The NFT Market – Some Issues For Investors
Almost every news outlet in the past week published a story about an artist known as Beeple selling a digital image titled “Everydays: The First 5000 Days” through Christie’s for $69.3 million dollars. The particular image is a jpeg file attached to a Non-Fungible Token, or NFT, which is a unique digital certificate that can be exchanged on a blockchain. The blockchain acts as public registry that can confirm the current owner and each transaction, which proponents say will mitigate theft or fraud. NFTs have also been used to sell virtual trading cards, a Lebron James dunk, and a virtual sneaker company; all in an attempt to create scarcity and therefore collectability for digital images.
Potential Uses For NFTs
Because NFTs can be used to identify a unique asset, they can be attached to practically anything and could be used in a variety of ways to publicly confirm the owner of an asset. Looking beyond the digital art craze, NFTs could be used as a public leger for anything unique. An NFT system could act as a register of deeds for real estate, inventory tracking, a lending library, or for trading title to physical art works. NFTs can also be used to impose additional rules on transactions. Many digital art NFTs include code that directs a percentage of each subsequent sale back to the original artist. This could help artists to make money even if they originally sold the work for a small amount of money, only to have it resold later for a larger amount.
Problems With Energy, Longevity, and Scarcity
Most blockchain systems, as currently structured, use a huge amount of energy and computing power to verify transactions and ownership. Transactions and ownership are authenticated by a network of computers each performing complicated mathematical problems and confirming the same answer. According to digiconomist.com, as of March 15, 2021, Ethereum is using 27 TWh of electricity per year, which is as much as many countries. While there are plans to move to less energy intensive methods, none have been widely implemented yet. Additionally, there is no guarantee that an existing system will still be in use in 10 years, let alone the hundreds of years timescale that might be useful for art collectors. Finally, with regard to digital art, an NFT places artificial scarcity for a digital file that can by definition be copied infinitely without any degradation of quality and almost zero costs. While there may be pleasure in owning the “original” copy, there is no physical difference between an original file and a copy of that file.
Many NFT offerings are evasive about what exactly is owned and copyright law complicates that further. Owning a particular copy of a work of art, does not usually include a copyright in the work itself. The copyright owner would still have the exclusive right to make and distribute copies. For paintings, books, or other works that have physical copies, this is not a problem, because copyright law allows for lending, reselling, or giving away a legally purchased copy, under what is known as the First Sale Doctrine. This has not translated well in the digital realm, because when you transfer a digital file online, technically a new file is created when copying to a new computer. In Capitol Records v. ReDigi, the Second Circuit Court of Appeals held that while you could resell a particular device with lawfully purchased digital files, transferring those same files over the internet necessarily required making new copies and that this was not covered by the First Sale Doctrine, even if the old copies were subsequently deleted. If you intend to purchase an NFT based digital artwork, owning the copyright or obtaining sufficient license terms is critical.
Securities and Financial Regulations
The Securities and Exchange Commission has been investigating various blockchain and cryptocoin schemes with increasing frequency in the past several years, and it is possible that NFTs will receive heightened attention now as well. In 2019, the SEC levied a $24,000,000 fine against Block.One for its offering of a token as an unregistered securities offering. Even prior to blockchain, people have used art sales to evade financial regulations, and NFTs could potentially be a vehicle for securities fraud, tax avoidance, or other financial misbehavior. Buyers and sellers should assume that regulators could look skeptically on large NFT transactions.
This post only covered a few of the many potential legal complications, which could also include tax, rights of publicity, anti-money laundering laws, among others. But investors should also pay careful attention to the players involved in the story so far. The $69.3 million buyer first referenced above is an investor in Metapurse, a fund that invests specifically in NFTs (and presumably has NFTs to sell) and he paid in Ether, a cryptocurrency similar to Bitcoin, and not in U.S. Dollars. That should cause more cautious investors to see the headline differently, and adjust their expectations as well. Investors should be careful not to get caught up in the hype and take any headline grabbing price tags with proportional serving of salt.