Blockchain Demystified: A Comprehensive Guide to Understanding Blockchain Technology (Part 9)
What’s an NFT?
NFTs are tokens that we can use to represent ownership of unique items. They let us tokenise things like art, collectibles, even real estate. They can only have one official owner at a time and they're secured by the Ethereum blockchain – no one can modify the record of ownership or copy/paste a new NFT into existence.
NFT stands for non-fungible token. Non-fungible is an economic term that you could use to describe things like your furniture, a song file, or your computer. These things are not interchangeable for other items because they have unique properties.
Fungible items, on the other hand, can be exchanged because their value defines them rather than their unique properties. For example, ETH or dollars are fungible because 1 ETH / $1 USD is exchangeable for another 1 ETH / $1 USD.
The Internet of assets:
NFTs and Ethereum solve some of the problems that exist in the internet today. As everything becomes more digital, there's a need to replicate the properties of physical items like scarcity, uniqueness, and proof of ownership. Not to mention that digital items often only work in the context of their product. For example you can't re-sell an iTunes mp3 you've purchased, or you can't exchange one company's loyalty points for another platform's credit even if there's a market for it. Here's how an internet of NFTs compared to the internet most of us use today looks...
The comparison
NFT examples
The NFT world is relatively new. In theory, the scope for NFTs is anything that is unique that needs provable ownership. Here are some examples of NFTs that exist today, to help you get the idea:
POAPs(Proof of Attendance Protocol)
If you contribute to ethereum.org, you can claim a POAP NFT. These are collectibles that prove you participated in an event. Some crypto meetups have used POAPs as a form of ticket to their events.[1]
Ethereum ‘.org’ has an alternative domain name powered by NFTs, ethereum.eth. Our .org address is centrally managed by a domain name system (DNS) provider, whereas ethereum.eth is registered on Ethereum via the Ethereum Name Service (ENS). And its owned and managed by Ethereum community.
How do NFTs work?
NFTs are different from ERC-20 tokens, such as DAI or LINK, in that each individual token is completely unique and is not divisible. NFTs give the ability to assign or claim ownership of any unique piece of digital data, trackable by using Ethereum's blockchain as a public ledger. An NFT is minted from digital objects as a representation of digital or non-digital assets. For example, an NFT could represent:
Digital Art:
GIFs
Collectibles
Music
Videos
Real World Items:
Deeds to a car
Tickets to a real world event
Tokenized invoices
Legal documents
Signatures
Lots and lots more options to get creative with!
An NFT can only have one owner at a time. Ownership is managed through the uniqueID and metadata that no other token can replicate. NFTs are minted through smart contracts that assign ownership and manage the transferability of the NFT's. When someone creates or mints an NFT, they execute code stored in smart contracts that conform to different standards, such as ERC-721. This information is added to the blockchain where the NFT is being managed. The minting process, from a high level, has the following steps that it goes through:
Creating a new block
Validating information
Recording information into the blockchain
NFT's have some special properties:
Each token minted has a unique identifier that is directly linked to one Ethereum address.
They're not directly interchangeable with other tokens 1:1. For example 1 ETH is exactly the same as another ETH. This isn't the case with NFTs.
Each token has an owner and this information is easily verifiable.
They live on Ethereum and can be bought and sold on any Ethereum-based NFT market.
In other words, if you own an NFT:
You can easily prove you own it.
Proving you own an NFT is very similar to proving you have ETH in your account.
For example, let's say you purchase an NFT, and the ownership of the unique token is transferred to your wallet via your public address.
The token proves that your copy of the digital file is the original.
Your private key is proof-of-ownership of the original.
The content creator's public key serves as a certificate of authenticity for that particular digital artefact.
The creators public key is essentially a permanent part of the token's history. The creator's public key can demonstrate that the token you hold was created by a particular individual, thus contributing to its market value (vs a counterfeit).
Another way to think about proving you own the NFT is by signing messages to prove you own the private key behind the address.
As mentioned above, your private key is proof-of-ownership of the original. This tells us that the private keys behind that address control the NFT.
A signed message can be used as proof that you own your private keys without revealing them to anybody and thus proving you own the NFT as well!
No one can manipulate it in any way.
You can sell it, and in some cases this will earn the original creator resale royalties.
