owned assets that are not controlled by a game company. They open the door for community-built gaming experiences where a DAO controls how the game is developed and updated. NFTs could revolutionize granting, licensing and conveyance of many types of intellectual property, including virtual titling, in that NFTs provide a secure and immutable way to verify ownership, resistant to corruption and enabling new forms of ownership and financial opportunity to develop. Since NFTs collapse the cost of ownership verification to nearly zero, they provide many small businesses around the world a way to maintain a virtual title, free of local or government corruption.
The Evolving Legal Environment Around NFTs
Currently, few laws and regulations relate directly to the creation, transfer, or use of NFTs. While the marketplaces for NFTs allow the purchase of NFTs, there are important questions about the legal status of exactly what is being conveyed and what rights are associated with the NFT transfer. NFTs are not the thing itself, whether a piece of art or music, a collectible or some other digital asset, any more than the deed to your home is the actual physical place you live. There is no real restriction on the minting of NFTs, but the rights conveyed with the purchase should not be assumed to include all of the IPR nor ownership of the actual physical asset that relates to the NFT. There are no common standards yet for what rights are associated or transferred with a smart contract that comprises the NFT.
One area of law obviously associated with NFTs is intellectual property rights (IPR), including copyrights, trademarks, patents, and other rights. Having the ownership of digital goods proven as an immutable record on a blockchain is a secure way provides proof of rights related to a digital asset. However, the smart contracts that enable rights to convey with the digital asset must be programmed to transfer the rights that are being managed. Even the transfer of digital IPR is problematic until a legal system develops to advance the field to deal with the lack of traditional writings required to transfer or license IPR, since smart contracts manage the IPR (payment of royalties, for example) with no human interference and no explicit “signed” contract.
One of the most important efforts to develop a national policy for digital assets is spelled out in an Executive Order on Ensuring Responsible Development of Digital Assets, published on March 9, 2022. This major government initiative is designed to produce numerous reports and assessments by government regulators about what digital assets are and how they should be regulated. Draft legislation is also in the works so that effort could result in more definition and clarity about what NFTs are as a means to manage IPR and other purposes.
Because anything that can be digitized could potentially become an NFT, there are almost no limitations on the potential utility of these digital mechanisms to help individuals and companies to own and manage their data and real assets. NFTs are increasingly being used by decentralized autonomous organizations (DAOs) as a means to join the community, mint a secure NFT avatar, adding the minting fee to the treasury and enabling voting on DAO projects. NFTs can also be adapted to assist records keeping for all manner of digital assets. They can also be used as a means to verify identity and ownership or real assets.
Blockchain technologies already are being used in Estonia to hold and secure most of the nation’s records. For example, the land titling system and all deeds are held on a public-facing blockchain, speeding the ability of landowners to demonstrate their title to real property. NFTs could conceivably be applied to that system or other systems, such as drivers’ licenses, voting records or other similar public records. The combination of immutable records on a blockchain with digital verification of identity via a standard type of NFT would potentially eliminate much of the hassle and time wasted dealing directly with government bureaucracies, such as Departments of Motor Vehicles and local paper record depositories, such as county courthouses.
One could envision all health records for an individual being wrapped in an NFT and provided to any medical professional as a simple transfer of the right to view such records. This is not far-fetched. BanQu in Africa is using blockchain to bring more than 600,000 small landowners farming commodity crops like cassava and coffee into the commercial system by enabling them to prove their ownership of their crops and obtain access to the banking system. This same type of ownership of each person’s digital data and rights to their own information can be enabled by NFTs.
While blockchain wallets for cryptocurrency are anonymous, in many cases regulators must insist on some proof of identity. The regulations likely to arise from the current government wide digital asset assessment will certainly include some form of identification for any accounts that link to public systems. NFTS offer a potential interface for identity information associated with wallets, with only the individual or entity authorized to view that information permitted to see it. So properly secure regulators could verify identity associated with a specific wallet, while the holder would retain anonymity for all others. Or people who wish to gain access to services not currently available to them (immigrants, refugees, asylum seekers, poor and marginalized populations) could use their NFTs and blockchain wallets to verify both identity and a non-bank account for digital assets. This has the potential to open up the economy to many people not able to participate currently.
In conclusion, the law must evolve in order to enable the potential of digital assets, NFTs, blockchain secured records, and related advances to enter into common use. NFTs provide an opportunity to disrupt industries that often end up working in the best interests of the third-party that holds ownership rights, and not in the best interests of the creator. Utilizing smart contracts can collapse the cost of ownership and put it into the hands of the actual owners and creators. NFTs have the potential to open up new avenues and markets for creators, improve how we buy and transfer property of all types, and more efficiently handle transactions concerning ownership. Proper legal clarity has the potential to create an effective framework for innovative development, while also regulating the ability for bad actors to misuse and take advantage of it.
∗ Justin Holbein has been active in the blockchain space in many capacities since 2014. He is certified in data analytics, Python programming and is actively building smart contracts and web3 Dapps. He is an active participant is several Ethereum-based decentralized autonomous organizations (DAOs). He contributes analysis and uses smart contracts to develop solutions to coordination problems in the DeFi and DAO space.
*James R. Holbein is Counsel to the Braumiller Law Group PLLC. He practices in the area of international trade and customs law, and has written several articles exploring the potential for new digital technologies to reshape supply chains and improve access to financial services.