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Digital Art and NFTs – An Overview and Lender Considerations

Andrew Evans
22/02/2022

Locations

United Kingdom

Andrew Evans discusses an overview into Digital Art and NFTs.

Background
 
For those of you already in the know, apologies, but it is probably helpful to set out some background to NFTs.
 
The world's first widely-adopted cryptocurrency was Bitcoin which was first created in circa 2008. Bitcoin is decentralised and allows for secure peer to peer transactions on the internet without the involvement of any bank, government or other institution. It was a major advance in computer science as it solved the fundamental problem of how to transfer money between two people without a trusted intermediary (like a bank) in the middle.
 
Every single transaction involving Bitcoin is tracked on the blockchain, which comprises a database held on a huge decentralised network of computers and is the equivalent to a bank ledger or log of funds going in and out of a bank. In basic terms, it is a record of every transaction ever made using Bitcoin that anyone can view and verify. It is highly secure based on a proof-of-work (PoW) consensus algorithm. The new information concerning Bitcoin transactions is periodically gathered together in a 'block' which is added to all blocks that came before forming a continuous chain. Unlike a bank ledger, however, blockchain is distributed over the entire network. No company, country or third party is in control of it and anyone can become part of that network.
 
Bitcoins are 'mined' via that huge decentralised (or peer-to-peer) network of computers which are constantly verifying and securing the accuracy of the blockchain. In return for contributing their computing power to the blockchain, miners are rewarded with small amounts of cryptocurrency. This does, however, consume enormous amounts of electricity. The miners' collective computing power is used to ensure the accuracy of the ever-growing ledger that is the blockchain.
 
Almost all cryptocurrencies including Bitcoin, Ethereum, Bitcoin Cash and Litecoin are secured by blockchain networks which results in their accuracy being constantly verified by a huge amount of computing power. The list of transactions contained in the blockchain is  fundamental for most cryptocurrencies as it enables secure payments to be made between strangers without having to go through a third party verifier like a bank. Blockchain is very secure because if anyone tries to manipulate a transaction it will cause the link to break and the entire network will see what has happened.
 
Bitcoin cannot exist separately from the blockchain. Each new bitcoin is recorded on it as is each subsequent transaction with all existing Bitcoins.
 
Payments via blockchain can be made more secure than standard debit or credit card transactions as when making a Bitcoin payment it is not necessary to provide any sensitive information so there is almost no risk of a payer's identity being stolen or financial information being compromised.
 
The Bitcoin blockchain was solely designed to manage digital money, but in 2015 along came the Ethereum blockchain which is much more flexible than the Bitcoin blockchain and can support programmability which enables smart contracts to be built also called decentralised applications dApps. Ethereum is now the second largest cryptocurrency with its ETH token by market cap after Bitcoin. Ethereum is more like a powerful and highly flexible computing platform that allows coders easily to build all kinds of applications leveraging off the blockchain including anything from games and advanced databases to complex decentralised financial instruments.
 
Smart contracts like old fashioned paper contracts establish the terms of a contractual arrangement between the parties, but unlike such paper contracts, smart contracts automatically execute when the terms are met without the need for either party to know who is the counter-party and without the need for any intermediary.
 
Ethereum, like Bitcoin, is an open source project that is not owned or operated by a single entity and allows any two strangers anywhere in the world to send and receive money without a bank in the middle. Unlike Bitcoin, however, Ethereum can also be used by any two strangers, anywhere in the world, to send and receive not just money, but tokens representing digital assets to each other without any intermediary.
 
Ethereum is the name of the network. 'Ether' is the cryptocurrency used by the network. Having said that in everyday language most people call the token 'ETH' or just 'Ethereum'. Users pay fees in ETH to execute smart contracts a bit like fuel which is why those fees are called 'gas'
 
A fungible asset can be replaced by an identical asset, such as money, oil or Bitcoins. An NFT is a non fungible token i.e. a one of a kind crypto asset stored on a blockchain. The token represents a digital file that contains data which varies according to what it represents.
 
