News & Views

Non-Fungible Tokens (NFTs) — Memes for the Mega-Rich or a Real Business Opportunity?

10 February 2022

Authors: Sarita Schröder, Antti Kuha, Jesper Nevalainen, Panu Siitonen, Maria Wasastjerna, Sanna Boow, Marika Sorsa, Stefan Stellato, and Essi Ellman

 

Over the past year, you may have come across reports of non-fungible tokens, or NFTs, being sold for astronomical sums of money. For instance, in March 2021, it was reported that the American artist Mike Winkelmann, also known as Beeple, sold an NFT for a collage of 5,000 digital images for over USD 69 million. The same month, it was also reported that Twitter co-founder and then-CEO, Jack Dorsey, sold an NFT for his first tweet for USD 2.9 million. NFTs have also been used to facilitate the sale of copies of famous memes, such as the ‘Nyan Cat’ meme, which sold for close to USD 600,000 in February 2021, the ‘Disaster Girl’ meme, which sold for close to USD 500,000 in April 2021, and the ‘Doge’ meme, which sold for USD 4 million in June 2021.

To date, the most valuable NFT transaction recorded involved a digital work of art called ‘Merge’, created by an artist known only as Pak. It has been reported that in December 2021, almost 29,000 buyers spent a total of USD 91.8 million to buy over 300,000 units of the artwork. However, this is only a small fraction of the total value of the NFT market. It has been estimated that in 2021, the value of NFT transactions using Ethereum, the most popular technology for NFT transactions, exceeded USD 40 billion — and the total NFT market size is larger still. 

But what are NFTs and why are they fetching such high prices on the market? Are they just a passing craze for individuals with too much money on their hands, or do they carry real business potential for companies in a wide range of industries? Read on below to find out the answer to these questions and more.

What Are NFTs?

To put it simply, NFTs are blockchain-based digital certificates of authenticity or ownership for physical or virtual items. Like physical items, virtual items associated with NFTs are often technically separate from the relevant NFTs. In other words, NFTs themselves do not have any inherent value. Rather, the prices paid for them reflect the value of the items with which they are associated — just as is the case with respect to more traditional types of certificates of authenticity or ownership.

What sets NFTs apart from more traditional types of certificates of authenticity or ownership — including ones in digital format — is that they are blockchain-based. This means that they are not stored in any single place (e.g., on a specific server) but instead distributed across multiple locations, referred to as nodes, on a growing list of records, called blocks, linked together to form a chain (i.e., a blockchain) in which each block containing information about the block preceding it. Consequently, NFTs — like other data stored on a blockchain — are resistant to unauthorised tampering because the data in any given block cannot be altered retroactively without altering the data in all subsequent blocks.  

Another notable feature of NFTs is that they can be programmed to include a variety of smart contract functionalities, i.e., self-executing contractual terms, such as resale restrictions or royalty clauses. As an example of the latter, an NFT can be programmed so that the party who originally created (or, in industry parlance, ‘minted’) and sold the NFT will automatically receive a certain percentage of the revenue generated through any subsequent resale of the NFT.

How Do NFTs Differ from Cryptocurrencies?

Blockchain technology is perhaps still more commonly associated with cryptocurrencies, such as Bitcoin or the Ethereum-based cryptocurrency Ether. Each unit of a cryptocurrency is typically fungible, i.e., interchangeable with all the other units of the same currency, without either party to the exchange being any better or worse off. For example, if you and I each have one Bitcoin and we exchange them with one another, we will both still have the same buying power in Bitcoin as we would have had without the exchange.

NFTs, on the other hand, are — as their name suggests — non-fungible. In other words, the value of each NFT is unique to that NFT. This means that unlike units of a cryptocurrency, NFTs are not mutually interchangeable. For example, if I have the NFT for the ‘Nyan Cat’ meme and you have the NFT for the ‘Disaster Girl’ meme, we can exchange them with one another just as we exchanged our Bitcoins in the example above. However, after the exchange, you and I will both have something of a different value than we each initially had. Moreover, the value of each of our memes will continue to develop independently of one another to the same extent as the value of two more traditional works of art would.  

Similarly, NFTs can be and often are exchanged for cryptocurrency. For instance, most of the transactions mentioned in the opening paragraphs were, in fact, carried out in the cryptocurrency Ether, and the US dollar amounts specified therein have been calculated on the basis of the exchange rate for Ether on the respective transaction dates.

