Non-fungible tokens (NFTs): Digital Rarity
On March 11, 2021, the digital artwork “EVERYDAYS: THE FIRST 5000 DAYS” by American artist Beeplesold for $69.3 million at Christie’s auction house. This record-breaking sale places Beeple among the world’s most highly valued artists and, above all, illustrates the revolution brought about by NFTs (non-fungible tokens) in the art world.
These non-fungible tokens, which have recently garnered significant public attention, are not limited solely to the arts. Numerous use cases are emerging daily in the fields of video games, sports, luxury goods, music (and more) to record proof of ownership of a unique asset in the public ledger of blockchain networks—which are immutable and tamper-proof.
The purpose of this article is to highlight the revolution driven by the NFT market—a cross-sectoral revolution that places digital scarcity at the heart of innovation in the crypto-asset sector—and to explain the underlying technologies.
At the same time, NFTs raise legal classification issues that need to be resolved in order to build greater confidence among investors and enable the emergence of new innovative projects.
Definition
Generally speaking, an NFT can be defined as a unique token that certifies ownership of an asset—whether physical (such as a work of art, real estate, or other tangible items) or digital (such as collectibles, digital avatars, digital artworks, or other digital items)—to its holder and is recorded on the blockchain’s public ledger. To date, most NFTs are issued via the Ethereum network. An NFT is typically accompanied by information regarding the work’s creator, the previous owner, and other more technical details specific to the underlying asset.
NFTs are unique. Protocol tokens, such as Bitcoin and Ethereum, are fungible and interchangeable. Unlike these crypto-assets, NFTs are so unique that it is not possible to exchange one NFT for another of the same value (just like a famous painting or a particularly rare bottle of wine).
NFTs are indivisible. Most protocol tokens can be divided by their holders. For example, 1 bitcoin can be divided into up to 100 million satoshis (the smallest unit of measurement in bitcoin). This is not the case with NFTs, which (in principle) cannot be divided into multiple units due to their unique nature.
Ultimately, NFTs play a central role in bridging the gap between the digital and physical worlds. Thanks to blockchain networks, they can be easily traded without the need for a trusted third party and can be securely stored indefinitely in a crypto wallet.
Timeline
The Early Days: 2012–2016
The Colored Coins. Colored coins emerged in 2012 due to the need to represent certain assets on the Bitcoin network as part of various types of financial transactions. These colored coins leverage Bitcoin’s partial fungibility (which is traceable via blockchain technology) and function as a metadata overlay that allows real-world assets (such as stocks, bonds, real estate, commodities, etc.) to be linked to Bitcoin addresses.
The platform Counterparty. Counterparty is a platform built on the Bitcoin blockchain and network. Counterparty was one of the most well-known platforms in 2014, alongside Mastercoin, Ethereum, and Ripple. It was a “metacoin” protocol in which new features could be attached to Bitcoin tokens to make them unique. The platform provided features such as user-created currencies, additional financial instruments, and a decentralized asset exchange.
The project Rarepepes. The Rarepepes project was launched in 2016 with the aim of creating a digital edition of collectible images featuring the character Pepe the Frog. The project has been a major success, with some cards created directly by renowned artists.
The Rise: 2017–2019
The Cryptopunks. Cryptopunks are among the leading NFTs that have driven modern crypto art. Created by Larvlab in 2017, Cryptopunks consist of 10,000 unique characters generated by an algorithm on ERC-20 tokens (i.e., tokens compatible with the Ethereum blockchain). Initially, these CryptoPunks could be obtained for free, but the project subsequently gained significant popularity. Now, four years after their creation,CryptoPunks sell for an average of $450,000.
The CryptoKitties. The CryptoKitties project is a blockchain game on Ethereum developed by Dapper Labs in 2017. This game allows users to buy, collect, breed, and sell tokenized virtual cats. Just like Cryptopunks,the game’s popularity led to a sharp rise in the value of these NFTs, with some CryptoKitties selling for as much as 600 ether.
In addition, this period saw the emergence of the first trading platforms dedicated to non-fungible tokens, such asOpenSeaandSuperRare. These trading platforms have significantly improved liquidity in the secondary NFT market by allowing any NFT holder to list their asset for auction.
