Non-Fungible tokens or NFTs have captured the zeitgeist of the collective world in recent months. Is it a craze, the latest bubble, or is this the groundwork of a new tomorrow? The COVID-19 pandemic has created a brave new world of digital transformation, and NFTs may just be the logical consequence of a new era.
THE NFT MODEL
NFTs may have only recently become part of the popular vernacular, but they have been around for some time. The first NFTs were launched back in 2015 with early successes like CryptoKitties, a video game that operates on Ethereum’s blockchain. Each CryptoKitty is a unique, collectable creature and is branded as a one-of-a-kind, irreplaceable and immutable furrever friend that is captured as a digital token. CryptoKitty tokens can be bought, sold and traded and the craze of CryptoKitties had many digital fans frantically building up their own collections. Between 2015 and 2018, CryptoKitties generated more than $40 million in transactions [1].
NFTs of today have built on this model to create more complex versions of these cryptographic tokens. The token acts as a certificate of authenticity or digital receipt that verifies that the token, and the asset that it represents, is unique. This is done through a cryptographic hash function (unique identifying code), which governs an owner’s rights to the NFT and may also cover a variety of other functionalities, including linking the NFT to assets and determining the rights associated with those linked assets [2]. In isolation, the purchase of an NFT will simply result in the purchase of that token. However, when an NFT is linked to an asset, the governing code may function as a smart contract granting the NFT’s purchaser particular rights in the linked asset. For example, the governing code of an NFT linked to a given piece of art may grant the NFT’s purchaser a commercial license to sell or license the artwork.
Many tend to think of NFTs as a new form of digital currency, and while NFTs can be bought, sold and traded like a digital currency, the uniqueness of each token sets it apart from a basic cryptocurrency like bitcoin. This directly relates to the term, “Non-Fungible Tokens”. Bitcoins are “fungible” or interchangeable, with there being no difference between each bitcoin. In contrast, NFTs are each unique and irreplaceable; this Non-Fungible nature opens up a new world that exceeds the capability and applications of a simple digital currency model.
The model of a Non-Fungible Token built on blockchain technology creates the ability to have an immutable ledger recording transfers of ownership and validating authenticity [3]. To take this back to an offline world comparison, if you own a piece of original art created by a recognized artist, the value of that artwork on the market is dependent on the owner’s ability to prove authenticity. NFTs may meet this requirement by allowing for definitive pedigree, easily producible and incontrovertible evidence that the work is authentic. This is based on NFT transactions being recorded on blockchains, which are distributed and replicated across multiple computer systems by peer-to-peer networking and create entries that are deemed unaffected by any outside interference. The resiliency of these entries to tampering make them, in theory, immutable. Consequently, the chain of title for an NFT may function as an absolute record of ownership.
As a result of being unique and fully traceable, transactions involving NFT-linked assets have a degree of legitimacy that cannot be found with traditional contracts. Thus, NFTs function as an indisputable digital receipt for the transfer of rights from seller to purchaser.
NFTS IN THE DIGITAL AND “REAL” WORLD
Artists and musicians have been quick to identify and adopt the benefits of NFTs. Musicians are using the tokens to modify traditional copyright ownership. Ditto Music launched an NFT exchange on its Bluebox platform that allows artists to auction NFTs holding a percentage of the copyright in select releases [4]. Once these NFTs are sold, the new owners will be entitled to receive monthly royalty payments for the respected work to their Bluebox wallet. This allows fans to invest in their favorite musicians early on in the artist’s career and be rewarded for later success.
Visual artists have similarly capitalized on the ability to profit from NFTs. In March, a collection of artworks created by digital artist, Beeple, sent shock waves throughout the art world when it sold as an NFT for a whopping $69 million at a Christie’s fine art auction [5].
The applications of NFTs are poised to shake up tangible property in the future. As noted by Andreas Park, associate professor of finance at the University of Toronto, “You could tokenize almost anything if you have a legal structure that would have a formal guarantee for something that isn’t living in the digital world that can be linked to a token” [6].
We may soon see NFT applications disrupting the offline world. This could include the purchase of cars and other transportation, where parties engage in a shared ownership structure. Cars purchased as NFTs would enable each designate to receive a percentage ownership in a vehicle, creating a new shared ownership model for cars that are not needed by their owners 24/7 [7].
NFTs may also extend to real property, where home owners can mint tokens to include descriptive and legal data about their property [8]. Currently, land owners are dependent on registries maintained by third parties, like government agencies, to record ownership and land description. Recording NFTs on a blockchain could eliminate that model by allowing an individual to prove ownership using a cryptographic secured digital token of authenticity.
LEGAL CONSIDERATIONS AROUND NFTS
The mass adoption of NFTs brings a myriad of potential legal potholes. First and foremost is a lack of understanding from consumers of exactly what is being purchased. In the case of a piece of art, the purchase of an NFT representing an artwork, does not, in itself, translate to the purchase of the underlying intellectual property (IP) rights in that artwork, for the sale only provides the owner with a version of that work. Smart contracts must define the ownership of IP rights and consumers must become aware of exactly what they are buying, including the rights that are acquired in the transaction.
