Non-Fungible Tokens (NFTs) have become one of the most talked about cryptoassets classes during 2021. To truly understand NFTs, and their potential to create a multi-trillion dollar industry, it is essential to understand the basic principles of how NFTs work.
Our research found that most articles discussing NFTs offer a one-dimensional viewpoint of NFTs focusing either on:
- the technical architecture of an NFT,
- or the regulatory framework governing NFTs and NFT marketplaces
Within this article, we have discussed both aspects in order to provide readers with information and material designed to give them a more comprehensive overview of NFTs.
Keystone Law Middle East offers unrivalled capabilities in advising investors on preparing regulatory submissions to apply for business licenses within United Arab Emirates (UAE) free zones and in front of UAE government regulators. Our banking and finance and technology lawyers have a deep understanding of how cryptoassets regulations dovetail with UAE financial and FinTech regulations. In addition, we regularly advise clients on how to establish viable, commercially-sound and compliant anti-money laundering, counterterrorism financing know your customer checks (KYC).
The technical aspects of ‘tokenisation’ and NFTs
Let’s look at the key technical principles underpinning NFTs:
What is a blockchain? A blockchain is a database. It exists on a network of ‘peer-to-peer’ computers across the world – this makes it decentralised. By contrast, your computer or a server can store databases within a single location.
Tell me about Bitcoin: Although not connected to NFTs, Bitcoin, at present, the world’s largest cryptocurrency (measured by market capitalisation) sits on its own blockchain. This means that every transaction ever undertaken using a Bitcoin since the beginning of time is stored on a single, decentralised blockchain.
So what about Ether? The second-largest cryptocurrency, Ether (measured by way of its present market capitalisation) also has its own blockchain standard, Ethereum. Just like a programming code, several standards have been developed detailing how different assets may be recorded on the Ethereum blockchain.
OK, so something is ‘fungible’ – is that a mushroom? The term ‘Fungible’ means an asset or item can be exchanged for a different form of asset. Cash is fungible. If a friend lent you an AED 100 note, you may if you wish return that money in the form of two AED 50 notes or 100 Dirham coins, although the latter will probably annoy your friend.
Cars are non-fungible. Why? ‘Non-fungible’ generally means an item cannot be readily exchanged or substituted. If you borrow your friend’s car, you are legally obliged to return their car to them – it would be a breach of trust and your legal obligation if you substituted a car which had the same make, model and colour, but which featured a different chassis number.
So what is Tokenisation? Millions of people around the world entrust their credit card and banking information (also known as ‘cardholder data’, or CHD) to eCommerce websites and payment processors. Back in the late 1990’s and early 2000’s, CHD was rarely encrypted – it was easier for criminals to steal CHD and commit banking fraud. In 2001, a company called TrustCommerce found a way to protect CHD by tokenising it. This system swapped CHD for a digital token issued by TrustCommerce, who would then process payments on behalf of an online merchant.
The key here is that anything can be tokenised. For example, developers create free-to-play games but create a primary digital market marketplace for tokenised gaming credits, upgrades, cheat codes and virtual weapons. This, in turn, generates immense profits for developers.
Ethereum users developed a smart contract standard which allows users to tokenise and record physical or digital objects in a unique way: Ethereum Request for Comments 721 (or ERC-721 for short) and more recently ERC-1155.
ERC-721 (and ERC-1155) enables theatre tickets, art works, property, paintings, and digital assets (for example, CryptoKitties, gaming credits and collectors cards) to be tokenised. Thereafter, they are listed on the Ethereum blockchain in a unique manner so that they may never be divisible, expendable, or interchangeable.
Other developers have created similar standards for blockchains such as TRON, Cardano, Tezos, and Flow. We’ve not discussed those standards here but they are similar to the concepts integrated within ERC-721 and ERC-1155.
That’s about as technical as we’ll get within this article – the ethereum.org website features a detailed guide about ERC-721 & ERC-1155 and the Python code required to record tokenisation and transactional events on the Ethereum blockchain.
The UAE’s cryptoasset regulatory framework continues to evolve
As we discussed earlier, anything can be tokenised. Online marketplaces enable users to auction, sell and buy NFTs. Since November 2020, we saw (and continue to see) a strong interest in online vendors looking to scale up and launch NFT marketplaces serving the UAE).
Due in part to the huge interest that NFTs have generated around the world, the UAE has stayed firmly ahead of the curve to create and promote an open, regulated, and attractive environment for cryptoasset platform owners, sophisticated investors custodial service providers:
- November 2020: the UAE Securities and Commodities Authority (SCA) published its new regulatory framework governing the licensing of cryptoassets.
- January- March 2021: the Dubai Financial Services Authority (DFSA), in its capacity as the independent regulator of financial services conducted in or from the DIFC, announced, it planned to draw up a regulatory framework for regulating tokens and cryptocurrencies and the firms providing trading services within the DIFC. In March, the DFSA announced a public consultation on a regulatory framework for security tokens, a copy of which may be found online.
- March 2021: The Dubai Multi Commodities Centre (DMCC) announced a new Memorandum of Understanding with the SCA, in effect granting SCA new rights to license cryptoasset service providers and platforms launched from within the DMCC.
- April 2021: Following in the footsteps of several crypto-assets trading platforms and custodians, BitOasis announced they had secured regulatory approval to launch a cryptoasset trading platform within ADGM, being Abu Dhabi’s leading financial free zone.
NFTs, and their association with the arts, and the online marketplaces upon which they are traded, form the ‘early adopters’ upon which, commentators believe entirely new industries, and jobs will eventually be created. Far from being a ‘fad’, NFTs are here to stay. The key for regulators, public policy makers and central banks is how to ensure that NFTs can be traded sustainably and in a manner which protects consumers.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.