Widespread Adoption: 2020 – Present
The year 2020 saw the emergence of a wide variety of new projects, with some transactions reaching very large sums. This trend demonstrates the widespread adoption and diversification of the NFT market.
Thisgrowth in the NFT markethas undoubtedly been driven by the significant growth of the crypto-asset market in 2020 and 2021.
Furthermore, the COVID-19 crisis, which led to people staying home around the world, helped facilitate the adoption of these non-fungible tokens. In the art world, some artists turned to blockchain networks as a medium for their work due to the closure of museums and galleries. This widespread adoption has led to a significant increase in the value of the NFT market—as of November 16, the total market value of crypto art was estimated at approximately $1.2 billion—and to record-breaking auctions for the crypto-asset industry. For example,ten digital works by Canadian musician Grimes were sold on the specialized platform Nifty Gateway for $6 million last March.
The frenzy surrounding the NFT market is such that the sale of certain assets has sparked debate within the industry. For example,the famous “disaster girl” meme—a staple of the web—was sold last April for 180 ether by its creator. Some view these sales as purely speculative and lacking any real economic value. Some even use these sales to argue that the NFT market boom is merely temporary and will not revolutionize the myriad sectors it touches.
In addition, recent months have seen an explosion in the popularity of metaverses, largely due toMark Zuckerberg’s announcementthat the Facebook brand will now be renamed “Meta.” Metaverses are entirely virtual worlds inhabited by communities of users represented as virtual avatars (issued as NFTs) who can move around, interact, and exchange digital value.
How it works
Since most NFTs are issued on the Ethereum blockchain, a significant portion of NFTs in circulation are based on the ERC-721, ERC-1155, and ERC-998 standards.
ERC-721 tokens
ERC-721 (Ethereum Request for Comments 721) was developed by William Entriken, Dieter Shirley, Jacob Evans, and Nastassia Sachs in 2017. It is a standard designed to enable the issuance of unique, non-fungible tokens whose value is derived from their rarity and/or originality. Unlike traditional ERC-20 tokens, ERC-721 tokens are indivisible (it is impossible for two addresses to hold the same Cryptokitty in equal shares) and cannot be destroyed.
To date, more than 23,000 ERC-721 tokens have been recorded on the Ethereum network.
ERC-1155 tokens
ERC-1155 tokens are what are known as semi-fungible tokens,proposed by Witek Radomski, Andrew Cooke, Philippe Castonguay, James Therien, Eric Binet, and Ronan Sandford. These standards allow users to register both fungible (ERC-20) and non-fungible (ERC-721) tokens using the same address and smart contract.
ERC-1155 enables the transfer of multiple types of tokens at once, thereby reducing transaction costs. Multi-token trading can be built on top of this standard, and it eliminates the need to “approve” individual token contracts separately.
ERC-998 tokens
ERC-998 tokens are similar to composable NFT standards. Proposed by Matt Lockyer, Nick Mudge, and Jordan Schalm in July 2018, ERC-998 can contain both unique non-fungible tokens (such as ERC-721) and uniform fungible tokens (such as ERC-20). The ERC-998 token can then be valued and traded.
ERC-998 is an extension of the ERC-721 standard that allows non-fungible tokens to hold other non-fungible tokens and ERC-20 tokens. Non-fungible tokens that implement ERC-998 also implement the ERC-721 standard.
NFTs and decentralized finance (DeFi)
NFTs and the decentralized finance (DeFi) sector are beginning to interact in several interesting ways.
Using NFTs as collateral for loans
When a user of a crypto-asset lending protocol attempts to take out a loan, they do not always have sufficient crypto-asset funds to provide adequate collateral for the loan and mitigate counterparty risk.
In response to this, projects such asNFTfiallow users to borrow funds in crypto assets by using NFTs as collateral for loans.
Improving Market Liquidity Through Fractional NFTs
NftfyandDaoFi, meanwhile, offer NFT holders a service that allows them to split non-fungible tokens (ERC-721) into fungible shares (ERC-20). As with financial products, these shares can be traded among themselves or for other crypto-assets on secondary markets. The goal is to create liquidity for these products, which are often illiquid. For example, one could imagine that the owner of “Everyday: The First 5,000 Days” could split their NFT to sell shares to those who wish to own a portion of this work for collection or investment purposes.
