The Limitations of Non-Fungible Tokens

NFTs are tokens that reside on a distributed ledger and hold or reference an asset, for example an in-game item, a song, art or even real estate. Although NFTs have grown exponentially over the last year, this technology is still early and has limitations that we explore in this post.

Introduction

In previous posts, we explored the key characteristics, benefits and use cases of Non-Fungible Tokens (NFTs).1 NFTs are tokens that reside on a distributed ledger, such as the Ethereum blockchain. In this post, we explore their key limitations. First, the technology is very new and, in some respects, incomplete. Second, the space is still unregulated. Third, consumers and investors usually lack the necessary knowledge and expertise to understand the capabilities and characteristics of the NFTs they buy and sell. Finally, the hype and speculation that currently surrounds the NFT space can make it difficult to distinguish good projects from the bad ones and investors should therefore exercise caution.

Custody

In most cases, the digital asset that is referenced by an NFT is not stored within the same distributed ledger, but on a separate private server. For example, most NFT marketplaces store the digital assets (such as jpeg pictures) on their own centralised servers, whereas the NFTs themselves reside on a public ledger. In this scenario the question arises, does the NFT give ownership of the digital asset, or merely access to it? What happens if the owner of the marketplace closes or decides to shut down their servers? A fully decentralised solution would require that the digital assets are also stored within the public ledger itself, however to hold such large digital files on decentralised infrastructure is currently less appealing.

Not all NFTs are Created Equal

An NFT is a token linked to a digital asset, however this does not mean that NFT owners have unrestricted rights to that asset. Different NFTs will confer different rights to their owners, so buyers need to be careful about what it is they are buying. Like traditional creative arts products, unless explicitly stated in the contract, the buyer does not buy intellectual property rights to the product. For example, an NFT of a video clip on sale in the NBA Top Shots store only gives rights for personal, non-commercial use. This means that although the owner can resell the NFT at any price in the future, they cannot broadcast it on their website and earn income through advertising. 

In principle, the terms of sale can be referenced by a link, stored in the metadata of the NFT. However, in many cases the terms of sale are not explicitly written. In general, when an NFT sale occurs, it is the responsibility of the seller to communicate the terms of sale to the buyer. This may happen when an NFT is sold through a well-known marketplace, However, when a secondary sale occurs in a peer-to-peer direct sale, the seller has discretion on whether they properly inform the buyer about the existing terms of sale and the rights that are conferred. If the initial owner receives a commission for every re-sale, then they also share responsibility to ensure all subsequent buyers are properly informed of the terms of sale.2 This creates implications that may be relevant in the event of a legal dispute.

Duplication

An NFT is unique, in the sense that the holder can prove ownership of the token that references the digital asset. Moreover, neither this token, nor the data it contains (the digital asset or reference to an asset), can be duplicated within the distributed ledger or transferred without control of the wallet in which it is stored. However, the NFT does not control the potential copying of the digital asset that the NFT represents. If it is displayed on someone’s computer, it can be copied repeatedly. One can also easily create a new NFT, on the same or on a different public ledger, that represents the same digital asset. e.g. copy an NFT on the Ethereum platform to the Solana platform Finally, the holder of an NFT does not have automatic intellectual property rights over the digital asset it represents, unless the terms of sale give such rights explicitly.

Regulation and Consumer Protection

Because the NFT space is so new, there is almost no regulation and consumer protection specifically covering NFTs. NFTs buyers are not protected in the same way as when they buy standard digital assets from software companies. While existing consumer protections can be applied where appropriate to NFTs, lawyers are still yet to agree on how best to apply and enforce these. Furthermore, given their innovative nature, there are areas which will unavoidably fall outside existing consumer protections. Specific questions around counterfeiting, copyright, licencing, tax treatment, and ownership, have yet to be fully resolved, either through new legislation or by the courts providing clarity on how existing laws should be applied. For example, if NFTs pay royalties, they may be considered securities, so the existing regulatory framework could be applied. On the other hand, if NFTs are issued in a decentralised manner, from people across the world, it will be difficult to establish what is the country of origin and therefore which authorities have the jurisdiction to regulate. 

Smart Contracts

Another misconception is that smart contracts are standard contracts that are embedded on the distributed ledger. They can automate several aspects of a transaction and they can introduce programmatic logic that governs when a transaction takes place and under which conditions. For example, a smart contract can ensure that the original owner gets a percentage of the price, each time the NFT is sold in the secondary market. However, smart contracts do not cover all aspects of a transaction. For example, if the buyer of an NFT starts monetising the associated digital asset, violating the terms of sale which allowed for non-commercial use only, compliance with the terms of sale cannot currently be enforced through a smart contract. The seller would still need to follow the traditional legal routes, via lawyers and courts, to ensure the terms of sale.

Illiquidity

NFTs are inherently illiquid relative to large cap cryptoassets, because they are either unique, or issued in very limited numbers. This means that it can take time to sell at expected market price and an investor may be stuck with an NFT that no one is willing to buy, especially during a market sell-off. Even though the most well-known NFTs sell for astronomical prices, there is a long tail of projects that never take off. For example, around three quarters of all NFTs sold on Open Sea had no more than one transaction in the last three months. Around 97% of all dollar volume was from trading 3% of available collections.3 Finally, illiquidity is usually associated with high price volatility which, in this case, is compounded by the volatility of the cryptocurrency of the ledger on which the NFT is issued e.g. Ether for the Ethereum platform.

Environmental Impact

Most of the creation and trading of NFTs is currently happening on the Ethereum network, which employs Proof-Of-Work to write new blocks, just like Bitcoin. This means that the energy use is substantial. However, there is a roadmap for switching to Proof-Of-Stake, which consumes 99% less electricity. Moreover, most of the distributed ledgers that came after Ethereum, such as Flow or Solana, do not use Proof-Of-Work and are more energy efficient.

Conclusion

There is currently a lot of hype and speculation around NFTs,  so buyers and investors should exercise caution. On the one hand, there is huge interest and anticipation that this technology is novel and could change the way we buy and sell any type of digital assets. If this expectation materialises, several industries will be disrupted. On the other hand, it is still very early in the adoption cycle and so booms and busts are unavoidable, whereas some aspects of the technology will prove to be speculative. Inevitably, several NFT projects will suffer from price bubbles, driven by irrational exuberance and informational asymmetries.

Footnotes

1 See https://en.aaro.capital/Article?ID=f0a18cb5-5926-4947-a64e-5e27cfcc7ade and https://en.aaro.capital/Article?ID=95da06fb-80fc-4555-9bb5-e19899e58fa4 for the characteristics, benefits and use-cases of NFTs.

2 See https://www.dwt.com/insights/2021/03/what-are-non-fungible-tokens for an interesting analysis about the legal implications of buying and selling NFTs.

3 See https://www.bloomberg.com/news/articles/2021-09-18/would-be-nft-millionaires-throw-a-dart-and-usually-hit-a-dud for interesting data on NFT trading activity.
 

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