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UNDERSTANDING NON-FUNGIBLE TOKENS(NFTs)

 

WHAT ARE NON-FUNGIBLE TOKENS?

Non-Fungible Tokens are cryptographic tokens created using blockchain technology. They represent and uniquely describe a valuable digital asset with special distinct features that allow for traceability and identification of the underlying asset which it represents (this underlying asset could be digital or a tangible real-life asset such as a vehicle, a gadget, a literal work or real estate).
The non-fungibility of these cryptographic tokens distinguishes them from other common cryptocurrencies such as bitcoin or ethereum which are created in multiples, each having the same features as all the others in circulation and each coin being of equal value. An NFT is encoded with an “indivisibility feature” i.e. the token cannot be broken into smaller elements of a whole such as you would a bitcoin (which can be broken into 100,000,000 satoshis) with each bearing a corresponding value of the fraction of a bitcoin. Each NFT is unique, exclusive and can only be transferred as a whole.

Nonfungible.com a website that tracks NFT marketplaces represents that the current NFT Market is worth over USD250 Million. For a market that was completely non-existent before 2017, it is expected that the market will balloon in geometric progression because of the boundless opportunity it opens for the trade of digital assets in a secure and efficient manner. Especially the possibility of easily converting all forms of assets into NFTs.

WHAT ARE THE KEY FEATURES OF A NON-FUNGIBLE TOKEN?

i. Uniqueness
The metadata attached to an NFT allows it to be defined by its unique features such that it can be clearly distinguished from other assets.

ii. Rarity
For NFTs it is impossible to create or reproduce the subject asset (there will always, only be a single version of the asset on the blockchain). This specifically is what influences the value of NFTs and makes them desirable to collectors.

iii. Indivisibility
An NFT cannot be split into smaller units of a whole. An NFT can only be held or transferred as a whole.

iv. Value
Only assets likely to be deemed valuable in the NFT marketplace may be converted to NFTs.

ARE ALL NFTS BACKED BY A TANGIBLE UNDERLYING ASSET?

An NFT is usually backed by an underlying asset which could be digital (such as digital art) or tangible real-life assets (such as an automobile or real estate). As previously explained the distinctive information relating to the asset is encoded into metadata on a blockchain platform. It is important for a buyer to understand the exact nature of the asset that is being acquired and to ensure that the smart contract purchased actually transfers legal and beneficial interest in the intended underlying asset and that the metadata are not a mere description of the same. It has been the case that some undiscerning buyers have acquired a mere description of an asset rather than the asset itself

WHAT NATURE OF LEGAL INTEREST DO I ACQUIRE WHEN I BUY AN NFT?

The Buyer of an NFT often expects to acquire the original, rare, and unique form of the underlying asset which the cryptotoken represents (if it is an artwork the original copy as digitally signed by the artist with a digital proof of authenticity and uniqueness in the form of metadata). The asset itself may not always be encoded into the Ethereum blockchain itself.
In simple terms, the NFT buyer acquires simply a smart contract on blockchain which contains metadata with the name of the asset, description of the asset, and a URI (Uniform Resource Identifier which provides technical details about how the asset works and in some cases link to an IPFS (InterPlanetary File System) a protocol that allows for the creation of permanent, immutable links to the blockchain where the asset is emplaced.

HOW IS THE VALUE OF AN NFT DETERMINED?

An NFT’s value is driven by demand and the value placed on it by potential buyers. There is therefore no empirical basis for determining its value, it remains very speculative. Offer prices are often driven by sentiments and its inherent features of rarity and uniqueness. A popular example is a digital collage created by the artist Beeple which after being converted to an NFT was traded for USD69Million at a public auction that started with a usd100 bid called the beginning of the Digital Collectibles craze. Or Jack Dorsey’s (Founder of Twitter) first tweet which he converted to an NFT and sold for USD2.9Million.

HOW DOES THE NFT MARKET PLACE OPERATE?

The NFT Marketplace is a virtual platform/website where NFTs can be traded, and where market participants take a sell or buy position and transact with each other via their digital wallets using cryptocurrencies as the medium of exchange. Whilst most marketplaces will trade a wide range of NFTs some operate as niche markets trading only one homogeneous category of NFTs a good example is Looking Glass Factory, a site that trades only digital holograms.

