The desire to increase efficiency and create value is driving the move toward digitization across all industries. Digitization is the process of converting information into a computer-readable format, allowing the extraction and analysis of data, as well as automating manual processes.
Distributed ledger technology (DLT) is among the technologies that support digitization. DLT can be used to immutably record information related to a transaction, share it with multiple parties, and authenticate stakeholders. Providing a single source of truth, DLT underpins business transactions.
Tokenization is a concept allied to DLT. Tokens are digital representations of tradeable assets. All the documentation relating to the purchase, sale, transfer and settlement of an asset can be associated with a token and recorded on the DLT platform. The processes that automate and enforce the legal structure are executed via smart contracts. Importantly, the immutability of the DLT reduces the likelihood of fraud. Securities, commodities and real estate are just a few of the many assets that can be tokenized. In some cases, a DLT represents the tokenization of physical assets, such as ownership rights to fine art, music and more.
Fungible vs. Non-fungible
Tokens can be fungible or non-fungible. Fungible tokens, such as cryptocurrencies, are identical to each other, so they can be used as a medium for commercial transactions. The market capitalization for fungible tokens is extremely volatile, but at times, the value has exceeded $2 trillion. Bitcoin and Ethereum dominate the market and are valued at $617 billion and $210 billion, respectively.1 By comparison, the market capitalization of the S&P 500 is valued at about $37.475 trillion,2 the bond market is valued at around $128.3 trillion,3 and the gold market is worth about $11 trillion.4
Non-fungible tokens (NFTs) are representations of unique assets, where authenticity is certified on a DLT platform. Creating and selling non-fungible NFTs has become much more common recently. Sales of NFTs soared to more than $2 billion in the first quarter of 2021 – more than 20 times the volume of the previous quarter, according to NonFungible.com.5
Examples of NFTs
Video gamers have used NFTs for years. Notably, CryptoKitties enables players to collect and trade digital cats using NFTs. Creating NFTs out of drawings, music, artwork and even tweets are some of the more recent developments. Christie’s’ sale of an NFT in March 2021 representing a print by a digital artist known as Beeple for $69 million was a huge media sensation.6 In the same month, American rock band Kings of Leon offered an album as an NFT available on the YellowHeart NFT platform for a two-week period.7 The band also offered NFTs representing “golden ticket” experiences such as front-row concert seats. Proponents maintain that NFTs could help music artists struggling with digital piracy, low streaming royalty rates as well as a lack of touring revenue during COVID-19.
In addition, platforms such as Superfarm, Ethernity and OpenSea facilitate the exchange of millions of dollars for digital assets, including trading cards and digital collectibles.8 They implement royalty downstreaming, where the original creator receives royalty payments each time the work is resold.
NFTs could play an important role in mainstream commerce. An NFT for a product would make it easier for different actors in a supply chain to interact with it and help track its provenance, production and sale through the entire process.
Intellectual Property (IP) Implications
Creators of NFTs must consider many factors prior to selling their tokenized assets. In particular, some kinds of art, in general, can be an IP minefield, and that also applies to NFTs. Understanding all terms and conditions as well as the ownership and copyright aspects is essential for both the buyer and the seller.
While it’s possible to mint an NFT without explicitly addressing IP issues, those who are thinking about IP can separate the ownership of a particular NFT and the ownership of the copyright rights embodied in that NFT.9 Even if the individual purchasing the NFT has bought the original work, the ownership does not necessarily give the purchaser the right to make and sell additional copies.
To illustrate, the creator of a collage work might run into copyright issues based on the underlying copyrights of the source material, whether the collage is a physical work or a digital work. Minting the collage as an NFT does not change the applicable IP laws, and infringement analysis with respect to the collage would proceed in most respects in the same manner as it would if the work was in physical form. Another issue that must be kept in mind with NFTs is that, once something is minted as an NFT, it might be difficult, based on how the minting is done and the nature of DLT technology, to take the NFT down. Such cases might be very challenging to the NFT owner from a liability perspective.
Opportunities for Marketplaces
The evolution of DLT and the ability to tokenize and trade any asset digitally have unveiled new opportunities for exchanges and startup marketplaces. Legacy manual processes can be turned into efficient digital workflows, and product coverage expanded to allow for capital formation and price discovery outside of traditional financial asset classes. We are excited to see how this space evolves and to support our clients as they innovate through tokenization.
2 As of May 28, 2021. Source: https://www.spglobal.com/spdji/en/indices/equity/sp-500/#data
3 As of August 2020. Source: https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/bond-market-size/#:~:text=corporate%20bond%20markets-,As%20of%20July%202020%2C%20ICMA%20estimates%20the%20notional%20value%20of,bn%2C%20constituting%202%2C185%20ISINs.
4 As of April 9, 2021. Source: https://cointelegraph.com/news/why-s-bitcoin-stuck-under-60-000-the-gold-market-cap-may-hold-the-answer