Non-Fungible Tokens From a Legal Perspective

In 2017 it was all about the utility and security tokens. For the last year, it is about non-fungible tokens (or shortly NFT’s). There has been a lot already said about what they are, how we use them, are they really not fungible and what are their real-world implications, but not so much about how do they fit into a legal framework.

A few weeks ago an EU-based cryptocurrency platform Kriptomat has partnered with a gaming platform Enjin and created their very own and special Kriptomat Founder Tokens, which you can read all about it in this article: https://kriptomat.io/platform/kriptomat-enjin-collaboration/. I covered the legal part of the creation of the tokens.

This is a short piece that aims to put NFT’s in the legal perspective of the token ecosystem and explain the legal logic behind the tokens. It has to be noted, that NFT’s are still in the development phase and legal consequences are not yet clear, so in this article, I will explain an opinion from my own legal perspective. I invite you to contribute your own thoughts if you agree or disagree with me.

DEFINITION OF NFT’s

When we talk about non-fungible tokens, we must first understand what fungible tokens are.

Fungible tokens (FT) are tokens of such a nature that one part or quantity may be replaced by another equal part or quantity, meaning that they can be easily exchanged for another item or value. Every token is the same as every other token and is capable of mutual substitution. For example, if someone borrows 1 ETH (Ether is a cryptocurrency, necessary to have for operating on the Ethereum blockchain), he will most likely spend that 1 ETH and give back another 1 ETH of the same value. The borrower can also give back for example 0.5 ETH twice, which means that fungible tokens are divisible.

On the other hand, non-fungible tokens (NFT) are unique items that can’t be exchanged for the same amount of the same kind, because they are unique, possibly rare (scarce) and each holds several different functionalities and characteristics. An example of this would be an item that cannot be replaced by another similar item, like the picture of Mona Lisa. If someone borrows this picture, he has to return the exact same picture. You can also picture NFT as a virtual form of the famous Tamagotchi. Every Tamagotchi is different and has its own personality, functionalities, and other properties.

One of the main differences between fungible and non-fungible tokens is the fact that FT’s are divisible and NFT’s are not. FT’s can be borrowed, returned and otherwise transferred in parts, whereas NFT’s cannot be divided into parts. As such NFT’s are distinguished from each other.

There is also a class of semi-fungible (partially fungible) tokens (token standard ERC-1410). A semi-fungible token allows the token to be fungible in some circumstances and not fungible in others. Those types of tokens form a basis for security tokens (token standard ERC-1400). I will not get into this type in this article.

USABILITY OF NFT’s

The use of non-fungible tokens are countless, and as I can see the tokenization  trend they will be used to tokenize practically anything that is possible to tokenize. Tokenization means replacing valuable and/or sensitive data, assets, rights, payments cards etc. with a less sensitive digital form.

GAMING — NFT’s serve as digital collectibles or gaming props, such as weapons, clothes, and other items. This basically creates digital scarcity for the gadgets in video games and is a new way of using decentralized blockchain technology in gaming for maintaining scarce items, instead of relying on the centralization, security, and validation of the game creator.

INTELLECTUAL PROPERTY — NFT’s could represent a painting, a song, a patent, or other intellectual property rights. There are companies who sell tokens as licenses. Tokenization of IP rights will allow authors to control over their work and ensure that they get properly paid.

PHYSICAL PROPERTY — real-estate, precious items, vehicles, and all other property can be tokenized and their tokenization can be used for financing, expansion or potential liquidity of the property.

RECORDS AND IDENTITY VERIFICATION — NFT’s can also serve to verify identity or represent birth certificates, licenses, academic credentials, honors, and more. All these items can be kept safe in a digital form and preserved from counterfeiting or abusing.

FINANCIAL DOCUMENTS — financial documents (invoices, orders, warranties, bills, etc.) can be turned into NFT’s and traded with them.

Non-fungible tokens can also be used for TICKETING, VOTING, LOYALTY PROGRAMS, KYC PROCEDURES, HUMANITARIAN AID, PRODUCT SUPPLY-CHAIN TRACKING, and more.

The positive side of NFT’s is that they are unique, scarce, durable and extensible. There are also some shortcomings such as (currently) their limited tradeability (they cannot be used out of a certain ecosystem).

Where to store your tokens? There is a communication provider for Ethereum called MetaMask. It is a browser extension that includes a secure identity vault, which provides a user interface to manage your identities on different sites and sign blockchain transactions. It has a wallet for non-fungible tokens.

TYPES OF TOKENS

Let’s first see the main types of tokens by their legal status — utility tokens, security tokens, and currency tokens.

Utility tokens provide access to a digital service, similar to a paid API key (a unique code — identifier, to identify a calling user or application), where token holders have exclusive access to functionality within a network or decentralized platform that others without tokens don’t. Examples of such tokens are Ether, Gno (Gnosis), Stellar. The token is needed in order to enter a platform or a network and use it. They are comparable to a voucher and allow a project to be funded without giving away and diluting ownership in an ICO company (ICO company is a company that issues a set of tokens, usually for fundraising purposes).

Security tokens represent ownership of an asset and grant token holders similar or same rights as securities — voting rights, dividends, profit shares, share in the success of an issuing entity, etc. In terms of economic function, such tokens are security assets, stock (equity) assets, debts (bonds) and liabilities. Examples of this would be the DAO, Bankera, etc. They grant all or some of the stated rights. Investopedia defines security tokens as “essential, digital and liquid contracts for fractions of any asset that already has value, like a house, a car or equity in a company”. Securities and security tokens derive their value from the underlying asset, however, a key difference is that security tokens represent programmable ownership, giving the assets more functionalities, more liquidity and easier market access, speed in creation, fewer middlemen, lower costs for issuing, transparency and built-in automation of security-related processes.