These projects address the liquidity issue in high-value NFTs by integrating with existing DeFi protocols. To sell these shares, it is suggested that liquidity pools be created on well-known DeFi platforms such as Curve or Uniswap, where other collectors and investors can purchase shares of the fractionalized NFT.
All of this is technically possible thanks to the ERC-1155 standard. Fractionalization occurs when the NFT holder locks the NFT into a smart contract while the shares are being created. The NFT can be retrieved provided that the claimant owns all existing shares associated with the NFT. NFT creators can also create “shares” for their NFTs. This gives investors and fans the opportunity to own a portion of a high-value NFT. Fractionalized NFTs therefore offer new opportunities for issuers and collectors.
Use cases related to NFTs
NFTs offer a wide range of use cases; to date, most of the current supply of non-fungible tokens consists of collectibles. However, the market could diversify significantly in the future. It is therefore worth taking a look—without claiming to be exhaustive—at the main use cases related to NFTs.
In the cultural sector (art, music)
The art world is where non-fungible tokens first gained prominence. An NFT allows any digital object to be stored on the blockchain: an image, a GIF, a video, or a clip. NFTs have enabled artists to offer their work in a new form—exclusive and digital.
In March 2021, the band Kings of Leon released their album via NFTs, a first.
In the video game industry
NFTs first gained attention in the gaming industry, particularly in collectible games. Subsequently, numerous NFT projects emerged in the video game sector, eventually making it one of the primary use cases for NFTs.
Many NFT projects have emerged around collectible card games inspired by more traditional card games such as Pokémon or Hearthstone.
In addition, NFT gaming projects have often been built around open worlds or the metaverse. The best-known project is Decentraland, launched in February 2020, which has brought together a large community within a metaverse.Last June, a plot of land was sold for $913,808 by a user of the game.
More recently, a trend has gradually emerged among NFT game players: “play-to-earn.” As seen in the game Axie Infinity, players can earn tokens (such as SLP in Axie Infinity) by gaining in-game experience, which allows them to generate income in crypto-assets as they play the game.
In addition, several traditional video game companies are developing their future projects around NFTs. In France, Ubisoft has partnered with Sorare to launch a free soccer game calledOne Shot League.
In the real estate sector
NFTs also hold some potential in the real estate sector.In the United States, an individual tokenized a portion of their home and listed it for sale on the Mintable platform.
In the luxury sector
In the luxury sector, NFTs could serve as a certificate of authenticity for luxury items. Linking editions of rare items to private keys would make it possible to authenticate each item, thereby reducing the risk of theft (since every transaction is traceable on blockchain networks) and counterfeiting.
In France, theArianee projectallows luxury goods to be linked to their own unique, tamper-proof digital passport. This digital passport serves as a secure, anonymous, and transferable channel of communication between brand products and their owners.
NFTs and physical goods
Although the success of NFTs demonstrates the potential of blockchain technology—particularly in terms of the immutability of transaction ledgers and proof of ownership—their use today is limited to the digital realm. While many aspects of our lives have moved into this domain, we are tempted to forget that our most valuable assets are found in the physical world around us. After this reflection and contextualization, we see that non-fungible token technology could also have applications in the physical world. Indeed, NFTs could be used to guarantee the authenticity and proof of ownership of physical assets in general. Whether in the fields of art, luxury goods, collectibles, or other physical products, this would mark a return to a model that guarantees the uniqueness of products.
However, unlike digital assets, physical NFTs face complex practical engineering challenges. How can a physical product be linked to an NFT on the blockchain in a way that is both secure and tamper-proof? QR codes, signatures, unique packaging—the techniques are varied but raise questions, particularly regarding product security and counterfeit prevention.
Beeple, best known for his work “Everyday’s Work,” has begun selling physical NFTs.“Human One”is a two-meter-tall sculpture paired with four screens that display the NFT in video format. This piece stands out for the playful and innovative way in which we interact with it. In this case, the product’s authenticity is verified through its unique packaging and distinctive form.
Other projects are turning to certificates of authenticity to verify the authenticity of a physical NFT. In the art industry, projects such as Verisart and Concept.xyz create certificates of authenticity for physical items. The document attesting to the product’s authenticity is then recorded within the NFT, secured by the blockchain.