Or, you can hold it forever, resting comfortably knowing your asset is secured by your wallet on Ethereum.
And if you create an NFT:
You can easily prove you're the creator.
You determine the scarcity.
You can earn royalties every time it's sold.
You can sell it on any NFT market or peer-to-peer. You're not locked in to any platform and you don't need anyone to intermediate.
Scarcity
The creator of an NFT gets to decide the scarcity of their asset.
For example, consider a ticket to a sporting event. Just as an organizer of an event can choose how many tickets to sell, the creator of an NFT can decide how many replicas exist. Sometimes these are exact replicas, such as 5000 General Admission tickets. Sometimes several are minted that are very similar, but each slightly different, such as a ticket with an assigned seat. In another case, the creator may want to create an NFT where only one is minted as a special rare collectible.
In these cases, each NFT would still have a unique identifier (like a bar code on a traditional "ticket"), with only one owner. The intended scarcity of the NFT matters, and is up to the creator. A creator may intend to make each NFT completely unique to create scarcity, or have reasons to produce several thousand replicas. Remember, this information is all public.
Royalties
ome NFTs will automatically pay out royalties to their creators when they're sold. This is still a developing concept but it's one of the most powerful. Original owners of EulerBeats Originals earn an 8% royalty every time the NFT is sold on. And some platforms, like Foundation and Zora, support royalties for their artists.
This is completely automatic so creators can just sit back and earn royalties as their work is sold from person to person. At the moment, figuring out royalties is very manual and lacks accuracy – a lot of creators don't get paid what they deserve. If your NFT has a royalty programmed into it, you'll never miss out. So, a new era of royalties and copyright laws is near?
What are NFTs used for?
Here's more information of some of the better developed use-cases and visions for NFTs on Ethereum.
Maximising earnings for creators
The biggest use of NFTs today is in the digital content realm. That's because that industry today is broken. Content creators see their profits and earning potential swallowed by platforms.
An artist publishing work on a social network makes money for the platform who sell ads to the artists followers. They get exposure in return, but exposure doesn't pay the bills.
NFTs power a new creator economy where creators don't hand ownership of their content over to the platforms they use to publicise it. Ownership is baked into the content itself.
When they sell their content, funds go directly to them. If the new owner then sells the NFT, the original creator can even automatically receive royalties. This is guaranteed every time it's sold because the creator's address is part of the token's metadata – metadata which can't be modified.
The copy/paste problem
Naysayers often bring up the fact that NFTs "are dumb" usually alongside a picture of them screenshotting an NFT artwork. "Look, now I have that image for free!" they say smugly.
Well, yes. But does googling an image of Picasso's Guernica make you the proud new owner of a multi-million dollar piece of art history?
Ultimately owning the real thing is as valuable as the market makes it. The more a piece of content is screen-grabbed, shared, and generally used the more value it gains.
Owning the verifiably real thing will always have more value than not.
Boosting gaming potential
NFTs have seen a lot of interest from game developers. NFTs can provide records of ownership for in-game items, fuel in-game economies, and bring a host of benefits to the players.
In a lot of regular games you can buy items for you to use in your game. But if that item was an NFT you could recoup your money by selling it on when you're done with the game. You might even make a profit if that item becomes more desirable.
For game developers – as issuers of the NFT – they could earn a royalty every time an item is re-sold in the open marketplace. This creates a more mutually-beneficial business model where both players and developers earn from the secondary NFT market.
This also means that if a game is no longer maintained by the developers, the items you've collected remain yours.
Ultimately the items you grind for in-game can outlive the games themselves. Even if a game is no longer maintained, your items will always be under your control. This means in-game items become digital memorabilia and have a value outside of the game.
Decentraland, a virtual reality game, even lets you buy NFTs representing virtual parcels of land that you can use as you see fit.
Making Ethereum addresses more memorable
The Ethereum Name Service uses NFTs to provide your Ethereum address with an easier-to-remember name like mywallet.eth. This means you could ask someone to send you ETH via mywallet.eth rather than 0x123456789......
This works in a similar way to a website domain name which makes an IP address more memorable. And like domains, ENS names have value, usually based on length and relevance. With ENS you don't need a domain registry to facilitate the transfer of ownership. Instead, you can trade your ENS names on an NFT marketplace.
