What is a Non-Fungible Token?

Fungible items, like dollar bills or shares, can be readily exchanged for other dollar bills or other shares in the same business and you continue to own the same thing. The item's value defines it, rather than its unique properties.

NFTs, on the other hand, are not interchangeable due to their unique properties. In the same way that you cannot readily exchange one plot of land for another, or one unique piece of artwork for another, without owning something fundamentally different. The value in an NFT is therefore derived from its “non-fungibility”, meaning that the token cannot be replaced with an identical token (giving its inherent scarcity).

NFTs are composed of software code and are typically in the form of one or more smart contracts. Like traditional cryptocurrencies, NFTs in the form of smart contracts are created - or "minted" - on a blockchain (that is, distributed ledger technology) using cryptography, and they can be bought and sold or otherwise exchanged on any NFT market based on the same blockchain. 

It is the smart contract constituting the NFT that contains details of the underlying digital or physical asset(s) (if any) to which the NFT relates, and also the rules and rights that attach to the NFT (for example, who owns it, how it can be transferred, what exactly the NFT represents, and perhaps a rule that the original creator of the NFT gets paid a percentage of any subsequent resale value).

Sometimes the NFT exists on a specific platform that is governed by additional terms in a traditional contract. As with other tokens created on a blockchain, the blockchain tracks the transaction history of the NFT from issuance to any number of subsequent transfers, and such record is immutable. 

The record, in turn, creates "provable" uniqueness and scarcity, and these concepts are what ultimately leads to value. NFTs, then, are essentially unique digital representations with blockchain-based transferability, authenticity, and ownership properties.

Gaming developers and purchasers should keep in mind which blockchain is used to mint an NFT, as many marketplaces will only work with certain blockchains, and once an NFT is minted on one blockchain, at the moment it may not be able to be moved to another blockchain.

The legal nature of an NFT

Is an NFT a type of property itself? Does it confer property (ownership) rights in anything else (for example, an underlying asset or a digitised representation of something)?

With respect to tangible things, there are potentially two forms of property: ownership of the physical thing itself, and sometimes, ownership of intellectual property in it. However, where a thing exists only in a dematerialised form (as in the case of an NFT), is ownership in anything possible other than intellectual property rights? Two recent cases, one English and the other Singaporean, have suggested that the courts may be willing to recognise that NFTs may be a species of dematerialised property, with ownership rights subsisting completely separately from intellectual property – see our blog, Are NFTs a type of property under English law?

Why is this important? End users value ownership. If all an NFT issuer is doing is granting a licence of the intellectual property in an NFT, that may detract from perceived scarcity (and therefore value). Conferring ownership, on the other hand, may augment perceived value, and facilitates the creation of a secondary market for NFT on-sales (and potentially, the payment of royalties to the initial minter in respect of such sales).

For the uninitiated, however, the idea that an NFT can itself be property – that it can be something that is owned to the exclusion of all others – can lead to confusion about what rights the NFT owner has in any underlying/off-chain asset/item to which the NFT refers.

Rights in underlying assets

If the underlying asset/item is:

• Digital, there is typically a link to a digital file on an off-chain server or, less commonly, a digital file stored within the NFT itself.
• A physical asset/item, then there is no option to use a link to the physical world. Most NFTs relating to physical assets/items therefore still rely on QR codes or, more simply, company records that record the link between the NFT and the physical asset/item.

Unless otherwise provided for contractually in some way, the NFT owner may find that it has no rights at all in the underlying asset/item. Rights in the underlying thing would simply be determined by, in the case of an artwork say, normal intellectual property rights principles. 

For more information on what rights NFTs confer in underlying assets/items and intellectual property rights, see What are the intellectual property rights issues, below.

NFTs in gaming and the metaverse

NFTs have many use cases, though gaming (in particular the gaming metaverse(s)) represents some of the key areas in which NFTs may bring radical transformation and enhance user experience. For instance, NFTs can be linked to in-game items such as weapons, vehicles, keys, collectibles and even lands. The inherent uniqueness of each NFT token confers to the game player a sense of ownership and authenticity of the particular in-game item.

In cases where the item is scarce in the game, it may be possible (online and offline) to sell the NFT representing the item. This allows the player to monetise the effort devoted to obtain the item, while at the same time the game developer may also get a share of the selling price by including appropriate terms in the NFT smart contract.

