Evolving Legal Issues For NFTs – Technology


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Introduction to NFTs

Throughout 2021 and 2022, Non-fungible tokens (NFTs) have
increasingly grown into public awareness. People often hear about
NFTs through collectible projects like Bored Ape Yacht Club, CryptoPunks, and World of Women. Usually, people then encounter
the hype, interest, and indignation about what exactly NFTs are
along with the corresponding potential use cases. Why have NFTs
exploded into the zeitgeist? Namely, because NFTs have the
potential to collapse the cost of verifying ownership of digital
goods, create new revenue streams and markets for artists, and
provide a sense of community built around user-defined identity.
This article aims to clear up some of the obfuscation around NFTs,
outline the evolving legal environment for NFTs, and explore their
current and potential use cases.

NFTs are provably unique digital assets, cryptographically
secured on a blockchain. Essentially, NFTs provide a potential
mechanism to secure and verify ownership of digital assets without
an intermediary. The ability to secure immutable ownership of
one’s digital assets without a third-party has implications for
cost and efficiency across industries and markets. Digital assets
can also be user-defined, leading to many different and innovative
use cases. The rapid development and iteration of NFT technology is
a catalyst in the expansion and reinvention of many digital
asset-based industries.

NFTs can take many different forms, including art, collectibles,
video game assets, membership tokens, immutable government records,
identity certifications, and digital representations of physical
objects. NFTs are tokens represented on a blockchain through smart
contracts, giving the token many unique properties and
interoperability with other smart contracts and token types.
Throughout this article, we will explore NFTs on the Ethereum
blockchain. NFTs are also hosted on other blockchain ecosystems
like Avalanche, Polygon and
Solana. Before
diving into the various use cases and projects utilizing NFTs, we
will explore fungibility vs. non-fungibility.

What does it mean for a token or any item to be fungible vs.
non-fungible? A fungible item is simply an item that is exactly
like another. US Dollars, Ether tokens, Euros, and Yen, are all
tokens (meaning here a symbolic representation of something; here
representing value), that are all interchangeable with one another.
1 dollar is always equal to 1 dollar. NFTs are everything else that
cannot be replicated 1 to 1. Any object that isn’t a 1 to 1
interchangeable replacement with another is considered
“non-fungible.” Your couch, your dog, your house, real
property, music, and art you create, all are non-fungible. The
non-fungibility of objects in the world seems an almost quibbling
definition over semantics, as this aspect of life is generally
obvious and unnecessary for us to worry about. On the blockchain
and particularly with digital assets, how to secure the
representation of an object’s “non-fungibility” is
all important.

Because computers and the internet make it trivial to cheaply
create many copies of a digital asset, it becomes difficult to
secure and demonstrate ownership of digital goods without a
third-party in place to help steward ownership of the asset. The
introduction of a third-party can eventually lead to many problems
we encounter today with digital asset ownership. Such issues
include users not owning their own data, property rights being
arbitrarily revoked by the third parties that access, security
issues when centralized servers are hacked, distribution fees when
working with third parties to sell digital goods, and increased
costs in having to pay intermediaries to verify ownership. NFTs
were created first on the Ethereum blockchain in an attempt to
solve these problems and provide decentralized, immutable ownership
of digital assets. How exactly does decentralized ownership work in
practice?

Simply defined, an NFT is a smart contract with metadata,
representing a token, hosted on a blockchain. An NFT must have a
certain set of properties, defined as a “token-standard”
that allow the NFT to interact with other smart contracts and NFT
marketplaces, like Opensea, Rarible, and LooksRare. NFTs also possess programmability,
allowing different attributes to be customized by the creator.
These attributes include verifiable randomness of traits, power
levels of characters, and stats for in-game items. NFT traits are
instantly viewable and verifiable on NFT marketplaces, which can
seamlessly interact with the smart contracts the NFTs are created
from. NFT marketplaces are essentially interfaces that use
blockchain technology to allow any NFT to be bought and sold,
without the marketplace having to hold or steward the assets. NFTs
also have corresponding metadata which describe what the underlying
asset is, often hosted on decentralized file hosting services like
IPFS, FileCoin, and Arweave. The
metadata underlying an NFT is key to how marketplaces are able to
show aspects of the NFT to the user. What allows the
interoperability of NFTs is the smart contracts they are built
with.