'Tokens' are the base units of exchange for cryptocurrencies i.e. any digital currencies with value and security determined by complex mathematics. That includes the blockchain cryptocurrencies like Bitcoin and Ethereum, but also includes non-blockchain cryptocurrencies like Hedera and IOTA.
 
What are NFTs?
 
As mentioned in the Background above, an NFT is a non fungible token. The alterations made to a cryptocurrency token to make it non-fungible are made up of information that is permanently associated with that token. As that token is part of a cryptocurrency public ledger, the security and verifiability of that cryptocurrency now protect that information. The information attached to an NFT is generally a number that is associated with an asset so that holding the NFT proves ownership of that asset.
 
The process of creating an NFT is called 'minting'. Anyone can mint an NFT, but it costs different amounts of money or gives you different abilities depending on which cryptocurrency network you mint your NFT on.
 
NFTs have two primary uses. The first is that the NFT is proof of ownership of an asset. The second is that, in the case of digital assets, the NFT itself can be a unique tokenised version of other assets and be used in a number of virtual environments. Apart from their verifiable scarcity and ownership, virtual worlds including Spatial afford NFT owners the opportunity to display their digital art and other collectables to interested online communities.
 
What do you actually get when you buy an NFT?

For example, when you buy a digital artwork, will the actual artwork or a video clip be transferred to your wallet? The answer is 'no'. What you are likely to receive is 'metadata' recorded on the blockchain i.e. you are buying a digital description of the artwork. The NFT is only the record of ownership or authenticity that is stored on the blockchain; it is not the image file which is stored elsewhere.
 
While a digital art NFT token represents the artwork, as it is costly to store an image or video clip inside the token, instead the NFT token might contain a URL (a weblink) that provides an internet address. If you click and follow the image URL it is likely that you will find that the image is stored on a third party's website. It follows that while the NFT securely provides proof of ownership of whatever image is at the third party's location, it doesn’t mean that the actual image itself is secure as data stored outside the blockchain does not benefit from the blockchain's security.

It is necessary to consider what happens to your NFT if the website containing the artwork shuts down or the content is changed. If, for example, the company which owns the underlying images which uses a private server to control its images ceases to trade, your NFT would lose all its value even though your NFT token continues to prove ownership, the asset you own can be lost leaving you with a cryptographically secure, but dead link.

One solution to this issue is to use an IPFS link. This type of link is an alternative to URLs that directs the owner of the NFT to an asset in a decentralised storage system. An asset can exist in multiple locations inside the decentralised storage system instead of a single server, reducing the likelihood of loss from a server issue. This also prevents the NFT platform from swapping out information, changing the image or deleting it altogether. However, there is still an issue with IPFS which relates to limited storage as unused files are often removed when the system runs out of space to make way for new files which need to be uploaded. If this happens, there is no guarantee that the file has been backed up on another IPFS server. It follows that while IPFS is a great improvement on URL links, it does not (of itself) offer a complete solution.
 
An owner of an NFT tokenised artwork therefore would be well advised to take additional precautions such as engaging the services of Pinata and similar service providers to make sure that files on IPFS servers never disappear. This is achieved by them periodically requesting the files throughout each day so that the file is never considered inactive and removed.
 
Owning an NFT by itself does not automatically grant you any rights to its intellectual property. By default, the original author of the work (a record of which is stored in the NFT) retains ownership rights of the copyright. Thus, in default of other terms, NFTs transfer very few rights to you. Having said that some NFTs do include additional terms that set out in more detail what you can do with your purchase. Some creators of NFTs will grant you a license giving you ownership of a form of licensed content, but not the copyright. It is therefore crucial that a buyer of an NFT reads and fully understands the terms under which he or she will own the NFT.
 
Energy Consumption
 
Cryptocurrency is the polar opposite of ESG as it has an unquestionably negative effect on the environment. The myriad of computers that generate blockchain constantly run at a very high capacity. It was discovered that mining cryptocurrency is more environmentally damaging than mining copper, gold and platinum. It is estimated that between January 2016 and June 2018, crypto-mining alone contributed 3 million to 15 million tons of CO2 emissions to the world's atmosphere. Environmentalists who criticise other industries for negative environmental impact should also turn their attention to crypto.
 
