Non-fungible token (NFT) – Swiss legal and regulatory considerations

Last week, Justin Biber bought an image from the Bored Ape Yacht Club collection in the form of a non-fungible token (NFT) for around $1.3 million. A few weeks earlier, you could buy 6’776 Australian Open-issued Art Ball NFTs during a few minutes, all of which sold out immediately. These NFTs are linked to a small square of a court, as well as live match data in the sense that each winning match ball of one of the matches that bounced on a square increased the value of the corresponding NFT. In any case, the owner of the NFT on which Nadal’s Winner landed enjoyed an exorbitant increase in value.

However, NFTs have already caused a media stir several times in the past year. The NFT of the painting Everydays: The First 5,000 Days by the artist Beeple was sold by Christie’s for over USD 69 million, although technically speaking it is merely an electronic data set that corresponds to a jpeg image. Someone else bought an approximately 8-second video by the same artist for USD 6.6 million despite this is a video that anyone can watch for free on YouTube. Meanwhile, NFTs worth hundreds of millions of dollars are traded every week on platforms like OpenSea, Rarible and Nifty.

NFTs have entered the mainstream (even if a search of the term NFT at the Swiss Federal Institute of Intellectual Property does not yield any hits). The reasons for the popularity of NFTs are manifold. Often it is a matter of collecting instinct, speculation or status (I own the first tweet by Jack Dorsey). There are also quite pragmatic reasons, provided the technology delivers what it promises: namely, a simplification, acceleration and/or increase in security for the transfer of certain rights or goods, as well as a redistribution of sales revenue in the art and music market. But NFTs are also slowly making their way into everyday life. In the US, for example, some restaurants have started using NFTs for reservations. Those who buy Forbes NFTs get ad-free access to their products. Samsung’s new smart TVs are to become NFT-enabled.

Whatever one’s stance on NFTs, it is worth following this development closely in order not to miss the new (business and legal) opportunities that NFTs open up and to understand the risks involved.

What is an NFT or what does one actually acquire when buying one?

An NFT is an indisputable proof of the authenticity and ownership of an individual cryptographic token anchored on the blockchain, which is itself linked to a good (typically digital at the moment). However, it can also be physical or immaterial goods from the “real world”. The circle of possible links is practically unlimited, but currently focuses primarily on works of art, gaming accessories, music files, videos, tickets or real estate (or participation rights that relate to real estate).

The digital file associated with an NFT is usually not stored on the blockchain, but off-chain on a server or network. So you do not buy the CryptoKitty image that you clicked to buy on the NFT platform, but just a proof of ownership and the link to the website where the kitty is stored.

Like all tokens, an NFT must first be created or “minted”. Anyone can create an NFT on the specialised platforms without any prior technical knowledge. During the minting process, the software (e.g. used on an NFT platform) assigns the NFT an identification number, the token ID, and provides the NFT with metadata such as name, short description of the linked work, information on its design, ownership and transaction history and the location where the digital work is located or the hash value of the work.  

NFTs usually contain a so-called smart contract, a computer code that automatically performs certain actions as soon as predefined conditions are met.

Thanks to the software used, all of this information is unchangeable and cannot be deleted or duplicated by another token. This means, for example, that the origin is automatically documented without gaps, from the address from which the NFT was minted, through all the wallets that once accepted it, to the current owner.

An NFT is thus a special form of a token. Unlike other tokens, an NFT is, as its name suggests, “non-fungible” or not fungible/replaceable. An NFT is unique. In the case of a so-called fungible thing, its value is determined by number, measurement or weight, which means that it can be easily replaced by another thing of the same type (e.g. money, cryptocurrencies, ordinary utility tokens or petrol), which is accepted by everyone in the market. An NFT, on the other hand, is equipped with features that make it unique – in the digital world.

To buy, hold and transfer an NFT, you must have a wallet that supports the NFT format.  

The exact design and functionality of an NFT depends, as with all tokens, on the programming standard used. Most tokens currently use one of the many ERC standards developed by Ethereum, the community-built technology behind the cryptocurrency Ether (ETH). While ordinary fungible tokens are basically programmed in the ERC-20 format (Token Standard), NFTs were first created thanks to the ERC-721 format (Non-fungible Token Standard). Before that, it had not been possible to give a token its own digital identity. However, by being able to represent digital property securely and indisputably by means of a TokenID, the ERC-721 standard has created a new asset class. In addition, ERC-20 can be split (into decimal values), whereas ERC-721 is indivisible. An example for the application of the ERC-721 standard is the POAP smart contract (“Proof-of-Attendance-Protocol”) that allows event organizers to issue NFTs to people who have attended or participated in a physical or virtual even in order to build or add to the community value and encourage engagement. Also, all land and other accessories in the Decentraland and Sandbox metaverses are NFTs based on the ERC-721 standard.

