The guide to NFTs – sold as an NFT

What is an NFT?

We suspect that if you’re reading this, then you’ve probably at least heard of Bitcoin or Ether before.

What about tokens? Somewhere across the internet (or life, but probably the internet) people may have used the term ‘token’ to describe cryptocurrencies like Bitcoin and Ether. It’s understandable — but it’s not strictly true as there are some differences between tokens and cryptocurrencies like BTC and ETH.

Popular cryptos such as BTC and ETH run on their own blockchain. Conversely, tokens are native currencies which are created/distributed as part of projects which piggyback off another blockchain. Those projects effectively use that particular blockchain as a host instead of running off its own mainnet. Oh, and it’s important to remember that tokens issued on the blockchain are digital representations of a wide range of assets — you can’t physically touch these assets because they live in the digital world. In fact, cryptos like BTC and ETH are exactly the same. But you already knew that.

The Ethereum blockchain is a real hotspot for these types of projects: Dapps (or if you’re really mad at it you can call it by its full name, distributed apps).

You may have heard this one really cool feature of blockchain tech — that it provides real transparency over the process of recording transactions. We say real transparency, because once you upload information on the blockchain, it’s there until the end of time for everyone to see and gives some serious meaning to #nofilter. But there’s another cool thing that the Ethereum blockchain is known for: smart contracts. Without smart contracts, there are no Dapps, and honestly, what’s a world without Dapps?

Here’s another piece to the Ethereum/Dapps puzzle — there are a bunch of different computers around the world called validators which are given the job of validating all transactions that go through the blockchain. This job is very energy intensive so anyone who participates in keeping the (blockchain) community thriving is given an incentive to do so. Enter tokens.

When a validator — let’s call it Bob — validates a transaction, Bob gets given a reward for carrying out that task. This reward is in the form of the native cryptographic token of a particular project. If, for example, Bob participates in validating a transaction for the Uniswap protocol, it’ll receive UNI tokens in return. Likewise, if it does the same thing for another project, say ChainLink, then it gets LINK as a reward. Both UNI and LINK are fungible tokens — tokens which are interchangeable with other assets of a similar type. Say, for instance, you’re hanging out with a friend at a restaurant, you both have some dinner and a few bevs, and the waiting staff wants to kick you out because it’s closing time so they subtly hint at you by coming over with the card machine. To make things simpler, you pay for the bill using your card, but then straight after, you ping over a ‘split the bill’ request on Monzo to your friend. Your friend could decide to transfer the money to you in one go — but they could equally decide to pay you in 2 separate payments. The value of what they send to you to pay for their half of the bill doesn’t diminish because of the separate payments. In fact, they could, in theory, pay you in 10 separate payments and the value would still be the same. This is what we mean by fungibility.

There is another set of tokens however, which don’t quite work in the same way: the non-fungible token or ‘NFTs’. These tokens derive their value from their uniqueness, or as they’re widely known by the mainstream press, their capacity to become a sought-after collectible — think Fabergé egg; think Pokémon cards; think old school comic book collectibles… but digital. You can’t split these assets into different parts, nor can you exchange it for another type of asset. If you did, it just wouldn’t have the same value. It would be like claiming that the pristine 1938 Action Comics №1 copy that sold in 2014 for $3.2million is the same as a non-pristine copy, or is the same as a copy of Action Comics №2… just, no.

Collectibles can be fun, exciting, and owning a rare item on a very basic level, does things to human psychology. But there are other use cases for NFTs too, which is explored below — don’t worry though, as we’ll briefly touch on some other fun examples in the collectibles space too.

