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NFT Evaluation, Opportunities and Challenges

The Non-Fungible Token (NFT) market is mushrooming in the recent couple of years. The concept of NFT originally comes from a token standard of Ethereum, aiming to distinguish each token with distinguishable signs.

This type of tokens can be bound with virtual/digital properties as their unique identifications. With NFTs, all marked properties can be freely traded with customized values according to their ages, rarity, liquidity, etc.

It has greatly stimulated the prosperity of the decentralized application (DApp) market. At the time of writing (May 2021), the total money used on completed NFT sales has reached $34,530,649.86$ USD.

The thousandfold return on its increasing market draws huge attention worldwide. However, the development of the NFT ecosystem is still in its early stage, and the technologies of NFTs are pre-mature.

Newcomers may get lost in their frenetic evolution due to the lack of systematic summaries. In this technical report, we explore the NFT ecosystems in several aspects.

We start with an overview of state-of-the-art NFT solutions, then provide their technical components, protocols, standards, and desired proprieties.

Afterward, we give a security evolution, with discussions on the perspectives of their design models, opportunities and challenges. To the best of our knowledge, this is the first systematic study on the current NFT ecosystems.

Recently, NFTs have received significant attention for the high-dollar sales of digital art and collectibles. However, the underlying, blockchain-enabled capability has potential to disrupt many industries, enable a wide span of transactions of both real-world and digital objects and support more direct transactions at scale between buyers and sellers.

"NFTs have the potential to transform how people execute real estate transactions and open the door to fractional ownership of properties, as just one example of their potential impact,” said Kent Barton, head of research and development of ShapeShift and author of the report.

“There is a lot to unpack with NFTs and work to be done to enable a future where NFTs are at the center of a more seamless, direct transfer of ownership. It’s important to understand what they can possibly mean for the future, and what work remains to get us to that future.

Unlike tangible assets such as an original Picasso, a LeBron James rookie card (which recently sold for $5.2 million), or even a piece of real property, buyers of NFTs are essentially purchasing non-physical certificates of authenticity in code form that can never be changed.

Sure, anyone can hop online and see an image of that Beeple collage, have a laugh at the expense of Brian, or read the NYT piece by Kevin Roose, but only one person or entity can actually boast ownership of the unique characters (read: stored information) living on the Etherium blockchain that represent the genesis of each creation being acquired.

It’s this uniqueness that makes an NFT non-fungible. While one bitcoin can be traded for another, leaving the owner with the very same thing (meaning a bitcoin is fungible), a one-off digital asset (say, that first Jack Dorsey tweet) is like a piece of art.

Sure, it can be copied or replicated, and even viewed by millions, but there’ll only ever be one original. To collectors, there’s considerable value to that, and the data NFTs contain can be used to prove ownership rights over these digital assets.

But is this new(ish) digital asset class destined for mass adaptation? Maybe yes, maybe no. Whatever the case may be, it's clear that NFTs are attracting a lot of attention these days. And with the buzz come potential legal pitfalls. Here are three to consider.

For many, NFTs are speculative assets, purchased as investments assuming their values will increase over time, in which case they can be sold at a profit. As such, despite their digital characteristics, NFTs run the risk of being considered “securities” for purposes of their treatment under the law.

Under the Securities Act of 1933, a security is essentially any type of negotiable instrument that represents some type of financial value. Some that immediately come to mind include fungible investments like stocks and bonds.

But the definition of securities as set forth by the U.S. Supreme Court also includes “investment contracts,” meaning an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." This so-called Howey Test begs the question: could release of an NFT implicate federal securities law?

The short answer is: it depends. For many NFTs, like Jack Dorsey’s inaugural tweet or Beeple’s aforementioned digital masterpiece, token purchases involve the investment of money, but do not contemplate a common enterprise or any further effort of others to produce profits.

Instead, as is the case of an investor buying a Monet or other valuable work of art, those acquiring NFTs hope that the marketplace will dictate their appreciation over time. Bottom line: neither Dorsey- or Beeple-type exchanges trigger securities concerns.

However, should an NFT be sold to fund a company’s business or—say—the development of its blockchain, it’s pretty clear such a transaction would meet all elements of the three-pronged Howey Test and, therefore, the token would be considered a security.

Likewise, if an NFT is purchased with the intent of licensing the underlying asset, or reselling copies for profit, then the analysis changes and securities laws could potentially come into play.

If characterized as a security after satisfying the Howey analysis, any given NFT would be subject to heavy duty scrutiny and regulation by the Securities and Exchange Commission, particularly when it comes time to sell. In that instance, sale of the token would require registration with the SEC, unless an exemption under federal securities law applied, and the NFT would fall under state “blue sky” laws. And there is more. Platforms facilitating any NFT transaction would also have to register as a securities exchange, alternative trading system, and/or as a broker-dealer.

For these reasons, NFTs and their relation to the Securities Act should be on the minds of all buyers, creators, and operators of NFT exchanges.

NFT deals are typically considered to be barter transactions for tax purposes, as tokens are generally characterized as property, as opposed to currency, by the IRS. This means that the fair market value of these assets must be reported on tax returns as income, and sales are to be set forth as capital gains.

For would-be Beeples looking to ride the wave of NFT mania, it's vital to be aware of the legal issues tied to these headline-making digital tokens. That means remaining mindful of the IP, securities, and tax law concerns that come with the territory when dipping a toe or jumping head first into this increasingly popular digital asset class.

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