What the NFT?

09 February 2022

The pandemic has brought many things to the forefront of popular culture: face masks, air fryers, and more recently, NFTs. If the third example has you scratching your head, you’re not alone. ‘NFTs’ (short for non-fungible tokens) were one of the most popular Google search terms in 2021. Why you ask? Because in some circumstances, they’re bringing in their owners serious money and incentivising a new wave of creativity for artists from all walks of life.

Let’s take a closer look.

What is an NFT?

An NFT is a cryptographic tool that acts as a certificate of authenticity for ‘scarce’ goods.1 As mentioned, NFT stands for ‘non-fungible token’. The ‘non-fungible’ component reflects the fact that NFTs cannot be transferred on a ‘like for like’ basis. The specific details of the NFT – for example, its creation date, creator, the assets linked to it, and consumer demand – determine its worth. This is in contrast, for example, with fungible items like money or cryptocurrencies like Bitcoin – if A and B both had a Bitcoin and swapped them, they would still each have a Bitcoin of the same worth.

These ‘tokens’ can be used to represent a myriad of different underlying assets. Broadly however, NFTs can be defined into two categories:

  • Digital certificates linked to entirely digital assets (such as gifs2, digital art3, and social media posts4); and
  • Digital certificates linked to physical assets.5

Connecting the dots, really anything has the possibility of being tokenised.

Here are some of our favourites:

Still a bit confused?

You can think about NFTs in the same way we think about fine art. Irrespective of their visual appeal, it is generally not the actual art contained within the work that is valuable (sorry Picasso, apologies Monet). Instead, the history and grandeur surrounding the work (including the chain of ownership) is where the value lies. By purchasing an NFT, you are essentially afforded the ‘bragging rights’ to an original or limited version of something that you can verify through a digital record, perhaps akin to an original signed by the artist rather than a later mass produced copy.

NFTs can also be likened to trading/collector cards. A card featuring a photograph of Michael Jordan has very little inherent utility, and that same photograph of Michael Jordan might even appear in other contexts, for example on posters or in magazines. But if the trading card is sufficiently rare, there may be value in being able to say that you possess it.

Okay, but how are NFTs created?

Stick with us, we’re going to get technical for a minute.

Cryptocurrencies like Bitcoin introduced a new form of technology known as a ‘blockchain’. A blockchain is a way of cryptographically maintaining a decentralised, immutable (fixed) ledger. It is used in cryptocurrencies to create a trusted system for exchanging ‘money’ without a central bank or other party controlling the system, while maintaining distributed public records of all transactions. Subsequent developments have seen blockchains expanded for use in broader contexts, including NFTs.

NFTs are created using ‘smart contracts’ on a blockchain which keep track of the ownership of tokens as they are transferred between parties. Smart contracts are unlike traditional contracts, and probably aren’t actually contracts in a legal sense. Instead they are written in computer code and contain pre-defined terms and conditions. Upon recognising that these have been met, a smart contract automatically executes its rules.

When a new NFT is created (or ‘minted’ as it is known amongst the tech community) this data is encrypted into a ‘block’ of transactions which is cryptographically linked to previous transaction blocks, thereby extending the ‘chain’ of information on the blockchain. Any attempt to vary a transaction will break the chain. Unlike a physical ledger though, blockchains are publicly viewable. This is what NFT advocates assert as the asset’s greatest protection against copying or duplication – its chronological existence on a public blockchain makes ownership irrefutable, and the cryptographic techniques involved make it easy to identify when someone (or something) has attempted to upset the status quo.

This all sounds fine, but why are NFTs a big deal?

When we said NFTs are bringing in big money for their creators, we meant it. Even if you’re new to NFTs, you’re at least likely to have heard of Beeple. No, this isn’t the some new social media platform the kids are on. Rather, Beeple (whose real name is Mike Winkelman) is a visual artist who managed to sell his NFT, ‘Everydays: The First 5000 days’ for a cool USD70 million, earning him the title of ‘one of the three most valuable artists alive today‘. However, even this huge sum was recently overtaken by artist ‘Mysterious Pak’, who recently sold their NFT ‘The Merge‘ for USD91.8 million.