Your ENS name can:
Receive cryptocurrency and other NFTs.
Point to a decentralized website, like ethereum.eth. More on decentralizing your website
Store any arbitrary information, including profile information like email addresses and Twitter handles.
Physical items
The tokenisation of physical items isn't yet as developed as their digital counterparts. But there are plenty of projects exploring the tokenisation of real estate, one-of-a-kind fashion items, and more.
As NFTs are essentially deeds, one day you could buy a car or home using ETH and receive the deed as an NFT in return (in the same transaction). As things become increasingly high-tech, it's not hard to imagine a world where your Ethereum wallet becomes the key to your car or home – your door being unlocked by the cryptographic proof of ownership.
With valuable assets like cars and property representable on Ethereum, you can use NFTs as collateral in decentralized loans. This is particularly helpful if you're not cash or crypto-rich but own physical items of value. More on DeFi
NFTs and DeFi
The NFT world and the decentralized finance (DeFi) world are starting to work together in a number of interesting ways.
NFT-backed loans
There are DeFi applications that let you borrow money by using collateral. For example you collateralise 10 ETH so you can borrow 5000 DAI (a stablecoin). This guarantees that the lender gets paid back – if the borrower doesn't pay back the DAI, the collateral is sent to the lender. However not everyone has enough crypto to use as collateral.
Projects are beginning to explore using NFTs as collateral instead. Imagine you bought a rare CryptoPunk NFT back in the day – they can fetch $1000s at today's prices. By putting this up as collateral, you can access a loan with the same rule set. If you don't pay back the DAI, your CryptoPunk will be sent to the lender as collateral. This could eventually work with anything you tokenise as an NFT.
And this isn't hard on Ethereum, because both worlds (NFT and DeFi) share the same infrastructure.
Fractional ownership
NFT creators can also create "shares" for their NFT. This gives investors and fans the opportunity to own a part of an NFT without having to buy the whole thing. This adds even more opportunities for NFT minters and collectors alike.
Fractionalised NFTs can be traded on DEXs like Uniswap, not just NFT marketplaces. That means more buyers and sellers.
An NFT's overall price can be defined by the price of its fractions.
You have more of an opportunity to own and profit from items you care about. It's harder to be priced out of owning NFTs.
This is still experimental but you can learn more about fractional NFT ownership at the following exchanges:
In theory, this would unlock the possibility to do things like own a piece of a Picasso. You would become a shareholder in a Picasso NFT, meaning you would have a say in things like revenue sharing. It's very likely that one day soon owning a fraction of an NFT will enter you into a decentralised autonomous organisation (DAO) for managing that asset.
These are Ethereum-powered organisations that allow strangers, like global shareholders of an asset, to coordinate securely without necessarily having to trust the other people. That's because not a single penny can be spent without group approval.
As we mentioned, this is an emerging space. NFTs, DAOs, fractionalised tokens are all developing at different paces. But all their infrastructure exists and can work together easily because they all speak the same language: Ethereum. So watch this space.
Ethereum (or any other blockchain in general) and NFTs
Ethereum makes it possible for NFTs to work for a number of reasons:
Transaction history and token metadata is publicly verifiable – it's simple to prove ownership history.
Once a transaction is confirmed, it's nearly impossible to manipulate that data to "steal" ownership.
Trading NFTs can happen peer-to-peer without needing platforms that can take large cuts as compensation.
All Ethereum products share the same "backend". Put another way, all Ethereum products can easily understand each other – this makes NFTs portable across products. You can buy an NFT on one product and sell it on another easily. As a creator you can list your NFTs on multiple products at the same time – every product will have the most up-to-date ownership information.
Ethereum never goes down, meaning your tokens will always be available to sell.
The environmental impact of NFTs
NFTs are growing in popularity which means they're also coming under increased scrutiny – especially over their carbon footprint.
To clarify a few things:
NFTs aren't directly increasing the carbon footprint of Ethereum.
The way Ethereum keeps your funds and assets secure is currently energy-intensive but it's about to improve.
Once improved, Ethereum's carbon footprint will be 99.95% better, making it more energy efficient than many existing industries.
The whole NFT ecosystem works because Ethereum is decentralized and secure.
Decentralized meaning you and everyone else can verify you own something. All without trusting or granting custody to a third party who can impose their own rules at will. It also means your NFT is portable across many different products and markets.