Applications

Non-collectible use cases

1. Certified Documents. Certificates can be faked, and sometimes they’re so good that you can’t even tell they’re counterfeit. Uploading certification details on the blockchain and checking the NFT distributed against that information is a great way to ensure a certificate’s eligibility.
2. Sports. Similar to certificates, fraudulent sports ticket sales have been an issue for some time. Ticket sales by way of NFTs helps to make sure that fans are getting genuine tickets, which they can verify on the blockchain. Additionally, there are also collectible use cases for sports from digital collectibles to NFT-backed sports fantasy games.
3. Loyalty Points. The concept of reward tokens isn’t new — McDonald’s, for instance, gives you a loyalty card for hot drinks. 6 stickers on your loyalty card and you can go get yourself a hot drink on the house. These cards can be easily misplaced though. The loyalty points NFT use case isn’t particularly looking to do anything novel — it just means that if your loyalty points are distributed by way of NFTs, you can’t misplace your points because it’s already on the blockchain, which you just can’t really lose.
4. Art. And Memes. Do Memes count as art? A self-portrait of Sophia the Robot created in collaboration with Italian artist Andrea Bonaceto recently sold for nearly $700,000. Plus, the Overly Attached Girlfriend meme recently sold for $411,000. Yup, you read both correctly. A robot and a meme. Literally.
5. Music. Lindsey Lohan recently partnered with Tron to release her new single “Lullaby” by auction. Not long before that, Kings of Leon released their album “When You See Yourself” as NFTs. They released three types: one which represents a special album package, one which offers advantages during live shows such as front-row seats, and another which represents exclusive audiovisual art.
6. Fine Wine. OpenSea, a marketplace for digital collectibles, has brought fine wine trading to its platform. It allows participants to trade fine wine via NFTs and redeem the physical bottles at the end of each sale.

Intellectual Property

When you buy a book, you do not expect to own the copyright in the literary work which is between the covers. All you have is the physical copy and, under a copyright concept called “exhaustion”, you can sell that copy without any need to obtain the creator’s approval.

Even before you move into the world of NFTs, buying a piece of digital content is different. What you are actually buying is a licence to download/stream the content and use it in the ways defined by the licence. So, I may be able to share e-books I buy with other members of my family, if that is how the e-book system is configured but I can’t re-sell them once I have read them.

So buying an NFT is, in IP terms, like buying any other piece of digital content, in that my right to any copyright material in the NFT is defined by the licence; the difference being that with an NFT, the licence is also locked into the token and validated through the blockchain.

From the perspective of the NFT creator, it is therefore important to ensure that you own whatever you are purporting to grant a licence for. And ownership of content is not always straightforward — for example, take a music collectible NFT featuring some artwork and a sound recording. The artwork is likely owned by the creator of that art (or the person who commissioned it, if they drew up a suitable contract). The sound recording will typically be owned by the record label and the copyright in the songs which are recorded for the sound recording will be owned by the music publishers (often a song will have multiple songwriters, each represented by a different publisher). So, in order to launch the NFT, you will need deals with all of these people, all of whom will want both a commercial benefit and they may also want to ensure their creative integrity is respected.

At the other end of the spectrum, there is no reason why an NFT could not be used to sell fractional ownership of some IP rights — a form of securitisation, which will no doubt be explored in the coming weeks and months.

Financial Regulation

Although the regulation of crypto is very new, it was developed before the recent explosion in popularity of NFTs. As a result, NFTs are not specifically addressed in the current laws or policies. However, this does not mean that they are not regulated. But it also does not mean that they are regulated. #Confused? You should be!

The non-fungible character of a token will not affect its regulatory status. It is the other characteristics and function of the token that will determine if and how it is regulated.

If a token has characteristics similar to those of traditional securities, like shares, debentures or units in a collective investment scheme, it will be considered a “security token”. A token which functions as electronic money will be considered an “e-money token”. Businesses conducting activities connected to these “regulated tokens”, such as issue, sale or marketing, will be regulated by the Financial Conduct Authority (FCA) in the same way as traditional financial services providers.

If the token does not confer any rights on the owner, other than the ability to hold, buy or sell, then it will be considered an “exchange token” and will not be regulated. If the token confers rights to obtain goods or services, including rights to other tokens, it will be considered a “utility token” and will not be regulated. If a token combines the characteristics of an “exchange token” and a “utility token”, it will also be unregulated.

Most common cryptocurrencies, including BTC and ETH, are considered to be exchange and/or utility tokens and as such they are unregulated.

So where do NFTs fit in? The NFTs in the use cases discussed above (collectibles and non-collectibles) will fall into the exchange and/or utility token categories and so will be unregulated. But in theory an NFT could have characteristics similar to those of traditional securities, in which case it would be regulated as a security. It is very unlikely that an NFT could have the characteristics of e-money, as fungibility is an essential characteristic of money.

