What started as a blockchain-based game allowing users to trade and sell virtual kittens has grown into a diverse—and sometimes wild—online marketplace
BY DAVID P. SHELDON AND LERON VANDSBURGER
NFTs, or “non-fungible tokens,” are one of the hottest topics of 2021. Stories abound of NFT sales transactions—including a work by the digital artist Beeple that sold for $69 million11 https://decrypt.co/62898/the-10-most-expensive-nfts-ever-sold. and various celebrities raising money through the sale of NFT collections22 For example, NHL player Tim Thomas sold a collection of digital memorabilia for $200,000. https://theathletic.com/2532968/2021/04/24/bruins-legend-tim-thomas-takes-a-step-backinto-hockey-world-im-looking-to-reconnect/.—and speculation on future value of NFTs is rapidly progressing through a boom-and-bust cycle. Other than a vague understanding that owning an NFT means that the buyer “owns” a related digital work, however, much of the discourse has not taken a close look at the underlying mechanism of the transaction or the rights that are transferred.
WHAT YOU’RE BUYING
There are a few ways of looking at what it means to buy an NFT. From a lay perspective, buying an NFT is often described as owning a unique copy of a digital work.33 NFTs can represent ownership of many different types of assets. Digital artwork is the realm in which NFTs are most often discussed and which raise the most pressing issues of artificially engineered scarcity, and so this discussion will focus on that use case. While this high-level description may be sufficient to market NFTs to various parties, a more precise understanding is needed to analyze the legal realities involved.
Two technologies are fundamental to the NFT ecosystem: blockchain and smart contracts.
Put simply, blockchain is a storage technology where thousands of computers act together to record transactions in a ledger. For purposes of the present discussion, it is enough to understand that the blockchain can be used to record transactions that are guaranteed by the underlying technology to be unchangeable. A basic example of a transaction stored on the blockchain is a transfer of funds from one account, or “wallet,” to another.
Smart contracts can be confusing because they are not contracts in the legal sense. Instead, smart contracts are small computer programs that are executed to record transactions in the blockchain. Typically, the computer program of a smart contract will check various conditions and, if the conditions are met, it will create new transactions on the blockchain.
On that technical foundation, an NFT can be best understood as a particular type of smart contract stored on the blockchain. The smart contract of an NFT specifies an owner, some publicly available information (such as a unique value identifying the NFT and a low-quality version of a work), and some private information available only to the owner (such as a link to a location storing a high-quality version of the work).
The smart contract of an NFT also checks conditions and executes actions to transfer the NFT. Typical NFT conditions ensure at a minimum that the owner and the buyer assent to the transfer and that the buyer’s wallet contains adequate funds for the transaction. Typical NFT actions include transferring the agreed funds from the buyer’s wallet to the owner’s wallet and recording the buyer as the new owner of the NFT. Other actions may also be performed, such as transferring a percentage of the funds taken from the buyer’s wallet to the artist, the marketplace, and/or another party as a commission. So when someone “buys an NFT,” a smart contract is executed to transfer some funds and store a record in the blockchain indicating that the NFT is “owned” by the buyer.
HOW NFTs ARE DIFFERENT
What the existence of the record of ownership in the blockchain means, in a concrete sense, is sometimes vague. While intellectual property protection for digital works is well settled, NFTs represent a departure from previous technologies and implicate different forms of protection for works, despite being treated in many respects as items of commerce. To that end, a key question is whether NFTs are better or worse than earlier technologies, such as trusted systems, for managing ownership of digital work.
The term “trusted system” describes an integrated platform controlled by a single party that regulates the transfer, authentication, use, and sale of digital works. Such regulatory activity includes verifying and tracking users’ activity on the platform, maintaining records of activity, and enforcing rules for transfer, adaptation, and ownership of digital works. The key point is that a trusted system is administered by a party that sets the rules and has full control over records of all transactions, in contrast to NFTs and other blockchain technologies, where control over the ledger is distributed among many untrusted parties by the technology.
Music streaming services such as Spotify are an example of a trusted system. Such services permit streaming and sharing of music, but also forbid duplication, modification, or transfer of the music files themselves. They also are trusted to pay proper royalties to rights holders. A more complex example is provided by virtual environments such as online games. An in-game environment can include tools for users to collect, customize, and exchange virtual items. The game provider operates a trusted system that imposes rules on what kinds of activity are permitted. The game provider can, for example, limit transactions only to in-game currency, or can provide a mechanism for exchanging virtual items for real-world currency. Similarly, duplication of items may be forbidden by the game provider.
Compared to trusted systems, NFTs provide a record of ownership. By using the blockchain, records of NFT ownership can be publicly inspected and verified without reliance on any specific party. Accordingly, multiple different parties can use the NFT as a proof of ownership without relying on a trusted system to provide access to such information. The stability of ownership provided by blockchain (“what is mine today will be mine tomorrow”) is also a large shift from trusted systems, where continued ownership relies on the continued availability of the trusted system itself.
NFTs have also affected the reputation of digital works themselves by engineering artificial scarcity. Until now, the perception that digital works are susceptible to unlimited perfect duplication prevented reputational intermediaries from vouching for their provenance and long-term value. In the brief time since NFTs found a place in the digital art world, numerous reputational intermediaries, including traditional auction houses such as Christie’s and newer NFT-focused marketplaces such as SuperRare and OpenSea, have leveraged the perceived technical characteristics to facilitate trade in NFTs on analogous terms with other forms of fine art.
