Not everyone's cup of NFT

Non-fungible tokens (NFTs) have been growing rapidly in prominence since the turn of the recent decade. Uses span from digital artwork to verifying the authenticity of luxury goods and, most recently, to represent in-game assets. NFTs are frequently traded on marketplaces such as OpenSea, Rarible and LooksRare, and can command valuations to the tune of millions.

The prominence of NFTs raises an important legal question: do NFTs constitute a type of property? The answer may, in part, depend on the NFT's technical implementation. There is also a related question around the fraud and security risk borne by the NFT holder and that arise from the NFT's technical implementation.

How do NFTs work?

The main difference between a fungible and non-fungible token lies in its interchangeability. The majority of cryptocurrencies, such as Bitcoin  and tokens based on the Ethereum ERC-20 standard, are fungible as each token is identical and readily exchangeable for another token at the same value. That said, whether a token is fungible depends on how it is perceived. In the case of Bitcoin, there is a market premium for "virgin coins" (that is, newly minted Bitcoin) as there is less risk that such Bitcoin represents money-laundering proceeds, having never undergone any prior transactions.

On the other hand, each NFT is unique as it contains non-interchangeable data that ties it to one specific underlying asset, such as an artwork or a video. (Multiple NFTs can be minted in relation to a single underlying asset. Each NFT is nevertheless unique and distinguishable from the other by their edition number.)

How exactly an NFT operates depends on its use and its stipulated terms of sale. While an NFT's underlying asset can be either digital or physical, this discussion focuses on the digital and will compartmentalise into two types in accordance with the technical implementation. Different NFTs may carry different legal characterisation depending on their technical implementation:

• Type A NFT  as an on-chain asset.
• Type B NFT as an on-chain record of an off-chain asset. 

For an NFT to be classified as a Type A NFT, the entirety of the asset represented by the NFT must be stored on the blockchain. An example of such an NFT is OnChainMonkey. The image represented by the NFT is stored on-chain in scalable vector graphics (SVG)  format via Base64 encoding to ensure that the image does not exceed the space constraints of on-chain storage. To retrieve the image, the user would subsequently call the tokenURI function of the NFT smart contract.

For an NFT to be classified as a Type B NFT, the data stored on the blockchain merely needs to be associated with the asset represented by the NFT. This form of implementation is necessary as blocks are limited in space and it is generally not feasible, or possible even, to upload the entirety of the underlying asset onto the blockchain. An instance of this is Bored Ape Yacht Club. The image represented by the NFT is stored on an external IPFS database, and the location of the image on the external IPFS database is stored on the blockchain. To retrieve the location of the image, the user would have to call the tokenURI function of the NFT smart contract.

A property right or a mere record?

While the Singapore International Commercial Court (SICC) in B2C2 Ltd v Quoine Pte Ltd [2019] accepted the parties' agreed position that Bitcoin was a type of property capable of being held on trust, the Court of Appeal noted that cryptocurrency as property was a complex issue and required more consideration in a future forum (particularly the question on what type of property BTC was). (See Quoine Pte Ltd v B2C2 Ltd [2020].)

Even if one accepts the SICC's characterisation of Bitcoin as property, this still begs the question of whether an NFT is a type of property. Bitcoin as a digital payment token is distinguishable from an NFT, which is tied to an underlying asset. Whether NFTs are a type of property (and, if so, what type of property) may in part depend on the technical implementation of the NFT and the nature of the transaction (whether it is only the NFT that is traded or whether the off-chain asset is also traded).

Type A NFTs are arguably personal property since they consist of an on-chain copyrighted artistic work wrapped in associated metadata. While some may debate whether the underlying asset should be treated as a literary work (that is, the SVG code itself) as opposed to an artistic work, it still stands that copyright may vest in the underlying asset.

Even so, NFT "ownership" generally does not confer copyright ownership over the underlying asset. In most cases, the legal ownership and copyright remain with the content creator unless the contract of sale provides otherwise. 

Singapore law

Under Singapore law, the transfer of copyright ownership must be evidenced by a contract in writing and signed. The terms of sale of the particular NFT may also contain certain licensing rights relating to the underlying digital asset. For instance, holders of a CryptoKitty NFT can use the underlying art to commercialise their own merchandise, provided that they do not earn more than $100,000 in revenue each year from doing so.

On the other hand, there is considerably more difficulty in conceiving Type B NFTs in its entirety as property. The primary issue is that the NFT itself does not embody the copyrighted artistic work. Another key issue lay with the lack of control exerted by the NFT owner over the off-chain asset. The off-chain asset is likely uploaded to an external database and managed by the creator of the NFT or marketplace. The content creator may remove the asset or fail to pay the hosting bill for the domain, after which the hosting service will be terminated and the web page address becomes invalid, returning an "Error 404" when the NFT holder accesses it.

The foregoing raises a peculiarity in the NFT market. Type B NFTs are being traded at high valuations with considerable volumes. Yet, it may very well be the case that the law does not view these NFTs as property, but rather as mere data that is associated with particular off-chain assets. 

Fraud and security risks

While fraud and security risks in NFTs can arise in a number of ways, including "wash trading" and "rug pulls", this discussion focuses on the risks that arise from the technical implementation of NFTs.

On the face of it, there are two such risks. The first relates to fraud due to the apparent ease of "counterfeiting" NFTs. The second relates to the decoupling of the NFT from its underlying asset, which is a risk specific to Type B NFTs.

Counterfeit NFTs are prevalent since the underlying asset of genuine NFTs are publicly accessible. "Copyminters" can attempt to illegally profit from a genuine NFT by referencing the underlying asset in the counterfeit NFT.

For Type A NFTs, copyminters can copy the on-chain data of the genuine NFT and include it with the counterfeit NFT. For Type B NFTs, copyminters can reference the location of the underlying asset within the counterfeit NFT.

The risk of decoupling between the NFT and its underlying asset arises in relation to Type B NFTs because the NFT owner lacks control over the underlying asset. Under typical sale contracts for NFTs or terms of service for NFT marketplaces, there is little recourse available for NFT holders against the content creator or the NFT marketplace should the digital asset become inaccessible via the metadata provided by the NFT smart contract.

To address the risk of decoupling associated with off-chain data storage, the NFT industry is shifting towards the use of decentralised data storage solutions. These solutions include the IPFS, as well as the platforms created by blockchain projects such as Filecoin and Arweave. That said, the technology is still nascent and files stored on IFPS have gone offline from time to time inadvertently.

However, even if a Type B NFT is decoupled from its underlying asset, the consequences may not be as severe as one may think. If the underlying asset is a well-known artwork with multiple duplicates circulating on the Internet, the NFT is likely to retain value if there is market consensus as to what the NFT represents.

The same cannot be said, however, if it is not possible for others to tell what artistic work the NFT is coupled to. In such a case, the NFT holder's license to display the digital asset would also be rendered otiose as there would be no digital asset to display. 

The commentator is grateful for the input of Associate Professor How Khang LIM of the Singapore Management University and Kenneth Bok of Blocks into the section on fraud and security risks.  All errors remain the commentator's.