Reed Smith In-depth

Branded the Internet 3.0, the metaverse promises to increase permeability and interoperability between different digital environments and the real world, and is set to challenge several long-held legal concepts, including the concept of ownership. ‘Owning’ has a completely different meaning in the virtual world, and what one owns or may own in the metaverse will likely be a question that is only relevant to a happy few and will also likely be the subject of films, books, heated societal debate, and many lawsuits before the notion settles. Could NFTs offer a solution?

This tension results from a very simple stance the internet is made up of code and content, yet there are no ownership rights in code and content except for those who wrote the code and created the content. Do you think you own your software, a piece of music, an audio book, a game character, a game asset, a virtual car? Think again. At best, you received a licence to use the items; at worst, you may be infringing upon someone else’s rights.

Yet, paradoxically, one has never bought and sold more than on the Internet; and in a society where capitalism is alive and well, study after study shows that owning continues to be far more valued than licensing. This ‘endowment effect’ explains why marketers and advertisers are so reluctant to use expressions such as ‘limited license’ or ‘permission to use’. Possessing runs the world, and the metaverse will have a hard time changing that. But here come the NFTs.

What is the endowment effect?

The endowment effect describes circumstances of human behaviour in which an individual is more likely to retain and place a higher value on an object they own than they would place on that same object if they did not own it – much like the old proverb dictates, “a bird in the hand is worth two in the bush”.

This is typically illustrated in two ways. In a valuation paradigm, people’s maximum willingness to pay to acquire an object is typically lower than the least amount they are willing to accept to give up that same object when they own it – even, for example, when there is no cause for attachment (such as having emotional or symbolic significance). The endowment effect is also triggered when people who are randomly assigned to receive a good (‘owners’) evaluate it more positively than people who are randomly assigned to receive rights to do certain things with the good (‘controllers’).

The endowment effect is a gigantic paradox that the metaverse will need to confront. While NFTs are posed to solve the ownership problem of the virtual world, without some weigh in from legislators, NFTs may turn into nothing more than a collective illusion of ownership.

What is an NFT?

In short, an NFT, or ‘non-fungible token’, is a unit of information recorded on a blockchain about a good or service that is not interchangeable.

Non-fungible? Cryptocurrencies, such as Bitcoin, or indeed any other currency such as the U.S. dollar, are fungible. One Bitcoin has the same value as another Bitcoin, just as one dollar bill has the same value as another dollar bill – they can be traded or exchanged equally. Conversely, NFTs are non-fungible. NFTs represent a particular good or a particular service, and they uniquely relate to the information they represent – they cannot be traded or exchanged equally.

Blockchain? One thing cryptocurrencies and NFTs do have in common is that they rely on a blockchain to record transactions. A blockchain is a decentralized, distributed, digital ledger that comprises transaction data assembled into linked ‘blocks’. One transaction is recorded in a block, and the subsequent related transaction is recorded in another block that is linked to the first one, using cryptography. The benefit of a blockchain is that in theory it is immutable, meaning that it cannot be modified as any alteration to one block will alter all other blocks in the linked ‘chain’. The fact that transactions are blocked together in an irreversible chain, as well as the decentralized peer-to-peer network, builds a ledger of transactions that are reliable and trustworthy for users of this technology.

But what makes NFTs so special? NFTs introduce the concept of ‘tokenization’. This key feature is what makes the asset that the information relates to ‘tradable’ due to the transaction layer which is added to the information layer, creating a new market for the underlying asset. In essence, it means that previously non-liquid assets can be ‘quasi-liquid assets’.