A digital image is worth a thousand ethers: NFT and digital art

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The past few months have seen an explosion in the popularity (and value) of non-fungible tokens (NFTs). An NFT is a unique (non-fungible) record on a public blockchain ledger that can be traded (a token) that represents ownership of a digital asset. You can read more about NFTs here.

Opportunities for digital art

Artificial scarcity. At the heart of the value of NFTs – and the skepticism surrounding them – is the fact that they create artificial scarcity. Digital art has arguably long been undervalued, as works can normally be perfectly reproduced indefinitely and there is rarely an identifiable “original” for the artist to sell. NFTs solve this problem by allowing digital artists to sell an NFT of their work as “the original”. The owner of an NFT does not own the underlying data or intellectual property rights, but does own a unique (thus rare) token, originating from the artist, representing ownership of the original work. This may have significant value: an NFT of a digital work by artist Beeple titled “Every day – The first 5000 dayssold at Christie’s for $69.3 million, making it the third most valuable work by a living artist (after works by David Hockney and Jeff Koons).

Skeptics, however, struggle to see the value of NFTs, pointing to the fact that the owner receives nothing tangible and that the copy of the digital asset they have is identical to any other copy. There are interesting parallels here with intellectual property rights. Without the monopolies created by intellectual property laws, intellectual creations could easily be exploited by anyone who could afford it. While some remain skeptical about whether this artificial scarcity has, or creates, significant value, there is little doubt about the commercial value of intellectual property rights.

Clear origin. Unlike tangible works of art whose provenance may be uncertain or disputed, once it is clear that an NFT was created by the original artist (which is usually the case), the public and immutable nature of the blockchain ledger means there is no doubt about the authenticity of, or the chain of title of a digital work.

Resale royalties. NFTs can be created so that a commission is automatically paid to the original artist on future resales of their work. This can avoid having to rely on statutory resale royalty regimes. These differ by jurisdiction, generally provide relatively low royalty rates (in the UK: 4% decreasing as the selling price increases, subject to a cap of €12,500) and often have strict (including, for example, in the UK that the re-sale is greater than or equal to €1,000, that the work is by an EEA artist and that it is resold through auction house or other art market professional). Artist Beeple sold an NFT of a different digital work, “CROSSROADS”, in October 2020 for 66,666.66 USD. Amid the hype surrounding NFTs, this artwork was resold earlier this year for $6.6 million. Beeple’s 10% commission earned him about 10 times more than the initial sale.

Liquidity. Digital art marketplaces for NFTs offer artists a simple and relatively inexpensive way to directly access a large international audience of potential investors. NFTs can be traded on these marketplaces without the need to coordinate the transfer of a physical work. NFTs can also be split, so ownership can be divided and sold to multiple investors.

Challenges

Crypto-volatility. NFT trading typically requires transactions in cryptocurrencies, which are notoriously volatile. This volatility – exemplified recently by sharp drops following Elon Musk’s tweet that Tesla was suspending purchases of vehicles using Bitcoin and China’s ban on financial institutions providing cryptocurrency-related services – can be off-putting to many potential investors. Stablecoins, which are cryptocurrencies pegged to the value of a fiat currency such as the US dollar, may offer a partial solution to this problem.

A bubble ? The popularity of NFTs is perhaps a product of the times. With travel restrictions and the closure of galleries and auction houses, it’s easy to see why the accessibility of digital artworks has increased their appeal. This, combined with the rise of cryptocurrency markets, may well have swung NFTs into the zeitgeist, triggering their exponential rise in value. It remains to be seen, however, whether the easing of restrictions or a crash in the cryptocurrency market can burst the bubble.

Environmental impact. Probably the biggest challenge for the NFT digital art market is the environmental impact of the blockchain networks it relies on. Many blockchain platforms operate using a proof-of-work consensus mechanism, which is, by design, very power-intensive. They require large amounts of computing power to perform complex calculations to validate transactions. The most popular blockchain network for NFT trading, Ethereum, is estimated to consume more electricity than the country of Hungary. Controversy around this environmental impact has caused some artists to withdraw their intention to sell NFTs from their works (and was cited by Musk as the reason Tesla suspended Bitcoin payment). Ethereum’s planned move from a proof-of-work mechanism to a proof-of-stake consensus mechanism promises to significantly reduce its power consumption, which could present a partial short-term solution to some of these problems.

Other legal issues

Useful for NFTs, there is a growing consensus in English law that crypto-assets can be viewed as legal property and smart contracts on blockchain platforms as legally enforceable (see here). There are also issues to consider around taxation (here), financial regulation (here) and data protection (here). Our UK chapter of the Blockchain Country Comparative Guide (here) provides more details on UK legal issues related to blockchain technology.

Conclusion

The opportunities that NFTs present for digital art, including solving the fundamental issues of scarcity and ownership of digital assets, are truly revolutionary. Greater adoption of stablecoins and less energy-intensive consensus mechanisms may also help address some of the biggest drawbacks of NFTs. So while making predictions in this area is notoriously unwise (so no attempt here to predict whether recent prices will hold or if this bubble might burst), it seems likely that digital art NFTs are here to stay.

Many thanks to Chaya Kupperman for her help with this post.

At the heart of the value of NFTs – and the skepticism surrounding them – is the fact that they create artificial scarcity.

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