Let’s talk Non-Fungible Tokens (NFTs)

Jan 25, 2022 | News

A look at the regulatory and legal challenges to NFTs and Non-Fungible Assets in general

Before delving into the regulatory and legal challenges related to NFTs it is necessary to define NFTs as a concept.

An NFT represents a digital or physical asset (such as a photo, video, audio file, or painting) and is created and stored on a blockchain (most are part of the Ethereum blockchain). Ethereum (“ETH”) is a cryptocurrency, like bitcoin or dogecoin, but its blockchain also supports NFTs, which store extra information which sets them apart from ETH coin for example.

NFTs are one of a kind and have an identifiable chain of possession that allows them to maintain value and be traded as collectible items (similar to a piece of artwork or a trading card). Hence, “non-fungible” which more or less means that it is unique and cannot be replaced with something else. For example, a bitcoin is fungible – trade one for another bitcoin, and you will have exactly the same thing, whereas a one-of-a-kind trading card is non-fungible.

In other words, NFTs are digital or physical assets that derive their value and individuality from their provenance which is stored on the blockchain. Therefore, while the whole world might have access to a photo or a meme, a minted[1] NFT will derive its individuality and value from its provenance stored on the blockchain. For example, the Mona Lisa hanging in the Louvre derives its value and individuality from its certificate of authenticity and recorded (physical) provenance. This is what sets it apart from the Mona Lisa you get at the gift store as a souvenir. In the case of NFTs, their provenance or certificate of authenticity is recorded on the blockchain which is a digital medium.

According to CBInsights, funding for NFT companies topped $1 bn for the first time in the third quarter of 2021, up 6, 427% year to date. In addition, major auction houses such as Sotheby’s and Christie’s have entered the fray with, Christie’s auctioning off a digital collage created by the American artist Beeple, in March this year, for $69.3 million. While the prominence of the NFT market might be a little while away, there is no doubt that NFTs are here to stay.

Now that we have an understanding of what an NFT is and the rights and values which accrue as a result of minting an asset, let’s turn our attention to the regulatory and legal challenges to this burgeoning industry.

While there are numerous advantages that NFTs bring to digital transactions and activities, there are several legal, regulatory, environmental, and operational challenges that must be overcome for businesses and organisations to take full advantage of this potentially game-changing technology.

Intellectual Property

At present possession of an NFT does not automatically grant ownership of the underlying asset. An NFT merely grants the holder the right to use the creative output or object it represents for their personal use. For example, if someone buys an NFT tied to a painting, he or she merely has gained the right to display the digital art in their token wallet. They will not have the right to reproduce, create derivative works, or sell prints or copies of the painting. From a copyright perspective, an NFT is simply a digital receipt indicating ownership of a particular version of the asset.

Given the lack of regulation of NFTs, criminals have already found ways to use them to steal intellectual property. Several prominent digital artists have seen their work sold as NFTs without their permission and have voiced concern that once their digital art has been hijacked and inscribed in a blockchain-enabled token, they will lose ownership over their work. The problem being the inherent difficulty in proving the place of origin of a piece of digital art places NFTs in a legal grey area.

Jurisdictional Issues

A principal idea behind the blockchain technology that underpins NFTs is that the ledger is not centrally located or managed. While this makes it near-impossible to reverse-engineer or fabricate transactions, it also poses a complex jurisdictional challenge, as the lack of a specific governing locale makes it subject to different and often conflicting legal frameworks. The problem posed by conflicting laws is especially important from the perspective of copyright.

Smart Contracts

One of the most striking features of blockchain technology and NFTs is the self-executing “smart contract’. Smart contracts are rights and obligations which are specified in a digital format that forms the basis of the parties agreement. Owing to their inherent uniqueness and complexity, it is difficult to say whether smart contracts fit into the legal framework governing traditional contract law.

Consumer Protection

NFTs raise significant issues related to consumer rights. Issues such as assigning permission and responsibilities for recording transactions, the legality of digital receipts, while anti-fraud and anti-money laundering procedures are of vital importance as many consumers have little conceptual understanding of what they are buying, the rights, and responsibilities, and complexities in relation to NFTs.

One can anticipate further legal, financial and logistical challenges, which will need to be addressed before NFTs become universally accepted. For example, most NFT transactions involve cryptocurrencies that are not legal tender in South Africa and are not backed by any central issuing authority or inherently valuable asset. Cryptocurrencies are regulated by individual states and presently there is no protection available to consumers in the event of fraud for example.

It is important, therefore, to consult an attorney before creating, launching, or buying an NFT as the regulatory framework is still evolving. They will be able to assist.

Article by Nick Roelf with input from Fairbridges Wertheim Becker’s corporate and commercial department.

[1] “minting” is the process of turning digital art into a part of the Ethereum blockchain.