With everyone from CNN to luddites talking about NFTs, we’ve embarked on a two-part article to kick off the new year of 2022 and demystify NFT, an acronym so popular that Collins Dictionary declared it as 2021’s word of the year. The first part of our article will discuss the basics of how NFTs operate and as with every NFT article, it must begin with the following question.
What is an NFT?
We could call it the New Face of Technology but NFT, the habitual resident of today’s headlines, simply means Non-Fungible Token. If you’re a crypto whiz with a huge collection of NFTs, or if you’re top of the leaderboard in the latest NFT game, or if you already know what NFT means, please have a look at part 2 of the article
where we will analyse some of the legal and regulatory issues surrounding NFTs. But if your only impression of NFTs is that they’re a scam used to convince people to spend thousands of dollars on images of ugly monkeys, here’s a primer on the basics.
An explanation might best start with the “non-fungible” nature of NFTs, a key aspect to their success and importance, but what exactly does “non-fungible” mean? In short, it denotes something that is unique and which cannot be replaced by another. A common illustration would be to compare NFTs to bitcoins but then, some readers might ask ‘Wait, what is a bitcoin?’ so let’s go with the following analogy.
Imagine if you borrowed RM5 from us, you could pay us back with any RM5 note in your wallet (or notes or coins which add up to RM5) and that would be fine. Even though every banknote is technically distinguishable from each other through its serial number, we would not expect to get back the same banknote, as the value of each RM5 banknote is the same, each RM5 banknote is thus fungible. In essence, when something is fungible, it can be exchanged with any other item, asset, or commodity of the same type and value, and neither party in that exchange loses out.
On the other hand, when something is “non-fungible”, it is unique, one of a kind, and non-interchangeable. Imagine if you entrusted us to babysit your child because you wanted to enjoy a getaway in peace. When you return from your getaway, you would logically expect to be reunited with the exact same child you had left in our hands, and would not accept any other child, even if we swapped said child with an identical twin (unless of course, you’re a terrible parent but let’s assume you’re at least a decent one). Your child is non-fungible, it cannot be replaced by any other, and in this sense, NFTs are like your beloved child.
But how do NFTs work?
At a very general level, distributed ledger technology (DLT) is used to demonstrate and verify the uniqueness and ownership of NFTs. Blockchain is only one type of DLT, but this article will focus on blockchain since it is the most commonly used DLT for NFTs. Yes, we know, too many buzzwords but bear with us.
When someone creates an NFT to sell on an NFT marketplace, this is called minting, which is done through smart contracts1
that assign ownership and manage transferability of the NFT. Minting essentially refers to the process of creating a unique digital version of something as a data file which is then deployed onto the blockchain. Think of blockchains like database systems that are very difficult or near impossible to change, hack or cheat, which makes them valuable methods for proving ownership. Because NFTs are supported by the blockchain, NFTs cannot be edited or deleted2
, and the ownership is forever recorded on the blockchain. Most blockchains which host NFTs are also publicly accessible, and ownership of NFTs can thus be viewed, and verified, by anyone in the world. NFTs can thus be freely traded with verifiable ownership and transaction traceability.
Beyond the basics of ownership and traceability, NFTs can also be programmed to include a variety of other applications and functionality. Smart contracts, as rights management tools, can be written to automatically allocate a portion of the amounts paid for any subsequent sale of the NFT back to its creator. For example, NFTs sold on OpenSea can be programmed, via an easy to use interface, so that each transaction includes royalties to be paid to the creator of the NFT.3
The NFT can also be programmed to include limitations on how it gets used, e.g. the asset can only be downloaded a dozen times, or the asset cannot be viewed on specific platforms. Whilst anyone can write and deploy a smart contract, this would involve some coding skills and deeper pockets as the costs for smart contract deployment are generally higher. As such, most creators typically mint their NFTs with one of the many existing smart contracts available online via open-source licences (Part 2 of our article will discuss the potential issues surrounding intellectual property rights).
