Non-fungible tokens: NFTs and the silence of the EU legislator

Hogan Lovells – FinTech Perspectives

You might expect that the European Commission, eager to act as an innovative regulator, would have non-fungible tokens, NFTs, firmly on their radar and to have dedicated a relevant part of its regulation for cryptoassets, MiCA, on this important phenomenon. Surprisingly, this not the case. MiCA specifically excludes NFTs from its scope and does not provide an answer to any legal question that they entice. This edition of FinTech Perspectives, looks into the legal implications of NFTs that deserve the legislator’s attention. Before doing so, we will briefly outline the rise of NFTs and re-visit the main characteristics and some of the most relevant use cases.

There is no question that non-fungible tokens are on the up. Global transaction volumes in NFTs have just crossed the US$ 10 billion line; Mike Winkelman’s “Everyday: the first 5000 days” scooped US$ 69 million at Christie’s and the NFT-based play-to-earn game, Axie Infinity, is set to generate a turnover in excess of US$ 1 billion by the end of the year. But it’s not limited to art and games. Supply chain solutions for industrial products as well as proof of provenance for precious goods are being built on NFTs. Considerations for further applications are wide ranging, from securing sensitive data, to managing digital rights and legal documents.

What are NFTs and how do they function?

An NFT is a blockchain based, cryptographically secured digital token. As with any other such token, it tracks and records its transfer history on a distributed and therefore de-centralized ledger. As opposed to other types of digital tokens, however, each NFT is one-of-a-kind – and therefore “non-fungible” by definition. Each NFT refers – by way of encryption on a blockchain – to a distinctive “object”, be it a digital, physical or a more abstract object, like a contract, a business relationship or a set of data.

There are a number of blockchain standards that enable the creation of NFTs, including Cardano or Wax. Yet the most important standards are still based on Ethereum which brought NFTs to  prominence in the first place: see standards ERC (Ethereum Request for Comments) 721, ERC 1155 and their modifications. Among the differentiators of the various standards are aspects such as:

(1) how many NFTs can be created (“minted”) at a time?,

(2) how easily can they be tied to a complex smart contract such as a digital rights management tool?,

(3) which payment model can be built in? or

(4) how transparently can they reveal any relevant meta-data?

Just as with other cryptoassets, NFTs can be held in digital wallets (programs that track the user’s account holdings on a given blockchain) and traded on a number of NFT-specialized marketplaces, such as OpenSea (large and all-embracing), Rarible (particularly feature rich), NiftyGateway (with specific digital rights management options), Enjin or Wax (both with their own comprehensive ecosystems for NFTs).

What are NFTs used for?

As set out in the beginning, the field of application for different types of NFTs is extremely wide and versatile. Some of the most prominent use cases are:

NFTs are not limited to digital images though. Damian Hirst’s “Currency” art project is a collection of 10,000 dot-filled papers that were each turned into a separate NFT, and Bansky’s print “Morons” (“I can’t believe you morons actually buy this shit”) was hooked on an NFT before its subsequent sale.

Why do buyers pay millions for an NFT of an image – whilst the image itself can, in most of the cases, easily be downloaded and enjoyed for free (see all the above links – that grant full access to all the actual images sold as NFTs for millions)? One of the main reasons for this phenomenon is the (attractive feeling of) scarcity that the NFT creates. Unlike the digital file of the image, which can be multiplied without limits by just anybody, the unique NFT belongs to only one owner. The singularity of the NFT (and the feeling that this stimulates) sets the NFT’s owner apart from anybody else who may access the related work – but without the joy of holding a cryptographic token for it.

  • Digital Rights Management: Just as with any image, almost every other piece of art can be represented by an NFT, be it music, text or video. In these cases, it is less the transfer of ownership but rather a royalty scheme for the consumption of its content that is intended.

The Ethereum blockchain that brought NFTs to prominence, also gave birth to what has become known as “smart contracts”. Smart contracts are not contracts in the legal sense – they are a piece of self-executing, immutable computer code. Quite typically, a payment is triggered in response to some activity, such as, for example, the download of a file or its sharing with others.

The combination of NFTs with smart contracts is powerful. It allows the tagging of a piece of art to an NFT, automatically triggering a royalty payment for the artist (or any other person) under certain circumstances.  The consequences are far-reaching. Whereas traditional forms of Digital Rights Management rely on platforms, NFT based DRM systems do not need these platforms, at least not to the same extent. The smart contracts attached to it, are setting the rules of use, and also execute upon them. So, no third party platform or digital rights management is required any more to realize and follow up on the transaction. Clearly, taking platform operators out of the game alters the equation for digital rights management quite significantly.

  • Gaming:Axie Infinity” is a trading and battling game that allows players to collect, breed, raise, and trade creatures known as "Axies". Each Axie is represented by an NFT. Taking all these Axie NFTs together, their collective value stands at US$ 7.5 billion.

As is the case with Axies, NFTs can typically be used as in-game-items, allowing players to create, shape and trade them. So where is the advantage to using NFTs – in comparison to traditional in-game-items that have been around ever since computer games have come into existence? Yet again, NFTs remove the need for platforms that provide the infrastructure and keep the game going. The rules of the game, including the handling of any in-game items are enshrined in the NFT’s smart contract, so no further supervision is typically needed.

  • Precious goods: Having launched with diamonds, firms like Everledger, IceCap and others currently tokenize all sorts of precious goods, such as gemstones, wine, watches or luxury fashion items. The link between the physical product and the NFT relies on different technical solutions such as Radio Frequency Identification or Near Field Communication (for more demanding solutions), QR, bar or other codes (for more simplistic applications) – or the creation of a detailed product specification, ie a digital product profile (for highly individualistic products).