While there is no guarantee that minting an NFT will gain you this level of financial success, the NFT realm has opened up an entirely new revenue stream for those willing to tap into it. This is welcomed news for those in the arts, who similarly to those in the hospitality and tourism industries, have been some of the hardest hit by the pandemic. American rock band ‘Kings of Leon’ were the first band to release an album as an NFT, producing two other tokens alongside this which offer ‘live show perks like front-row seats for life‘ and ‘exclusive audio-visual art‘. Here we can see how NFTs can help to bridge the gap created by COVID (ie the inability to perform or go on tour). Artists can continue to engage their audiences and monetise these endeavours.6

Now you may remember us putting quotations around the word ‘scarce’ in our description of NFTs. While the digital certificate component of an NFT certainly guarantees ownership of the asset, it’s the NFT creator who gets to decide the level of scarcity attached to it. In many respects, the scarcity is entirely artificial – an NFT attached to a digital artwork does very little to prevent that work from being replicated ad infinitum. Other NFTs do offer some level of genuine exclusivity or functionality for the holder. Coachella, for example, have recently minted 10 NFTs allowing their holders lifetime tickets to the festival. This veers off slightly from how NFTs are generally held out (as a one-of-a-kind investment opportunity), and evidences that NFTs are not necessarily limited to use as a ‘status symbol’ – they can hold functionality too.

And artists are not only gaining the initial windfall of funds from selling NFTs, but also potentially benefiting repeatedly via re-sale royalties. The smart contracts used to create NFTs often have standardised royalty provisions coded into them, meaning that when an NFT is resold the original creator receives anywhere from 2.5 to 10% of the purchase price. Unlike traditional sales of a famous painting, say, where artists seldom directly benefit from rising prices on subsequent sales, NFTs allow them to share in those gains with the associated smart contract doing all the heavy lifting.

Big thinkers are even suggesting that NFTs, smart contracts and the blockchain might just be start of a broader revolution. Where in the mid-to-late 00s the explosion of social media and other interactive websites was lauded as ‘Web 2.0’, some are suggesting that NFT-style tokens will underpin ‘Web3’. Others go further again, seeing the potential for an entirely tokenised economy, where smart contracts trade assets and commodities, and consumers can see the history of goods they purchase via immutable blockchain records.

NFTs are even already being deployed as part of ‘metaverses’, like Tennis Australia’s recent Australian Open metaverse. Here, participants could travel around Melbourne Park as they would if they were at the real event, play online games, watch matches, and purchase various NFTs (such as clothing for their avatars) to enhanced their online experience.

Between artists seeking new avenues for their work, speculators seeing potential investment gains, and technologists envisaging broader applications, there are certainly a lot of people excited about NFTs.

I’m sold! How can I own an NFT?

Notice the use of ‘a’ rather than ‘the’ prior to references to ‘blockchain’? Unsurprisingly for an internet-based activity, NFTs don’t just exist on one blockchain. While Ethereum is generally the most popular blockchain platform for NFTs and smart contracts in general, there are other competing technologies, as well as a myriad of different ‘marketplace’ websites that simply the process of transacting, with some of the most popular being OpenSea and Nifty Gateway. Buying or selling NFTs will typically require using the cryptocurrency associated with the underlying blockchain.

Otherwise, anyone (again, in theory) can create an NFT. All that is required is internet access and a digital wallet, used to store cryptocurrencies and NFTs and interact with the blockchain. While at a technical level the NFT minting process involves deploying a smart contract to the blockchain, most of the process can be streamlined via an NFT marketplace.7

NFTs can only be owned by one person or entity at a time and are indivisible, meaning that they cannot be divided or replaced. However, NFTs are transferrable. This is how they are sold on, with those sales being how they acquire their value. When an NFT is minted, initial ownership is assigned through the associated smart contract, with provisions generally coded into the smart contract allowing its owner to assign it to a future purchaser.