Secure meaning no one can copy/paste your NFT or steal it.
These qualities of Ethereum makes digitally owning unique items and getting a fair price for your content possible. But it comes at a cost. Blockchains like Bitcoin and Ethereum are energy intensive right now because it takes a lot of energy to preserve these qualities. If it was easy to rewrite Ethereum's history to steal NFTs or cryptocurrency, the system collapses.
How is your NFT minted?
When you mint an NFT, a few things have to happen:
It needs to be confirmed as an asset on the blockchain.
The owner's account balance must be updated to include that asset. This makes it possible for it to then be traded or verifiably "owned".
The transactions that confirm the above need to be added to a block and "immortalised" on the chain.
The block needs to be confirmed by everyone in the network as "correct". This consensus removes the need for intermediaries because the network agrees that your NFT exists and belongs to you. And it's on chain so anyone can check it. This is one of the ways Ethereum helps NFT creators to maximise their earnings.
All these tasks are done by miners. And they let the rest of the network know about your NFT and who owns it. This means mining needs to be sufficiently difficult, otherwise anyone could just claim that they own the NFT you just minted and fraudulently transfer ownership. There are lots of incentives in place to make sure miners are acting honestly.
Securing your NFT with mining
Mining difficulty comes from the fact that it takes a lot of computing power to create new blocks in the chain. Importantly, blocks are created consistently, not just when they're needed. They're created every 12 seconds or so.
This is important for making Ethereum tamper-proof, one of the qualities that makes NFTs possible. The more blocks the more secure the chain. If your NFT was created in block #600 and a hacker were to try and steal your NFT by modifying its data, the digital fingerprint of all subsequent blocks would change. That means anyone running Ethereum software would immediately be able to detect and prevent it from happening.
However this means that computing power needs to be used constantly. It also means that a block that contains 0 NFT transactions will still have roughly the same carbon footprint, because computing power will still be consumed to create it. Other non-NFT transactions will fill the blocks.[2]
Legal issues and NFTs
“Critically, issuers must be clear what rights are being "sold" with the NFT. These could include certifying ownership of an asset, a licence to use intellectual property rights (IPR), or even contractual rights, for example a right to receive or use a particular asset (whether digital or virtual) or to access benefits. Clarity upfront will avoid the issuer giving up unintended rights and potential claims from purchasers alleging misrepresentation of the rights on offer. Equally, the purchaser of an NFT needs to understand what they are acquiring. For example, if the NFT incorporates smart contract functionality, this will be encoded into it and may not be evident on the face of it. Purchaser due diligence is needed to establish what rights and obligations are being acquired, particularly if they might impact on the current or future value of the NFT and the underlying asset. What an NFT represents, how much is expected to be generated from selling it, and even whether it is capable of fractional ownership, will largely be driven by the commercial rationale for issuing the NFT. For example, if the value lies in the scarcity of an NFT or the underlying asset, an issuer may want to restrict fractionalisation (and must ensure it can enforce those restrictions), and purchasers may seek assurances in that respect. However, if the NFT or the underlying asset is high-value, fractionalisation of the NFT (without dividing the underlying asset) may open up investment opportunities for those otherwise unable to afford it. Those factors will also determine (for example) the content of any conditions of sale or smart contract and the applicable regulatory framework.”[3]
Intellectual Property Rights
Issuers’ will want to secure certain IPR rights associated with their NFT. At first glance, the selling of an artwork or whatever NFT is pointing towards might be considered as an assignment of copyright. But legally, copyright and the IPR will still be retained by the issuer, and the buyer will just be given the right to trade and display the underlying asset. The issuer's valuable brand must be preserved, hence care must be taken in how and whether IPR is licenced through the sale and subsequent transfer of the NFT (including effective remedies if their IPR is misused).
The ownership of an NFT is determined by any code or smart contract built in the NFT (or the terms of sale in a traditional contract format). For example, NFT producers may construct an NFT to automate the payment of royalties or commissions on any resale of the tokens. The issuer will be able to follow resales because they will be stored on the blockchain where the NFT is held, and payment might be automated via a smart contract within the NFT.
