Non-Fungible Tokens (NFT) are being touted as the next big thing in the digital world. Enthusiasts proclaim that NFTs are the future of digital real estate, and asset tokenization has the potential to disrupt how digital (and in the future, real-world) assets are acquired, owned, and transferred.
In law, the tokenization of real-world assets has a long history. A negotiable document, bill of lading, deed and security certificate each represent an asset and the rights and interests therein. They therefore qualify as tokens. Tokenization evolved to ensure safety, security of the asset and convenience in transfer of ownership. The law also developed in step with these new forms of property, and with the long-established trade customs it provided the necessary conceptual framework for determining the rights and obligations of the parties.
In each of these cases, the token represents the proof of ownership of the underlying asset, and the transfer of the token results in the transfer of ownership with all its events.
In this article, I examine whether NFT as a token meets the test.
The technology
The value proposition for NFT lies in its uniqueness, immutability and exclusive ownership. Blockchain technology enables these functions. Blockchain is a database that no entity controls, and subject to the protocol, anyone can make an entry in it. A new transaction (or entry) can be entered on a block. A new block is created through the mining process (or minting). Once the transaction is complete, the block is closed. A new block is linked to the block before it. The information in each block in the chain is encrypted along with the information in the block before it into a mathematical representation called a “hash”. The unique thing about “hash” is that the moment an input changes, a new “hash” is created. So any change in any of the blocks in the chain will change the “hash”. Therefore, every time a new transaction is entered, the “hash” changes and the new transaction is revealed. This makes fraudulent transactions extremely difficult, if not impossible. This gives the token its unique characteristic of being non-fungible or immutable.
There are two options for storing digital assets related to NFT – on-chain and off-chain storage. In terms of on-chain storage, the digital asset is hashed and entered into the token. And in the case of off-chain storage, the digital asset is stored somewhere else on a server and the token is linked to it through a URL pointing to it. In such a case, the token only serves as a record of the purchase terms and the URL of the digital asset.
Simply put, an NFT is an entry in a blockchain ledger that registers a right to an underlying asset. The rights and interests that the token represents are embedded in it, and sometimes also the underlying digital asset (on-chain storage). Furthermore, since it is based on distributed ledger (or blockchain) technology, past transactions involving it are recorded on the blockchain, and the origin of ownership can therefore be verified. Tokenization of an asset means creating a digital entry on a blockchain ledger that is associated with or associated with the asset being tokenized. The token is thus minted. Once a token is minted, it can be sold to any willing buyer on the same platform where it was minted or elsewhere.
Application of NFT technology
NFT, as we know it, came into vogue for digital assets, especially digital art. NFT-enabled marketplace for digital art has opened up a whole new world of possibilities for digital artists. An artist can tokenize their digital artwork and sell it to a collector, who can sell it to other buyers if and when its value increases.
There is a thriving market for tokenized digital collectibles – Jack Dorsey’s first tweet, a memorable moment in a sporting event, musical composition or just a collectible fad like CryptoKitties.
NFT is also used for physical (or real) assets. In such cases, the rights and interests created in the physical asset are embedded in the NFT. Tokenization, in such a case, enables digital transfer. Since it is on a blockchain, there is an added benefit of being able to verify past transactions and the origin of the title. A physical item can thus be traded digitally, and a buyer who wants to take possession of it can redeem the chip. Securities lend themselves very well to digital tokenization, as do negotiable instruments.
Tokenization has potential for application in the real estate market (and dispensing with the need for title searches), securities trading, documentary credit, commodity trading (through tokenization of bills of lading) and other commercial activities.
NFT sites represent that a buyer acquires the NFT and the ownership of the underlying asset. They make specific representations regarding the acquisition of ownership of the NFT (and implicitly the asset associated with it) and its unrestricted transferability.
The concept of ownership
Ownership is a bundle of rights. It is “a right [over a thing] unlimited in terms of user, unlimited in terms of disposition and unlimited in terms of duration”. An owner always has the right to use the thing he owns in the way he chooses and to dispose of it as he wishes. It can be absolute or limited by previous encumbrances.
NFT as a medium for transferring ownership
When a person buys an NFT, he would like to believe that he owns the token and title to the underlying asset without encumbrance. He is free to sell it to any willing buyer for the value he negotiates, or the market determines, and the seller has no control over the further sale. But is it really so?
NFT platforms promote NFT as proof of ownership of the underlying asset. However, the creation of the NFT and the rights attached to it are subject to the terms of use of the NFT platform where it was created.
In reality, the rights acquired by the buyer fall far short of the legal ownership with all the events described above due to the terms of service of these platforms and the control they exercise over NFT due to the nature of the technology.
In an article published in the Florida Law Review, the authors reviewed the terms of service of eight NFT platforms. They concluded that:
Although the website relinquishes control over the token, the terms of service allow the website to block access to the token created. The Terms of Use also allow the Site to remove digital assets in some cases.
The terms of use do not provide a direct link between the token and the underlying asset. In the case of digital artwork, the Terms of Service impose restrictions against commercial use.
NFT does not grant intellectual property rights in the underlying creative work.
The authors concluded that NFTs do not embody the property rights of the reference asset. They found that the claims made by the NFT platforms in that regard were often confusing and conflicted with their terms of use. There was a complete lack of clarity regarding the link between the NFT and the underlying asset. In the case of off-chain storage of underlying assets, the link is further weakened due to the buyer’s lack of control over the storage.
Historically, tokenization worked because there was an elaborate legal framework to support it. It is the law that created the link between the token and the underlying asset. For example, the bill of lading embodies the title to the goods because the law recognizes it. There is no such legal framework for NFT. The contractual framework under which the NFT is created does not fill that gap. On the contrary, as described above, it increases confusion and thus creates more uncertainty.
However, the fact remains that NFTs, despite their legal flaws, are becoming mainstream for digital assets. It needs a legal framework for it to succeed.
No doubt the existing law can be retrofitted to provide such a framework. Indian law recognizes intangible assets as a form of property. Therefore, the laws that regulate the sale of goods and the transfer of property can provide the necessary framework. However, the law must first recognize NFTs as personal property, which is a challenge. The NFTs, as they are currently composed and offered, provide a weak link to the underlying asset. They are closer to a bundle of contractual rights in relation to it, rather than its representation in the form of a symbol.
This article was first published at