Tagging a physical object with an NFT may allow better documentation of the ownership and authenticity of any valuable item. To put it differently: it may be less risky to purchase an NFT backed product on a secondary market, and there may be less need for depreciation or risk discount accordingly. Values may be preserved more easily down the distribution line.

There is a challenge though. Unlike with digital goods, any tagging of a physical objects with an NFT requires a person or organization (or another system) that performs and maintains the link between the product on the one side, and the NFT on the other side. Accordingly, these specific NFTs will typically not fully function without relying on at least some support to track this link. Accordingly, it will be difficult for this specific application to remove all need for intermediation and to achieve the same level of decentralization as for other NFTs.

  • Supply Chain Management: Driving quality, efficiency and compliance of all relevant parts and processes of a production line is a critical objective for all supply chain management. Data accuracy, proof of provenance and transaction documentation are vital in this context. Any increase in transparency typically leads to stronger confidence and thereby higher appreciation by any stakeholder, including customers, end-consumer and the general public.

Every component part of a complex product - and in fact its entire documentation and (contract) history - can be tagged with an NFT. This allows the tracking of any such part before and after its integration into a machine, pharmaceutical or consumer good. This field of application is still in progress and time will tell whether NFTs will become as relevant in supply chain management as in other areas. Should NFTs ever take off for supply chain management, they may usher in a new level of compliance and awareness – through ever greater visibility of any given product’s processing and production history.

Legal questions to be addressed

The EU’s draft Regulation on Markets in Cryptoassets, MiCA, specifically excludes NFTs from its scope. Article 4 (2) provides that issuers of “crypto-assets that are unique and non-fungible” do not need to publish or register a white-paper for them. For NFTs, therefore, no rules about their functionality and reliability need to be set out in public. That may make sense for some NFTs given that a white paper is hardly feasible for the creation of every singular token.

However, the latest version of the draft of MiCA does make it clear in the recitals that the fractional parts of NFTs should not be considered unique and would therefore be subject to MiCA. The latest draft of MiCA also states that the proposed Regulation should explicitly apply if the NFT grants to the holder or its issuer specific rights linked to those of financial instruments, such as profit rights or other entitlements. In these cases, the tokens may then be assessed and treated as “security tokens”.

The EU legislator’s approach to NFTs is simplistic and leaves all the relevant questions without an answer. Some of the most pressing ones are these:

  • Regulatory regime: For most cryptoassets, it is as important as it is difficult to define their legal nature and apply the corresponding regulatory regime. Does the specific cryptoasset at issue qualify as a financial instrument, security or e-money? Which money laundering, tax and market regulations apply? Finding good answers to these questions is difficult for most cryptoassets – but it is particularly so for NFTs.

In all likelihood, an NFT that represents a single object and isn’t tied to any sophisticated smart contract – like an NFT for an individual diamond – will not qualify as a financial instrument and in particular not as a “transferable security”. Yet the answer is much less clear if the NFT is structured in a more complex way. What about:

(1) a fractional NFT, for example an NFT for a diamond that is split into 4 equal parts that can be traded separately?
(2) an NFT for a fully commoditized product, such as a specific quantity of a raw material?
(3) an NFT that is used as collateral, and therefore a security, for another financial transaction?
(4) an NFT that entitles to be redeemed in fiat currency (“real money”) – and may thus qualify as e-money?

In all these cases, various financial services regulations may apply. It is unfortunate to have a regulation for cryptoassets, like MiCA, that simply remains silent on these highly relevant questions. It leaves the issuance of NFTs with significant uncertainty. All the more so, as many if not most NFTs are tied to a smart contract that is used to enshrine certain payment rights. This will therefore always place them at the brink of any financial services regulation.

  • White paper exemption: In many cases, it makes sense that MiCA exempts issuers of simple NFTs from the obligation to publish a white paper, ie a document that sets out the functionality and workability of a blockchain based token. Yet the situation is different if a bigger number of NFTs is created in a uniform style and on the basis of the same rules. For example: why should the, sometimes extremely expensive, game characters like Axies be exempted – as they form part of a highly commercialized system of similar NFTs  (which is the reason that Axie Infinity is actually supported by some sort of white paper). In such cases, consumers have just the same interest in protection, and therefore in the publication of a white paper, as with regard to other cryptoassets.
  • Ownership: the question of ownership of NFTs is also significantly more complicated than for other cryptoassets – and thus deserves the legislator’s attention. Who is the owner of an NFT for an artwork that was tokenized without the author’s permission? Who is the owner of an NFT that the author created subsequent to the sale of a first NFT for the same object? In fact, fraud prevention and various cases of “double-spending-problems” can easily occur for NFTs. It is almost an irony that those cryptoassets that are most suitable for fraudulent activities are the least regulated by the current MiCA draft.
  • Royalties: As we have seen, smart contracts are pieces of computer code that are self-executing. It is worth noting that the smart contracts linked to NFTs typically leave some room for circumvention by “smart users”. For example, the licensee of an NFT-backed piece of art may put it in another wallet that may not support the NFT-based royalty scheme. Likewise, the purchaser of an NFT may re-token the artwork and thereby disassociate it from any of the author’s ongoing payment rights.

As diligently as the EU legislator addressed similar situations in the context of its previous copyright legislation for digital rights, it would need to address it once again for the novel situation of NFTs.

We will continue to discuss these issues and help shape the collective understanding of how to approach them in future editions of our FinTech Perspectives.

Authored by Leopold von Gerlach and John Salmon

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