Latham & Watkins Provides Beginner’s Guide to NFTs

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Earlier this month, a blockchain firm bought a US$95,000 print by the British street artist Banksy, only to burn it in a livestreamed video and re-sell it for US$380,000 as a virtual asset called a non-fungible token (NFT) — sparking a flurry of news around what may prove to be this year’s hottest crypto craze.

How did the Banksy sale work? The group explained that by removing the physical piece from existence and releasing the NFT as digital art, the value of the physical piece will be moved onto the NFT. This trend isn’t just setting the art world ablaze; in fact, musicians and even footwear companies are finding ways to break into the space.

At the same time, NFTs are raising novel legal questions — including those concerning digital ownership and intellectual property, royalty collection and payments models to benefit artists, financialization of non-fungible asset classes, and unique contracting and financial regulatory issues in the digital realm.

This post is an introduction to NFTs, and a jumping off point for the more specialized posts in Latham’s blog series on NFTs. This installment will explain what an NFT is and why people may start hearing a lot more about them. It will also preview some of the key legal issues that Latham lawyers will explore as a part of this series.

What is an NFT?

At its core, an NFT is a special, one-of-a-kind crypto asset. It is not mutually interchangeable, and this is really what sets it apart.

For comparison, consider a cryptocurrency like bitcoin. One bitcoin could be replaced with any other bitcoin, and still essentially be the same asset — it’s like trading one dollar bill for another dollar bill, at the end of the day you still have $1. NFTs, on the other hand, are more like Fabergé eggs; they all follow the same basic concept (a jeweled egg), but each one is an original creation with a different shape, size, or pattern. As such, the eggs are not like-for-like interchangeable. This feature is the essence of an NFT.

Importantly, the Fabergé egg analogy only works to a point: each egg came from the same source (Peter Carl Fabergé), and they are limited in number. By contrast, anyone can create an NFT, and there is no limit on the overall number of NFTs in circulation. The key point is that each NFT is unique, which is why NFTs derive value as a crypto asset class and, because they are unique, there is also a relatively easy way to trace ownership of the asset.

How do they work? 

To understand how creative works get tied to NFTs, one has to understand exactly how an NFT functions. NFTs are unique crypto tokens that are managed on a blockchain. The blockchain acts as the decentralized ledger that tracks the ownership and transaction history of each NFT, which is coded to have a unique ID and other metadata that no other token can replicate. This process gives NFTs the attributes of originality and scarcity that makes them so attractive when coupled with digital media.

NFTs are coded with software code (called smart contracts) that governs aspects like verifying the ownership and managing the transferability of the NFTs. Like any software application, NFTs can be further programmed beyond the basics of ownership and transferability to also include a variety of other applications and functionality, including those linking the NFT to some other digital asset. For example, a smart contract could be written to automatically allocate a portion of the amounts paid for any subsequent sale of the NFT back to the original owner, thus giving the owner an ability to realize the benefits of the secondary marketplace. (For more information, see the proposed EIP-2981 standard for handling royalty payments for ERC-721 tokens.) 

Thus, when someone makes (or “mints”) an NFT, they are writing the underlying smart contract code that governs the NFT’s qualities, which are added to the relevant blockchain where the NFT is managed. Many blockchains can be used to manage NFTs, including Ethereum (with its long established ERC-721 and ERC-1155 smart contract standards), Flowchain, and Wax, all of which use a similar process. Notably, certain NFT marketplaces only function with certain blockchains, and so the choice of blockchain to use for an NFT can have real commercial implications for the seller.

Why are they in the news?

There are a few key reasons why NFTs have taken off recently, all of which involve certain unique properties that they exhibit.

Notably, almost anything can be a digital asset linked to an NFT. One of the early NFT experiments was the Cryptopunks, a series of 10,000 individual collectable “punks” — with each punk exhibiting its own distinct characteristics. This development evolved into what is probably the most famous trend to date: the Cryptokitties blockchain game featuring digital, collectible, one-of-a-kind cats. More recently, NFTs have evolved to encompass music, art, and even tweets. The NFTs can be linked to physical works (as with the Banksy piece before the fire) or can exist solely in the digital realm. This inherent flexibility leaves open huge opportunities for monetization that require artistic or other unique appeal, but not necessarily massive technical specialization — providing an appealing avenue for revenue, especially in creative sectors.

NFTs also make traceability much easier, which helps establish authenticity and the provenance of the work. This feature, in turn, makes the work easier to buy, sell, and trade. Just last week, Christie’s auctioned a purely digital collage last week for US$69.4 million with an NFT to “guarantee” authenticity. This ownership of the NFT is recorded on the blockchain ledger with identifiers and associated metadata (although this does not completely address issues around counterfeiting and ownership disputes, as other articles in this series will explore).

NFTs are also not in themselves divisible — a feature that brings certain advantages. Many other cryptoassets are easily tradeable because of divisibility and fungibility; for example, many platforms allow retail users to purchase fractions of one bitcoin as an investment asset. However, back to the Fabergé egg example, there is almost no value in a piece of eggshell — the value derives from owning the whole entity. The indivisible nature of NFTs also assists with ownership rights and establishing provenance. However, there are moves towards fractionalisation and decentralized autonomous organizations are emerging to share ownership in an NFT — which, at a very high level, operate like a group of individuals pooling resources to acquire the NFT.

What are the legal implications?

Already in this fast-changing field, NFTs are being posted as collateral, new standards are developing for royalty and licensing payments, and other financialization techniques are emerging beyond the initial creation and purchase of the NFTs. Such developments raise a host of novel legal issues, which Latham lawyers will explore further in this series.

Additional posts in this series:

This post comes to us from Latham & Watkins LLP. It is based on the firm’s memorandum, “NFTs: A Beginner’s Guide to Understanding the Hottest Crypto Craze,” dated March 19, 2021, and available here.