Mercator Blog

Non-Fungible Token (NFT) – Good Investment or Ripe for Fraud?
Date: April 27, 2021
Tim Sloane
Vice President, Payments Innovation

The idea that you can claim ownership of a physical or digital item using a blockchain's immutable ledger is so compelling that it has become the darling of the blockchain world. By one estimate, more than $2 billion was spent on non-fungible tokens (NFTs) during just the first quarter of 2021 - representing an increase of about 2,100% from Q4 2020. Let's dig in to understand what NFT's are, and how the blockchain is supposed to register items so that digital items can be owned in perpetuity and royalties for usage of registered items can be established.

What does non-fungible mean?

Currency is fungible. It has a fixed denomination and is interchangeable from the perspective that my ten dollar bill can be interchanged with yours - they have the same value. A non-fungible item is unique and its value varies, typically based on the perception of its value. The NFT solutions coming to market are for digital items, but those digital items could also represent something in the physical realm. This means that NFTs are similar to a commodity where the value is established by what someone else will pay for it. Objects that are considered to be of artistic worth are one example, but almost any digital item can be registered as an NFT.

What does it mean to have something registered as an NFT?

In short, an NFT is a digital asset, perhaps an image, an article, or a recording, that is deposited into an immutable ledger with details of ownership verified through blockchain technology. At the most simplistic level, registering ownership of an object with the NFT is nothing more than creating a record in the immutable ledger that contains the digital object, or points to it in some other storage medium, and documents that ownership. In most instances there are also smart contracts associated with the object that define transferability, which might include royalties for every resale in perpetuity. Everything becomes much more complicated when you delve beyond this simple description because there are multiple implementations of this basic concept already in market. In general, however, Mercator suggests that the following issues need to be examined if you really want to understand the value of any particular NFT solution:

Provenance

Without some external effort to identify the provenance of the object, there is nothing to prevent me from registering a duplicate or a flat out fake. Assuming the act of registering an object in some way guarantees the object is actually yours or even real would be a terrible mistake.

Preventing Duplication

In some instances, as with digital art, it may be possible to tag the original object such that duplicates can be identified, but no technology will prevent duplication in the digital age. When the digital item is included in the immutable ledger, then anyone can grab a copy.

Preventing Unauthorized Distribution

As identified above, making copies of a digital object is simple. Duplicating that object is also simple, but utilizing that copy might be managed if the actual delivery or presentation requires a special application. In theory, a smart contract might encapsulate the digital item in a secured PDF format (or some application that is even more secure) and then send the unlock keys when a purchase or rental is entered into, although Mercator is not aware of any NFT platform that performs this feature as yet.

Risk of Fraud

This is perhaps the weakest link in NFT implementations today. Criminals create duplicates and even fake originals supposedly by famous artists and then falsify the provenance. No technology, including immutable ledgers and smart contracts, can validate the provenance of a digital item. In essence the NFT infrastructure enables this criminal activity by expanding that activity into the world of e-commerce. NFTs also enable the identity of the seller and buyer to remain undisclosed, so prosecution in this instance would be impossible - buyer beware!

Regulatory

If you discover that the item purchased was counterfeit, it is unclear how that can be prosecuted under existing laws. First, the identity of the seller may be unavailable. Second, the law assumes the buyer and the seller are in the same jurisdiction. If this was an international transaction (which may also be unknown) it is highly unlikely existing laws will operate as you hoped they would. It has already been reported that there have been many intellectual property infringements in the NFT world.

Governance

The hype around blockchain technology - that it is distributed with no central control - is not true for blockchain and even less true for NFTs. The blockchain needs to be upgraded with new features on a regular basis. If the blockchain in question isn't already operating based on quantum resistant cryptography, then a major upgrade will be required in the next seven to ten years. Mercator expects some of the smaller blockchain implementations, including those running unpopular cryptocurrencies, will fail to be upgraded. The NFT infrastructure requires even more management and operates more like an exchange. Remember, the exchange is where almost all crypto thefts have taken place. Two primary areas of concern would be maintaining and upgrading smart contracts that manage the asset as well as external vaults that store digital representations to assure longevity.

Environmental

Lastly, there is the environmental impact created by the basic operation of the blockchain. It has been estimated that one small image stored as an NFT could consume as much power as is used to power a home for two months. Since that environmental cost is simply additive to all the different use cases that are implemented on Ethereum, it is unlikely the environmental impact will weigh heavily on most of those considering the utilization of NFTs.

Conclusion

So should you buy a non-fungible token? If you do, you should know exactly what it is you are buying, what you aren't buying, and if it protects you under existing laws (for the most part it doesn't). Recognizing that acquiring an NFT doesn't guarantee the provenance of the object or prevent its duplication and distribution, what does an NFT provide? When everything is operating properly, and you are not mistakenly interacting with criminals, then NFTs provide an automated mechanism for owning, selling buying, and profiting from digital goods.

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