The acronym “NFT” stands for “non-fungible tokens” and it’s basic asset-backed tokens or digital assets with unique identification codes and metadata recorded in s 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-swampable 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 transaction value. This means convertible assets in the same denomination imply the same value. Rather, NFTs are by definition, not interchangeable, irreplaceable and unique.
The concept behind NFTs is to create a certain scarcity and scarcity in the flood of the seemingly infinite supply of virtual items. As a result, NFTs bring the promise of creating a “digital original” that is one-of-a-kind and clearly attributable 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 peer in the sense of a ” digital original” “.
The non-manipulating 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 to earn their business. NFTs also allow collectors to value digital art in a similar way to physical art, thus creating new opportunities for digital artists. So it’s not surprising that it was initially the digital art market where NFTs became a mainstream phenomenon.
In other words, NFTs combine the best features 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 actually own and control your own NFTs.
NATURE OF NFTs
Utility, Security and Payment Tokens are all Fungible Tokens. They are interchangeable with any other token of the same class. For example, 1 Bitcoin can be exchanged for 1 Bitcoin. On the other hand, NFTs show 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 do grant access to future content or grant rights to royalties.
NFTs also do not entitle their holders against the issuer. NFTs are transferable, but not to organized markets. Important features of NFTs are immutability and scarcity. As discussed earlier, an NFT is rare and unique.
Their main characteristics are:
- Unique: Non-flippable tokens contain information within their code that describes the characteristics of each token that make them different from others. A piece of digital art may have encoded information about individual pixels, while signed in-game items may contain details that allow the game client to understand which item the player owns and its properties.
- Traceable: Each NFT has a record of transactions in the chain, from when it was created, including every time it changed hands. This means that each token can be proven to be authentic, and not a forgery – obviously a very important thing for owners and prospective buyers.
- Rare: To make non-fungible tokens attractive to buyers, they must be provably rare. This will ensure that assets remain desirable in the long term, and that supply does not exceed demand.
- Indivisible: NFTs mostly cannot be traded as fractions of a whole. Just like how one cannot buy half of a concert ticket or trading card, non-swampable tokens cannot be divided 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 uncertainty surrounding the legal validity of cryptocurrencies in India, because as mentioned earlier, NFTs are only tradable in cryptocurrencies. Furthermore, all Indian platforms that have started trading in NFTs so far 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 trading in cryptocurrencies, it held that the impugned circular was unreasonable and therefore contravened section 19(1)(g) of the Constitution of India. Furthermore, early 2021 saw a drastic change in the government’s approach in dealing with cryptocurrencies with the Minister of Finance saying that the government was not considering a total ban on cryptocurrencies and that it would allow windows for people to do experiments. RBI also issued a circular directing the banks not to rely on the 2018 circular as it was struck down by the Supreme Court of India.
What emerges from this discussion is that there is absolutely no clarity on the legal sanctity of cryptocurrencies in India, which consequently makes trading in NFTs more risky.
Currently, no law prohibits 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 regarding the classification of the NFTs. Some consider NFTs to be contracts, while some call NFTs a derivative.
Section 2(ac) of SCRA defining “derivative” provides that derivative instrument also includes a contract that derives its value from prices or index of prices of underlying securities. If NFTs are considered derivatives, they cannot be traded on virtual platforms under Section 18A of SCRA which states that contracts in derivatives will be legal only if they are traded on a recognized stock exchange. Under such circumstances, the platform where NFTs are traded will have to apply for recognition as a 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. Therefore, if a specific NFT relates exclusively to an existing asset and it is marketed as an assurance for authenticity of the ownership of such asset, it would be inappropriate to consider it as a security (derivative). Rather, it should be governed by the general principles of contract. On the contrary, fractional NFTs (which provide partial ownership interest in the NFT) that arose as a result of excessively priced NFTs, which most people cannot afford, can be termed as a security. Furthermore, if promises are made regarding return on investment, NFTs will look like a speculative investment rather than a digital collectible, and thus can be considered a security in India.
THE US POSITION ON NFTs
NFTs in the 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 April 12, 2021, recommending that the regulator introduce a framework for the regulation of NFTs. Apart from this, there is no formal document regarding NFTs. However, SEC officials opined that trading in NFTs can amount to violation of law because NFTs can often take the form of ‘investment contract’.
At this juncture, it is pertinent to note the much-discussed ‘Howey test’ as laid down by the Supreme Court of the United States in SEC v. WJ Howey Co. The definition of ‘security’ under US law also includes ‘investment contract’ among many other things. The Supreme Court of the United States has held that an investment contract exists when money is invested in a common enterprise in which profits are expected through the efforts of others. The most controversial aspect here is ‘efforts of others’ which are nothing but third party attempts to realize an asset’s investment potential. Whether the gains are a result of others’ efforts depends on a case-by-case basis.
NFTs are the newest class of crypto assets. And as highlighted above in certain situations, NFTs can act as securities that can 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 on the validity of cryptocurrencies in India, NFT trading is risky. Secondly, a clarity from the government whether NFT amounts to derivative or not is inevitable.