The acronym “NFT” stands for “non-fungible tokens” and these are basically asset backed tokens or digital assets with unique identification codes and metadata recorded in a blockchain ledger representing the ownership and authenticity of an associated unique tangible or intangible asset. As suggested by its name, NFTs are characterized by their non-fungible nature.
In economic terms, fungibility is the ability of an asset to be exchanged with other individual assets of the same type for the purpose of transacting value. This means fungible assets in the same denomination imply the same value. On the contrary, NFTs are, by definition, not interchangeable, irreplaceable and unique.
The concept behind NFTs is to create a certain scarcity and shortage in the flood of the seemingly infinite supply of virtual items. Accordingly, NFTs bring the promise of creating a “digital original” that is one of a kind and can be clearly attributed to the respective owner. In the “real world” there is always a unique original of a work, such as the painting that the artist created with his or her own hands, in the digital world there has so far been no counterpart in the sense of a “digital original”.
The non-manipulative nature of NFTs enables both real and digital art objects to have verifiable scarcity and original ownership. For artists, this is a way to combat plagiarism as well as monetize their business. NFTs also allow collectors to value digital art in a similar way to physical art, creating thus new opportunities for digital artists. It is therefore not surprising that it was initially the digital art market where NFTs became a mainstream phenomenon.
In other words, NFTs combine the best traits of decentralized blockchain technology with non-fungible assets. Unlike regular digital assets that are issued and regulated by centralized entities, which can be taken from you at any time, it is possible to truly own and control your own NFTs.
NATURE OF NFTs
Utility, security, and payment tokens are all Fungible Tokens. They are exchangeable with any other token of the same class. For example, 1 Bitcoin can be exchanged with 1 Bitcoin. On the other hand, NFTs tokenize assets although they are not financial instruments.
When the token holders have the right to profit-sharing, what they have is a security token. As such, it is subject to financial regulations. NFTs do not grant such rights, although they grant access to future content or give rights to royalties.
NFTs also do not grant their holders entitlement against the issuer. NFTs are transferable but not to organized markets. Important characteristics of NFTs are immutability and scarcity. As discussed earlier, an NFT is rare and unique.
Their main properties are:
- Unique: Non-fungible tokens contain within their code information that describes the properties of each token that make them different to others. A piece of digital art might have coded information about individual pixels, while tokenized in-game items might contain details that allow the game client to understand which item the player owns and its attributes.
- Traceable: Each NFT has a record of transactions on-chain, from when it was created, including every time it changed hands. This means each token can be verifiably authentic, and not a counterfeit – obviously a very important thing for owners and prospective buyers.
- Rare: In order for non-fungible tokens to be attractive for buyers, they should be provably scarce. This will ensure that assets remain desirable in the long run, and that supply does not outstrip demand.
- Indivisible: NFTs mostly cannot be transacted as fractions of a whole. Just like how one cannot purchase half of a concert ticket or trading card, non-fungible tokens cannot be split into smaller denominations.
- Programmability: Like all traditional digital assets and tokens built on smart contract blockchains, NFTs are fully programmable.
LEGALITY AND ENFORCEABILITY OF NFTs IN THE INDIAN CONTEXT
- NFTs and the Crypto Currency Conundrum
The biggest obstacle in NFT trading is the obscurity surrounding the legal validity of cryptocurrencies in India because as stated earlier, NFTs are tradeable only in cryptocurrencies. Further, all Indian platforms which have launched trading in NFTs till date are cryptocurrency exchanges.
On the contrary, the Supreme Court of India in Internet and Mobile Association of India v. Reserve Bank of India, while striking down the April 2018 RBI circular directing all regulated entities to refrain from dealing in cryptocurrencies, opined that the impugned circular was unreasonable and hence violative of Article 19(1)(g) of the Constitution of India. Furthermore, early 2021 saw a drastic change in the approach of the government in dealing with cryptocurrencies with the Finance Minister stating that the government was not considering a complete ban on cryptocurrency and that it will allow windows for people to do experiments. RBI also issued a circular directing the banks to not rely on the 2018 circular since it was struck down by the Supreme Court of India.
What emerges out of this discussion is that there is absolutely no clarity as to the legal sanctity of cryptocurrencies in India which consequently makes trading in NFTs riskier.
Currently no law bans trading in NFTs in India. The legality of NFTs in India is uncertain and adding to the chaos is the belief that trading in NFT is not permitted under the Securities Contract (Regulation) Act, 1956 (“SCRA”). There is no separate legal framework for NFTs in India. This has led to polarization as to the classification of the NFTs. Some opine that NFTs are contracts whereas some state NFTs to be a derivative.
Section 2(ac) of SCRA which defines “derivative” provides that derivative also includes a contract which derives its value from prices or index of prices of underlying securities. If NFTs are held to be derivatives, then they cannot be traded on virtual platforms by virtue of Section 18A of SCRA which provides that contracts in derivate shall be legal only if they are traded on recognized stock exchange. Under such circumstance, the platform where NFTs are traded will have to apply for recognition as Stock Exchange with the Central Government.
As pointed out earlier NFTs are non-fungible, and it is this non-fungibility that separates them from other securities. Hence, if a particular NFT relates solely to an existing asset and it is marketed as an assurance for authenticity of the ownership of such asset, reckoning it as a security (derivative) would be improper. It should be rather governed by the general principles of contract. On the contrary, fractional NFTs (providing partial ownership interest in the NFT) which have come into existence due to exorbitantly priced NFTs, which most people cannot afford, may be termed as a security. Furthermore, if promises pertaining to return on investment are made then NFTs will resemble a speculative investment rather than a digital collectible, and therefore, could be deemed as a security in India.
THE US POSITION ON NFTs
NFTs in US, like India, are unregulated and the legal position is in a confusing state of affairs. A petition was filed with the Securities and Exchange Commission (“SEC”) on 12 April 2021 recommending the regulator to enact a framework for the regulation of NFTs. Apart from this, there is no formal document pertaining to NFTs. However, SEC officials have opined that dealing in NFTs can amount to breaking of law because NFTs can often take the shape of ‘investment contract’.
At this juncture it is pertinent to note the much talked about ‘Howey test’ as laid down by the Supreme Court of the United States in SEC v. W. J. Howey Co. The definition of ‘security’ under US law also includes ‘investment contract’ among many other things. The Supreme Court of the United States opined that an investment contract exists when there is investment of money in a common enterprise wherein profits are expected through the efforts of others. The most contentious aspect here is ‘efforts of others’ which is nothing but third-party efforts to realize an asset’s investment potential. Whether the profits are a result of others’ efforts depends on a case-to-case basis.
NFTs are the newest class of crypto assets. And as highlighted above in certain situations NFTs can act as securities which may be traded on peer-to-peer decentralized exchanges. Cryptocurrency legalization is essential for a smooth trading of NFTs in India. Unless and until, there is a firm decision as to the validity of cryptocurrencies in India, NFT trading is risky. Secondly, a clarity from the government as to whether NFT amounts to derivative or not is inevitable.