NFTs: Speculative hype or genuine revolution?

With the participation of Hubert de Vauplane, lawyer who leads the FinTech team of Kramer Levin LLP (Paris) and is a specialist in topics such as digital, blockchain and cryptos, and David Chreng-Messembourg, Founding Partner of the venture capital fund LeadBlock Partners, specialized in blockchain technology and digital assets

Glossary:

Token: digital asset created and tradable on a blockchain.


Blockchain: A blockchain is a distributed database that is shared among nodes of a network. As a database, a blockchain stores information electronically in digital format. Blockchain guarantees the fidelity and security of a record of data and generates trust without the need for a trusted third party. It enables NFT holders to save on a digital distributed ledger the proof of ownership of an asset and all the information linked to that asset (creator, type, price).


NFT: Non Fungible Token. Fungible means that a good or asset can be interchanged with other individual goods or assets of the same type. A one-dollar coin is fungible for instance as it can be interchanged with any other one-dollar coin. On the contrary, a piece of land or a sculpture aren’t fungible as they have distinct characteristics. NFTs make it possible to link a non fungible asset (music, art piece, video) to a digital token. This digital token represents the ownership over the asset and its authenticity is backed by the blockchain.



NFT are thus considered as a major technological breakthrough as they could enable any user to become the owner of digital creations. They are a form of digital certification that goes beyond physical certification thanks to blockchain technology. Only the editors of a physical certificate and skilled professionals can guarantee the validity of a certificate whereas a digital certificate on a distributed ledger can be checked and validated by anyone.


NFT exist since 2014 and various art projects based on this technology have progressively appeared 

such as CryptoPunk in 2017. The hype of 2021 comes from record auction sales of NFT helped by the strong appreciation of the Ether cryptocurrency - the backbone of the Ethereum blockchain on which rely numerous NFT. The digital artist Beeple reached a new record when his art piece “Everyday: The First Five Thousand Days” was bought for $69.3 million and the CryptoPunk #7523 conceived by Matt Hall and John Watkinson was sold for $11.8 million four years after its creation.

It is thus critical to determine if the boom of the NFT industry comes from a speculative hype or if it is the indication of an imminent revolution in the field of digital assets.


“Before NFT, there was no real automated way to guarantee the authenticity of a digital item in a distributed ecosystem,'' points out David Chreng, co-founder of LeadBlock Partners, a venture capital fund specialized in blockchain technology and digital assets.
“If the NFT happens to only be a simple medium to listen to musique or access the copy of an art piece, it is a mere copy with limited rights attached to it,” considers Hubert de Vauplane, lawyer expert in blockchain issues, “However, if the NFT represents an original digital artwork, it becomes digital art and this is a genuine change”.



One of the main reasons NFTs are becoming popular is the fact that anybody with a minimum of technical knowledge can create a non fungible token and link it to an underlying asset such as a JPEG file or a collectible. David Chreng puts forth an analogy to explain a key benefit of the NFT technology: “nowadays if someone starts a software company and goes bankrupt, the capital of the company won’t become public. Someone who would wish to pursue the work of this company would have to start all over again unless he agrees to buy all the patents and hire the previous staff. The way Web 3 - and especially NFTs - works is different: all the code is open source so one can simply do a copy and paste of what exists, hire a team of software engineers and start improving the existing work. This distinctive trait explains why there is such fast innovation in this field and why so many projects and improvements were made in the past few years.” 



Are we heading for a speculative bubble?

The use of NFT soared thanks to multiple factors. First, the accessibility of these digital assets. “Right now, you only need a smartphone and an Internet connection”, indicates David Chreng, “Furthermore, you can access this range of assets with any budget, be it €5 ou €150”. Second, distributed systems - such as blockchain - that support these digital assets exist now on a large scale thanks to the sharp drop in the costs to access computing power. 

“The pandemic emphasized this trend as we switched to a very digitized environment”, continues David Chreng. Last, “Web 3 has developed a sense of community: when you have access to an unique asset, you also have access to a community that trades and upholds that underlying asset. Since the supply is limited and the demand is growing, this creates an inflation trend of the prices of the underlying asset.”


Are we witnessing the creation of a speculative bubble around NFT? Hubert de Vauplane thinks so and refers to the hype cycle to explain it: “When a technology launches, there is a very strong ascending phase followed by a disappointment phase and then, but sometimes not, by a phase of genuine adoption. I think that NFTs are currently in the ascending phase as we find very sound projects next to dubious ones. However, all this should settle down once artists progressively decide to mint NFT on genuinely digital art pieces and not on pieces already existing in the physical world.”


It is crucial to understand that NFTs are not subject to the same logic that prevails for fungible tokens. “Tokenization, which is the process of converting physical (and non-physical) assets into digital tokens, is only at the beginning of what it could achieve”, acknowledges Hubert de Vauplane, “There are some promises appearing in the real estate and the finance fields. But I can’t see how unique tokens like NFTs could be used in strictly financial activities where assets are mainly fungible to create liquidity.”


