Non-Fungible Tokens (NFTs)

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Non-Fungible Tokens (NFTs)

by James G. Barr

Docid: 00018009

Publication Date: 2105

Publication Type: TUTORIAL

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A current crypto craze, non-fungible tokens (NFTs) are digital assets
that represent real world items like art, fashion, and real estate;
virtual world entities like virtual land and structures; and intellectual
property like licenses, certifications, and patents. Being non-fungible, each
has a unique value and digital signature. While NFT applications are still
emerging, today’s primary use case involves artists and art sales.

Executive Summary

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In a transaction aimed to attract attention – as well as gather profits
– Twitter co-founder Jack Dorsey sold his first ever tweet (“just setting
up my twttr”) as a non-fungible token (NFT) for more than $2.9 million.

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A current crypto craze, non-fungible tokens are digital assets that
represent:

Real world items like art, fashion, and real estate;
Virtual world entities like virtual land and structures; and
Intellectual property like licenses, certifications, and patents.

NFTs reside on a “blockchain”, a distributed public ledger that not only
records transactions but certifies their authenticity. If it sounds
familiar, blockchain is the technology that undergirds cryptocurrency, like
Bitcoin or Ethereum.

Cryptocurrency, however, is “fungible”, meaning it can be freely
traded. One Bitcoin is equal to every other Bitcoin, just as one
dollar is equal to every other dollar.

In contrast, NFTs are “non-fungible,” meaning they each have a unique
value and digital signature and, therefore, cannot be traded or exchanged
for one another on a one-for-one basis.

While NFT applications are still emerging, today’s primary “use case”
involves artists and art sales. As analyst Robyn Conti explains:
“NFTs afford artists and content creators a unique opportunity to monetize
their wares. For example, artists no longer have to rely on
galleries or auction houses to sell their art. Instead, the artist
can sell it directly to the consumer as an NFT, which also lets them keep
more of the profits. In addition, artists can program in royalties
so they’ll receive a percentage of sales whenever their art is sold to a
new owner. This is an attractive feature as artists generally do not
receive future proceeds after their art is first sold.”¹

Figure 1 offers an original photograph that an enterprising photographer
might craft into an NFT.

Figure 1. Masai Mara, Kenya Landscape

Source: James G. Barr

In addition to providing a money-making vehicle for artists and
entrepreneurs, enterprises are exploring the use of NFTs to enhance their
bottom lines. For example, many large enterprises have extensive
patent portfolios. By transforming these patents into NFTs,
enterprises can take financially under-performing assets and convert them
into commodities that are liquid and sellable.²

Although promising, the future of NFTs is uncertain, given their
connection to blockchain and cryptocurrency, as well as their
newness. While some argue that the market is already collapsing, the
evidence so far indicates otherwise, with “more than $2 billion …
spent on NFTs in the first quarter of 2021 – representing an increase of
about 2100 percent from [the] last quarter of 2020.”³

For many enterprises – like many individuals – the cost of not engaging
in the NFT space may be too high to absorb.

What Are NFTs?

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Non-fungible tokens (NFTs) are digital assets that represent:

Real world items like art, fashion, and real estate;
Virtual world entities like virtual land and structures; and
Intellectual property like licenses, certifications, and patents.

NFTs reside on a “blockchain”, a distributed public ledger that not only
records transactions but certifies their authenticity.

Blockchain

A blockchain is a group of computers that, working together, verify the
integrity of data and transactions. Each block represents a piece of
data, such as the record of a transaction, and the blocks are linked in a
sequential chain. This sequential record, called a ledger, is stored
by – and visible to – all of the members of a particular blockchain. Such transparency is a key feature of blockchain’s security. Importantly, blockchain is a concept, not a proprietary technology, so
there are multiple blockchains operating independently.⁴

Today, most NFTs are part of the Ethereum blockchain. Ethereum,
like Bitcoin and Dogecoin, is a cryptocurrency but its blockchain also
supports NFTs.⁵

Non-Fungible

As their distinguishing characteristic, NFTs are “non-fungible,” meaning
they each have a unique value and digital signature and, therefore, cannot
be traded or exchanged for one another on a one-for-one basis. As
more rigorously defined by the US National Institute of Standards and
Technology (NIST), a non-fungible token is “a data representation or
abstraction that assigns uniquely identified and uniquely formatted
qualitative data objects to blockchain addresses with programmable
lifecycle management.”⁶

The NFT vehicle is perfect for assigning a unique digital identity to a
non-digital asset for the purpose of selling, buying, or trading said
asset.

