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’.
Early use of NFTs: the example of the ‘art’ NFTs
While the scope of application for NFTs is significant and it is fair to assume that NFTs will, one way or another, play a much greater role in our lives than they do now, the hype and publicity surrounding NFTs have largely been focused on the use of NFTs to trade artworks. Indeed, the NFT craze began in March 2021 with the sale of a Beeple NFT by Christie’s for US$69 million. However, traditional auction houses have since turned to trading other assets – recently, Sotheby’s sold the internet’s original source code as an NFT for US$5.4 million.
‘Owning’ art.
Ownership is a legal concept as old as human civilization. It is a surprisingly simple but, at the same time, complex concept that has had to adapt quite dramatically to the advent of the digital era. As discussed in an earlier blog post, in law, property is “the right to enjoy and dispose of things in the most absolute manner”. This is clear when it comes to, for instance, your house. You bought it; it is your property in absolute.
By contrast, intellectual property (IP) is a far younger concept. IP is a branch of law that comprises the rules applicable to ‘intellectual’ or ‘immaterial’ creations, which are elevated to the rank of ‘intangible property’ by the law. For instance, the law designates patentable inventions, trademarks, and creative content as intangible assets that may be appropriated and ‘owned’. By contrast, the law does not designate mere data or information as being protectable by IP rules and therefore capable of being ‘owned’ – and for good reasons. In democratic societies, information and data, just like ideas, are free-flowing. Data, in itself, is not something that can be appropriated or ‘owned’. It is not possible to own the information that Joe Biden was elected president of the United tates in the 2020 elections, just as you cannot own the idea of painting flowers.
So now, if you apply this logic to the world of art, you end up with the following situation. Two kinds of property exist in physical artworks: the tangible property and the intellectual property, whereas only one kind of property exists in digital artworks: the intellectual property. What this means is that unlike a physical work, a digital artwork cannot be owned by two persons or entities at the same time. Only one property exists, and that is the intellectual property of the creator.
Many commentators have tried to draw an analogy between purchasing a digital art NFT and buying the physical original of a painting; the analogy they would draw, for instance, is that buying an NFT of digital art is akin to purchasing the Mona Lisa. But this analogy does not hold water. When a person buys a painting from a gallery, what they buy is the tangible property – that is, the canvas and the paint – not the IP. NFTs do not replace canvas and paint because NFTs are nothing more than information, and information cannot be owned.
While there are respected legal commentators who have suggested that some common law systems (English law in particular) may well have sufficient flexibility to expand the application of property law to certain types of purely informational crypto-assets, reconciling this notion with the freedoms of expression and information enshrined in international conventions1 seems a particularly difficult task. Without legislative intervention, the absence or existence of property rights in information will continue to provoke difficult questions for crypto stakeholders.
What our research shows is that most NFTs being minted today are far more akin to providing a service (the authentication of a work of art) or granting a license (a limited permission to use and enjoy the digital art), but very rare are the occurrences where true ownership is being passed to the acquirer. The key takeaway from this is that purchasers of NFTs should understand what they are ‘buying’. Equally important is for those tokenizing artwork to be careful in how they market and advertise their NFTs. Advertising the ‘sale’ of artwork could be potentially misleading if all the NFT creator is offering is a digital certificate. As we learn from behavioral economics and the endowment effect, the temptation might be strong to advertise NFTs as nothing less than a sale, but the consequences of doing so might be fraught with serious legal issues.
The (smart) contract issue
A key feature of NFTs is that they are (or ought to be) liquid and thus easily tradable. This is what gives them their apparent value and why we are seeing digital assets being sold and bought for millions. But where the NFT is nothing more than a license, how liquid can it really be? A typical license agreement invariably offers some form of warranty or indemnity from the licensor to the licensee, against anything disturbing the quiet enjoyment of the rights granted, but if the NFT changes hands 20 times, who will stand behind the content?
Another challenge of using NFTs to ‘sell’ certain limited licenses or usage rights over digital artwork is knowing how to effectively ‘attach’ the contract or terms and conditions to the NFT such that the purchaser (and future purchasers) of the NFT is bound by them. The related issue is, how can a seller or marketplace easily enforce the terms of those contracts against the applicable purchaser? Sellers and marketplaces have to walk a fine line between ensuring they impose appropriate terms on purchasers of NFTs and ensuring those NFTs can be traded easily, with little formality. The more sophisticated the usage rights are, the more critical it will be to ensure the seller imposes robust contractual restrictions and remedies on purchasers. Sellers will need to bear this in mind when choosing which marketplace to sell NFTs through.
Regulation, regulation
There is currently no specific regulation governing NFTs. However, those currently observing the NFT craze unfold should not be led astray by the seemingly carefree attitude of early adopters operating in this space: the reality is that NFTs are regulated exactly like any other type of asset you can buy online, most notably the following:
a. Securities regulation. As described above, NFTs have been designed to carry a number of similar characteristics to a financial asset. Although they are not fungible, NFTs have been encouraging, and used as a tool for, speculation. Consequently, it is possible that they may come to be subject to financial regulation, but the question is still open. One of the primary factors that will determine whether an NFT is a security is the purpose for which it is being created and sold. If the NFT is being created and sold as a way for members of the public to earn investment returns, then that type of NFT is more likely to be considered a security. Those considering minting an NFT should take advice before doing so to avoid unintentionally breaching financial regulatory law. Even the way in which the NFT is described and marketed can influence the extent to which it may be considered falling within the scope of securities law, and we foresee some marketplaces and sellers coming unstuck if they do not consider this seriously.
b. Consumer law. NFTs are offered to the public; they are not restricted to professional buyers only. Accordingly, marketplaces and sellers are subject to local consumer law, which requires them to operate with a high level of transparency and brings them within the scope of consumer protection laws on unfair commercial practices, including the right for consumers to withdraw and to receive appropriate information about the NFT in their local language, subject the NFT sale to their local law, etc.
c. Tax law. The nature of the transaction will determine its tax status (is it a sale or a licence, a national or an international transaction, B2C or B2B, etc.?). The tax treatment will also be different for marketplaces, sellers, and purchasers. With the high fluctuation in prices, it will be critical to obtain proper tax advice to understand your exposure to VAT and other taxes.
As transaction volume grows, we suspect there will be greater scrutiny applied by regulators, authorities, and watchdogs. We only need to look as far as Bitcoin and other crypto-assets which have turned the heads of regulators, triggering the European Commission to produce the draft Markets in Crypto-Assets Regulation (MiCA) back in September 2020. This was closely followed by the European Central Bank’s generally supportive opinion on the MiCA in February 2021.
In conclusion, NFTs will no doubt assist in bridging the gap between the real world and the virtual world, facilitating a space where creations can be easily monetized in a world where IP is everywhere. However, those seeking to do business in the metaverse must be cognizant of the risks and limitations of NFTs, and should approach NFTs as they would any other asset. Stakeholders must have in place a robust due diligence process to fully understand the concept of digital ownership in the metaverse to ensure that they do not come unstuck in this developing landscape.
The metaverse – or, as it’s called, the Internet 3.0 – offers tremendous opportunities for growth and creativity. Read all about doing business in the metaverse in the recently published Reed Smith Guide to the Metaverse, and register for our upcoming webinar on this topic.
- Including article 10 of the European Convention on Human Rights, which states: “Everyone has the right to freedom of expression. This right shall include freedom to hold opinions and to receive and impart information and ideas without interference by public authority and regardless of frontiers.”
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