About Non-Fungible Tokens (NFTs) - 10 Leaves

All about Non-Fungible Tokens – NFTs

Non-fungible Tokens, or NFTs, have gained significant attention ever since the big-ticket Beeple sale at Christie’s. While Cryptokitties made a noticeable debut way back in 2017, the NFT space exploded in 2021, with transactions reaching all-time records.

The UAE too had it’s share, with the DIFC coming up with NFT exhibitions and Emirates Post issuing an NFT stamp collection to celebrate the Year of the 50th.

While a lot of the NFT talk centers around art and collectibles, non-fungible tokens have many interesting applications in the digital and the real world. There are also many questions raised on regulation (if any) that currently exists for NFTs and mechanisms for solving legal disputes that may arise.

 

 

What are NFTs?

In short – something unique, or that which represents something unique, recorded on a blockchain.

NFTs are created using smart contract protocols on blockchains and stored on digital wallets. Each is uniquely identifiable and one cannot be exchanged for another (funged) with the exact same characteristics.

Currently, ERC-721 is the leading protocol used to mint (create) NFTs, with Ethereum and Flow being the leading blockchains in the NFT space.

What is a token?

The DFSA defines a token as a digital representation of value, rights and obligations that are created, stored and transferred electronically, using distributed ledger technology (DLT) or similar technology.

Generally, crypto assets depend on cryptography and distributed ledger as part of their perceived or inherent value. They are created, stored and transferred using a DLT application, using:

  1. An address,
  2. a public key corresponding to that address, and
  3. a private key, also corresponding to that address.

From a legal standpoint, tokens represent control of the underlying asset (not necessarily ownership).

Types of NFTs

Digitally-native: These NFTs are inherently digital and do not represent real-world assets. These include collectibles, in-game assets, digital artwork etc.

NFTs representing other assets: These tokens have links to real world assets such as art, property, vehicles, diamonds etc.

How to integrate NFTs into a business

  1. Identify the NFT use case – What will the NFT be used for? Some of the popular and early-adopter use cases have been in art and collectibles such as CryptoPunks (a limited edition of 10,000 unique characters) and the Bored Ape Yacht Club. The NBA made it’s maiden foray into the NFT space through the NBA Top Shot NFT collectible series.
  2. Determine the appropriate blockchain – NFTs are usually built on top of a single blockchain and so factors to consider include transaction cost, available ecosystem of applications and degree of decentralization. It may also be required to create the NFT on multiple blockchains, given the limited interoperability between chains at present. The leaders in NFT activity are Ethereum (including adjacent blockchains or 2nd layer networks) and Flow (NBA Top Shot).
  3. Mint the NFTs – cryptographic key is used to create a token on the BC that represents a price of digital media (name, description and edition size) – find providers who mint according to custom smart contracts.
  4. Decide storage – either minted to contain digital content file or a reference to the digital content. NFTs can be stored either directly on the blockchain, using decentralised storage solutions like Arweave or centralized storage, such as normal cloud storage providers. Minting the NFT directly on the blockchain ensures that the NFT is truly “immortal” (or at least until that protocol is active), however, the costs and energy required for this effort are substantial. Using other means of storage usually means that the NFT “points” to the digital file, much like an address, and so the lifetime of an NFT is dependent on the cloud storage provider.
  5. Store and access securely – There are multiple options for storing NFTs. They are held in digital wallets that can be non-custodial unrestricted (your own wallet in your control), non-custodial restricted (in a limited ecosystem), custodial (with third-party providers) or on-platform only (limited to platform ecosystem only). OpenSea and SuperRare integrate non-custodial wallets, which means that custody of the NFT is customer responsibility.
  6. Distribution – There are multiple marketplaces that can be used to distribute NFTs. Some considerations when choosing a marketplace to host NFTs include if they allow purchase with fiat or virtual currency, whether they allow card payments, and the audience that the platform has access to.

NFT Marketplace

Types of marketplaces include open marketplaces (usually non-custodial), crypto-native curated marketplaces (approved creators and non-custodial), closed NFT marketplaces (that have their own storefront and branding, and take custody of NFTs, and white-labelled marketplaces (given that creating own marketplaces cost a lot).

