In March 2021, a relatively unknown graphic designer, Mike Winkelmann (a.k.a Beeple), sold a digital collage of 5000 images, “Everydays: The First 5000 days”, for approximately USD 69.3 million. At the close of the transaction, the buyer only received a non-fungible token (“NFT”) associated with the digital collage.
If you are unfamiliar with NFT, an NFT is a unique and non-interchangeable unit of data stored on a digital ledger. NFTs can be associated with easily reproducible items such as photos, videos, audio, and other types of digital files as unique items, and use blockchain technology (typically Ethereum) to give the NFT a public proof of ownership. In other words, NFTs can be 01 of 01 “original” digital memorabilia minted of blockchain.
An NFT is a digital instrument that is minted, recorded, and traded on the blockchain. Each NFT is unique and can be used to determine the ownership of a particular item or asset (both tangible and intangible), i.e., akin to a title record with a public registry. In the case of Beeple’s artwork, the issued NFT is attached to the authorized copy of the collage. It is interesting to note that the collage can still be accessed for free online. Therefore, NFTs have a unique way of democratizing art.
NFTs are traded on blockchains. Blockchains are publicly distributed digital ledgers that record transactions and other information in relation to the particular NFT in a decentralized manner. Blockchains are considered secure by design as the transactional data is verified and stored by system participants using a consensus mechanism. Therefore, once an NFT is created, it cannot be modified or altered. Further, each NFT token is unique, non-fungible, and cannot be interchanged since each token is coded in such a manner that it records distinctive data/information relating to the creation of the NFT, associated timestamps, and transaction history.
After the speculative fervor with GameStop and Dogecoin, now NFTs reeks of the 21st-century version of the Dutch tulip bulb market bubble*. In March 2021, Twitter CEO Jack Dorsey’s first tweet was sold for approx. USD 2.9 million in the form of an NFT memorabilia. In the first quarter of 2021, the sale of NFTs crossed USD 2 billion. Given such irrational exuberance about NFTs, government regulators across the world are likely to pay keen attention to the rise of NFTs. Therefore, it will be helpful to understand whether NFTs will be classified as a ‘derivative’ instrument or a ‘commodity’.
The term “derivative” indicates that it has no independent value, i.e., its value is entirely “derived” from the underlying asset’s value. The underlying asset can be securities, commodities, currencies, or anything else. Therefore, it may be possible to argue that NFTs are in the nature of derivatives, since NFT derives its value from the linked (underlying) item or asset. To illustrate, in the case of “Everydays: The First 5000 days”, the digital collage was valued at USD 69.3 million, and not the NFT issued by Beeple.
Having said so, if an NFT only records the ownership of an item such as a digital music album, videogame collectibles akin to a title record, then it is arguably not a derivative. For example, Kings of Leon released their album, “When You See Yourself” as an NFT. In this case, it will be difficult to argue that the NFTs issued for the album will be considered as derivatives. Moreover, the U.S. Commodity Futures Trading Commission has categorized cryptocurrencies such as Bitcoin and Ether as ‘commodity’. Given the broad similarities between NFTs and cryptocurrencies, i.e., both act as a record for transactions and use blockchain as the underlying technology, NFTs can also be categorized as commodities.
A simpliciter conclusion on the nature NFTs would be erroneous. It is crucial to analyze the circumstances and facts of each NFT project on a case-by-case basis to determine whether it is a derivative or a commodity. However, “fractionalized” NFTs will undoubtedly fall within the ambit of derivatives. The concept of “fractionalized” NFTs, allows a single NFT to be split into multiple tokens that collectively establish ownership of the NFT. The token or the fractional interests in NFT will be considered as the derivatives instrument.
*The Dutch tulip bulb market bubble occurred in Holland in the 1600s, where speculation drove the price of tulip bulbs for as much as six times the average annual salary of a person.