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October 05, 2021
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The rush of news about NFTs and the outrageous sale prices paid for some is so eye-popping, everyone is asking, “Should I get in on the trend?” The next question they ask: “What exactly is an NFT?”
We’ll answer the second question first by revisiting some of the wildest NFT transactions so far this year: In July, the very first tweet by Twitter founder and CEO Jack Dorsey sold for $2.9 million. In March, a digital art print by a little-known artist named Beeple went for $69 million at a Christie’s auction. That same month, the National Basketball Association (NBA) sold a Lebron James highlight video “trading card” for $200,000.
Each of those items is an NFT, or “non-fungible token,” a unique digital asset that represents ownership of almost anything, such as an asset, a piece of content, a contract or a form of identity, and is tracked on the blockchain. If you want to know more about blockchain and the definition of “fungible,” see the sidebar.
Blockchain, Fungible: Defined
A blockchain is an immutable digital ledger. Data entered into it cannot be reversed and is viewable to all who use it. That provides security and guarantees authenticity. A fungible item can be substituted or exchanged for a similar item. Fiat currencies are fungible — a dollar can be exchanged for another dollar. A non-fungible item is not interchangeable, making each item unique, and this scarcity may lead to long-term value and speculation about that value.1,2
Although the applications of NFTs are numerous, what has really grabbed the public’s attention are digital forms of content, primarily art. Currently, the NFT market is highly speculative and that drives businesses to explore ways to monetize their own content, market to customers and “tokenize” other applications, such as intellectual property. However, businesses are tiptoeing around in part because the market is developing so rapidly that regulators are playing catch-up. Questions of compliance, financial liability and copyright infringement hang in the air.
If that reminds you of the cryptocurrency market, you’re a step ahead. Just as multiple regulators are attempting to corral crypto exchanges for digital currencies like Bitcoin, Ethereum and Litecoin, they are also poking into NFTs. Ambiguity over which regulatory body has jurisdiction over certain digital assets adds confusion, and ongoing litigation around a few NFT transactions is also driving scrutiny.
The evolving regulations are tricky to navigate. Nevertheless, many businesses are taking the leap. To return to the first question posed above — Should I get in on the trend? — the answer then depends on your appetite for risk, and also on the content you want to monetize. The possibilities are almost endless.
The following five hypothetical examples of NFTs may apply more directly to individuals, but as you’ll see, they also provide insight about how imaginative the market for non-fungible tokens is and how regulators are responding.
NFT: Digital recording of your mint condition Red Hot Chili Peppers’ 1984 debut album
Yes, music files can be a type of NFT. What’s in your vinyl collection?
In April, a star DJ-producer named Justin Blau auctioned off previously unreleased music and digital artwork for $11.6 million. Almost anything can be an NFT: a piece of music, a meme, a video, a photo, a portion of code. Proof of ownership of the original source and authenticity are validated through the blockchain technology used by the particular marketplace (also known as a platform), which is often aligned with a preferred type of cryptocurrency for payment. Most NFT platforms require buyers to have a digital wallet and use the specified cryptocurrency. A few top NFT marketplaces include OpenSea, Rarible and BakerySwap.
NFT: A digital portrait of the painting of those poker-playing dogs in your rec room
As of the end of July, the 2021 digital art market was valued at $429M. What’s hanging on your wall?
You can download a cat meme for free from the internet. But without buying the original version of the file, or a fraction of it, on a blockchain, it’s not an NFT. Interestingly, “fractional” NFTs, or “f-NFTs,” are growing in popularity as a way for sellers to appeal to buyers priced out of the digital art market. The original creator can realize some liquidity without losing complete ownership.
Quite naturally, the creative financial gymnastics of f-NFTs have caught the attention of the Securities and Exchange Commission (SEC), which, as we’ll see below, is already wrestling with how to classify NFTs in general.
NFT: A cellphone video of your niece’s fourth birthday party with the runaway pony
The viral video of Charlie Bit Me from the early days of YouTube recently sold for $761,000. What’s on your phone?
In May, the blockchain company that developed the digital platform that houses the NBA’s Top Shot video series was sued for allegedly selling the product as an unregistered security. That raises the question: Should NFTs be considered a security?
The SEC, though not a party to the NBA Top Shot lawsuit, is leaning in that direction: When using the standard of the Commission’s “Howey Test,” the main issue in analyzing a digital asset is whether “a purchaser has a reasonable expectation of profits” (or other financial returns) “derived from the efforts of others.” The framework adds, “A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market.”3
The lawsuit speaks to the fact that the NFT market is currently a bit like the Wild West, as entrepreneur Mark Cuban described it in January.
NFT: The first text draft of an email you sent to the alumni magazine
A New York Times columnist minted an August piece about NFTs — as an NFT. It sold for $560,000. What’s in your email?
The Internal Revenue Service is cracking down on NFTs from a tax evasion standpoint, citing trillions of dollars in revenue lost to cryptocurrency and the dark web. The Treasury Department will soon require any transfer of “cryptoassets” greater than $10,000 to be reported to the IRS. The Commodity Futures Trading Commission is working to develop “a framework to promote responsible innovation in digital assets.”
Meanwhile, the Office of the Comptroller of the Currency’s Office of Innovation updated the framework for banks around “crypto custody” in January. There’s also potential for movement on anti-corruption from a national security perspective: In June, President Biden ordered an interagency review to be completed in the next 200 days.
NFT: A spaghetti boiling process stop motion animation gif
If an animated gif of a cat with a Pop-Tart body flying through space sold for $560,000, what have you got to lose?
Businesses like Taco Bell, Warner Music Group and Nike are all producing their NFTs, and more corporations are likely to mint their own tokens in the coming year. Creativity and innovation are the name of the game. Budweiser, for instance, recently invited anyone visiting its Twitter feed to submit a digital illustration to the corporation’s open digital wallet. Each illustration became an instant NFT. The goal was not to sell the NFTs but to generate buzz for the brand.
IBM announced in April that it has teamed up with IPwe, an intellectual property specialist, to “unlock $1 trillion or more in patents and other intellectual assets” by turning them into non-fungible tokens.
If it seems like anything can be digitized and sold as an NFT, you’re not far off. We’ll see what regulators have to say as the market pushes further into uncharted territory.
Footnotes:
1: “The Truth About Blockchain”. Iansiti, Marco and Lakhani, M. Jan-Feb 2017. Harvard Business Review. https://hbr.org/2017/01/the-truth-about-blockchain
2: “Fungibility”. Frankenfield, Jake. Investopedia. 23, Jan. 2021. https://www.investopedia.com/terms/f/fungibility.asp
3: “Framework for “Investment Contract” Analysis of Digital Assets.” U.S. Securities and Exchange Commission. Modified 3 Apr. 2019. https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets
© Copyright 2021. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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October 05, 2021
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