A few years ago, NFTs were the subject of interest only for tech geeks and the cryptocurrency community. It seems, however, that nowadays, NFTs are almost everywhere. For those who don’t yet know, NFTs (non-fungible tokens) are digital objects using a similar type of blockchain technology to secure cryptocurrencies. This technology makes it possible to create a unique, one-of-a-kind digital token, which embodies a virtual or physical asset. The process of creating an NFT is known as “minting”. NFT can be digital art, a video clip, or even a virtual figure in a video game. In some instances, it can even be a physical asset connected to such a token. This connection enables new forms of ownership and transferability. The uniqueness of each NFT distinguishes them from other cryptocurrencies such as Bitcoin, Ether, and many other virtual tokens.
But make no mistake about it. NFTs are valuable and increasingly important assets in the marketplace. They will be important in both future marketing and investing decisions. Since late 2017, hundreds of millions of dollars have been spent on NFTs. Their use has exploded over the past year, and this number will grow.
NFTs’ Impact on the Physical World
An important thing to remember is that because NFTs are secured using blockchain, it creates a singularly secure way to transfer ownership of these NFTs and indirectly transfer ownership in whatever (virtual or physical) asset they represent. This can potentially revolutionize commerce as we know it. The immediate and direct impact is on the e-commerce of virtual assets, which exist in the virtual world (rapidly turning into the “metaverse“), but there are more and more indications that NFTs will impact the commerce of physical assets as well.
One interesting example of this impact is forming a new type of asset, one that is “hybrid”. Parts of the “hybrid” asset are in the physical world and parts in the virtual world. For example, in the summer of 2021, world-known artist Damien Hirst sold “hybrid” artworks that consisted of actual real-life paintings that each had corresponding NFTs. Another interesting example is the announcement made by Nike in December 2021 regarding the purchase of a virtual shoe designer and manufacturer by the name of RTFKT Studios. This transaction will enable Nike to start acting in the metaverse by selling shoes and clothes (minted as NFTs) for use by virtual avatars (that may very well be represented by NFTs).
New Types of Ownership
The next step in the evolution of NFTs is the “tokenization” of physical assets and then using these NFTs to prove ownership and enable the transfer of these physical assets. For example, an NFT can reflect ownership of a physical piece of art. Provided that trusted third-party custody and safekeeping exists, this can revolutionize the purchase and sale of art. Potentially, any physical asset can be “tokenized,” and blockchain technology can be used as a global trusted registry of ownership and a platform for liquidity of such tokens.
In other words, NFTs are influencing our day-to-day lives in of several vectors: NFTs enable the creation of new types of assets; NFTs boost the development of the metaverse, where people can own virtual assets and use their avatars to create value; and, at the same time, NFTs are becoming a bridge connecting the physical world with the metaverse.
Where Regulation Comes In
Given their dramatic disrupting impact, we should not view NFTs as anecdotes relevant only to hardcore blockchain proponents. They are changing our world, and therefore governments and regulators must pay close attention to their impact. Financial regulators, for example, are focused on the stability of financial institutions, the integrity of capital markets, and consumer protection. NFTs impact all of these, and alongside their promise and advantages, they create risks that we must address. But make no mistake, governments and regulators should not and cannot try to ban trading of NFTs or attempt to restrict the use of blockchain technology. Stopping technological innovation is impossible and foolish, especially given the many advantages this technology brings along with it. Harnessing these advantages for the benefit of consumers and commerce is imperative.
Currently, most regulators and governments are on the fence. They are waiting to see what other jurisdictions do or how the market develops. In some instances, governments and regulators are trying to address this issue more actively, but with very different outcomes. For example, United States federal regulators apply legal principles developed decades before anyone even dreamed of cellular phones, let alone the internet, to classify different types of digital tokens like securities, utilities, or types of commodities. China banned crypto-related services altogether, while El-Salvador adopted Bitcoin as legal tender. It is quite clear that this is an extremely uncertain area where the law is still developing, and that differs significantly depending on the jurisdiction.
Do or Don’t
And when the law is uncertain, lawyers find themselves in a difficult position. On the one hand, companies developing NFT-based products want to do business. In many cases, these products and technologies have real value. As an example are NFTs that can protect artists from the infringement and counterfeiting of their artworks, NFTs that distribute royalties to creators in an immediate and ongoing way without reliance on third-party intermediaries, or NFTs that allow talented individuals to earn a living by controlling their virtual avatar in the metaverse.
On the Other hand, when the law is unclear, the easiest and safest advice a lawyer can give her client is “don’t do it.” This is where lawyers need to rise to the challenge. They need to find the right balance between protecting their clients and developing their businesses. This requires a deep understanding of the regulatory principles governments and regulators will apply and the risks that concern them. It also demands working with the clients to proactively develop products that adequately address these concerns. One such example is NFT platforms that reduce money-laundering risks and enhance consumer protection mechanisms.
Evolving Is Necessary
Ultimately, governments will evolve and develop laws and regulations that address these challenges while ensuring regulatory certainty that enables these technologies to grow. The world is changing, and our reality exists in two dimensions, physical and virtual. That means consumers must receive protection in both dimensions, and actions taken in any of these dimensions should not jeopardize economic systems. Fraud and theft, for example, also exist in the metaverse, and governments must develop the ability to address them adequately. NFTs tied to physical assets exist in both dimensions, and governments must provide the legal infrastructure for rights and obligations to exist in both dimensions.
Regulators also need to evolve. It is possible to address some aspects of these regulations by tapping into the technological advantages that NFTs and the blockchain provide. For example, using technology that can detect suspicious sources of funds can mitigate some of the risks of money laundering. Smart contracts can address potential conflicts of interest between financial institutions and consumers. Decentralized finance (DeFi) may change the conventional thinking about conflicts of interest in the financial world because, in some instances, there will no longer be a need for central third-party intermediates. These examples do not mean we will no longer need regulators. It just means that regulators will have to develop a deep understanding of these technologies and their risks.
Indeed, these are significant challenges. But our governments and regulators will rise to the challenge. They will learn to operate in this new and complex reality in two separate but connected dimensions. Until that happens, lawyers will have to work harder and become more sophisticated in their technological understanding, to provide their clients with good and effective advice.
Our firm is highly experienced in Blockchain and NFT legal matters. Feel free to contact us with any questions.