The newer ERC-1155 format (Multi Token Standard), in contrast to the ERC-721 format commonly referred to as the “gold standard”, can produce and transfer NFTs more cheaply and in a more energy-efficient way, and uses less storage capacity on the blockchain (ERC-721 needs a separate smart contract for each NFT, while ERC-1155 can programme or transfer multiple NFTs with the same smart contract). In addition, the format supports fungible tokens and NFTs, so that one can, for example, trigger a payment in cryptocurrency and an NFT transfer at the same time. Another new feature is the ability to retrieve NFTs that were sent to the wrong address.  

Interesting for crypto historians: the actual NFT pioneers, the famous CryptoPunks, were still built without the ERC standard. Since smart contracts are irrevocably left to the blockchain, manufacturers can no longer upgrade their CryptoPunks to the ERC standard.

What problem do NFTs solve?

Origin, ownership, status. As mentioned at the beginning, many people wonder how tokens on the internet can be worth their money – especially when many of them only represent the “ownership” of a jpeg image, a copy of which anyone could download for free and reproduce en masse. Until now, digital files were infinitely reproducible and interchangeable. The combination of digital and unique did not exist before the ERC-721 standard. Because NFTs are unique, they now suddenly confer “authenticity” in the digital world, which until now could not or would not offer such authenticity. It was therefore not possible to identify someone as the owner of a digital file and distinguish them from someone who owned a simple copy of the digital “original”. Since NFTs cannot be duplicated, and the minter can set the maximum number of a series of replicas or not mine a series of the NFT at all, the NFT becomes a scarce commodity. Digital files can thus also become status symbols (in the past, one had signed LPs, today one owns the original of a Kings of Leon album, digitally signed by the artist himself, so to speak).

Trade. Once ownership of a good is secured, trade also occurs. NFTs have enabled the trade of goods for which there was previously no market. In the licensing or perhaps one day in the real estate and mortgage environment, NFTs could cut out middlemen from the economic cycle who are still needed today.

Copyrights. The author of a work can now collect a certain percentage every time the work is resold, without having to share the proceeds with a record company or other intermediary players. As we have seen, the licensing system is currently still unclearly regulated and not yet as technically mature as is often reported in the media.

Branding. NFTs can give access to exclusive events, clubs or merchandise, or allow direct interaction with an artist or athlete. Brands can send certain products to all NFT owners and thus start a hype or test a product.

Main risks when creating or purchasing NFTs

No preliminary clarifications. Ideally, the artist has minted his work himself, or another person who has indisputably acquired the right to mint. However, this need not always be the case. In order to avoid possible complex legal issues, the following questions in particular should be asked before mining or buying an NFT:

As Minter:

• Am I authorised to create the NFT or am I infringing the rights of a third party? How real is my risk in case of infringement?
• What rights, if any, do I want to transfer to the buyer? Does the Smart Contract correspond to my idea and does it clearly assign the respective rights? What applies if there is a contradiction with the platform’s GTCs? What applies / is possible in the event of a transfer of the NFT to another blockchain? What happens in the event of a fork?
• Which ERC standard is best suited to my needs? How are my licence rights best protected in the event of resale?
• How is my NFT to be qualified from a regulatory point of view and do any licensing or authorisation obligations under financial market law apply?

As a buyer:

• Was the minter authorised to create the NFT? If not, am I protected in my purchase or could a third party turn against me? Even when buying directly from the author, the question is whether (i) the author still had the right to create NFTs or whether he had assigned this right to a third party, and whether (ii) his work itself infringes third party copyrights.
• What rights do I acquire, ownership, licensing rights for private or commercial use? What applies in the case of a transfer to another blockchain, in the case of a fork?
• Does the NFT use URL or IPFS as locator (more on this in the next paragraph)?
• Is the ERC standard used sufficient for my purposes (e.g. can I stake my NFT)?

As this is partly a new form of use, the answer to this may not always be clearly regulated (in some cases in contracts dating back years).

This raises the question of whether minting is equivalent to making a copy (protected by copyright) or whether it is merely a link to the protected digital work. Another question concerns the minting of publicly accessible works whose protection has long since expired.

The applicable law is not always likely to be Swiss law. An idea of the current uncertainty is also given by the fact that certain general terms and conditions let the buyer confirm, somewhat unworldly, that he has clarified the smart contracts, the ERC format, as well as the storage type (URL or IPFS) and releases the platform, as well as the seller (sic!) from any liability for missing rights of the minter or seller.

Problems with the link. Many NFTs use the URL locator to find data anywhere on the Internet. Often, the server of the website to which the NFT’s link points is centrally controlled by a single party. If the website stops working for any reason, the NFT’s link goes nowhere. Apart from the fact that the average life span of a website is only about 30 years, there is a risk that:

• the owner of the domain redirects the URL so that it points to something else;
• the owner of the domain does not pay his hosting bill;
• the NFT platform disappears from the network;
• the website is attacked or the domain’s server collapses;
• the domain expires.

