Jean-Michel Basquiat is one of the world’s most renowned and timeless artists. Recently, someone minted one of his artworks as an NFT. The intention was to offer the NFT at an auction, with the winning bidder allowed to destroy the original.
But just last week, the NFT was withdrawn from sale on, OpenSea. This happened after the late artist’s estate confirmed that the minter of the artwork did not own the license or the rights to the work. This raised many questions around NFT regulations and governance, as they rapidly evolve.
NFTs are in their very early stages of development. The sudden expansion of digital art has led to many benefits. These include the democratization of the digital art market, offering secure ownership recorded on the blockchain, faster payment to artists, and royalties paid through smart contracts.
There are common misconceptions about blockchain and trustless technology. How do we know if a token, or NFT, is genuinely backed by what it claims? Like the fast-moving wild west of the cryptocurrency market, we have a lot to learn about how we make NFTs work. This includes the legal frameworks needed to help it survive and thrive.
Let’s talk about tokenization
If you’ve hung around the blockchain or crypto space long enough, then you’ve no doubt heard a few common sayings.
Things like “blockchain enables trustless, peer-to-peer transactions and replaces expensive intermediaries and middlemen” or “fractionalization enables completely new understandings of ownership” or “tokens allow single high-value items like real estate or artworks to be owned by hundreds of people at once.”
This is still technically true, the community needs to discuss some important caveats. Unfortunately, in most cases, they aren’t spoken about.
This has led to some pretty big misconceptions in the blockchain community and the general public concerning what blockchain technology can do in the real world.
The industry is past the point of talking about the future potential of blockchain technology. However, broad acceptance and procedural frameworks haven’t evolved to match.
We’ll discuss two common points of misconception regarding tokenization — what “trustless” really means in a peer-to-peer environment and the realities of fractionalization.
What does trustless even mean?
There’s a common misconception about blockchain that has, over the years, been left untouched.
The implication is that, as a “trustless” technology, blockchain technology removes the need for 3rd parties to guarantee a reliable transaction between two parties. This is technically true, but there are two issues.
First, trustless doesn’t mean there is no trust mechanism. It just means that blockchain’s distributed ledger replaces the bank or broker through its decentralized network of cryptographic confirmations.
So you’re actually trusting the technology to work properly rather than a person or financial institution.
But what about the actual tokenization part that comes before the transaction is even made? How do you know that the token is truly backed by what it claims? With crypto, it’s relatively easy to confirm this by looking at the wallet.
However, this becomes particularly problematic when dealing with asset-backed tokens.
It’s similar to buying something on eBay. On the site, you have to trust that the pictures and description are accurate and true to the real item you’re buying. If they aren’t, you have to hope you’ll be able to get your money back.
However, because tokens allow for some truly high-value transactions, for example, raw materials or precious metals, “hope” isn’t a satisfactory answer.
So, what’s the solution to ensure you get what the token says you will?
You rely on a time-honored method to verify. You get a third-party auditor. This means that you still need that third party to guarantee trust, at least in the tokenization phase. There’s just no way around it.
So, blockchain is neither trustless nor removes 3rd parties?
Not so fast. Blockchain certainly can be both, but those terms just mean slightly different things than you might have thought.
Blockchain hype was/is so strong that it’s easy to mistake a simple distributed ledger system for a miracle that can solve all of our modern problems.
It’s important to remember that the blockchain itself should not be the focus, but rather the use cases it improves or enables.
For example, blockchain doesn’t solve human nature. “Trust but verify,” as the saying goes.
While blockchain may enable some degree of trust that a transaction will go through, you still need a third person to verify the asset being transacted.
This isn’t a negative, but simply a reality of the hybrid physical/digital world that asset-backed tokens inhabit and their place in a global trade system.
Auditors have helped ensure quality in trade for hundreds of years. Their inclusion in a token-based system is common sense.
Tokenization and fractional ownership
Fractionalization is usually brought up in discussions around tokenizing assets, especially a few years ago when the ability to do this was new and exciting. This included discussion around a variety of use cases.
Fractionalizing high-value artworks to open up the typically stuffy market to new investors was a popular example.
So too was real estate. Many people talked about how fractionalizing housing could enable the increasingly burdened younger generation to at least own some equity.
All in all, fractionalization sounded like a technological solution to democratize and improve financial inclusion. But while all these statements are possible, basically, in real life, none of this is enforceable or practical.
Legal and reasonable roadblocks
Now, it’s essential to keep in mind that this is all true from a technological standpoint.
However, engineers shouldn’t be the ones writing media stories because, in the real world, fractionalizing ownership isn’t actually possible for reasons both legal and practical. Fractional ownership is possible with virtual items, but it is just not practical for most physical objects.
Imaging working out ownership issues for a house with 100 other co-owners? Often, it can’t be enforced in real life, as most jurisdictions aren’t prepared to arbitrate for something this complex or even recognize multiple owners. That’s why, specifically when talking about fractionalization, we need to add a caveat.
Take real estate, for example. Imagine that you buy a fraction of an apartment along with ten other people for investment purposes. Technologically speaking, this number could be in the hundreds, but let’s stick with ten for the sake of argument.
Now, all of you have equal shares of ownership in this apartment, so you all have to agree on practical matters like repairs and improvements, who can rent it, what color the curtains are, etc.
Making these decisions is already complicated enough with a few roommates or even just a spouse, and that’s without the complications of wanting a return on investment.
Tokenizing for investment
Finally, there’s the legal issue, or rather the lack of one. The vast majority of jurisdictions have no precedent for these kinds of cases of multiple ownership.
If you tokenize the ownership of real estate to distribute ownership, say, an apartment with hundreds of token holders, there is no legal framework that would recognize 100 parties as owners.
This is particularly important for settling inevitable disputes between the owners. How do you settle the cost of repairs and improvements? What happens if 99 of the owners want to sell and one does not? There is no legal precedent for this.
As an investment product, there are other legal issues too. One workaround is based on an old-fashioned method called usufruct.
Rather than tokenize ownership, you tokenize the right to participate in revenue. A company is founded to own the property, and then two tokens are created.
The first granting the token holder the right to a share of the companies revenue, and the second being that revenue itself.
The first tokens, which must be bought, grant the company liquidity. At the same time, the second tokens grant the investor more flexibility since they can sell, trade, or convert those tokens.
We call this investment model revenue participation.
So with a simple workaround, courtesy of a time-honored practice, all the original promises of fractionalization, like democratizing investing and improving financial inclusion, are still possible and legal without all the practical issues of dealing with hundreds of other co-owners.
Remembering the limits of technology
There are a few lessons to take away from this. First and foremost that, despite all the hype, blockchain is just a technology. A powerful one, no doubt, but one that functions within strict technical, legal, and practical limits.
It’s also a reminder that there are some features of the past (auditors, obscure procedures like usufruct) that we simply haven’t found better alternatives for in our rush to move forward and progress.
The digital, virtual future is coming, but in the meantime, we still live in the real world.
NFTs hold great potential and will be used in the near future for much more than just NFT art. They will be used for tokenized bonds, tokenized corporate debts, where debts can be paid out automatically through high yield. Thus, bringing financial tools, we have never seen before.
We cannot forget the need for verification technology and auditors to ensure the blockchain and digitized unique token technology, and art can truly be trusted.
It will be powerful when it is structured within the technical, legal, and practical limits. If we can get to that point before the bubble bursts, we will see immense potential for democratizing the future of finance where anyone has an opportunity to participate in the global financial system.