If you are not minting your own NFTs, but are looking to buy, then the steps for getting your hands on an NFT are usually quite similar to our online shopping analogy. You peruse an NFT marketplace until you find a token of interest, purchase this from its owner using your NFT-compatible cryptocurrencies, and that NFT will then be associated with your digital wallet. If you are more adventurous, you could even transact directly on the blockchain to transfer ownership of an NFT with another willing user, without the use of a marketplace. Either way, once the transaction has been recorded, anyone who looks up that NFT on the blockchain will see your wallet as the owner.

This all sounds seemingly straightforward, are there any issues associated with NFTs?

Being such unchartered territory, a number of legal concerns surround NFTs.  Let’s take a look at some of the main ones.

Decentralised and Unregulated(ish)

An aspect of NFTs raising hairs is its decentralised nature, the effects of which are twofold.

First, the value of NFTs derive from the perceptions of the buyer (which are invariably influenced by the broader market). While some NFTs may be linked to physical assets with some inherent value, the vast majority are intangible artworks whose value is driven only by their popularity. As such, your entire NFT portfolio is at the mercy of popular culture, making the assets incredibly risky to invest in. One day your NFT could be worth $1 million, the next, $0, without any explanation available as to why.

Second, there is as yet very little Australian legislation that specifically governs NFTs, but they are not immune from more general laws which might apply. For example, Australian contract and consumer frameworks can apply to the minting, issuing and sale processes of NFTs if such transactions occur in Australia (i.e. between an Australian seller and buyer).  The extent to which these existing frameworks are enlivened depends on the representations made in respect of each specific NFT, and any other rights that might be attached to them through separate legal agreements.

When purchasing NFTs from outside of Australia, which is highly possible given the boundless scope of the internet, this ‘legal grey area’ is amplified.  Much like Australia, most other countries are similarly still catching up with the intensified interest in NFTs, meaning that legislation specifically relating to the cryptoassets is largely non-existent.  This is similarly true for NFT-related case law, equally in its infancy due to the limited existence of NFTs.  While such laws and related disputes will inevitably emerge, the additional challenge of international NFT trade is knowing when and if the laws of different jurisdictions apply.

Even if relevant regulation did exist, it could prove difficult to enforce.  By design, dealings with NFTs are self-executing, and the immutability of the blockchain makes them difficult (if not impossible) to roll back. Australia’s unfair contract term regime, for example, makes terms in certain standard form contracts unenforceable if found to be unfair by a Court.  However, a smart contract will automatically fulfil any such terms without regard for, or recourse to, those laws.  This point has been acutely felt by some NFT owners who lose their tokens as a result of fraud, with the rigidity of the blockchain leaving no recourse to traditional legal remedies, and marketplace operators attempting to fill the gap as discussed further below.

Smart contracts and NFT marketplaces

The smart contracts used to mint NFTs are typically very mechanical, without legal terms, such as licensing conditions. Where any such licence is required or any other express terms are desired, a separate legal agreement will be required. Despite the arrival of smart contracts removing the need for intermediaries, this omission can actually complicate and intensify the risk of NFT trading, especially for those lacking in legal ‘know-how’.

This is similarly the case for the trading platforms used to create, sell and purchase NFTs. These marketplaces can differ in relation to their terms of service, meaning that different obligations may apply to you as a user of an NFT platform depending on which site you use. For example, OpenSea seeks a ‘world-wide, non-exclusive, sublicensable, royalty-free licence to use, copy, modify and display’ any content submitted on its platform, though this licence does not necessarily extend to the NFT holder. However, NBA Top Shot (a curated marketplace solely for NFTs relating to the NBA), provides NFT users with a limited licence for personal or non-commercial use.

Copyright and NFT ownership

NFTs are frequently being used to provide some sort of exclusive ‘ownership’ rights over an artistic work. But the laws of most countries around the world already provide a system for owning artistic works – copyright.  How do these interact?