Some of the most common NFT marketplaces are:
i. Opensea, which is acclaimed as the largest NFT marketplace trading a variety of NFTs including art, virtual worlds, sports, trading cards, and other forms of collectibles. On Opensea, collectibles can be listed at a fixed price or for auction;
ii. Rarible, another popular marketplace that is community owned. It trades several categories of NFTs including art, photography, games, metaverses, music, domains, and memes amongst others;
iii. SuperRare is a marketplace for people to buy and sell unique, single-edition digital artworks. Each artwork is authentically created by an artist in the network and tokenized as a crypto-collectible digital item that you can own and trade;
iv. Atomic Market another popular platform is a shared liquidity marketplace that feeds other marketplaces. It allows its users to tokenize and create the digital asset and thereafter sell or auction the asset;                                         v. Another common platform “valuables” is a niche market solely for trading tweets.

NFT marketplaces have become mainstream in the crypto space whilst NFTs have become the most trending asset class of 2021, sparking the interest of traditional investors and several high net worth individuals.

HOW ARE NFTs CLASSIFIED?

The subject of the classification of NFTs remains quite unsettled, however as the market deepens we expect more clarity around their classification. A school of thought argues that NFTs are securities in respect of which local securities law should apply, others argue that they are simply a digital identifier of any form of asset whose legal title is transferrable. The test of whether an NFT will be classified as security will depend on:
i. The purpose for which it was created: If the NFT is being created and sold as a way for members of the public to earn investment returns with a line of recourse to the issuer it will be more likely to be considered a security. Especially if the smart contract has features of an investment contract.
ii. How it is traded: where an NFT is traded on a marketplace that operates similarly to exchanges and capital trade points shares where other securities or commodities are traded, it is likely to be classified as security especially where there exists is a secondary market feature on the trading platform.

WHAT FORMS OF INTELLECTUAL PROPERTY RIGHTS ARE ATTRIBUTABLE TO NFTs?

The storage of NFTs on a blockchain ledger provides a way for asset holders to establish proof of ownership and possession with the innate benefit of immutability and security. It is important to understand the bundle of intellectual property rights which may be applicable NFTs or transferrable to a buyer.

Patent: Where the mining of an NFT or the cryptotoken involves innovation that solves a technical problem, it may be possible to patent the innovation subject to meeting the applicable registration criteria. The patent right is likely to remain proprietary to the creator.

Copyright: In relation to copyright, the metadata related to an NFT are by themselves a creative expression over which the creator automatically acquires exclusive copyright. There is a marked distinction between ownership of the NFT and ownership of the content in the metadata. Where not expressly assigned in the ‘smart contract’ between the creator and the buyer, any incidental copyright remains with the owner. The owner of the copyright remains the only party who can reproduce, make derivative works of, perform, display or distribute copies of the content. Where an NFT relates to artistic or literary work, it is curious what nature of interest is transferred to a buyer if he is not granted the intellectual property right in the work whether in form of a full assignment or a license to use.
Trademarks: In relation to trademarks, NFT creators may protect the name or other graphic property in the work by registering the name or the visual representation.

CONCLUSION
Even though Non-Fungible Tokens are gaining popularity and momentum as a digital asset class, it is no gain saying that the market is new and evolving. Market regulations are therefore still at infancy. At best, the law and regulation applicable to the class of underlying asset will apply to all related transactions. It remains important to exercise caution and seek professional advise when dealing in NFTs especially to guarantee that a buyer of an NFT actually acquires the intended interest in the subject underlying asset.

 

HOW TO GET STARTED

Do you need to know more about NFTs? Our Technovation team is available to support you.
You may contact our team on: Email: info@dealhqpartners.com Telephone: +234 1 4536427 or +234 9087107575

Click here to download PDF

 

Simply by DealHQ Podcast – Cryptocurrencies and the Nigerian Financial Market

Simply is the sponsored Podcast of DealHQ Partners, where we engage thought leaders on trending issues around law and business in the most simplistic manner.