  1. Engagement – NFTs can be traded based on increase in their perceived values. However, there are many other use-cases that can unlock more value with the NFT community. Some of these include using NFTs to create a loyalty or incentive mechanism to reward certain behaviour and gamification as well. NFTs can enable the closed community of fans to vote on outcomes within that community and earn rewards and experiences. They can also be used to collate fan data, without compromising on the identity of these fans, thus gathering important information with data-protection built into this functionality.

Legalities around NFTs

1. Intellectual Property – who owns the NFT, and who owns the copyright?

Arriving at the provenance of assets is made easier through the use of NFTs, since they are created on blockchains that support programmable smart contracts. Accordingly, NFTs may be protected by software copyright in the jurisdiction of creation of the NFT. When the NFT is only a proof of ownership or title pointing at a real-world asset, this proof cannot be altered, thereby providing protection to its legal owner.

Trademarks are treated similarly, since the origin of the NFT is encoded onto the blockchain. The same goes for patents.

Most big brands have already made the move to extend their trademarks to digital assets, as part of the overall move towards making forays into the metaverse.

2. Contractual terms

The rights of the creator of the NFT can be protected in many ways. Naked NFTs are becoming popular, where the NFT is sold without IP rights to the underlying work attached to it. The rights attached to the underlying artwork such as copyrights, trademarks or other intellectual property rights remain the sole property of either the marketplace itself or the NFT creator. This helps the creator to derive residual value from subsequent transfers of the NFT.

As with other IP, owners can be restricted from commercial use or selling derivative products of the underlying artwork.

Regulation of NFTs

There does not exist a comprehensive regulation around NFTs yet, given that they can represent anything from a piece of digital piece to a physical asset. Accordingly, NFTs can be classified as Security tokens, or utility tokens, or others, depending on the nature of the asset and the rights it confers on token holders.

Dubai International Financial Centre (DIFC)

Security Token is defined (by the DFSA) as a token that confers rights and obligations that are:

(i)  the same as those conferred by a share, debenture or futures contract (Investments); or (ii)  substantially similar in nature, purpose or effect, to those conferred by Investments.

In effect, a Security Token is a token that behaves as a security (equity, debenture, convertible, future, option etc.) and is hence considered by the DFSA as a specified investment.

Utility tokens, on the other hand, usually represent some rights in a closed system and mostly fall outside the purview of regulation. This slight loophole led to a lot of Security Token Offerings (STOs) masquerading as Initial Coin Offerings (ICOs), by avoiding the classification as a security token and purporting the rights to future utilities, without the company even being in existence at that time.

This is the reason why most regulators start with the definition of the token, and evaluate it based on substance, and not form. The first part of DFSA’s Digital Assets Regime covers security tokens, and the second part of the regime is expected to cover utility tokens, payment tokens (crypto) and fiat tokens (stablecoins). NFTs would ideally fall under security tokens or utility tokens, based on this classification.

Abu Dhabi Global Market (ADGM)

The ADGM Virtual Assets framework define a “virtual asset" as a digital representation of value that can be digitally traded and functions as

(a) a medium of exchange; and/or

(b) a unit of account; and/or

(c) a store of value.

The definition does not include “representation of ownership” and hence NFTs may not come under the purview of FSRA Regulation.

Emirates Security and Commodities Authority (SCA)

The current Crypto Asset Regulations issued by the Emirates SCA captures NFTs that are Security Tokens or Commodity Tokens (i.e. traded on exchanges). Accordingly, NFTs traded or brokered on marketplaces that operate in a peer-to-peer fashion may not be covered under the current regulations. There may be AML requirements however, that would need to be adhered to by market participants.

Setting up an NFT-related business in the UAE

As we have seen, the NFT-space is still very nascent. NFTs can be used in a variety of applications, and we anticipate that developing a locally-grown NFT marketplace may be an interesting business for the region. Collecting and trading of NFTs can be another business that brings with it many auxillary services such as valuation, custody and the like. It is too early to fully understand the extent of the potential applications centered around NFTs, and we encourage a continuing dialogue to keep up to speed with developments.

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