Under the Australian Copyright Act, an artist (or the artist’s employer) automatically receives copyright in their original artistic works. That copyright remains with that owner, unless and until assigned in writing (per section 196(3)). The owner of a work has certain exclusive rights in respect of that work, including the right to reproduce it, and the ability to license others to exercise those same rights.

Simply put, the minting of NFT does not magically change this position.

If a smart contract or a separate legal agreement contains some express element which satisfies the legal requirements for assignment of copyright, then the sale of an NFT could in theory also see copyright transferred. Otherwise, even though they will be indisputably linked to the relevant digital token, NFT owners are generally only purchasing the right to use the original work in a limited way, meaning that in actuality, they cannot download, share, re-create or print copies of the work – this remains the right of the copyright owner. This can be a difficult concept to grasp given the way in which ‘ownership’ of NFTs is discussed. One recent example saw a group purchase an NFT linked to a book of Dune artwork. Shortly after purchasing this token, the group announced their intention to produce a television programme based on the book linked to their token, only to discover that it did not automatically convey such rights to do so.

Even without grand plans for television programmes or other big projects, many NFT owners have the potential to be unintentionally infringing copyright, for example in cases where they want to share an image of their NFT to their social media page, reproducing that  artwork. In addition, only the copyright owner would be in a position to legally prevent someone else from reproducing the artwork, limiting the NFT holder’s ability to ensure the ‘exclusivity’ of the NFT.

Some NFT projects have attempted to address these issues with express licensing provisions. The proprietors of the popular ‘Bored Ape Yacht Club’, for example, have express licensing terms which provide the NFT holder with an ‘unlimited, worldwide license to use, copy, and display the purchased Art for the purpose of creating derivative works based upon the Art‘. This licence is not conveyed directly by the NFT, but instead is granted via those separate contractual terms to the relevant NFT holder. Using these permissions, one Bored Ape owner plans on featuring their character in a music project produced by Timbaland.

Unless the creator of an NFT expressly assigns copyright or some form of exclusive licence to the holder, they remain able to deal with the underlying copyright work as they see fit. Perhaps most concerningly, there is no reason why that copyright holder couldn’t mint another NFT for the same work, diluting the exclusivity and value of the first.

Controversy has also been quick to arise when users ignore traditional intellectual property rights, and mint NFTs purporting to represent works that they do not own. The ABC has recently reported, for example, on complaints by musicians about an NFT marketplace which had been selling tokens corresponding with songs, allegedly without any permissions from artists or labels.

We have even seen high-profile lawsuits disputing who has the right to mint an NFT based on a particular work. Quentin Tarantino had proposed to mint a collection of NFTs featuring digitised images of his handwritten script for Pulp Fiction. The studio behind the film, Miramax, filed a lawsuit alleging that it owned the relevant copyright, and that use of the Pulp Fiction branding also constituted trade mark infringement and would be likely to confuse consumers. That lawsuit will likely turn significantly on interpreting the provisions of Tarantino’s original contract with Miramax in respect of the film, agreed decades before anything remotely like NFTs would have been contemplated by the parties.

Ultimately, NFTs for digital assets are held out as a way to introduce scarcity for what would otherwise be infinitely replicable items. In that sense, this is not dissimilar to intellectual property rights that exist at law, which give proprietary rights over intangible reproducible works. Some have suggested that NFT-style tokenised ownership schemes could replace traditional systems of intellectual property rights. The owner of a work may be able to effectively grant licences, for example, by issuing cryptographically signed tokens that only permit the user to deal with the work in a particular manner – for example, a film studio issues tokens that effectively amount to a movie rental, allowing the movie to be watched during a particular time period. Those restrictions and licensing conditions would be enforced automatically by the technology, rather than being able to be enforced by Courts as a matter of law. However, any such system would still ultimately seem to need to fall back to traditional legal structures to enforce rights against any misappropriation of works, and would lack much of the nuance of copyright law in dealing with matters like remix and modification, and fair dealings with works.

