Introduction to NFTs
Introduction
An anonymous digital artist named Pak made history on December 2, 2021 by selling US $91.8 million worth of The Merge, Pak’s series of digital artworks. A total of 28,983 collectors bought 312,686 non-fungible tokens, or NFTs, of the artwork. The price set a record for a digital artist’s sale and it happened at Art Basel in Miami. Duncan Foster, founder of a leading NFT marketplace, claimed that “this is further validation for NFTs as a medium of art and innovation”.
If you are skeptically raising your eyebrows after reading the above paragraph, you’re probably not alone. Why do people pay so much money for digital art? What does non fungible mean? And what does it have to do with the blockchain? Unfortunately, we can’t easily answer the first question but you’re in the right place to learn more about the last two.
What is an NFT?
An NFT is a non-fungible token. The term “non-fungible” means that an NFT cannot be replaced. A one dollar bill, for example, is fungible because it can be exchanged for another identical one dollar bill. A rare Pokemon card, by comparison, is non fungible, because it is unique and can not be replaced by another generic Pokemon card. NFTs are like rare Pokemon cards because they are non-fungible, or non replaceable.
NFTs are a disruptive technology because they are unique, scarce, and provide secure ownership tracking. An NFT is unique because it holds digital signatures in a way that real life art displays an artist’s signature or is authenticated by experts. For example, the original painting of The Starry Night by Vincent Van Gough is unique because experts can verify that Van Gough is the painter although copycats have created many replicas throughout the world. Similarly, people can simply screenshot an NFT but the original NFT remains authentic forever thanks to the digital signature. An NFT’s digital signature is the virtual equivalent of a physical signature under a painting. For unsigned paintings, many experts are needed for authentication. With NFT’s, a digital signature does all that work.
NFTs also share another aspect of artwork like The Starry Night. They are scarce and can’t be replaced for anything similar because nothing similar exists. Scarcity, in turn, has been one of the main drivers of demand for NFT’s. It’s a win-win: for creators, you can make your work be valued more and monetize from it; for users, you can own a digital asset with a unique set of digital technology. Some argue that scarce, limited edition NFTs run counter to principles of expanding access and promoting a creative commons. NFTs can be offered to the public under a creative commons license as well as limited edition NFTs. This enables artists to benefit financially and for the public to enjoy open access. For more information on NFT’s and the creative commons check out this link.
An NFTs unique set of data technology also keeps a record of ownership. This is done via blockchain. Once digital content is added onto the blockchain, every transaction or sale of the NFT is recorded on the chain. Most NFTs are part of the Ethereum blockchain but other blockchains can implement their own version of NFTs. This means that there is an easily accessible, immutable ledger of price and ownership history for the NFT.
Prior to NFTs, it was more difficult for digital artists to protect their work or maximize their profit because anyone could screenshot a copy of their work. With the NFT innovation, digital artists can protect their unique work through blockchain. Instead of worrying about their work being replicated without due pay, artists can invest more time in creating their pieces and marketing via social media.
What, technically speaking, makes an NFT unique?
Ok so you’re probably thinking sounds straightforward, minus the blockchain part. Let’s dive in to make that part a bit clearer.
NFTs are essentially smart contracts that live on the blockchain. They contain encrypted information. The encrypted information makes the NFT unique: a unique fingerprint (a hash!) of the element, its name, its symbol, among others. So, imagine that you created a digital art, such as a picture, on your computer. You can create an NFT, or smart contract, that will represent this art by holding the unique properties of the art, such as its hash, name, and symbol, as mentioned. Now, when the NFT is stored on the blockchain, you, the creator of the art and NFT, and the only possessor of access to the unique hash that represents the art, become the ultimate owner of that unique token.
The blockchain, in turn, makes the NFT immutable and allows the token to be bought/sold between people in the blockchain, also keeping track of all the transactions made on the NFT that you created. As a creator, the information stored in the blockchain is a game-changer, since besides storing the NFT’s properties, it keeps track of both the current owner as well as all previous owners of the NFT, allowing you, the initial creator, to monetize from each transaction made on your NFT.
(For more detailed info on the basics of blockchain see our article, Blockchain: The Basics).
Where do we find NFT’s?
Virtually on any platform that is digital!