A considerable reduction of this risk is achieved by using the Inter Planetary File System (sic!), IPFS for short. IPFS is a decentralised file storage network and is not controlled by a single party. Furthermore, it is a content-based system and not a domain/location-based system like URL. That is, it can identify any file assigned an IPFS address throughout the IPFS network and does not search only in a specific domain. This is achieved by assigning a cryptographic hash value that is used as the address for each stored file. So as long as the file is still present somewhere in the network, it will be found. It can also track the movement of data on the network. Finally, there is the Arweave protocol, where the file is registered on a decentralised hard drive for a fee (permanent, according to its own advertising). In any case, a cautious buyer will check whether both the artist and the website hosting the digital work are reputable.

Unilateral platform decision. It is often and gladly emphasised that an NFT is immutable. However, the immutability of the NFT loses its appeal if it is no longer visible. This could actually happen as many platforms’ general terms and conditions reserve the right to block or remove the link.

Storage/Wallet. Currently, you need a specialised platform to create or trade an NFT. If for some reasons the platform no longer exists or is closed by the authorities, the NFT can be lost. To acquire and dispose of an NFT, as with all tokens, you need a wallet. Not all wallets can accept NFTs, so you need to make sure before you buy.

Interoperability. As long as there is no bridge between two blockchains, an NFT cannot be transferred to another blockchain. As we have seen, certain smart contract functions no longer work on another blockchain.

Fork. If the operators of a blockchain on which an NFT is registered change the protocol, it may be that two alternative blockchains coexist with the result that the “unique” NFT could continue to exist on both blockchains. What happens in such a case, or what decisions the operators will make, is apparently not yet clearly regulated anywhere. Depending on the decision, it is therefore conceivable that two NFTs refer to the same object or that only one NFT still has a functioning link (the “old” one or the one on the new blockchain?).

Unclear regulation of copyrights. Little known and often not mentioned in all the hype is the fact that the acquisition of ownership of an NFT does not automatically include the copyrights to the underlying work.

Usually, the terms and conditions state that one acquires ownership of the NFT, but point out that the copyrights to the underlying work are not transferred along with it. The right for private use is granted only as a license right. Such licenses are limited to personal, non-commercial use (viewing/listening, copying, performing, exhibiting). Depending on this, the buyer of the NFT can thus reproduce the jpeg image for personal, non-commercial use only. Sometimes commercial use is allowed, but usually limited to certain maximum revenues per year.

What is usually not transferred is the right to modify the material, to use it to promote third-party products or even the right to use the material in a video or in another medium. Thus, the buyer may not even be able to use his NFT in a YouTube post or brag about it on Twitter.

In order to know what rights one is acquiring, one cannot avoid painstaking detective work to check the general terms and conditions of the platform, the general terms and conditions of the NFT manufacturer’s website, as well as the terms and conditions of the smart contract set out in the NFT itself.

Certain NFTs contain actual license contracts or, more precisely, the automatic execution of the money flows usually specified in such contracts. For example, the minter can programme the NFT to track ownership changes and transfer 10% of the sale price to his wallet as a fee from the second resale. Like the rest of the NFT data, the smart contracts cannot be deleted or changed by anyone. In this context, one therefore also speaks of a trustless environment. It is therefore important to clarify such rights before buying so that one can price in the license fees and not be surprised when a considerable percentage of the sales price is diverted to an unknown wallet (e.g. of the artist). In addition, the platforms also charge a fee in each case. It should be known that every transaction costs “gas”, i.e. the transaction fee charged by the blockchain itself and passed on to the validators.

EU law already knows this principle of unlimited royalties for secondary sales. Switzerland has repeatedly rejected this principle. It seems that thanks to NFTs, this Swiss go-it-alone approach will become obsolete and the licensing right will also become enforceable for Swiss artists.

There is currently discussion about how the licensing system for sales could work off the blockchain (e.g. by tracking sales off-chain on the blockchain and automatically notifying the licensor so that he can claim his right off-chain directly from the seller). But the most discussed problem in the cryptosphere at the moment is the fact that the smart contracts of the previous ERC standards can only ensure the programmed automatic forwarding of royalties to the artist on the blockchain on which the NFT has been mined. This function can therefore not always be transferred between different platforms. A buyer can therefore move his NFT to another platform, thereby circumventing the sharing of the sales proceeds with the artist provided for by the smart contract.