Moral rights

Moral rights accompany copyright, similarly arising automatically and vesting in the creator of a work. However, in contrast to copyright, moral rights cannot be transferred, meaning that they remain with the creator of a work. These moral rights impose obligations on anyone dealing with works to properly credit original creators, as well as use the work in a non-derogatory manner or way that puts the reputation of the original creator into disrepute. Accordingly, even if an NFT holder has appropriate copyright positions to put use the referenced work, they will still need to ensure that they do not subject that work to any treatment contrary to the artist’s moral rights.

There is even a possible scenario where the legitimate owner of a copyright work (not being its original artist) mints an NFT of that work, and the artist subsequently alleges that doing so infringed their moral rights by failing to provide credit, or even attempting to claim that the process itself is a derogatory treatment of their work. Such a series of events would certainly pose very new questions for any Court asked to consider it!

Privacy

As previously discussed, blockchain technologies involve shared, decentralised ledgers, effectively leaving a publicly verifiable chain of ownership via an individual or entity’s digital wallet URL. Despite being championed as advantageous for its user-accountability, this equally raises concern in terms of privacy. If A knows B’s digital wallet address, then A can also observe B’s NFT transaction history. Although digital wallets don’t have to be created using personal details, ‘Know Your Customer’ rules in anti-money laundering legislation have started to limit that ability, even absent which your dealings on the blockchain produce a unique pseudonymous digital ‘footprint’.

Money laundering

The traditional art market has long presented opportunities for money laundering. Per an article from the International Monetary Fund’s Finance & Development magazine:

“Art is a very attractive vehicle to launder money,” says Peter D. Hardy… “It can be hidden or smuggled, transactions often are private, and prices can be subjective and manipulated—and extremely high.”

While the blockchain drags NFT transactions out into the open, it replaces traditional currencies and banking systems with unregulated pseudonymous cryptocurrencies, and is free of any of the physical constraints which might slow down dealings with tangible assets, leaving great scope of money laundering. And the fact that sales are public introduces new means to artificially pump values by transferring between wallets at inflated prices – when an NFT sells anonymously at some record high price, there is always scope for scepticism as to whether that transaction was actually a true arm’s length reflection of value.

Anti-money laundering legislation has already given AUSTRAC some oversight over how fiat currency enters and exits the cryptocurrency ecosystem, but the purely digital transactions in respect of NFTs are hard for authorities to track.

Linking token to asset

While the blockchain provides indisputable proof as to who holds a particular token, there can be more ambiguity when translating that token to the underlying asset.

For NFTs which relate to physical assets, there is an inherent difficulty in translating from the digital to physical. There are many proposals for blockchain-based, tokenised systems which track the provenance of physical goods, like farm-to-plate systems for tracking produce. Such a system might be able to indisputably show that meat from a cow on a particular farm has taken a journey via various suppliers, but how do you know that it correlates with the steak on your plate?

For digital assets, these kinds of questions should be able to go away, but current implementations of many NFTs are surprisingly weak in this regard.

Because storing large amounts of data on a blockchain is typically cost and computationally prohibitive, most NFT implementations today do not store the digital asset itself on the chain. Instead, the token on the blockchain will merely record an owner against a URL linking to the relevant asset. An NFT of an artwork, for example, would involve storing an JPG or PNG of that image on a normal webserver, with the NFT effectively containing a hyperlink to the URL of that image. This creates a great degree of uncertainty, especially as time goes on – files on servers could change, a server could malfunction, or the associated domain name could lapse or otherwise change hands, for example.

As technical readers will already understand, a URL can potentially even return different results for different people. This was recently exploited by Moxie Marlinspike to prove a point about NFTs – he minted an NFT pointing to a URL he controlled, and had that URL return different images depending on who accessed it. This caused the NFT to show one image on the OpenSea marketplace, a different image on the Rariable marketplace, and an image of a poop emoji in any other context (including a purchaser’s wallet).

There are already varieties of NFTs which address these issues, such as by adding a ‘hash’ of the artwork to the NFT as a kind of authenticating fingerprint. However, many of the big money NFTs on the marketplace today could prove far less permanent than their owners might hope.