Although such in-game trading market already existed in some games without involving any NFT technology, such in-game items were tied to the specific gaming platform. The blockchain technology that supports NFTs provides the possibility for the item to exist independently of the gaming platform and to be traded outside the game developer’s system. However, in order for a virtual object from one game or metaverse to be used in another game or metaverse, the gaming companies have to agree on interoperable software coding.

What are the intellectual property issues?

There are a number of ways in which NFTs might deal with intellectual property rights:

• Intellectual property rights are purported to be assigned (transferred) to the NFT owner in relation to the underlying asset.
• A licence of intellectual property rights in the underlying asset is granted.
• No intellectual property rights are granted at all in relation to the underlying asset. At best, the NFT may operate as a mechanism for certifying provenance of the underlying asset.

Buyer beware

The obvious way that an NFT can be monetised is by selling it to a third party. However, for the buyer, the reality of purchasing an NFT is often not as straightforward as purchasing a physical asset. While the owner of an NFT can prove it owns the NFT, it does not necessarily own anything more than that.

An NFT is essentially metadata about an asset which is added to a blockchain. This means that, while an asset is used to encode the NFT to make a unique representation of that asset, the NFT is not usually - unless there are terms to the contrary in the smart contract encoded in the NFT or in any associated terms of sale - the actual asset itself. 

To use an analogy of the limited edition print of an artwork, if a collector owns a physical limited edition print, the collector would own the physical print itself but would not usually own any proprietary rights in the original artwork. This is an important distinction. Those buying an NFT should carefully consider what they are getting when they purchase an NFT, as the ownership of an NFT does not automatically give rise to any ownership rights in the underlying asset.

Selling an NFT and the underlying asset

An NFT seller can sell both the NFT and the underlying asset together. The NFT can then be used as a digital proof of ownership. This raises two important considerations:

• Ownership of the underlying asset

The purchaser of the NFT should check who owns the underlying asset. Typically, the sale of the NFT does not include sale of the underlying asset or any intellectual property rights that vest in it.

• Possession of the underlying asset

The purchaser of the NFT should also check who has possession of the underlying asset, particularly where the underlying asset is a digital file - for example, a digital piece of art. 

An NFT is linked to the underlying asset either by the digital work being encoded in the NFT (which is not very common) or by the NFT containing a cryptographic code that links to, or that can be used to identify, the digital copy of the artwork (which is the more common).

In the latter scenario, the NFT will typically contain what is known as a “hash” of the digital file. The hash is produced by applying a cryptographic mathematical function to a digital file to get an alpha-numeric string of characters, which acts as a unique identifier of the original file.

The hash value is used to authenticate that the NFT relates to that digital file. It is not possible to reverse engineer the digital file from the hash, so the hash in the NFT does not give the purchaser of the NFT the ability to possess the digital file to which the NFT relates. The purchaser will still separately need a copy of the digital file in addition to the NFT.

The purchaser should consider:

• Where the digital file will be stored and who will be responsible for maintaining it. In some cases, the digital file is hosted online and the NFT would then contain a URI or URL that points to the webpage where the digital file is hosted.
• What assurances it has that the digital file is going to continue to be hosted on that webpage, and that the file that is hosted there is not going to be altered. This should be included in the terms of sale of the NFT and/or the smart contract encoding the NFT.

Licensing of intellectual property rights in the underlying asset

A more common approach than for an NFT seller to sell the underlying asset is for NFT seller and IP rights owner to license use of the intellectual property rights in the underlying asset to the purchaser of the NFT for certain purposes. 

Such licence should be set out in the smart contract or in a separate agreement between the NFT seller and purchaser. In the absence of an express licence, under English law principles at least, a licence will be implied, but will probably be quite narrow. Depending on the circumstances, in the case of an NFT relating to a digital asset, the licence may be limited just to the right to use or display the underlying digital asset for personal use and for the purposes of re-sale of the NFT.

Royalties on subsequent sale

NFTs open up a potential new revenue stream for asset owners, as it is possible to code an NFT’s smart contact to make a royalty payment automatically to the original NFT seller on each onward sale of the NFT. The royalties are normally paid as a percentage of the secondary purchase price, and open up the possibility of ongoing revenue streams.