NFTs are defined by the
ERC-721
and ERC-1155 token standards. ERC-721 is a smart
contract standard that represents unique ownership, while the
ERC-1155 introduces aspects of fungibility. To not get too bogged
down in the specifics, an ERC-1155 allows multiple, fungible
versions of a unique asset to be created. This is very useful in
the case of content creation and in virtual video game assets,
release of a music album, or for making batched transactions more
efficient. Each standard has been linked above for more
information. Token standards provide the minimum functions a token
requires to be considered an NFT. It is important to note that the
standard implementation is often just the start, as these assets
can be customized and created with different abilities according to
user needs. Examples include programming an art-drop NFT with
royalties for the creator, enabling air-drops to a community where
the NFT is the access token, and allowing users to create
derivatives of an NFT based on the metadata.

What types of NFTs are currently being created? NFTs are
primarily being used for art and collectibles, such as collectible
player profile pictures (PfPs), with many projects being developed
for video game assets. However, collectibles and art aren’t the
only forms NFTs can take. The high value transactions involving
these digital assets obscure other benefits these types of NFTs
bring to their owners: identity and ownership in a community. NFTs
provide a sense of shared ownership and identity, and NFTs are
programmable and allow communities to build their own type of
organization. NFTs provide a unique opportunity for creators to
eliminate third-party gatekeepers so that artists are able to
directly control and monetize their own work.

Direct control and ownership of NFTs an individual created or
buys is a subtle and important distinction, that is often
misunderstood by many first exposed to NFTs. A common meme in the
NFT space is that anyone can “right-click save” an NFT
and have the same ownership of it that anyone else does. While
amusing, it isn’t the “gotcha” many think it is.
Anyone can take a picture of any piece of art hanging in any museum
at any time. Having a copy of a piece of artwork gives no essential
ownership rights over the original piece of artwork, just the copy
they have created. NFTs provide unique, verifiable, and immutable
proof of ownership of digitally created goods that are also
programmable by the creator. Programmability allows artists to
build-in royalties, oversee the distribution of their work, and
benefit from decreased costs in having to secure their work with a
third-party.

Now that we’ve defined different types of NFTs, we return to
the “Why?” Besides speculative activity, users of NFTs
often purchase them for a sense of belonging and identity in
various communities, as mentioned above. As our digital lives
increasingly intertwine with our physical lives, NFTs also allow
users to own their own data on the internet. When we extend
identity and personal data ownership to a community, big
possibilities begin to open up in how communities are organized and
owned by their members.

A crucial use of NFTs is in Decentralized Autonomous Organizations (DAOs),
where they serve as an efficient and automated ticketing system for
voting and membership. NFTs not only provide a membership token in
the community, but they also serve as valuable pieces of culture
that the community builds around. In DAOs where voting is
commonplace for deciding upon activities, a membership NFT provides
an immutable record of your vote on the blockchain. As these
possibilities are only beginning to be explored, there are several
other areas that could benefit from utilizing NFTs.

NFTs provide unique advantages in several different areas:
content creation, data security, membership to communities,
identity verification, and provenance for verifiably rare
collectibles. This is far from an exhaustive list of the
possibilities of the use of this new technology. NFTs have the
potential to revolutionize how artists own and collect royalties
for their work. Digital rights management can be included within
the smart contract that effectuates the NFT. They can be made
highly efficient for use in ticketing, couponing and other types of
ways of how we use digital assets with utility. For video game
communities, NFTs provide user owned assets that are not controlled
by a game company. They open the door for community-built gaming
experiences where a DAO controls how the game is developed and
updated. NFTs could revolutionize granting, licensing and
conveyance of many types of intellectual property, including
virtual titling, in that NFTs provide a secure and immutable way to
verify ownership, resistant to corruption and enabling new forms of
ownership and financial opportunity to develop. Since NFTs collapse
the cost of ownership verification to nearly zero, they provide
many small businesses around the world a way to maintain a virtual
title, free of local or government corruption.