Another area of consideration lies with the sellers of NFTs. Anyone is free to mint a token, which may mean that forgers can exploit the digital space, much like they have in the tangible art world, to represent a work from a well-known artist when in fact the work is a forgery or replication of the original. There exists a real and present danger that some buyers lured into NFTs by their popularity may lack the sophistication to perform adequate due diligence prior to buying into the latest craze. The principle of caveat emptor is paramount in NFT transactions. Forgeries are bound to make their way to the market as are other malicious actors reaping the vulnerabilities of a new and prolific marketplace.
There is also the question of tax regimes. The purchase of an NFT may create obligations to pay sales tax, but which jurisdiction should receive that tax may not be apparent at the outset. The purchase of an NFT at $69 million, like the work sold by Beeple at Christie’s, can create some serious sales tax obligations. Sales tax is usually owed in the purchaser’s jurisdiction but this may not be contemplated during a transaction in the digital sphere – a nasty surprise for buyers who think that the crypto market is out of reach of the tax man.
Governments across the world have wrestled with the best methods to address these types of concerns and protect citizens transacting in cryptocurrencies. Cryptocurrency exchanges have become a key priority for securities regulators as of late, partially due to the new popularity of NFTs.
In late March 2021, the Canadian Securities Administrators unveiled new guidance on how cryptocurrencies should be regulated (the “Guidelines”). The 56-page guidance document clarifies that existing securities legislation applies to all cryptocurrency service providers operating in Canada. The Guidelines mandate that cryptocurrency exchanges register as investment dealers and become members of the Investment Industry Regulatory Organization of Canada (IIROC), which would subject them to the same rules as offline (traditional) investment dealers [9].
In tandem with the Guidelines, the Ontario Securities Commission issued a warning to crypto trading platforms operating in the jurisdiction that failing to bring their businesses into compliance by the deadline of April 19, 2021, will face regulatory action [10].
These government actions mark major steps towards imposing a legal structure in this space, however, it is far from the final measures that will be taken by Canadian jurisdictions to regulate cryptocurrency platforms. Given the vast potential for innovation with NFTs, with many applications still yet to be determined, a proposed legal framework must mirror the technology it seeks to regulate and undergo its own upgrades to adapt to the world of the digital token.
Article by: Jennifer Davidson and Imtiaz Karamat
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[1] Dean Takahashi, “Warriors’ Steph Curry will auction off celebrity CryptoKitties (updated)” (7 May 2018), VentureBeat GamesBeat, online at: https://venturebeat.com/2018/05/07/warriors-steph-curry-will-auction-off-celebrity-cryptokitties/.
[2] Calum Docherty & Christian McDermott, “NFTs: A Beginner’s Guide to Understanding the Hottest Crypto Craze” (19 March 2021), JD Supra, online at: https://www.jdsupra.com/legalnews/nfts-a-beginner-s-guide-to-4385470/.
[3] Jeremy Goldman, “A Primer on NFTs and Intellectual Property” (11 March 2021), Frankfurt Kurnit Klein & Selz PC: IP & Media Law Updates, online at: https://ipandmedialaw.fkks.com/post/102gt4b/a-primer-on-nfts-and-intellectual-property.
[4] Carly Kessler, “NFTs Are Reshaping Artists’ IP Rights” (24 March 2021), Bloomberg Law, online at: https://news.bloomberglaw.com/us-law-week/nfts-are-reshaping-artists-ip-rights; Tim Ingham, “Music Business Worldwide: Why Non-Fungible Tokens Could Transform Who Gets Paid From Music Rights, And How” (18 March 2021), online at: https://bluebox.info/music-business-worldwide-why-non-fungible-tokens-could-transform-who-gets-paid-from-music-rights-and-how/.
[5] Christie’s, “Beeple’s Opus”, online at: https://www.christies.com/features/Monumental-collage-by-Beeple-is-first-purely-digital-artwork-NFT-to-come-to-auction-11510-7.aspx.
[6] Salmaan Farooqui, “‘There’s literally no limit’: NFTs could soon be used for cars, real estate: Experts” (6 April 2021), Toronto Star, online at: https://www.thestar.com/business/2021/04/06/theres-literally-no-limit-nfts-could-soon-be-used-for-cars-real-estate-experts.html.
[7] Ibid.
[8] Natalia Karayaneva, “NFTs Work For Digital Art. They Also Work Perfectly For Real Estate.” (8 April 2021), Forbes, online at: https://www.forbes.com/sites/nataliakarayaneva/2021/04/08/nfts-work-for-digital-art-they-also-work-perfectly-for-real-estate/?sh=6d9be13243f3.
[9] “Securities regulators publish guidance for cryptocurrency asset trading platforms” (29 March 2021), The Canadian Press, online at: https://ca.finance.yahoo.com/news/securities-regulators-publish-guidance-crypto-175610782.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAAI0cuDpPmwQma1NnPeDJ79YqvflNVlJcYzqzmpTddP_cG5YISJj2UJMav_cf-56DnSQJbbQWpL1ETBeVTFDTWkHVunbh8onELEyiX0NV_xaLUkZ_YfkxjeMoMOapHVP6PvCN3LB6ohb_4a7Kvovi9Cc_h1X7ddXJL_BqeJxTGN5.
[10] Ibid.
This article originally appeared in the OBA Insider on May 1, 2021.