Not Quite New

The NFT concept is new, but not that new. As analysts Paul Bain,
Caleb Green, and Cindy Villanueva remind us, “Video game developers have
used NFTs in gaming for many years. A prominent example of previous
applications of [NFTs] includes CryptoKitties, which was one of the
earliest adaptations of non-fungible token technology and enabled players
to collect and trade digital cats using NFTs. They can also be used inside
gaming environments to represent in-game assets, which can be controlled
by the user instead of the developer.”⁷

The Climate Controversy

While NFTs have existed for only a few years, their widespread adoption
may be derailed due to concern over climate change. As analyst
Justine Calma acknowledges, NFTs “are at least partially responsible for
the millions of tons of planet-heating carbon dioxide emissions generated
by the crypocurrencies used to buy and sell them.”⁸

Some artists who have benefited from NFTs believe a clean-energy solution
is in sight; others are less sanguine about the possibility of producing
green – or, at least, greener – non-fungible tokens.

NFT Marketplaces

Facilitating the buying and selling – as well as the creating (or
“minting”) – of non-fungible tokens are NFT marketplaces. Among the
more popular destinations are:

OpenSea – “the world’s first and largest digital marketplace for
crypto collectibles and [NFTs];” and
Foundation – a more exclusive NFT presence where “creators are invited
to join … by members of the [creative] community.”

In addition to showcasing NFTs for possible sale, the marketplaces often
instruct the uninitiated on minting artistically and financially
attractive NFTs.

NFT Applications

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As with most digital inventions, the value and viability of non-fungible
tokens will be determined by the value and variety of their applications.

Art

NFTs can be a critical medium in connecting artists with their customers
and patrons. As analyst Diego Geroni reports, “The recent news of
digital artist, Beeple, selling an NFT of his artwork at a whopping $69
million at [a] Christie’s auction, created ripples throughout the
blockchain world.”⁹

Licenses and Certifications

Employers, universities, and other relevant parties often require the
production of school diplomas, professional licenses, training
certifications, and other documents of accreditation and
achievement. Rendering these items as NFTs reduces the dual burden
of record keeping and record production.¹⁰

Patents

Many large enterprises have extensive patent portfolios. By
transforming these patents into NFTs, enterprises can take financially
under-performing assets and convert them into commodities that are both
liquid and sellable, monetizing at least some of the assets on their
balance sheet.¹¹

Real Estate

NFTs can be used to apportion real estate holdings. Consider the
following scenario advanced by analyst Rakesh Sharma. “[A] piece of
real estate [is] parceled out into multiple divisions, each of which
contains different characteristics and property types. One of the
divisions might be next to a beach while another is an entertainment
complex and, yet another, is a residential district. Depending on
its characteristics, each piece of land is unique, priced differently, and
represented with an NFT. Real estate trading, a complex and
bureaucratic affair, can be simplified by incorporating relevant metadata
into each unique NFT.”¹²

Fund Raising

NFTs can benefit non-commercial causes. As analyst Robyn Conti
reveals, “Charmin and Taco Bell have auctioned off themed NFT art to raise
funds for charity.

“Charmin dubbed its offering ‘NFTP’ (non-fungible toilet paper); and
“Taco Bell’s NFT art sold out in minutes, with the highest bids …
equal to $3,723.83 (as of March 24, 2021).¹³

Other Apps

Other applications of NFTs include:

Fashion – Verifying the provenance of luxury items and
accessories, and thwarting counterfeiting attempts.
Collectibles – Producing special versions of already unique and
valuable items.
Sports – Offering game tickets that feature information
tailored to their registered owners.¹⁴

NFT Concerns

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In addition to concerns over resource consumption and its climate impact,
NFT users – especially the enterprise variety – should be aware of the
following risks.

Fixture or Fashion

At least in their present incarnation, NFTs are too new to forecast
whether they’re a fixture – destined to become a standard blockchain
entity – or a fashion – destined to disappear or be diminished, a fate
some have predicted for cryptocurrencies.

There is, however, a growing belief that the NFT’s contribution to
digital rights management may keep non-fungible tokens relevant.

Intellectual Property Ownership

As analysts Paul Bain, Caleb Green and Cindy Villanueva caution, “When
considering intellectual property implications of NFTs, it is important to
distinguish between ownership of the NFT and ownership of their underlying
intellectual property. The rights granted by an NFT seller depend on
the rights transferred via a license or assignment, and these can vary with
every NFT. You may own a particular video clip or photo of a LeBron
James dunk in NFT form, but the underlying rights belong to the NBA.

“In the context of copyright, ownership of the underlying rights will
only transfer if the author of the original work expressly agrees to
transfer those rights to the NFT owner. Generally, without such an
agreement, ownership of an NFT will not grant ownership of the underlying
content or any associated intellectual property rights. As a result,
an NFT owner may not be permitted to reproduce, distribute copies,
publicly perform, display, or make derivative works of the original
work. Instead, the copyright owner retains the exclusive rights.”¹⁵

Non-Fungible Token Fraud

It is, perhaps, ironic that NFTs, built with “security in mind,” can be
subject to scams and other fraudulent activities. Nonetheless,
analyst Robyn Conti warns that “Some artists have fallen victim to
impersonators who have listed and sold their work without their
permission. In addition, the verification processes for creators and NFT listings aren’t consistent across platforms – some are more stringent
than others.” Finally, “Buyer protections appear to be sparse at
best, so when shopping for NFTs, it may be best to keep the old adage
‘caveat emptor’ (let the buyer beware) in mind.”¹⁶

NFTs and Taxes

The tax implications of buying and selling NFTs are unclear, as IRS and
other rules are still evolving.¹⁷ Capital gains taxes
should apply to NFT sales, similar to stocks sold for a profit.¹⁸ Any individual or enterprise venturing into the NFT market should consult
their tax professionals in advance.