Financial regulation
 
Although regulation of cryptocurrencies is very new, it was developed before the recent burgeoning popularity of NFTs and as a consequence current laws and policies in the UK do not specifically address NFTs. Some NFTs may be regulated, but it very much depends on the characteristics and rights attached to the token itself. For example, if the token does not confer any rights on the owner, other than the ability to hold, buy or sell, then it will be categorised as an 'exchange token' and will not be regulated. If the token confers rights to obtain goods or services, including rights to other tokens, it will be categorised as a 'utility token' and will not be regulated. If the token has characteristics similar to traditional securities e.g. shares or units in a collective investment scheme, it will be categorised as a 'security token' and will be regulated. If the token functions as electronic money it will be categorised as an 'e-money token' and will also be regulated.
 
NFTs will normally fall within the exchange or utility token categories and will therefore be unregulated. Given that an NFT is non fungible it is highly unlikely that it could be characterised as e-money. Only if the NFT is given the characteristics of traditional securities could it be regulated as a security.
 
The UK Government recently confirmed in its response to a consultation to its proposal to expand the Financial Promotion Order, that non fungible tokens were outside the scope of its proposed regulation of qualifying cryptoassets.
 
AML Regulation
 
Generally speaking, if a business provides services of exchange or custody of crypto, it will be subject to Money Laundering Regulations (MLRs). Such a business needs to be registered with the FCA, perform KYC checks on its customers and monitor their transactions and comply with other AML requirements.
 
As with financial regulation discussed above, NFTs are not specifically covered by MLRs. The MLRs define a 'cryptoasset' as 'a cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically.' An NFT could fall within this definition or not depending on its characteristics. Although the Treasury appears to view NFTs as falling in principle within the definition, regulations are awaited to clarify the position. In the meantime, whether an NFT is subject to MLRs will need to be decided on a case by case basis.
 
Given that sellers and buyers of NFTs are usually anonymous and the transfer of NFTs for cryptocurrency takes place on blockchain (most often, Ethereum (ERC 721 tokens)) there is a good opportunity for money launderers to convert tainted money into NFTs or cryptocurrency. It doesn’t help that many high-profile NFT platforms do not carry out any AML checks on prospective buyers and sellers of NFTs and allow them to register without such checks being made.
 
The high and fluctuating value of many NFTs also facilitates the introduction of significant capital into the system and for onward sales at significantly different prices making it a potential haven for money launderers.
 
Unauthorised Minting
 
Although NFTs have created many opportunities for digital artists to sell their art, there are also potential issues in that anyone can 'mint' a digital art file as an NFT, whether or not they have the rights to do so in the first place and the process is virtually anonymous-it's as simple as click and save. There is then the issue of how to sue the anonymous holder of a crypto wallet and in which jurisdiction do you do so? Thefts of artist's images can be and are already being carried out repeatedly despite the artists' takedown requests to the platform.

NFTs and DeFi
 
Backed by a number of prominent crypto investors including Franklin Templeton and Pantera Capital, Arcade comprises a decentralised finance (DiFi) marketplace that allows borrowers to secure loans with NFTs that they own. It is possible for an NFT owner to secure a loan with one NFT or a single 'wrapped' NFT (i.e. multiple NFTs bundled together to reduce processing costs).The pledged NFTs will be escrowed in the smart contract deployed by Arcade and will remain irretrievable unless the loan is fully repaid or defaulted.
 
Risks in buying and lending on NFTs
 
As discussed above, there are manifold risks involved in buying and lending on NFTs which include:
 
* The digital image itself is not protected by the blockchain. Many NFTs simply contain a link to the digital asset in question. If this link breaks the owner redirects the URL to a different location and if the hosting account is not renewed, your NFT may become worthless. However, more and more NFTs are now being hosted via IPFS which goes some way towards protecting against this risk
 
* Currently, the NFT market is largely unregulated. The artist David Hockney appeared to speak for many in the art world when he described NFTs as being a market for 'crooks and swindlers'
 
* An author of an NFT could potentially mint a digital art file to which he had no rights as an NFT and, given the nature of an NFT, this may not breach the copyright of the owner of the original work. The author could also mint more copies of your 'rare' digital asset and you might have no redress
 