NFTs encompass the world of digital representations such as music, art, GIFs, etc. The most popular application of NFTs is digital art and sports memorabilia. As many industries become increasingly more digital and technology accelerates the bridging of our physical and virtual worlds, almost anything has the potential of becoming an NFT. We’ve already seen Jack Dorsey, Twitter’s founder, sell his first tweet as an NFT for almost US $3 million and Top Shot is now selling NBA moments as NFTs. Individual users are now creatively generating NFTs: a sneaker, essay, domain name, ticket that gives you access to an event, and even real estate.
NFT’s are also linked to the increasingly popular metaverse. Metaverses are digital worlds where NFTs represent digital assets. Imagine each building, territory, or even item in the metaverse being an NFT. This means that NFTs not only represent and prove ownership of elements, but also power all the monetary transactions that can happen within the metaverse. For example, imagine creating your own avatar by dressing it with a Nike jacket NFT that you purchased in the metaverse. Gaming is currently the most popular aspect of the metaverse, but the metaverse is set to expand its use to every corner of our lives. Experts at Bloomberg Intelligence estimate that the global metaverse will generate close to US$800 billion in revenue in 2024.
NFTs are also part of developing free, accessible interactions in the metaverse. In January 2022, individual creator Chinwe Onwudiwe created the first African Museum on the Metaverse. Chinwe Onwudiwe also decided to keep the virtual museum free for anyone to enjoy! NFT applications are set to keep growing along with the metaverse.
Legal & Policy Considerations
NFTs, although digital, are still an asset class similar to real estate or physical art. NFTs are thereby subject to legal restrictions such as ownership rights, copyright requirements, fraud prevention, cyber security precautions, and contract liabilities. Two of the more common issues in the NFT sphere are fraud and securities regulation.
Fraud and complex scams on NFT platforms are a growing concern. Although NFTs lower the barrier to entry for artists/creators, they also present an accountability challenge. For example, platforms such as OpenSea, the world’s largest NFT marketplace, have a relatively quick process to sign up and create NFTs. OpenSea’s processes include less onerous authentication and verification requirements as compared to other traditional online transaction platforms that ask users to prove their identity, provide bank account information, and submit other paperwork. OpenSea accounts are not all verified therefore the likelihood of scams is higher than other platforms with more rigorous sign up processes. Recently, scammers posed as OpenSea employees to wipe out user accounts. OpenSea has added an SOS button to prevent wipe outs but many experts argue that more due diligence and safety protocols are needed to prevent fraud in the NFT space.
There is also another debate on whether NFTs should be regulated as securities. This is at the forefront of the May 2020 case between Jeeun Friel and Dapper Labs Inc., the blockchain studio behind the world famous CryptoKitties game. Jeeun Friel alleges, in a class action, that Dapper Labs Inc. violated securities laws by selling NFTs on its platform. The plaintiffs assert that the NFTs should have been registered with the Securities and Exchange Commission (SEC) because they derive their value from the success or failure of a project.
Categorizing an asset as a security is critical because securities are much more heavily regulated than commodities. A security is a financial instrument that has value and can be traded. Think about stocks and bonds. Most NFTs are not categorized as securities but this may change over time or with court rulings such as the Jeeun Friel and Dapper Labs dispute.
Courts use the Howey Test to determine what is a security. For more detailed information on how the Howey Test is used, check out this link.
Conclusion
The legal space is going to continue feeling pressure from the new frontiers that NFTs and other blockchain innovations are charting. Legal complications also arise when it comes to NFTs and cyber security issues. For example, OpenSea was also involved in a controversy in September 2021 when users suddenly lost money in digital wallets because someone posting NFT art embedded the art with malicious code. Users clicked on the NFT and accepted a “gift” that stole money from the users’ accounts. Threats like these need to be rigorously investigated and addressed by NFT platforms like OpenSea. Greater legal and policy guidance and resources are needed to advance NFT platform trust and safety. There are a lot of unknowns but the legal and policy space is set to grow rapidly to keep up with the expanded use of NFTs.
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*Mohammad is an International Fellow focusing on governance and financial inclusion in the blockchain, digital currency, and fintech sector. It will also support urban use of emerging technologies initiatives. Mohammad completed his JD from Harvard Law School, his MPP from the Oxford University and his degree from the University of Maryland. Mohammad is passionate about technology-based solutions to economic and legal challenges in emerging markets. He speaks seven languages and has traveled to nearly fifty countries.
**Computer Science Undergraduate Degree Candidate Stanford University