NFT, an innovation in the field of royalties

NFT are favoured in activities such as art or gaming. Why so? “In the art world, it is in fact very difficult to set up royalties on the sales of the secondary market”, points out David Chreng, “If an artist sells a collection of ten paintings to ten buyers, the artist will win a financial gain on the sale in the primary market but he is also betting that his notoriety will grow over time. This will lead to a positive impact on the value of the art piece he previously sold because of the limited supply and the growing demand. However, once the artist carries out the primary sale, he struggles to earn a return on the following sales in the secondary market. NFTs allow him to set up a set of rules linked to the sale or the life cycle of his assets. As an artist, I can mint digitally my artworks and embed in the lines of code of their NFT some rules to ensure that I receive a certain percentage on each one of the sales that will then take place on the secondary market. For me, this is something truly innovative.”


Regarding the gaming industry, David Chreng has a concrete example: “When I stopped playing World of Warcraft, I couldn’t do much except sell my credentials. Now, a non fungible token can store all my game experiences. I am able to lend or sell my avatar with this new tool, it can help me benefit from the time and money I invested in the game, beyond the hobby practice.”



In the blockchain world, “everything is about trust”

How can one guarantee the unicity or the authenticity of a NFT? Hubert de Vauplane explains that “depending on the blockchain protocol you use, you will have a certain trust in the unicity of the NFT but also in the issuer that can be the artist or a platform with a serious reputation. The problem is that with some NFT, we don’t know what rights are handed over through the NFT. Does the NFT grant access to a copy of an art piece or does it grant access to the art piece itself? Once again, everything is about trust as we have to check what rights have been given through the NFT medium.”


The idea of linking NFT to smart contracts is more and more shared to improve this legal framework. “The idea of automating an action coming from the combined completion of several criteria is interesting”, states David Chreng, “It would help creators fluidify their cash-in after primary or secondary sales thus avoiding frictions in many cases. Nevertheless, we have to stress the fact that smart contracts are nothing but a tool. A product must target a market need and rely on the most relevant technologies available to solve the chosen need.”



Are smart contracts just like any other?


As a lawyer, Hubert de Vauplane wonders: “Are smart contracts only simple automated operations or do they grant rights in the contractual sense of the word? If they are contracts, we must look at all the basic legal issues such as consent, legality, applicable law, jurisdictions… But if they aren’t contracts juridically speaking - smart contracts are rather simple automatic processing instructions - there are still some responsibility issues to solve that will create hurdles in case of litigation. This matter points back to other topics in the industry around blockchain such as disputes being solved by individuals with technical skills rather than by judges.”


Legal issues become even more complex when discrepancies between jurisdictions regarding the nature of tokens (fungible and non fungible) are taken into account. “The British - who don’t want to miss out on the current digitization trend - are presently developing a specific legal framework project for smart contracts”, reveals the lawyer, “They are updating their set of rules so that in the end their legislation will be adopted worldwide. The United Kingdom and the United States traditionally use law as a commercial weapon and they have understood the stakes related to this new technology. On the contrary, France and continental Europe generally speaking are completely absent in the undergoing reflections.”

“It is mandatory to improve our legal framework if we want to achieve a broader adoption of digital assets - including NFTs - by institutions and companies”, approves David Chreng.



Moderation of sensitive content

NFTs raise several issues, especially regarding hateful content moderation for instance. “It’s just like nazi collectibles: it isn’t forbidden for someone to create a NFT with hateful content but it is outlawed to commercialize it ; the creator and the person distributing the NFT will bear the criminal liability. It is thus critical to have the capacity to identify these two persons. However, this can be very difficult with a NFT totally decentralized using DeFi systems”, acknowledges Hubert de Vauplane.

“Some solutions already exist”, explains David Chreng, “a NFT (meaning a “ERC-721”, the standard to create a digital non fungible token on the Ethereum blockchain) must include in its code a link pointing to the file stocked on an external server. If NFTs with sensitive content are identified, it is possible to cut the link between the NFT and the server.”



“Proof of stake” could be the key to a lower energy consumption

NFTs also raise an issue about energy consumption. “It is however absolutely necessary to differentiate the different types of cryptographic proofs”, warns David Chreng, “The ‘Proof of Work’ is the most energy-consuming system because it requires considerable computing power (powerful IT hardware) to secure and confirm each transaction. This process relies on an informatic race between computing contestants to be the first to solve a complex mathematical problem. The first one to solve it receives a reward in digital currency.”

Hence, several blockchains considered as competitors of the Bitcoin blockchain rely on the ‘Proof of Stake’ to fix some issues including energy consumption and scalability (amount of transactions per second or costs per transaction). “Instead of using a hardware network, the algorithmic system enables the native token holders to act as validators inside the decentralized network. These new cryptographic proof mechanisms are an answer - albeit still under work - to all the issues related to energy consumption”, concludes David Chreng.


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