Recommendations

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From an enterprise perspective, the ability to mint and market
non-fungible tokens represents a new and perhaps lucrative business
opportunity, particularly if financially under-performing assets, like
patent and real estate holdings, can be converted into revenue-earning
resources.

The current crop of NFT marketplaces are relatively new, and likely
immature in their security and privacy governance. Before engaging
with these firms, enterprise analysts should approve their operations (as
they would – or should – with any new supply chain partners). As an
alternative, large enterprises should consider founding their own
marketplaces; first, for their own protection; and second, as a possible
line of business designed to attract other enterprise clients.

As part of the cryptocurrency ecosystem, NFTs have been greeted with some
skepticism. Enterprise officials should conduct a risk-reward
analysis in an effort to determine whether NFT investments are
economically sound and reputationally prudent.

In terms of risk, the climate change-accelerating nature of NFTs should
be thoroughly studied. Key questions are:

In an era when companies are switching from gasoline to electric cars
out of respect for the environment, does doing NFT business undo any
carbon-reducing or carbon-neutral initiatives?
Can the climate-negative impact of proposed NFT projects be mitigated
to a reasonable level?

Overall, the best approach to NFT involvement for most enterprises is
probably wait-and-see.

Web Links

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Ethereum: https://ethereum.org/
Foundation: https://foundation.app/
OpenSea: https://opensea.io/
US National Institute of Standards and Technology: http://www.nist.gov/

References

¹ Robyn Conti. “What You Need to Know About Non-Fungible
Tokens (NFTs).” Forbes. April 29, 2021.

² Esther Shein. “NFTs: What They Are, and Why They’re Worth
Millions.” Innovation. April
29, 2021.

³ Ipsita Agarwalla and Meyyappan Nagappan. “Taxing
Non-Fungible Tokens (NFTS).” The National Law Review. May 4, 2021.

⁴ Geoff Keston. “Blockchain." Faulkner Information Services.
November 2020.

⁵ Mitchell Clark. “NFTs, Explained.” The Verge. March 11, 2021.

⁶ Loic Lesavre, Priam Varin, and Dylan Yaga. NISTIR 8301:
“Blockchain Networks: Token Design and Management Overview.”
US National
Institute of Standards and Technology. February 2021:6.

⁷ Paul Bain, Caleb Green, Cindy Villanueva. “What You Need to
Know: Intellectual Property and Non-Fungible Tokens.” JD Supra. May 10, 2021.

⁸ Justine Calma. "The Climate Controversy Swirling Around NFTs.” The Verge. March 15, 2021.

⁹ Diego Geroni. “NFTs and Their Use Cases: A Complete Guide.”
101 Blockchains. March 24, 2021.

¹⁰ Ibid.

¹¹ Esther Shein. “NFTs: What They Are, and Why They’re Worth
Millions.” Innovation. April
29, 2021.

¹² Rakesh Sharma. “Non-Fungible Token (NFT) Definition.”
Investopedia. March 8, 2021.

¹³ Robyn Conti. “What You Need to Know About Non-Fungible
Tokens (NFTs).” Forbes. April 29, 2021.

¹⁴ Diego Geroni. “NFTs and Their Use Cases: A Complete Guide.”
101 Blockchains. March 24, 2021.

¹⁵ Paul Bain, Caleb Green, Cindy Villanueva. “What You Need to
Know: Intellectual Property and Non-Fungible Tokens.” JD Supra. May 10, 2021.

¹⁶ Robyn Conti. “What You Need to Know About Non-Fungible
Tokens (NFTs).” Forbes. April 29, 2021.

¹⁷ Ipsita Agarwalla and Meyyappan Nagappan. “Taxing
Non-Fungible Tokens (NFTS).” The National Law Review. May 4, 2021.

¹⁸ Robyn Conti. “What You Need to Know About Non-Fungible
Tokens (NFTs).” Forbes. April 29, 2021.

About the Author

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James G. Barr is a leading business continuity analyst
and business writer with more than 30 years’ IT experience. A member of
“Who’s Who in Finance and Industry,” Mr. Barr has designed, developed, and
deployed business continuity plans for a number of Fortune 500 firms. He
is the author of several books, including How to Succeed in Business
BY Really Trying, a member of Faulkner’s Advisory Panel, and a
senior editor for Faulkner’s Security Management Practices.
Mr. Barr can be reached via e-mail at jgbarr@faulkner.com.

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