In this maiden episode, Our Lead Advisor, Tosin Ajose is in conversation with Mr. Michael Ugwu, the Founder and CEO of Freeme Digital Limited and pioneer General Manager for Sony Music Entertainment West Africa, a venture capital investor and cryptocurrency enthusiast discussing issues bothering on cryptocurrency adoption, market trends, trading, counterparty risks and regulations from a Nigerian perspective and from a broader Africa wide view.

The whole world acknowledges the unprecedented growth in the global cryptocurrencies MARKET with Nigeria recording over $400 million traded in 2020 alone inspite of its low internet penetration. Statistics show a high level of enthusiasm around the adoption of cryptocurrencies, especially amongst the youth. This episode examines the cryptocurrency market in Nigeria from an investor’s perspective, opportunities in Decentralised Financing (DeFI), lessons, and opportunities for new adoptors.

Listen here:   linktr.ee/DealHQ

 

CBN FRAMEWORK FOR REGULATORY SANDBOX OPERATION

In June 2020, the Central Bank of Nigeria (CBN) released the exposure draft of its Framework for Regulatory Sandbox Operations which set out the rules, processes and guidelines for participation in the CBN regulatory sandbox in a bid to get stakeholder input ahead of its adoption. Following the exposure, on the 13th of January 2021, the Apex Bank published the final version of the Framework which establishes the CBN regulatory sandbox – a controlled facility where fintech developers/innovators can test new and innovative services under the Supervision of CBN. This will enable safe and reliable deployment of innovative fintech solutions without compromising the integrity of the financial system or the experience of the consumers.

WHAT IS A SANDBOX?

In simple terms, a sandbox is an isolated, safe, testing environment where developers/innovators can test new programmes or software applications under a system that promptly identifies and quarantines malware or other zero-day vulnerabilities without compromising the host device(s). These tests are typically conducted prior to go-live.

WHAT ARE THE OBJECTIVES OF THE CBN REGULATORY SANDBOX?

The Apex Bank, has recognized that the introduction of the CBN regulatory sandbox will:

  1. Reduce time to market for innovative products by allowing developers and the CBN to simultaneously monitor the pre go-live product testing in the sandbox thereby shortening approval timeline.
  2. Ensure customer protection safeguards as prescribed by CBN are adhered to;
  3. Promote adequate regulation and an enabling environment for innovation without compromising consumer safety;
  4. Encourage innovative solutions that will advance financial inclusion; competition and ultimately lower cost to consumer;
  5. Define the roles of different stakeholders within the sandbox ecosystem and the bigger payment systems industry.
  6. Provide a communal environment for continuous engagement between fintech innovators/developers and the CBN.

WHO IS ELIGIBLE TO PARTICIPATE?

The Sandbox application process is open to both existing CBN licensees (financial institutions regulated by the CBN) and other Nigerian Companies or Enterprises not regulated by the CBN but who wish to test innovative payment products deemed acceptable by the CBN. Innovators whose proposed solution involves technologies which are not covered under existing CBN regulations may also apply to the CBN for special consideration to participate.

Apart from the Applicant’s eligibility, the underlisted are additional criteria for selection to participate:

  1. The product or service must be innovative and show potential to improve efficiency, security and quality of services in the overall financial market or enhance risk management amongst financial institutions;
  2. The proposed project must fall within prescribed value and volume for effective risk management and mitigation;
  3. The product or service must clearly demonstrate usefulness and functionality;
  4. The applicant must have all resources required for testing in the sandbox;
  5. The applicant must have a business plan showing how the product is to be deployed to market after testing is completed.

HOW DO I APPLY TO PARTICIPATE IN THE CBN REGULATORY SANDBOX?

CBN will make a call for applications once in each calendar year via its website and local newspapers. The advertisement will include minimum eligibility criteria, interested participants are to address their application to the Director, Payments System Management Department and submit same through the CBN official email address: sandbox@centralbankofnigeria.gov.ng. Successful applicants will be issued a letter of approval within 45days from close of application.  Upon the issuance of the letter of approval, the applicant is required to comply with all necessary documentary filings prescribed in the framework.  Upon entry into the Sandbox, Applicants are additionally required to comply with the operational and reporting requirement prescribed in the framework.

