Brief Overview of Non-Fungible Tokens (NFTs)
Blockchain technology has been growing immensely over the past decade. This explosion urges us to delve deep into the different available options with regards to crypto investment. NFTs are a fairly nascent concept but are rapidly growing therefore, it is imperative for us to understand the basics before we explore its legal implications.
What is an NFT?
NFT stands for Non- Fungible Token. In order to get a brief idea on NFTs, we may take the example of some fungible assets, such as, money. Money is interchangeable in nature, for example, an AED 100 note can be interchanged for two AED 50 notes, and this change will not have an effect on the value of the money that it was swapped for.
On the contrary, non-fungible assets are those that cannot be interchanged. Their value remains as is due to its unique properties. For ease of understanding, we may relate the nature of an NFT to a unique and one of a kind items such as antiques or paintings, these items uphold their value owing to their originality. Sure, these items can be reproduced and duplicated but there can only ever be one original.
Therefore, NFTs are unique and one of a kind. They can be bought and sold in the market like any other kind of property but they do not have a tangible form.
What makes NFTs different from any other crypto asset?
NFTs are a lot like bitcoin with the exception that they cannot be interchanged, only exchanged for its like. A defining feature of NFTs is that it can store extra information, which allows elevation of its status from that of a simple currency. They can take varied forms, such as digital art, music art, or any collectible item of value in its digital form.
How do NFTs work?
They are basically held as individual tokens with accommodate extra information to be stored in them. This may take many forms, such as a video, GIF, JPGs, MP3s and so on. The reason for their increased demand in the market is because of their ability to be valuated based on market demand and be bought and sold thereafter.
A common misconception is that, NFTs can be downloaded by the click of a button and be sold thereafter because of the simple reason that, the file will not contain the information that makes it a part of the blockchain. Therefore, it cannot be hacked into.
What are the different types of NFTs?
Based on its legal status, we may divide NFTs into three different types:
- Utility Tokens
These tokens are required to access and use a portal or network. They draw similarity to a voucher in that they enable a project to be financed without giving away or diluting ownership in an ICO (ICO company is a company that issues a set of tokens, usually for fundraising purposes).
- Security Tokens
These tokens reflect asset ownership and offer token holders rights similar to or identical to those granted to stockholders — voting rights, dividends, benefit shares, a stake in the performance of the issuing company, and so on. Security assets, stock (equity) assets, debts (bonds), and liabilities are examples of such tokens in terms of economic operation.
- Currency Tokens
These are also known as payment tokens. They serve as a means of storing value and a medium of exchange. Bitcoin, Monero, and Tether are examples of such coins. However, they do not take the aforesaid form but are hybrids which means that they have certain utility features that bestow ownership rights upon the holder.
Do NFTs grant entitlement to the owner against the issuer? Will it result in monetary entitlement or profit sharing?
Typically, NFTs do not allow token holders any rights against the issuer neither do they give the owner any decision-making rights over the issuer’s project. Unless expressly exempted, the owner does not possess the ability to know the supply assets of the issuer.
Are they transferrable?
NFTs are generally transferrable, however, this transferability does not apply when being traded in an organized market.
What are the legal issues surrounding NFTs?
Considering the nascent nature of NFTs, the legal framework surrounding it is largely unresolved. This tends to give rise to legal and regulatory issues and makes it fairly difficult for potential issuers and owners to trust this venture.
The creator of the NFT holds rights of legal ownership of the asset. Therefore, in case there are multiple owners of a singular asset, there may arise potential conflict owing to unclear ownership structures.
Further, owners’ rights also bear the risk of piracy due to its public accessibility. Just like digital content on the internet is prone to use and abuse, the digital nature of NFTs give rise to potential illegalities.
Transfers and Marketplaces
Thanks to marketing campaigns of auction houses and marketplaces, the new NFT market is thriving. Smart contract and marketplace's house rules govern NFT transactions. The marketplace can allow the asset to be exchanged in a double transaction with the NFT, depending on the type of asset, particularly in the case of jpeg art works.
Compromising personal data is the biggest concern surrounding NFTs. Data protection laws offer individuals the ability to erase personal data, however, as previously discussed NFTs are immutable in nature, therefore, this serves as an obstacle in exercising this right.
Data privacy laws allow alteration of personal data or remove inaccuracies therein. However, Blockchain technology poses impediments and makes it difficult to exercise this right.
Intellectual Property Rights
Purchasers of NFTs are not necessarily experts in the legal field. Therefore, many a time they may be unaware about the legal restrictions attached to copyrights which may lead to infringement. With the introduction of NFTs, we are transitioning into the digital world; creators are able to permeate digital assets with qualities such as uniqueness, scarcity and ownership.