However, interoperability between platforms is central to the functioning of royalties, as it cannot matter on which platform an NFT is sold. This is the problem that the ERC-1190 format, which was specifically aimed at more complex copyright and licensing agreements, sought to solve. However, the ERC-2981 format seems to be gaining acceptance. However, even this standard only allows the identification of the licensable transaction, but is explicitly dependent on the cooperation of the respective platform. It therefore depends on the platforms at the moment whether a functioning licensing system will establish itself across platforms. As is so often the case, the market will help the idea achieve a breakthrough.

Terms and Conditions. Certain NFT platforms indicate that possible licensing rights to the material linked to the NFT are governed exclusively by the creators of the NFT (i.e. by the NFT smart contract), others are silent. What seems simple, however, could lead to ambiguities, as the following examples show:

• Whose general terms and conditions apply if you buy an NFT on platform A and sell it on platform B?
• What applies if the general terms and conditions and the NFT Smart Contract resolve an issue differently?

Certain T&Cs raise more questions than they clarify. For example, the T&Cs of Bored Ape Yacht Club grant the buyer the license for personal use free of charge, while the commercial license neither mentions the fee-free status, nor does it indicate any license fee that may be applied.

Interestingly, the license is often described as non-transferable. So the minter owns all the rights and the first buyer gets a non-transferable license. What does this mean for the second buyer? It is not always stated in the general terms and conditions that the license is tied to the ownership of the NFT, so that one loses all license rights upon sale (but the new owner implicitly gets to enjoy them again).

NFTs as asset tokens. Forsome time now, there has been discussion abroad about whether and when an NFT could be a financial instrument or a security. We are also seeing increased interest from regulators in this area.

Apart from their uniqueness, NFTs are comparable to other tokens. The categorisation applied by the Swiss Financial Market Authority (FINMA) into payment tokens, utility tokens and asset tokens must therefore also be applied to NFTs for the time being. Accordingly, tokens can have investment character (and are considered asset tokens) if they:

• make physical items of value tradable on the Blockchain or represent an asset, in particular a debt claim against the issuer (e.g. shares in future earnings or future cash flows) or a membership right; and
• are standardised and suitable for mass trading (= publicly offered in the same structure and denomination or placed with more than 20 clients, unless they are specially created for individual counterparties; Art. 2 para. 1 FMIO).

An NFT is a unique token. Furthermore, an ERC-721 token cannot be fragmented. Therefore, an NFT in ERC-721 format cannot, in principle, qualify as “standardized and suitable for mass trading”. The same applies to the ERC-1155 standard, provided the token is an NFT. Whether the asset linked to the NFT is itself fungible or not remains irrelevant. An NFT should therefore not qualify as an asset token (in principle).

It can also be assumed that NFTs are not issued for the purpose of being used as a means of payment between third parties (to the extent that they are not fragmented or can hardly be fragmented in practice). Therefore, NFTs should also not qualify as payment tokens and the issuance and trading of NFTs should not be subject to Swiss money laundering regulation.

Fractionalised NFTs (F-NFTs) are a new phenomenon. F-NFTs are created when a smart contract generates several fungible ERC20 tokens that are all linked to a non-fungible, indivisible ERC-721 NFT. To do this, an NFT is first locked in a smart contract or vault. Then the smart contract mints ERC-20 tokens, each representing a share of the NFT. The NFT can only be released from the vault if someone redeems all ERC-20 tokens. F-NFTs allow a wider audience to own at least a small portion of an otherwise priceless NFT. The holders of F-NFTs can also, for example, receive governance rights in relation to the underlying NFTs or the smart contract can distribute revenue generated by the NFT to the holders of the F-NFTs. If ERC-20 tokens are issued “in the same structure and denomination”, the question indeed arises whether such F-NFTs qualify as asset tokens.

Since, as seen, the design of smart contracts can vary greatly, case-by-case consideration is unavoidable and even desirable. However, until the Swiss Financial Market Authority (FINMA) (or the courts) develop clear guidelines, the uncertainty remains considerable and the direct exchange with authorities correspondingly valuable.

Another problem is the often different treatment of tokens by FINMA and the Swiss tax authorities (even sometimes different between VAT and income tax treatment), which does not make the current situation any easier. Let’s hope that the regulatory and tax handling can quickly come to clear and pragmatic, technology-neutral guidelines without overregulating Switzerland.

Final remark

Due to the various possible applications, we expect NFTs to become established in a wide range of economic sectors. The potential applications are practically unlimited and the technology is constantly developing. There are already countless startups engaging in the development of NFTs and marketplaces in Switzerland, especially in the Crypto Valley. However, until the technology and the legal environment have matured, any minter and buyer of NFTs would be well advised to make certain preliminary clarifications so that they are clear about what they are actually minting, selling or buying. In addition, minters and developers of NFT-projects should clarify the applicable regulation in Switzerland in advance.

Legal Note: This newsletter does not constitute legal advice and may not be relied upon by any person for any purpose. Any liability for the accuracy, correctness or fairness of the contents of this newsletter is explicitly excluded.