This aspect of NFTs is of particular interest to digital content creators within the gaming sector, where financial benefits to creators can incentivise game developers to record their ownership of in-game items and help to fuel in-game economies. See NFTs in gaming and the metaverse, above.

Misuse of IP and potential infringement

With all the opportunities that NFTs present for a business, there is also the inevitable opportunity for misuse of a business’s or brand owner’s intellectual property rights held in any underlying asset through minting of unauthorised NFTs. For instance, who has the right to mint (create) an NFT based on an underlying digital (or other) asset? Minting an NFT without securing rights in the underlying asset (whether by ownership or a licence) could constitute copyright infringement.

Taking English law as an example, there are two main types of infringement that may arise as a result of the unauthorised minting of an NFT relating to a digital asset:

• Infringement of the reproduction right (i.e. the restriction against reproducing or copying copyright works).
• Infringement of the communication right (i.e. the restriction against communicating copyright works to a new public not originally envisaged by the copyright owner).

With respect to the reproduction right, if the NFT includes a digital copy of the asset, there is potential for this to amount to an unauthorised reproduction that may amount to infringement of copyright. However, in circumstances where there is no reproduction of the underlying asset in the creation of an NFT, there is arguably no infringement.

With respect to the communication right, the minting of an NFT linked to an underlying asset is arguably a different act from that of making the asset available in a new forum. On the other hand, if the NFT does include a digital copy of the asset, the act of minting the asset may well amount to a communication to a new public that was not envisaged by the copyright holder.

Another issue that arises is how will the location of NFT use and jurisdiction be established. Most IP rights are territorial, so how will this work for NFTs in virtual worlds where it is harder to make the connections to a particular jurisdiction (compared with the use of country domains / languages / currencies on websites)?

Similarly, identifying the real-world parties may be an issue because, even though the blockchain ledger may verify the NFT owner, online anonymity may still not help point to an actual individual or organisation for enforcing a claim or making a real-world infringement claim.

At the moment there appear to be more questions (and arguments on each side) than there are answers. Where this lands will ultimately depend on the individual facts of each case and also any policy drivers that a court takes into account. 

Copyright owners must develop effective strategies to protect and enforce their copyright from “entrepreneurs” and copyists. In the NFT context it is particularly important to guard against others offering an artist’s work as an NFT without the artist’s permission, assuming that the artist has maintained ownership of the copyright in the work.

Access to viewing NFTs on the various NFT platforms is public. This is useful for copyright owners in identifying potential unauthorised reproductions or derivative works of their copyright work.

For example, on 1 July 2021 NFT CryptoPunk creator Larva Labs used the takedown procedures available under the U.S. Digital Millennium Copyright Act (DMCA) to request the NFT Platform Foundation to remove the online display of CryptoPunk work offered by Ryder Ripps as a work of his own.

The number of gaming and metaverse platforms is growing, and it is important for the copyright owner to employ and rely on effective enforcement techniques, such as watermarks and (in the case of the U.S.) DMCA takedown notices.

In the U.S. it is also expected that the Copyright Management Information provisions of the DMCA (17 USC § 1202) will likely provide copyright owners with a robust tool to police misuse of the copyright work.

In addition, trade mark infringement may arise where an unauthorised party mints an NFT linked to the underlying asset, without the asset owner’s permission, and advertises, offers for sale and/or sells the NFT using the asset owner’s registered trade marks. This is often an issue where branded (physical) goods are reproduced virtually via NFTs for use in a virtual environment. For more information, see part 2 of this series, Gaming, IP rights and the metaverse.

Concerns over scenarios where branded (physical) goods are reproduced virtually (say, via NFTs) for use in a virtual environment like a game or a metaverse have led the European Union Intellectual Property Office to publish its recommendations regarding the class to be opted for when applying for a trade mark designating virtual goods, NFTs and other products displayed in the Metaverse. For more information, see our blog, Guidance on metaverse and NFTs trade marks.

Counterfeiting

Counterfeiting in relation to NFTs raises significant risks to brands, particularly in virtual environments such as games and the metaverse.

Although the unique digital token associated with an NFT will be securely stored on a blockchain, this does not mean it is free from risks relating to counterfeiting – for example, what is to stop a minter from creating numerous NFTs, all of which are - in and of themselves - unique, but which each produce the same underlying digital asset? The value in an NFT – its scarcity – is immediately eroded in such cases.