NFTs are still in their initial stages therefore, laws and regulations do not particularly govern issues surrounding the use and distribution of the same. The fintech market is ever-evolving and with that come challenges in the legal realm as well.
Buying NFTs in UAE
For a first-time investor in NFTs it would be advisable to;
- Firstly, set up an account with a cryptocurrency exchange that would assist you with dealings thereof.
- Once the account is set up, the next step is to buy NFTs. Crypto asset exchanges allow trading in bitcoin (BTC), Ripple (XRP) and so on. For the purpose of purchasing NFTs one must look into Ethereum (ETH) which can be purchased using credit card and upon payment of a transaction fee.
- Creation of a wallet.
- Once the wallet is created, the ETH can be transferred into that wallet address/ID.
- Lastly, once all of the above are set up, you may now proceed to purchase an NFT. The portal shall allow you to buy from an originator or artist. Thereafter you may choose to transfer or sell the said NFT as per your requirement.
Applicable legislations on crypto assets in the UAE
The UAE’s Securities and Commodities Authority (SCA) has published “The Authority’s Chairman of the Board of Directors Decision No. (21/R.M) of 2020 Concerning the Regulation of Crypto Assets” (Decision).
The SCA’s decision describes the SCA’s licensing regime for anyone who wishes to offer crypto assets within the UAE. This includes ICOs, exchanges, marketplaces, crowdfunding platforms, custodian services, and related financial services based upon, or leveraging crypto assets.
In effect, SCA’s decision concern crypto assets as an electronic network or a distribution network that acts as a medium of exchange, storage, unit of account representation of ownership, usufruct that can be transferred electronically from one person to another through the operation of a computer programme or an algorithm governing its use.
Pre-requisites to offering crypto assets in the UAE
Providers who wish to offer crypto assets (or any related services) must be incorporated onshore within the UAE or within one of the UAE’s financial free zones (i.e., the Dubai International Financial Centre or the Abu Dhabi Global Market). Licensees may ‘passport’ the listing of crypto assets on one or more crypto currency exchanges.
Providers who wish to offer crypto assets within the UAE must be licensed by the SCA. As a part of that process, applicants must demonstrate strict compliance with UAE’s anti-money laundering and counter-terrorism financing laws, cyber security compliance standards and data protection regulations.
Alternatively, in the case of service providers who use offshore servers or public cloud facilities to encrypt, store, process or transfer crypto assets, or personal data, the SCA’s Decision requires such providers to utilise onshore cloud computing services to provide parallel backup and disaster recovery facilities.
Ambit of employees and sub-contractors
There are strict provisions governing the use of subcontractors and employees working for crypto asset providers, custodians, escrow companies and other contractors insofar that they must possess the requisite skills and experience to perform their roles.
Licensees may appoint subcontractors but will bear the risks and liabilities stemming from any breach of the Decision committed by their subcontractors. For this reason, the SCA’s Decision requires licensees and their subcontracts to formulate a detailed service level agreement spelling out the division of responsibilities between both parties relating to cyber security and data protection.
The SCA clarified that it has full powers to audit licensees and to monitor online transactions. In the event of any breaches, the SCA has wide ranging powers to impose fines, suspend or withdraw a licensee’s right to offer crypto assets and to publish the names of violators.
Permissible types of offerees to an NFT transaction in the UAE
The SCA’s Decision created two classes of people to whom crypto assets may be offered to: a) Qualified Investors; and b) other people who do not meet the eligibility criteria as a Qualified Investor. Licensees must file documents with the SCA in advance of offering crypto assets to Qualified Investors. In all other cases, licensees must request prior approval from the SCA before offering crypto assets to non-Qualified Investors.
A Qualified Investor is broadly defined as:
- Institutional investors (i.e., banks, financial institutions, or companies) who hold more than AED 75m in assets, or have a net turnover of AED 150m, or state governments, foreign governments, and international bodies.
- Individuals who hold AED 4m in funds or an annual income of no less than AED 1m, and with whom a licensee can verify that they possess sufficient knowledge and understanding about the risks of investing in crypto assets.
Exercising Due Diligence
The SCA has clarified that all customers must be classified and assessed as if they were a ‘high risk’. This is considering prevailing economic environment and its challenges pertaining to global money laundering.
This broadly translates into conducting ‘enhanced due diligence’ into a customer’s source of funds, ultimate beneficial ownership structure, political exposure risks, the potential risks of customers being used as conduits for money laundering activities and any geographical risks presented by customers, their directors, shareholders and associated suppliers and intermediaries.