What Does the Owner of an NFT Actually Own?

A key question when dealing with NFTs is what the owner of the NFT actually owns. There is, unfortunately, no straightforward answer to this question. A common misconception is that by purchasing an NFT for a particular item, the buyer of the NFT would also gain ownership to the intellectual property rights (IPR) underlying the item associated with the NFT. Whether that is the case depends on what has been agreed between the parties to the transaction or, in the absence of any specific agreement on IPR ownership, the content of the law governing the transaction.   

As a rule of thumb, it can be stated that IPR ownership is generally not transferred together with the ownership of a physical or virtual item unless the parties have specifically agreed on such a transfer. For example, if I purchase a printed book or an e-book, I gain the right to read and enjoy that book, but the right to modify that book or distribute copies of it to the public (i.e., the copyright) remains with the author or other copyright holder. The same general principle applies in the context of NFTs associated with physical or virtual items. For instance, through the ‘Disaster Girl’ meme transaction, the buyer gained ownership of the original copy of the meme. However, the seller retained the copyright and related distribution rights to the meme.

What is the Business Potential of NFTs?

At least at present, the market for memes and other such eccentric virtual collectibles is rather niche — and it may remain so. However, the business potential of NFTs extends far beyond this much-hyped market, as is described in more detail below.

Increased Security and Transparency

Firstly, as mentioned earlier, NFTs are more robust than more traditional types of certificates of authenticity or ownership, because they are more difficult to alter fraudulently without leaving behind evidence of wrongdoing. On the other hand, each authorised transfer of an NFT is also logged on the blockchain, making it easier to ascertain in a reliable manner the chain of title to the physical or virtual item to which the NFT is linked. Thus, among other things, the use of NFTs can help impede the sale of counterfeit or stolen goods.

In addition to the transaction history of an item, other information about the item can also be recorded on the blockchain by linking the item to an NFT. Such other information can include, for example, information about the various parties to the supply chain or information about maintenance or repairs that have been carried out on the item. Recording this type of information can help increase transparency about the sustainability and quality of the item. However, it should be noted that there are certain sustainability concerns associated with NFTs and other blockchain-based technologies, as they typically require a vast amount of computing power and, thus, generate substantial carbon emissions — although more sustainable variations of these technologies are being developed and introduced.

New Revenue Streams

For the above-mentioned reasons alone, NFTs may eventually replace more traditional certificates of authenticity and ownership, for example, in the fields of art, luxury goods, and consumer electronics — just to name a few. However, what makes NFTs perhaps even more appealing from a business perspective are the smart contract functionalities that can be incorporated into them.

For instance, due particularly to increased sustainability awareness among consumers, the second-hand market is experiencing unprecedented growth. It has been estimated that the second-hand market for fashion, valued at USD 36 billion in 2021, is expected to double by 2025 to USD 77 billion. Currently, profits from this market are being derived primarily by specialised second-hand retailers — not by fashion brands themselves.

However, by using NFTs incorporating self-executing royalty clauses, fashion brands could change the situation without necessarily needing to get actively involved in the second-hand market. Of course, for this to work, each item must be sold together with the associated NFT. At least for more upmarket brands, this should, however, not be a major challenge, as second-hand buyers are savvy and usually unwilling to pay full market value or even purchase an item at all if it is not accompanied by the appropriate certificate of authenticity and ownership.

Naturally, the profit-making potential of the use of self-executing royalty clauses is not limited to the fashion industry. It applies equally in any context in which the sale of an item together with an accompanying certificate of authenticity and ownership — in this case, in the form of an NFT — can be rendered either technically necessary (e.g., virtual items) or at least customary (e.g., physical works of art and many high-end consumer goods).

Increased Control Over Distribution Channels

In addition to self-executing royalty clauses, NFTs can also be programmed to include, among other things, self-executing resale restrictions. This can give brands better control over where and through which channels their goods are distributed and even for what price. For example, by linking their goods to NFTs, a brand operating an exclusive distribution system could render it technically impossible for their authorised distributors to sell the goods outside of their designated territories.