Currency (or payment) tokens are tokens that are cryptocurrencies, meaning that they act as a storage of value and medium of exchange. Examples of such coins are Bitcoin, Monero, Tether.

Most of the tokens that we see are none of the above but are hybrids that represent features of different categories, meaning that they have utility features and give certain ownership (especially economic) rights. It is advisable that you consult a fintech lawyer if you are unsure how to categorize your token.

There are also so-called Donation tokens, which are tokens that do not fall into any of the above classes. The tokens are classified as a donation in the contribution terms (user agreement in the ICO) in order to avoid regulatory classification. An example of such a token would be Tezos, a “self-amending cryptoledger”.

The above-stated classes are those who are also stated in a report on Initial Coin Offerings and Crypto-Assets, drafted by European Securities and Markets Authority.

From an economic point of view, utility and security tokens can be tokenized assets at the same time, where the economic value of an asset is converted into a digital form. As already written above, practically any asset can be tokenized — IP rights, real estate, precious items, etc. It is important to clear out, that tokenized assets do not represent ownership (property rights — the right to use the good, to earn income from the good, to transfer the good to others, to enforce property rights), but can grant some of the economic rights; token holders of such assets get merely monetary rights.

Let’s say that the underlying assets are a commodity (gold). Such asset tokens share characteristics with commodity derivatives or with securitized commodities. They may facilitate trading in such goods, without the good physically changing hands. On the other hand, an asset can be real estate or can function as a digital identifier for the underlying physical asset (digital ID document). So, are asset tokens / tokenized assets security tokens or not? They can be, but not necessarily — it basically depends on the two facts: (i) are they transferable and (ii) what kind of rights do token holders have.

In the report I mentioned above ESMA stated that “asset tokens representing a monetary claim on the issuer share characteristics with securities or derivatives. They may, therefore, have similar benefits: facilitating financing and risk-transfer. Asset tokens representing a physical good may facilitate increased trading for speculative purposes. In order to determine whether asset tokens are covered by MiFID II, the Prospectus Regulation, and the Market Abuse Regulation, it should first be determined whether they are financial instruments (for MiFID purposes and the MAR) and transferable securities (for purposes of the Prospectus Regulation).”

LEGAL NATURE of NFT’s

The above types vary from jurisdiction to jurisdiction. The general (mostly unofficial) outline of the current state in several countries is that tokens, which aren’t clearly a utility token or which aren’t a pure cryptocurrency can easily be classified as security tokens.

Most of the aforementioned tokens are fungible by nature. This means they are interchangeable with any other token of the same kind, 1 Bitcoin for 1 Bitcoin, 2 Ripples for 2 Ripples, and so on. Fungible tokens can be security tokens if the token grants rights of a security token. Securities are normally fungible (one stock of Coca Cola is usually interchangeable with another stock of Coca Cola).

NFT’s can tokenize assets but will usually not represent a financial instrument. So, what kind of tokens are non-fungible tokens in a legal sense — are they utility, security, currency, asset token or even a new special not yet determined class? When creating any kind of token it is vital to determine what kind of rights will be granted to token holders. If token holders will have profit sharing rights or similar, such token will most probably be treated as a security token and will fall under the financial regulations. NFT’s normally won’t grant any such rights, but will instead grant access to a future content or an avatar in a game or can hold rights to payment of royalties (standard ERC-1190).

In order to determine what crypto-assets are in a legal sense, the questions below must be thoroughly answered:

1. Does the token give the owner an entitlement against the issuer? If yes, is it an entitlement in kind (property itself) or a monetary entitlement? If it is a monetary entitlement, is it profit sharing, a predetermined entitlement, or undetermined other kinds of entitlement?

2. Is the token transferable?

3. Is the token scarce, and how is scarcity controlled (having the ability to know and anticipate with absolute certainty the supply of the asset)?

4. Does the token give decision power on the project of the issuer?

NFT’s does usually not grant the owner (token holder) any entitlement against the issuer; there is also no decision power on the project of the issuer and there is usually no ability to know the supply of the assets (exceptions apply). Even though the NFT’s are indeed transferable, they are usually not transferable on the organized market (such as Kraken or Bitstamp). One important feature of the NFT’s is also the immutability and scarcity. This means that non-fungible token represents something rare and unique.

If we go back to Kritpomat Founder Tokens, they will be used in a multiverse of games created on the Enjin platform. Kritpomat issued a supply of 100 Silver Dragons, 300 Purple Dragons, 600+ Blue dragons and Gold Dragons, for which the supply is not yet known. The tokens will have different functionalities within the multiverse, but will not grant any entitlement in kind / property rights in Kriptomat, nor will grant any monetary rights or give decision power to the project. The tokens are a clear props or collectibles (for whatever token holders wish to use them). From the legal perspective for issuing such NFT tokens MiFid ii and Prospectus regulation will not apply, however, issuers must be careful to check the applicability of the AML laws nonetheless.

CONCLUSION

Even though non-fungible tokens are still rather new invention it is important to create and launch them with diligence and care.

The regulation of such tokens is still not developed. For this reason it is important to consult with your fintech lawyer, who will make sure that the creation of non-fungible tokens will be compliant with the AML regulation, financial regulation and will create all the necessary terms and conditions for your airdrop, reward campaign, prize game, sale or whatever other means of distribution of new NFT’s you decide to go with.

Even in the case where your NTF does not grant any kind of property or monetary rights, it is important to carefully create your token economics and to comply with the relevant international and national laws.

If you need a crypto lawyer, contact us here.