Financial Regulations
Businesses must determine if their NFT is a regulated investment, security, or payment instrument, and whether selling it, or providing related services like custody or exchange, is a regulated activity for the purposes of financial regulation. Although NFTs are not (yet) officially regulated, they may trigger national and supranational legal requirements if they exhibit characteristics of other regulated investment units. Issuers will need to show that any NFT they offer is non-fungible in order to avoid it being classified as a security token or cryptocurrency, which could be subject to financial regulation.
These regulatory obligations range from "know your client" identification and verification, as well as accompanying record-keeping and monitoring obligations and other compliance obligations, to far more onerous requirements when securities regimes or other investment laws are triggered. Generally, issuers and service providers will be subject to regulation in the country in which the NFTs or related services are issued, especially if they are supplied to the retail market. Because these digital assets are intrinsically global, multi-jurisdictional examination will almost always be required.
The regulated entity will bear the burden of compliance, which is difficult to transfer. Non-compliance carries a significant reputational risk in addition to any cash fines.
Aside from financial regulation, businesses must ensure that any marketing activity relating to their NFTs is compliant, keeping in mind that several regulators have taken action in the crypto space, including in relation to advertisements for unregulated crypto that did not adequately highlight financial risks.
Data security and ESG
Because the selling of NFTs is unlikely to include the revelation or exchange of sensitive personal data, compliance with privacy rules will not be a factor. The security of data and NFT transactions in general, however, will be paramount. Technical teams will have to decide the security and data-sharing protocols to use, as well as which blockchain technology to use (the most common being Ethereum). Furthermore, adequate technical arrangements will be required to secure the permanence of NFTs and, more importantly, any digital assets they represent.
With environmental, social, and corporate governance issues at the forefront of the corporate agenda, corporations issuing NFTs, particularly those based on Ethereum (a proof of work system), will need to examine if they connect with the organization's overall environmental policy. In addition, if an NFT is subject to the Sustainable Finance Disclosure Regulation (or any other relevant regulation), issuers must ensure that sufficient disclosure is made on their website and in pre-contractual documents.
Contractual
To "mint" NFTs, issuers frequently hire a third-party technology vendor. The "minting" agreement must clearly specify the scope of the provider's responsibilities and provide assurances that intellectual property and confidential information will be adequately protected (particularly as NFT projects can be commercially sensitive).
To "mint" NFTs, crypto funds will be required, hence organisations should consider purchasing an enterprise-grade crypto wallet. To ensure effective protection in the event of loss or misuse of crypto assets in the wallet, thorough vendor due diligence will be required.
The terms under which NFTs are offered for sale to purchasers must be carefully defined, in addition to any agreements with technological partners. These will most likely take the form of "conventional" legal conditions that the buyer accepts at the point of sale, possibly combined with a smart contract that automates some elements. They'll have to be written in accordance with local consumer protection laws, which could provide buyers enforcement rights in their own nation. Even if the terms are well-drafted, issuers must consider the practical obstacles of identifying possibly anonymous criminals in any country, as well as how disputes will be resolved and judgements executed.
Estate and Sequence Planning
Everywhere, legal systems handle digital valuables after the owner's death in nearly the same way. Even so, you should double-check your local laws first. If you want to ensure that your digital works are passed down to your heirs in the event of your death, estate planning is essential. Non-fungible tokens must be strategically included in a personal Estate Plan, which requires careful preparation.
Given the number of estates with a digital footprint, this is a significant concern. It has emphasised the importance of thorough estate planning when it comes to the NFT token market.
The fact that NFTs may only be accessed with a personal key and password is a major issue. As a result, many users are unsure what to do in the event of the owner's death. In this instance, valuable assets may be permanently lost. For investors, mitigating these risks is critical. Recognizing personal representatives for these assets, as well as access to them, is a good concept. In this way, in the event of one's death, trusted persons will be able to access and govern the state.
What happens if an NFT isn't included in an estate plan to pass on to heirs? They might simply be removed. It's necessary to keep important information like keys and passwords in separate, secure locations. It's part of a well-developed "digital legacy."
Cloud data storage platforms can be used to back up such plans. If something goes wrong, third parties can get backup keys from special multi-sig wallets. If the owner dies, their trustee will be able to withdraw cash and carry out the owner's wishes. Everything hinges on the owner's last will and testament. Investors, on the other hand, should be aware of the potential risks connected with sharing their access, as well as the prospect of cyber-hacking.