The Evolving Legal Environment Around NFTs

Currently, few laws and regulations relate directly to the
creation, transfer, or use of NFTs. While the marketplaces for NFTs
allow the purchase of NFTs, there are important questions about the
legal status of exactly what is being conveyed and what rights are
associated with the NFT transfer. NFTs are not the thing itself,
whether a piece of art or music, a collectible or some other
digital asset, any more than the deed to your home is the actual
physical place you live. There is no real restriction on the
minting of NFTs, but the rights conveyed with the purchase should
not be assumed to include all of the IPR nor ownership of the
actual physical asset that relates to the NFT. There are no common
standards yet for what rights are associated or transferred with a
smart contract that comprises the NFT.

One area of law obviously associated with NFTs is intellectual
property rights (IPR), including copyrights, trademarks, patents,
and other rights. Having the ownership of digital goods proven as
an immutable record on a blockchain is a secure way provides proof
of rights related to a digital asset. However, the smart contracts
that enable rights to convey with the digital asset must be
programmed to transfer the rights that are being managed. Even the
transfer of digital IPR is problematic until a legal system
develops to advance the field to deal with the lack of traditional
writings required to transfer or license IPR, since smart contracts
manage the IPR (payment of royalties, for example) with no human
interference and no explicit “signed” contract.

One of the most important efforts to develop a national policy
for digital assets is spelled out in an Executive Order on Ensuring Responsible
Development of Digital Assets
, published on March 9, 2022. This
major government initiative is designed to produce numerous reports
and assessments by government regulators about what digital assets
are and how they should be regulated. Draft legislation is also in
the works so that effort could result in more definition and
clarity about what NFTs are as a means to manage IPR and other
purposes.

Because anything that can be digitized could potentially become
an NFT, there are almost no limitations on the potential utility of
these digital mechanisms to help individuals and companies to own
and manage their data and real assets. NFTs are increasingly being
used by decentralized autonomous organizations (DAOs) as a means to
join the community, mint a secure NFT avatar, adding the minting
fee to the treasury and enabling voting on DAO projects. NFTs can
also be adapted to assist records keeping for all manner of digital
assets. They can also be used as a means to verify identity and
ownership or real assets.

Blockchain technologies already are being used in Estonia to
hold and secure most of the nation’s records. For example, the
land titling system and all deeds are held on a public-facing
blockchain, speeding the ability of landowners to demonstrate their
title to real property. NFTs could conceivably be applied to that
system or other systems, such as drivers’ licenses, voting
records or other similar public records. The combination of
immutable records on a blockchain with digital verification of
identity via a standard type of NFT would potentially eliminate
much of the hassle and time wasted dealing directly with government
bureaucracies, such as Departments of Motor Vehicles and local
paper record depositories, such as county courthouses.

One could envision all health records for an individual being
wrapped in an NFT and provided to any medical professional as a
simple transfer of the right to view such records. This is not
far-fetched. BanQu in Africa is using blockchain to bring more than
600,000 small landowners farming commodity crops like cassava and
coffee into the commercial system by enabling them to prove their
ownership of their crops and obtain access to the banking system.
This same type of ownership of each person’s digital data and
rights to their own information can be enabled by NFTs.

While blockchain wallets for cryptocurrency are anonymous, in
many cases regulators must insist on some proof of identity. The
regulations likely to arise from the current government wide
digital asset assessment will certainly include some form of
identification for any accounts that link to public systems. NFTS
offer a potential interface for identity information associated
with wallets, with only the individual or entity authorized to view
that information permitted to see it. So properly secure regulators
could verify identity associated with a specific wallet, while the
holder would retain anonymity for all others. Or people who wish to
gain access to services not currently available to them
(immigrants, refugees, asylum seekers, poor and marginalized
populations) could use their NFTs and blockchain wallets to verify
both identity and a non-bank account for digital assets. This has
the potential to open up the economy to many people not able to
participate currently.

In conclusion, the law must evolve in order to enable the
potential of digital assets, NFTs, blockchain secured records, and
related advances to enter into common use. NFTs provide an
opportunity to disrupt industries that often end up working in the
best interests of the third-party that holds ownership rights, and
not in the best interests of the creator. Utilizing smart contracts
can collapse the cost of ownership and put it into the hands of the
actual owners and creators. NFTs have the potential to open up new
avenues and markets for creators, improve how we buy and transfer
property of all types, and more efficiently handle transactions
concerning ownership. Proper legal clarity has the potential to
create an effective framework for innovative development, while
also regulating the ability for bad actors to misuse and take
advantage of it.

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The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



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