CAN CBN WITHDRAW OR REVIEW AN APPROVAL TO PARTICIPATE AFTER IT IS GRANTED?

At any time before the end of the prescribed testing period, CBN may review or withdraw an approval granted to any participant who:

  1. Fails to comply with prescribed safeguards;
  2. Submits misleading information conceals or fails to disclose material information;
  3. Contravenes any applicable law which impacts directly on applicants integrity or reputation;
  4. Goes into liquidation;
  5. Breaches data security or confidentiality requirement;
  6. Compromises consumer safety;
  7. Fails to address identified risks, technical flaws or vulnerabilities.

Before withdrawing its approval, CBN will give the defaulting Participant 45days prior notice and the opportunity to respond to the grounds of the withdrawal. In cases where delay is deemed detrimental to consumers or the Financial System generally, CBN may proceed to withdraw the approval without notice. Once approval is withdrawn, the affected Participant must immediately implement its planned exit from the Sandbox and desist from promoting or taking its product/service to market. It must also comply with other obligations imposed by CBN regarding disposal of confidential information and mandatory post-exit reporting.

WHAT RISK ASSESSMENT SAFEGUARDS MUST BE ADHERED TO WHILE IN THE SANDBOX?

Whilst in the Sandbox, Participants are required to promptly identify all potential risks to consumers, financial institutions or the financial systems generally and to develop appropriate safeguards to respond to/address the risks in ways that demonstrate;- sound financial practices, fair and equal treatment of all consumers, compliance with anti-money laundry regulations, preserves confidentiality of consumer information and encourages healthy competition amongst similar financial products or services.

HOW MANY APPLICANTS MAY BE ADMITTED TO THE SANDBOX AT THE SAMETIME?

The number of applicants admitted will be pre-determined by the CBN based on available resources and capacity at the given time. Each group of innovators admitted into the Sandbox at a given time will be referred to as a “Cohort”. It is expected that CBN will admit one cohort per calendar year. Selection will be based on the Sandbox’s strategic objectives and CBN’s prescribed eligibility criteria.

WHAT HAPPENS AT THE END OF THE TESTING PERIOD?

When a Participant has completed its product testing in the Sandbox, the result will be benchmarked against the product objectives and the CBN will determine whether the product or service is suitable to be deployed to the market. Deployment could be direct by the Participant to the market or by licensing the product to another firm to take to market or taken to market in partnership with other CBN regulated firms. Where CBN deems the test as failed either on account of sub-optimal output or unintended negative consequence on the public CBN will prohibit the deployment of the product. A participant may on its own elect to discontinue testing in the sandbox in such case it shall seek the consent of the CBN which may be granted subject to satisfactory performance of all prescribed regulatory obligations. For successfully tested products, participants may proceed to apply for the requisite license to deploy the Product. CBN will typically support successful participants in addressing risks and vulnerabilities detected during the testing phase.

ARE THERE CIRCUMSTANCES UNDER WHICH EXTENSION OF TIME FOR TESTING MAY BE GRANTED TO A PARTICIPANT?

Typically, applications from participants would indicate proposed testing timeline. Each cohort however will generally run for 6 months. Where a participant feels that it is expedient to extend the testing period, an application shall be made to the CBN at least 30days before the end of the initial testing timeline stating the additional time required and the reason for the application. CBN will not permit frivolous or protracted extensions. Where a general positive outcome has been recorded and extension is only required to respond adequately to risks or vulnerabilities identified during initial testing CBN will be most inclined to grant the requested extension.

HOW WILL THE CBN REGULATORY SANDBOX DRIVE PRODUCT INNOVATION AND FINANCIAL INCLUSION?

The CBN sandbox provides the needed anchored support for fintech innovators by reducing the cost and time to completion of new products, more importantly the sandbox will be a major repository for market data whilst also providing the regulator with wider coverage and more intimate interaction with innovators and their products. It is expected that the regulatory sandbox will provide a good foundation for the wider adoption of open banking systems in Nigeria.

HOW TO GET STARTED

Do you need more about the CBN Regulatory Sandbox? Our Finance and Technovation team is available to support you. You may contact our team on: Email: info@dealhqpartners.com Telephone: +234 1 4536427 or +234 9087107575

Click here to download PDF

 

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