Insights Redeemable NFTs and the conundrum of intrinsic rights

Contact

What started as a way of immutably verifying ownership of otherwise copyable assets (eg., digital media) has grown into a true internet phenomenon. Non-fungible tokens (NFTs) came about in 2017 some 10 years after Bitcoin primarily to represent visual artwork. NFT trading is currently at a 2-year low with major marketplaces seeing trading volumes decline by up to 40% month-over-month from previous peaks. That said, NFT technology is developing rapidly, and is increasingly used to verify ownership of a wide range of rights. Virtual land in the metaverse, artist royalties, skins and other video game assets, event tickets, and even fractionalised quasi-securities.

As the market has developed, so has the need for NFT issuers to offer something more than an ERC-20 token. For example, fan tokens issued by a sports team or association, might offer their holders ‘off-chain’ (i.e. real world) benefits such as VIP passes, discounted merchandise, or the right to vote on goal celebration music.

Whilst the idea may sound simple, the nuance of how these property and/or contractual rights ‘attach’ to an NFT is vital for their legal classification.

The principal crypto-specific law in the UK is the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (the MLRs). The MLRs regulate businesses providing in scope-services in respect of cryptoassets, such as cryptoasset exchanges and custodial wallets. Cryptoassets are defined as:

“a cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically”

This is often interpreted to exclude NFTs, since NFTs are largely associated with pure collectibles. However, as the technology becomes more sophisticated and the scope of ‘rights’ that are offered to NFT holders expands, understanding what is meant by a representation of contractual rights in relation to an NFT is paramount.

A fashion brand that issues an NFT and offers a free ticket to a fashion show to anyone who holds the token is unlikely to create a right that is intrinsic to the token. While there may be a contract governing the offer enforceable by the NFT holder against the fashion brand, that NFT is not a representation of that contract without something more fundamental. In a trickier example, an online casino that mints and issues an NFT that unlocks levels and increased jackpots in its online games doesn’t necessarily create an NFT that itself attaches contractual right to such features. Does it matter if the NFT and the offeror of the redeemable is the same party? It might; but it really comes down to a technical question about how these rights actually attach to tokens – there needs to be something about its coding and architecture that gives its holder a right to something, rather than being a right that exists as part of the broader offering surrounding the NFT.

The examples above fall within a loose definition of ‘redeemable NFTs’, allowing issuers and creators to extend the concept of digital ownership by adding layers of experience and utility. However, OpenSea, the largest NFT marketplace by trading volume, has identified the need for a common standard for redeemables both on-chain and off-chain.

The notion of an open standard for NFT redemption is relatively new. It is easy to imagine how it might be implemented for on-chain redemption where an NFT is redeemed for another digital asset or other Web3-specific right. Currently, this is usually managed by issuers burning the original token upon redemption. However, adding a “trait redeemable” to an NFT (1) allows a user to keep the NFT in their wallet post-redemption, (2) allows for multiple and varied redemptions as defined by the issuer, and (3) means that issuers can issue new rights to existing token holders at the token level by simply adding a new trait redeemable variable. Such rights would be intrinsic to the token and may cause the token to fall within the definition of cryptoasset to the extent they represent contractual rights.

While on-chain redemption rights are more likely to be considered intrinsic to the token, off-chain redemption is messier and harder (or even impossible) to verify. How does the fan-NFT know when it has been redeemed for the football shirt?

A technical solution could be developed to solve this problem. It is possible to imagine a series of APIs that allow NFT redemption to be effected and verified off-chain. This is similar to the way that some smart contracts reference external ‘oracles’ (e.g., a bet on whether it will rain on a given day in the form of a smart contract that settles automatically by reference to the Met Office API). Similarly, large marketplaces, media businesses, and others may soon offer connectivity allowing trait redeemables to be updated automatically.

The primary reason that most NFTs do not attach intrinsic rights is that this is simply too hard to give effect to in the real world in the current paradigm of “burn-to-redeem”. You ultimately need someone in the real world to offer the contractual right (imagine a drive-through that, as a promotion, gives a free milkshake to anyone driving a specific kind of car – the offer isn’t intrinsic to the car; nor can the car owner enforce the right to the free milkshake against the car manufacturer). As it becomes easier to track redemption at the token level by the inclusion of redemption variables and reference to external sources, we will likely see more NFTs that really do attach contractual rights.

These developments lead to a change in regulatory treatment or possibly an update to the definition of cryptoassets because the MLRs clearly weren’t designed to regulate the offer of sports merch to fans. But it is hard to see how a token can fall outside of the UK’s regulated cryptoasset definition once a contractual right becomes technologically inseparable from the token itself.