However, it is important to keep in mind that everything that is technically possible with the help of NFTs is not necessarily lawful. Thus, before imposing such resale restrictions, it is crucial for a brand to ensure that they can do so in a way that does not run afoul of, among other things, competition laws and regulations (which the brand would risk doing, e.g., if the aforementioned territorial restrictions were to apply not only to active but also to passive sales or if the brand were to impose self-executing minimum resale prices or in other ways restrict the distributor’s ability to determine its resale prices).   

Entirely New Markets

Finally, an article about NFTs can hardly be written without mentioning their potential to create entirely new markets for items that it would previously have been difficult — if not impossible — to commercialise. In particular, this potential relates to the emergence of the so-called metaverse.

There are varying definitions for what is meant by the metaverse. However, the company formerly known as Facebook (now, Meta Platforms), which stirred up much attention around the term through the announcement of its recent rebranding, has defined it rather simply and comprehensibly as “a set of virtual spaces where you can create and explore with other people who aren’t in the same physical space as you”. According to the company, in the metaverse, “[y]ou’ll be able to hang out with friends, work, play, learn, shop, create and more.”

As our lives increasingly move from the physical world to various virtual spaces, there is a growing demand for virtual items, such as avatars and virtual fashion, to enhance our virtual identities. NFTs can be used to facilitate the sale and reliably record the ownership of such items not only within a single virtual space but potentially also across numerous different virtual spaces. For instance, if I purchase a virtual outfit in virtual space A (e.g., Fortnite), an NFT can function as a receipt that ensures I am able to redeem the same virtual outfit in virtual spaces B (e.g., Roblox) and C (e.g., Minecraft).  

In addition to purely virtual items (or purely physical items, as discussed earlier), NFTs can be used in relation to items that combine elements of the physical and virtual worlds. For example, already in 2019, it was reported that Nike had obtained a US patent for its CryptoKicks technology, which enables the owners of NFTs associated with physical pairs of shoes to “breed” their virtual counterparts and have the “offspring” made in physical form.

Some Legal Considerations with Respect to NFTs

NFTs are an emerging technology, whose potential is only just beginning to be realised through experimentation and innovation. As is inevitably the case with respect to all new technologies, the legal framework governing the use of NFTs is not yet fully established. Nevertheless, before introducing NFTs as part of your business’ commercial offering, it is worth considering at least the following questions:

  • What commercial terms will govern transactions involving NFTs? In particular, who will own the IPR underlying the physical or virtual item with which the NFT is associated?
  • If you plan to offer NFTs to consumers, how can you ensure compliance with consumer protection legislation, for example, are the terms of the transaction sufficiently clear to consumers and can the consumers’ statutory rights, such as their right of cancellation, be fulfilled?
  • How can you ensure compliance with data protection legislation, such as the General Data Protection Regulation (GDPR), when dealing with NFTs? For example, in the light of the immutability of blockchain ledgers, how can you fulfil the data subjects’ right to be forgotten?
  • Are any resale restrictions you may be planning to impose lawful, for example, from a competition law and contract law perspective?
  • Are there other competition law risks associated with the planned activities? For instance, given that blockchain technology relies heavily on information sharing and transparency, it is important for the companies involved to ensure that the activities do not lead to anticompetitive information exchange between competitors.
  • What are your income tax liabilities? For example, if you purchase an NFT, are you subject to income tax because you pay for the NFT in cryptocurrency? Or, if you mint an NFT, is taxation delayed until you sell the NFT and what is the applicable income tax rate?
  • Are you liable to report and pay value-added tax (VAT)? Among other things, it must be assessed on a case-by-case basis whether the transaction constitutes a sale of goods or the provision of services, in which country possible VAT liabilities arise, and whether any VAT exemption rules apply.
  • Are there any financial regulatory requirements with which you need to comply in the relevant jurisdiction(s)? This assessment may be impacted by, among other things, whether the NFT is sold as a whole or whether the rights related to it are divided into smaller fractions that can be held by different parties.
  • Do your current trademark registrations cover the relevant NFT-related goods or services, or are new trademark registrations necessary?
  • What is your strategy for brand enforcement in the metaverse? (Note: This question is relevant regardless of whether you plan to use NFTs in your business.)

Should you wish to explore further any legal consideration with respect to NFTs in the context of your business, our experts are on hand to assist you in their respective fields of specialisation:

 

More News