NFTs OR TRADITIONAL TECHNOLOGIES—WHICH TO USE?
NFTs may have advantages for some authors of digital works by providing perceived scarcity and authenticity that are not otherwise available. The market for digital art may treat NFTs as a digital-world analog of a signed, limited-edition print. Further, modification/duplication restrictions, ongoing royalties, and other contractual terms, which can be incorporated into the smart contract of an NFT and automatically executed without requiring ongoing monitoring, may be valuable to creators.
On the other hand, the current NFT ecosystem consumes enormous amounts of energy due to the power-hungry computer “mining” operations associated with Ethereum, the blockchain technology used to implement most NFTs. Also, after the rise in interest that peaked in early 2021, NFTs saw a decrease in popularity, with average prices dropping by approximately 70 percent by April after hitting a high in mid-February.44 Joanna Ossinger, “NFT Price Crash Stirs Debate on Whether Stimulus-Led Fad is Over,” Bloomberg News, April 3, 2021 (available at https://www.bloomberg.com/news/articles/2021-04-03/nft-price-crash-stirs-debateon-whether-stimulus-led-fad-is-over). With that in mind, the efficiency and stability afforded by a trusted system may outweigh the potential benefits of NFTs to some authors. Despite limiting the market for works to the “walled garden” provided by the trusted system, the greater level of control can be desirable for several reasons. In the example of a gaming system, allowing exchange of virtual items for real-world value can introduce issues that are undesirable from a creative, legal, or ethical standpoint. Also, a trusted system can use technical means to prevent modifications or resale of works under its control.
Top Shot—an NFT platform associated with the NBA—provides an interesting example. Top Shot provides NFTs of short video clips depicting popular sports moments. The platform allows viewing of clips and resale of its NFTs as digital collector’s items, controlled by the marketplace through terms in the smart contract. While all this functionality could be provided via a trusted system, NFTs provide an ownership record akin to a “certificate of authenticity” that is transferrable and verifiable on the blockchain independently from the Top Shot system. The question of whether these factors provide value over a trusted system could be answered by the success of Top Shot in the marketplace, which saw $6 million worth of original sales and a whopping $123 million in resales over its first five months of operation.55 Alex Moskov, “What is NBA Top Shot? A Booming Blockchain-based Market of NFTs,” Coin Central, Feb. 24, 2021 (available at https://coincentral.com/nba-top-shot-nfts/).
Many attorneys will face NFT-related questions from clients. While much in this area remains unsettled, there are some approaches that can help provide answers.
If a client is minting NFTs, the issues are similar to situations in which a client is seeking to commercialize a work in an analogous traditional way, such as producing limited-edition prints. Does the client have an agreement in place with the artist, who assigns the client the exclusive right to mint NFTs? It is important that this right is exclusive because the NFT ecosystem does not provide a technological mechanism to prevent the artist from assigning similar rights to another party. Does the client want an ongoing commission for sales, and/or does the agreement with the artist require an ongoing royalty to be paid? If so, such transfers can be implemented within the smart contract of the NFT and some such terms (like adjustable ongoing royalties to a single party) are provided in standard NFT smart contracts. If additional or non-standard actions are desired to be enforced by the smart contract, a developer skilled in blockchain technology may need to be engaged for implementation.
It is also important to consider what the NFT does not provide the buyer. The blockchain and smart contract guarantee authenticity of the NFT itself, but continued access to the work, which may be hosted by any system referenced by the NFT, is not guaranteed. Ownership of the NFT also does not guarantee the ability to view the NFT or the referenced work through any given marketplace. For example, some marketplaces will refuse to display a work referenced by an NFT if a take-down notice is submitted with respect to the work. Further, while the NFT is likely transferrable, the smart contract may enforce ongoing commission payments for each transfer, so the seller may not receive the entire sale price. Finally, there are no technical means provided for ensuring that only a single NFT is minted for a given work. Remedies in consumer protection or other laws would likely need to be sought against the minter if additional NFTs are created for the same work.
At the very least, the artificial scarcity and guarantees of authenticity provided by NFTs have temporarily given digital artists a new option for monetizing their work outside of the walled gardens of trusted systems. It remains to be seen whether NFTs will retain significant value over time, or whether they will pass into history as just another short-lived speculative bubble.
2. For example, NHL player Tim Thomas sold a collection of digital memorabilia for $200,000. https://theathletic.com/2532968/2021/04/24/bruins-legend-tim-thomas-takes-a-step-backinto-hockey-world-im-looking-to-reconnect/.
3. NFTs can represent ownership of many different types of assets. Digital artwork is the realm in which NFTs are most often discussed and which raise the most pressing issues of artificially engineered scarcity, and so this discussion will focus on that use case.
4. Joanna Ossinger, “NFT Price Crash Stirs Debate on Whether Stimulus-Led Fad is Over,” Bloomberg News, April 3, 2021 (available at https://www.bloomberg.com/news/articles/2021-04-03/nft-price-crash-stirs-debateon-whether-stimulus-led-fad-is-over).
5. Alex Moskov, “What is NBA Top Shot? A Booming Blockchain-based Market of NFTs,” Coin Central, Feb. 24, 2021 (available at https://coincentral.com/nba-top-shot-nfts/).