Each NFT contains a unique identifier which distinguishes it from all other NFTs, giving it its “non-fungible” characteristic, and metadata, which describes the digital file or item the NFT represents. Aside from the unique identifier, creators have the choice of including a variety of different data and information in their NFT when minting it. For example, creators may decide to incorporate the entire dataset of their digital art in the NFT although in practice, most creators simply provide a link to the art, which is stored elsewhere. The metadata of an NFT can also include a variety of different information, including the artist/creator of the underlying item, a description of the item, the ownership of the item, and specifications on royalties. Creators also have the choice of incorporating contractual/licensing terms in the metadata of the NFT (more on this in part 2 of the article).
Who’s been getting involved with NFTs?
NFTs have often been lauded as the next step in digital art collecting and much of its current popularity stems from the digital art sector. As an example, the popular digital artist Beeple had in March 2021 sold an NFT of his art piece entitled, ‘Everydays: The First 5000 Days’ for a whopping $69 million. Celebrities have also jumped onto the NFT bandwagon, with the likes of Lionel Messi launching his NFT art collection ‘Messiverse’, and the band Kings of Leon releasing its album, ‘When You See Yourself, as an NFT in March 2021. Snoop Dogg has also recently ventured into the NFT space, launching his NFT art piece titled “Decentralized Dogg” on SuperRare.
Must it be art?
Not at all. The hype usually revolves around something creative but really, anything that a creator wants to make unique can be represented by an NFT. The underlying asset can be digital (like gifs and tweets) or physical (like Picasso and wine) but in essence, anything tangible or intangible with a unique value can be represented by an NFT.
Some notable examples include:
What’s so special about buying an NFT?
The Internet is a great place but it’s also where digital files are constantly copied. DLT like blockchain introduces scarcity or uniqueness into this world, which allows NFTs to hold value in a way that’s similar to how paintings or limited-edition sneakers can hold their value. In other words, the value is based on how well received the item is by the public: first ever tweet by Jack Dorsey (valuable!) vs one of our authors’ first ever tweets (certainly not as valuable).
This scarcity makes NFTs more attractive for buyers, but it also unlocks a potential for the assets to thrive in the secondary market in a way that still rewards their creator, one example being royalties. It also allows creators to expand their offerings – like Barrett-Jackson selling NFTs of cars already sold for charity (the NFT here representing the digital packaging of an exclusive video, an illustration and still images to commemorate the sale of the physical cars10
NFTs are not only beneficial to sellers, they can also benefit the buyer in different ways. For instance, buying an NFT not only gives the buyer access to great art (“great”, of course, is relative), but if the NFT is part of a valuable series such as Cool Cats or the Bored Ape Yacht Club, the buyer gets exclusive bragging rights which, as we know, is an invaluable asset in the social media-centric society we live in, and possibly gain additional rights such as access to exclusive events or more NFTs, giving them more to sell.11
For some of these NFT projects, buying an NFT is less about money, and more about connection and community (and no, it’s not quite the same as joining Reddit). A more sentimental soul would say NFTs brought culture to blockchain, but a realist would add that scammers and fraudsters have tagged along, so be wary of fraudulent tactics such as ‘shill bidding’, an age-old scam where low-value items have their price artificially inflated through collusion. In a nascent marketplace that remains largely unchecked, it is an inescapable reality that NFTs of “great” art which anyone can copy or save, and which is sitting on a centralised server might not be worth the $500,000 you paid. On the other hand, the blockchain’s semi-transparency also makes it harder for shoddy transactions to hide.
It’s still early days for Web3 but the present NFT hype is an impetus for mainstream adoption of distributed ledgers where bureaucracy and market friction can be reduced. Notwithstanding that there is a healthy amount of scepticism and cynicism from certain groups, we are of the view that the token economy will not stay a fringe phenomenon for long once the underlying technology matures and irons out its kinks. Make no mistake, NFTs, and to a larger extent DLT, are here to stay, and will represent a huge shift in how we represent ownership of items in the near future.
Article by Natalie Lim (Partner) and Cheam Tat Sean (Associate) of the Intellectual Property Practice of Skrine.