Finally, projects likeMattereumandNiftifyoffer a different approach to their B2C services, allowing users to purchase NFTs linked to physical goods. In this model, the goods remain in the company’s possession while the owners hold the associated NFTs, enabling simplified, 100% digital transactions thanks to the NFT. Transactions are now digitized as many times as desired, while benefiting from blockchain-based transaction security. Once the owner decides to reclaim the physical goods, the company will destroy (“burn”) the NFT in order to return the physical good to its owner. Thus, the company acts as a trusted third party to guarantee the product’s authenticity.
Fractional NFTs
The immutable and secure nature of an NFT recorded on a blockchain guarantees proof of ownership but does not solve all the problems for those who view them as investment products. One of the major issues with these investments is the lack of liquidity. As with works of art, the high price presents a significant barrier to entry. DAOs (decentralized autonomous organizations) present themselves as a solution to this problem, although acquisitions can now be made collectively,in an organized manner through voting.
So, several projects are introducing a new operating method: FNFTs (Fractional NFTs). Once again, there are several approaches to fractionalizing NFTs.
Fractions of Physical NFTs
Sygnum Bank, the owner of Picasso’s painting titled “Girl with a Beret,” recentlyfractionalized the physical artwork, which is valued at $3.68 million. The shares, valued at $6,000 each, were sold through SygnEx, the Swiss digital asset trading platform.
In both cases, the assets associated with the NFT remain in the possession of the company that manages the physical goods. As a result, the third-party company holding the product verifies the authenticity of the asset associated with the NFT using the accompanying certificate of authenticity.
In addition to facilitating transactions involving these products, this approach allows users to invest in assets or products that can sometimes be very valuable. These shares can then be sold on NFT trading platforms.
The Legal Nature of NFTs: A Non-Traditional Digital Asset
To date, while NFTs have caught the attention of most lawmakers, they are not subject to any specific regulatory framework. Simply put, two scenarios seem possible for French lawmakers.
Scenario 1: NFTs are treated as digital assets
Classifying NFTs as digital assets would allow NFT service providers to be treated as digital asset service providers (DASPs). Consequently, depending on the services offered, the NFT project sponsor would be subject to the obligation to register with the AMF upon approval by the ACPR, in accordance with Article L. 54-10-3 of the Monetary and Financial Code.
Such an assumption would imply that most NFT projects—including trading platforms like OpenSea—would need to implement measures to combat money laundering and terrorist financing.
However, such a classification should not require NFT issuers to obtain regulated status, provided that they merely sell the NFTs and do not seek to provide additional services (e.g., creating a platform on which the NFTs will be listed, organizing a secondary market on a dedicated platform, etc.).
Scenario 2: NFTs are not treated as digital assets but as the underlying asset
If NFTs were not classified as digital assets, one could consider treating them as the underlying asset. From this perspective, certain NFT service providers would be classified as intermediaries in miscellaneous goods within the meaning of Article L. 551-1 of the Monetary and Financial Code. This article already applies to the sale of works of art (paintings and sculptures) and collectibles.
In fact, because of their wide variety, NFTs could be linked to the asset underlying the token, representing movable or immovable property, tangible or intangible, depending on the provisions of the Civil Code.
From a tax perspective, if we follow this legal analysis of NFTs, gains realized upon the sale of an NFT would be subject to the capital gains tax regime for movable property, with a tax rate set at 36.2% and an exemption for any sale of an NFT with a value of less than €5,000.
Conclusion
Since 2020, the NFT sector has been gradually gaining widespread adoption—an adoption that is, incidentally, still in its early stages. And while the sometimes high amounts resulting from NFT sales have sparked some unwelcome controversy, the technology underlying these assets is already fully functional, and new use cases are emerging every day, significantly diversifying the crypto-asset industry.
It goes without saying that the democratization of the NFT market is inevitable. To facilitate this democratization, efforts must still be made: on the one hand, in terms of education, as users and traditional players must gradually embrace this technology by exploring all the opportunities offered by NFTs; and on the other hand, in terms of regulation, as NFTs will ultimately need to be subject to a clear framework to foster a climate of trust and security among investors.