Taxation Aspects
“Are NFTs taxed? Most often, they are. In case you are not a side that made money on selling a non-fungible token, you should report the proceeds as income on a tax return. Thus, the same laws that apply to fungible crypto work for non-fungible assets. In case someone invests in them, any revenues that come from sales are taxed as property and subject to the capital profit tax. You may face such activities as:
Buying an asset with fungible crypto. This action is a disposal of the crypto and incurs a capital gain/loss. Let’s say, if one purchases a collectible card at Rarible using Ethereum (ETH), they would incur a capital gain, forcing them to pay taxes. In the case of depreciated crypto, a seller would experience a capital loss.
Offering an NFT for crypto. In this way, a seller incurs a capital gain/loss. For instance, they purchased a token for $20,000 just to sell it later for $25,000 BTC. It means they receive a gain of $5,000.
Trading one piece of art for another. This event triggers some taxes as well. Buying a token for $3,000 of BTC and trading it for another token worth $4,000 would mean a taxable capital gain of $1,000.
In each case, an asset would be subject to legal regulations related to taxation. If you simply come up with a token. it isn’t considered a taxable action. Selling it is different. Such marketplaces as Rarible or OpenSea have their own taxes on trading NFTs. Any profits that you obtain in this case are your personal income and should be taxed just like anything else that you sell. Usually, an income tax rate may vary from 10%-37%. It’s almost identical to those rates that show up when receiving payments in cryptocurrencies or mining. Besides, your profit will be subject to self-employment taxes at a rate of around 15%.
Even though these numbers are confirmed by most services and regulatory bodies, some questions are still left regarding NFTs taxation. As taxes and related regulations are different around the globe, one should refer to their local laws. For instance, in the United Kingdom, HMRC has updated the “Crypto-Assets Manual” that relates specifically to crypto.
Non-fungible tokens belong to a special category of a digital asset. This guide claims that NFTs aren’t “pooled” for Capital Gains Tax (CGT) goals. On one side, it is obvious that Capital Gains Tax deploys to revenues or losses on disposals of NFTs. However, the accurate tax position is not fully clear.
So, is NFT right for tax objectives? Foreigners with assets abroad should consider this primary issue. Their assets risk falling outside the scope of UK taxation. Crypto owners should pay taxes in the location where they are residents, so the same method may work for non-fungible tokens. It applies mostly to assets like digital NFT artwork, but the law is still obscure.
In other words, it does not mean if you are developing an NFT or investing in one. You should memorize some tax implications. The more transactions there are, the more complex tracking and estimating of taxes is. Not all services display taxes that users should pay. It is in your interest to keep records of both NFTs you sell and crypto used to buy them.”[4]
Comment:
While there are still some unanswered problems concerning some NFT applications, there is undoubtedly a surge in interest in the technology that is difficult to ignore. NFTs provide opportunity for issuers, acquirers, and investors in a variety of industries. Their potential to generate and sustain revenue streams is particularly attractive, most notably in the context of art, sports, collectibles and in sectors where brand strength drives value. With these opportunities, however, comes a greater need for businesses to act carefully to avoid unintended regulatory implications and to protect their commercial interests.
DATA PROTECTION
The Government of India constituted a Committee of Experts on July 31st, 2017 under the Chairmanship of former Supreme Court justice B.N. Srikrishna with the objective to identify and study the key issues relating to data protection in India and make specific suggestions on principles to be considered for data protection in India and suggest a draft Data Protection Bill. The “White Paper of The Committee of Experts on A Data Protection Framework for India” was released by the Ministry of Electronics and Information Technology on November 27th, 2017. This white paper is the first step on the part of the Union Government to put in place a robust data protection regime1 to ensure data protection against the dangers posed to an individual’s privacy by state and non-state actors. The contents of the Whitepaper are as follows to understand the principles behind the data protection regime.
[1] https://ethereum.org/en/contributing/#poap [2] https://ethereum.org/en/nft/ [3] osborneclarke.com/insights/what-are-legal-issues-around-nfts [4] https://opengeekslab.com/blog/legal-issues-nfts/
By Siddharth Dalmia
The StartUp Sherpa
+91-9971799250
dalmiasiddharth1994@gmail.com