Gatekeepers

The manner in which the NFT market appears to be converging on a small number of large marketplaces also begins to put those marketplaces into a gatekeeper role, notwithstanding that blockchain systems are lauded as having no central authorities.

Given the ledger’s role as a canonical, immutable record of NFT creation and ownership, no party can later amend or correct that record. If someone were to mint an NFT of a copyright image they did not own, no amount of legal threats could remove that NFT from the ledger. If a user is hacked or defrauded, and loses their token, no one has authority to reverse that transaction.

This puts marketplaces in awkward situations – they can’t sit idly by while knock-off NFTs circulate and fraudsters sell their stolen wares, but they don’t have any authority or ability to properly address the situation.

Instead, one of the few mechanisms these marketplaces have available to them is to de-list or block sales of the offending NFTs via their websites. This is usually a relatively poor remedy, as the underlying NFT continues to exist and be able to be traded (just not via that marketplace), and it rarely addresses the underlying issue – the fraudster will still have stolen, and the victim lost, the misappropriated NFT.

To the extent that such a remedy does at least prove effective in blunting further trade in the token, it tends to undermine a core selling conceit of the NFT system as a whole – that the ledger is canonical, immutable and indisputable, and that it is not subject to centralised regulation.

Environmental concerns

The blockchain technologies used by NFTs typically rely on a concept known as ‘proof of work’. In short, the work involved in verifying each block of transactions involves an artificially inflated volume of computer processing power, such that it is impracticable for any bad actor to later attempt to amend the chain given the sheer amount of computing that would be required in order to do so.

All this computing work uses a lot of electricity, which is likely to involve significant carbon emissions.

For an NFT on the Ethereum blockchain, each transaction is estimated to use around 244kWh of power, roughly equivalent to the amount of electricity needed to power the average US household for more than 8 days. The annual power consumption of the Ethereum network as whole is estimated to be roughly comparable to the power consumption of the Netherlands, although there are plans for it to move away from its ‘proof of work’ approach.

Some artists are declining to release NFTs on the basis of these environmental concerns, while others are conspicuously avoiding using proof of work systems because of those issues. Doja Cat, for example, is quoted as saying of her NFTs released on a more energy efficient system: ‘I don’t know that much about NFTs… But what I do know is that they can be bad for the environment and cost a fortune. Mine won’t.’

So, what are the takeaways?

NFTs are certainly causing a splash, providing new revenue streams and opportunities for artists, a promising new asset class for investors, and whole bunch of interesting concepts which have the potential to upend previous norms of business, the arts and law. As an area where big money and emerging tech collide, interesting legal questions are arising but lawmakers are on the back foot, and anyone engaged in this space needs to keep their wits about them. Remaining vigilant to the nuances of NFT marketplaces, and having good cybersecurity practices, are crucial to avoiding financial misfortune.

NFTs haven’t created a new Intellectual Property regime. However, they are intersecting with existing legal frameworks in ever-evolving ways. Although moving your curser straight to the ‘I accept’ button is often the most tempting and time-saving option in the online sphere, in the case of NFTs, we would suggest pausing to take a closer look. If you need help in doing so, HWL Ebsworth is here for you. Get in contact with our Intellectual Property team today to discuss all things nifty and NFT!

This article was written by Luke Dale, Partner, Daniel Kiley, Special Counsel and Annabel Bramley, Law Clerk. 


We’ll talk more about the concept of scarcity a bit later on.
https://twitter.com/tacobell/status/1368807880434982912.
https://www.abc.net.au/news/science/2021-03-06/nft-crypto-digital-art-could-be-bonanza-for-artists/13220228.
https://v.cent.co/tweet/20.  
https://thenextweb.com/news/nike-blockchain-sneakers-cryptokick-patent.
Previously, virtual engagement was limited to social media posting, which can only create revenue for an artist in certain circumstances (i.e through ad sponorships).
Noting that not all marketplaces support general public NFT creation.  If you were looking to mint NFTs, this would also be the point where the relevant marketplace would provide instructions on how to put whatever asset you had up for sale.

Daniel Kiley

Special Counsel | Adelaide

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