AML Regulation

In general, if a business provides the services of exchange or custody of crypto, it will be subject to the Money Laundering Regulations (MLRs). Such a business must be registered with the FCA, perform KYC checks on its customers and monitor their transactions, along with other AML requirements. “Exchange” appears to cover any business that sells cryptos to customers in return for fiat or crypto, including where the business also creates or issues the crypto. “Custody” includes a business holding crypto on behalf of customers or holding their private keys. Businesses that only provide unhosted (non-custodial) wallets or software are not subject to AML requirements.

As with the financial regulation discussed above, NFTs are not explicitly included or excluded from the MLRs. The definition of “cryptoasset” in the MLRs is “a cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically”. An NFT could fit into this definition or not, depending on its characteristics, and it appears the determining factor would be whether it is a “representation of value or contractual rights”. For example, a sports ticket would representation of the contractual right to attend the event. A digital artwork, like a meme, might not necessarily represent any value or contractual rights.

However, a recent consultation from HM Treasury on crypto regulation suggests that it views the MLRs definition as including NFTs in principle. Hopefully the position will be clarified by the regulators soon. For now, whether a particular NFT is subject to the MLRs will need to be determined on a case-by-case basis, looking at both the token itself and the business that is providing exchange or custody for it.

NFTs and Emtech Transactions

Many features of Emtech transactions that lawyers work on are features of NFTs. For example, NFTs:

1. can be programmable contracts (also known as smart contracts). They can be set up to deal neatly with the aspiration of creators to continue to benefit from the commercial life of their work. For example, the token can have terms that will automatically pay a share of future sale proceeds to the original creator. Legal takeaway — smart contracts are capable of giving rise to binding legal obligations under English (and other jurisdictions’) law. But, they still need to satisfy the traditional rules on formation of contracts (parties, entering into a bargain, intended to be enforceable against them, with terms that are clear enough to an outsider, and not offending against any mandatory rules of public policy). And, this requires some legal analysis of smart contracts (how they: split between natural language and code, deal with marketing representations, interact with laws on sale of goods, are interpreted, are signed, deal with governing law and jurisdiction).
2. overcome the question of remedies and smart contracts. Programmable contracts incorporate the transfer of value. They therefore don’t need to be “enforced” in practice through court action. Legal takeaway — remedies for deals gone south will rely less on contractual damages and more on remedies from pre-contract dealings, torts, insolvency rules and equity.
3. can be used as collateral. They therefore extend the market for alternative asset lending. There is a small but expert group of lenders already providing liquidity against (illiquid) fine art assets. NFTs are property, they can secure loans and, if they trade more frequently than physical fine art, valuations will be more predictable than in a market where few pieces are sold each year. Legal takeaway — taking security interests over intangible digital property is different to taking security interests over tangible physical property so deal documents need to be rewritten
4. are an entry point to DeFi. They can be traded and used as collateral on DeFi platforms and this will bring new participants representing different interests to sit alongside those currently dealing with fungible tokens on the platforms. Legal takeaway — this is likely to boost AML in DeFi as the art world has been through a similar process of ensuring that regulations on source of wealth are followed.

We created an NFT

We jumped on the NFT bandwagon and made an NFT out of this note on NFTs (challenge: how many times can you get ‘NFT’ into one sentence…). You can take a look at it here: That-NFT-o… NFT for sale at Mintable.app
The NFT is a digital representation of this note. What the purchaser gets is the original form document that this note came in. We should probably also mention that there’s only one of these NFTs in existence, so once one person buys it, it’s gone!

How to make NFTs (for non-techies)

Step 1: Check out your platform options in terms of minting your NFT. There are plenty of great ones out there like Rarible, Mintable, Opensea and Foundation. 

Step 2: For our NFT, we used Mintable as our chosen platform, and we chose the version which is powered by our friends at Zilliqa. Here’s Zilliqa’s website too, for good measure.

Step 3: Create and list your NFT. Mintable has a very easy to follow set-up, and it auto-generates the NFT for you — no need to be a total techie!

Step 4: Release an NFT about the fact you’ve just released an NFT to promote the fact that you’ve released an NFT. #NFTception

NB: We also worked with our other friends in the space, NFT42 about how best to launch this project, and they gave us plenty of useful advice.

PSA

This project was a collaboration between CMS (London) and the Crypto Curry Club — a huge thanks to Erica Stanford for her valuable input in this. If you’d like to get in touch with the team, you can contact us by sending an email to: crypto@cms-cmno.com for CMS, or Erica.stanford@cms-cmno.com to say hello to Erica.