A Digital Picture is Worth a Thousand Ether: NFTs and Digital Art

Recent 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 is capable of being traded (a token) and which represents ownership of a digital asset.  You can read more about NFTs here.

Opportunities for Digital Art

Artificial scarcity  At the heart of NFTs’ value – and the scepticism surrounding them – is the fact that they create artificial scarcity.  Digital art has arguably long been undervalued, as works can normally be perfectly replicated indefinitely and there rarely exists any identifiable “original” that the artist can 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, instead they possess a unique (therefore scarce) token, originating from the artist, representing ownership of the original work.  This can have significant value: an NFT of a digital work from the artist Beeple titled "Everydays – The First 5000 Days" sold at Christie’s for USD 69.3m, making it the third most valuable work by a living artist (after works by David Hockney and Jeff Koons).

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Sceptics, however, struggle to see value in NFTs, pointing to the fact that the owner receives nothing tangible and the copy of the digital asset they have is identical to any other copy.  There are some interesting parallels here with intellectual property rights.  Absent the monopolies created by intellectual property laws, intellectual creations could easily be exploited by anyone with the means to do so.  While some remain sceptical of whether this artificial scarcity has, or creates, meaningful value, there is little doubt about the commercial value of intellectual property rights.

Clear provenance.  

Unlike for tangible artworks where provenance can be unclear or disputed, once it is clear that an NFT was created by the original artist (which it usually is) the public and immutable nature of the blockchain ledger means there is no doubt about authenticity of, or the chain of title to, a digital work.

Resale royaltiesCROSSROAD”, in October 2020 for USD 66,666.66.  Amidst the hype around NFTs, this work was re-sold earlier this year for USD 6.6m.  Beeple’s 10% commission earned him around 10 times more than the original sale.

.  NFTs can be created so that a commission is automatically paid to the original artist on future re‑sales of their work.  This can avoid the need to rely on statutory resale royalty schemes.  These differ by jurisdiction, usually provide relatively low royalty rates (in the UK: 4% decreasing as the sale price increases, subject to a cap of €12,500) and often have strict requirements (including, for example, in the UK that the re-sale is for €1,000 or more, that the work is by an EEA artist and that it is re-sold through an auction house or other art market professional).  The artist Beeple sold an NFT of a different digital work, “

Liquidity

.  Digital art marketplaces for NFTs provide artists with a relatively inexpensive and straightforward means of directly accessing a broad international audience of potential investors.  NFTs can be traded on these marketplaces without any need to coordinate the transfer of a physical work.  NFTs can also be fractionalised, so ownership can be divided and sold to multiple investors.

Challenges

Crypto-volatility

.  Trading NFTs usually requires transacting in cryptocurrencies, which are notoriously volatile.  This volatility – illustrated recently by large falls following Elon Musk’s tweet that Tesla was suspending vehicle purchases using Bitcoin and China’s ban on financial institutions providing cryptocurrency-related services – may be off-putting for many potential investors.  Stablecoins, which are cryptocurrencies that are pegged to the value of a fiat currency such as US dollars, may offer a partial solution to this problem.

A bubble?   

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

Environmental impact.  

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

Other legal issues

Helpfully for NFTs, there is a growing consensus in English law that cryptoassets can be regarded 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 detail about UK legal issues surrounding blockchain technology.

Conclusion

The opportunities that NFTs present for digital art, including solving the fundamental problems of scarcity and ownership of digital assets, are genuinely revolutionary.  Greater adoption of stablecoins and of less energy-intensive consensus mechanisms may also help to solve some of NFTs’ biggest drawbacks.  So while making predictions in this area is notoriously unwise (hence no attempt here to predict whether recent prices will be maintained or whether that bubble may burst), it does seem likely that digital art NFTs are here to stay.

A big thank you to Chaya Kupperman for her help with this post.