* Buyers might think that they are acquiring the underlying work of art and all its accompanying rights, whereas in reality they are simply buying the metadata (i.e. a metadata file and a short string of numbers and letters) associated with that work and not the work itself. The terms and conditions governing a buyer's right and interest in the NFT is contained in the smart contract (i.e. the agreement written in code between different parties that is stored on the blockchain and cannot be changed). The smart contract could grant the buyer of the NFT a licence to use the digital art which would otherwise be in breach of copyright and set out e.g. the governing law, but most smart contracts are very basic, do not offer licences of any type and contain contradictory provisions. It is important for a buyer to understand exactly what rights and obligations the smart contract gives him or her in relation to the NFT

* The price of NFTs can be extremely  volatile
 
* It is easy to get scammed when buying an NFT like anything on the internet as there are fake marketplaces, fake sellers (who may well be impersonating real artists and selling copies of their work at a fraction of what the original would sell for) and unverified sellers. As in the case of many things, anything that looks too good to be true probably is
 
* If a buyer wishes to pursue a seller in respect of an NFT, what jurisdiction should/can the buyer choose? It is not an easy question given that the smart contract relating to the NFT is probably silent as to governing law and jurisdiction, the buyer might be  in one jurisdiction, the seller in another and the market place where the NFT is traded may be headquartered in yet another jurisdiction, but operate worldwide

* The lender needs to be able to block the owner's access to his/her digital wallet holding the NFT and obtain access itself in order to protect its mortgage over the NFT and to be able to sell the NFT if the owner fails to cooperate. This might be achieved by an escrow arrangement
 
What security can a lender take?

Assuming that a lender has done its due diligence on the borrower and the NFT and is comfortable to lend (which is a big assumption) what type of security can the lender take? Here we need to make a further assumption that in this instance the lender is satisfied that the security instrument can be governed by English law.
 
To decide the appropriate type of security it is necessary to work out what an NFT is. As previously discussed, an NFT is a contractual right (possibly a licence) to download or stream a piece of digital content and use it in the manner prescribed by the smart contract embedded in the NFT and validated through the blockchain.
 
Under English law, security can be taken over rights under a contract or a licence (which is a chose in action) by way of an assignment by way of security which operates as a mortgage. This would be an equitable mortgage unless ownership of the NFT on the blockchain was transferred to the lender or its nominee. Even in the case of an equitable mortgage it would be necessary to ensure that the owner's access to his/her digital wallet holding the NFTs is blocked and that the lender has access to such wallet including the owner's 12-word seed phrase and password so that the lender can sell the NFT.A possible solution here is for the wallet to be made subject to an escrow arrangement pending repayment or the underlying loan or default by the owner on such loan. If the security is given by a UK company it would need to be registered at the UK Companies Registry within 21 days of creation. If given by an individual, it would not be registrable.
 
There are also the obvious valuation considerations and insurance issues.
 
Conclusion
 
NFTs are part of the new crypto revolution and represent (amongst other things) an interesting new way for strangers around the world to buy and sell tokens representing the right to use digital art without involving third party intermediaries other than the selling platform.
 
Ownership of the NFT using blockchain is uniquely secure.
 
The risks involved in NFT for a buyer or lender are currently high given that in the main they are unregulated and there are risk that proper KYC is not being carried out by the selling platforms to weed out money launderers, the underlying digital image is not protected by being embedded in the blockchain itself, sellers may not have been granted the right to mint the original artwork into an NFT and the terms of the smart contract to which the NFT is subject may be wholly inadequate for the buyer's needs.
 
It is technically possible for a lender to finance the purchase of digital art associated with NFTs and take security over them. Given the heavy due diligence required for a lender to satisfy itself that the NFT would constitute good and marketable security and the current adverse environmental impact of crypto which flies in the face of ESG (whose principles are being adopted by most mainstream lenders) it is likely to be a while before any of the established lenders against physical art do anything more than dip their cautious toes into financing and taking security over digital art in the form of NFTs.

This article is intended for guidance only and does not constitue legal advice.

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