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4 April 2022

NFTs and cryptoassets – 3 of 6 Insights

NFTs and real-world assets: trading in the physical

Clare Reynolds looks at the benefits NFTs can bring to real-world assets, particularly if legal issues can be resolved.

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Clare Reynolds

Clare Reynolds

Senior Counsel

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Much media attention has been devoted to NFTs uses for digital artwork and collectibles. NFTs that represent real-world assets have received less focus. Yet they have the potential to open up whole new models of owning and trading assets.

We look here at the benefits NFTs can bring to real-world assets, some of the existing legal questions, and developments that might help this use case reach its potential.  

Trading assets with NFTs

NFTs are distinguishable, unique assets, that are sometimes described as "tickets" to an asset, be it a piece of digital art or a real-world asset.

A secure way to trade luxury assets

Take the example of high value assets such as a luxury Rolex Daytona watch or a first edition of a book.  Investment and trade in such items is becoming increasingly popular among both investors and collectors who want to own a part of rare or novel items. To preserve its value, the watch or book needs to be stored securely.  Each time it is physically delivered to a new buyer involves risks and costs of physical delivery.

What if those parties could instead trade an NFT that represents ownership of that watch or book, saving the parties the cost, time and risks associated with physical delivery, or potential fraud risk of an internal ledger? The blockchain and cryptographic hash function would record a secure and immutable record of ownership (as opposed to a simple internal ledger, which can be vulnerable to fraud, edits by a centralised party, or hacking by malicious third parties).

New models of ownership and trade in physical assets

Another model for ownership of high value or novel assets is 'asset fractionalisation' or 'asset tokenisation', where ownership of an asset is split into multiple parts each represented by a 'token'. This enables multiple parties to share ownership, where purchasing the entire asset might be out-of-reach to one person alone. The tokens can then be traded on the blockchain (or using other distributed ledger technology). Depending on how this is structured, the token might be fungible or non-fungible; for example a token for a specific page of a first edition Beatrix Potter would be non-fungible, whereas a token for one of 100 identical parts would not.

An intelligent asset: advantages of NFTs for physical assets

NFTs for physical assets have the same characteristics and features as NFTs for digital assets. This presents a number of advantages for trading physical assets, including:

  • Demonstrating provenance. Novel assets such as a rare antique or original painting by a famous artist derive their value from their authenticity and provenance. NFTs can act as a digital record of authenticity and provenance on the blockchain; each sale, trade and owner is built into the NFT's ledger, and the NFT's metadata might contain a digital certificate of authenticity. By resolving uncertainty around as asset's provenance, an NFT might actually enhance the asset's value.
  • Security and immutability. As NFTs utilise DLT, the transaction record is stored on an immutable distributed ledger that offers a tamper-proof record of asset ownership and transfers. NFT holders will still need to ensure that their private cryptographic keys are sufficiently secure. However, the use of DLT and cryptography provide additional security protection compared to, for example, a single centralised asset registry.
  • Decentralisation and disintermediation. Traditional means of buying and selling collectibles are often highly centralised. For example auction houses can charge a premium for auctions of luxury goods because of their role validating the items' provenance and bringing potential buyers and sellers together in a centralised auction. By contrast, NFTs can provides a decentralised means for demonstrating provenance, while also supporting trade across decentralised networks.
  • Smart contract integration. NFTs can be embedded within smart contracts to provide added utility and automate trade. For example, a smart contract could provide that transfer of a physical asset NFT self-executes once the buyer has provided the necessary KYC documentation, helping to reduce transaction risk and the need for intermediaries.
  • Monetisation of secondary trading. Smart contracts can also be programmed to enable royalty payments upon secondary sale. For example, an NFT representing ownership of a rare sculpture could be programmed to allow the original sculptor to receive a percentage each time the sculpture is sold.
  • Creative possibilities. As well as representing ownership, NFTs can enable other ways for holders to interact with items, such as embedding additional digital assets in the token itself or functioning as tickets to exclusive content or events. For creators, NFTs can therefore act as a vehicle for distributing further content.
  • Accessibility and inclusive growth. NFTs can open up new avenues of ownership and participation with assets that might otherwise be out of reach to a single collector. That might be by enabling a book collector to own a page of a rare first edition, or enabling liquid trading of assets across continents and social divides.

Despite these advantages, the law has not developed as quickly as the multitude of case uses for NFTs.

The legal status of digital assets and the problem of possession

The legal status of digital assets such as NFTs is important.  With some NFTs selling for millions of pounds, questions including how rules applicable to other types of property (such as succession on death, vesting of property on personal bankruptcy, tracing of assets etc) have practical consequences.

For example, can physical asset NFTs qualify as 'property' with the same legal rights as the underlying asset? English courts have shown flexibility in recognising certain digital assets, including cryptocurrencies, as capable of being a form of personal property.  Less clear is how digital assets fit with the two broad categories of personal property, 'things in possession' or 'things in action', or whether there is a third category of property.

Whether an item is capable of 'possession' has practical consequences, including for how the asset can be transferred and the remedies available to protect it. Currently, English law (like that of many other jurisdictions) does not recognise intangible things as being amenable to possession, in the same way that physical assets can be. As a result, currently NFTs cannot be 'possessed' under English law, meaning they do not benefit from rights or obligations inferred in property that can be possessed, and cannot necessarily function in the same way as their real-world equivalents; the Law Commission refers to this as the "possession problem".

These important questions (and others, including relating to ownership, transfer, and taking of security) are the subject of the Law Commission's project on digital assets - see our earlier briefing here.

Linking an NFT to a physical asset

Further, English law does not currently provide a legal mechanism for the 'linkage' of an NFT to the underlying physical asset it represents. This means that for NFTs subject to English law, there is currently no established legal mechanism by which the transfer of an NFT representing a physical item from one digital wallet to another can have the same legal effect as the parties transferring possession of the item itself.

Take the Rolex Daytona as an example. As the watch is a 'thing in possession', ownership of the watch could be transferred from the seller to the buyer by delivering the physical watch to the buyer. By contrast, an NFT representing ownership of the watch cannot be possessed, and English law does not recognise a way to 'link' the NFT with the watch. A transfer of the NFT from the seller's wallet to the buyer's wallet will therefore not necessarily transfer ownership of the watch itself.

There are potential contractual workarounds. As a matter of private law, the parties can contract to transfer title from the buyer to the seller, provided they satisfy the necessary legal requirements to do so. However where they do not, it is less clear how the transfer of ownership of the tokenised asset operates from a legal perspective.

Other jurisdictions have implemented statutory frameworks to provide such a mechanism. In particular, Liechtenstein has introduced technologically-neutral legislation to recognise the innovative "token container model", that enables a token to effectively represent whichever assets (whether stocks, physical assets, or real estate) are included in the 'container'. The relevant asset-specific laws continue to apply. The model provides a framework for the tokenisation of pre-existing legal rights; whoever owns the token owns the assets in the container.

It remains to be seen what approach will be taken under English law, and whether the Law Commission's work on digital assets might recommend changes to the law.

Electronic trade documents and the Law Commission's proposed Bill

In international trade, could NFTs help with tracking the movement of goods through the supply chain and digitalising existing paper-based trade processes? In traditional global trade shipments, the consignee presents a bill of lading to the shipper to indicate legal ownership and transfer possession of the goods, which would need to be carefully verified in order to serve as proof of ownership. Tokenising this bill of lading into an electronic NFT-based bill of lading could enable a more secure and reliable way to verify ownership and transfer possession of goods.

However, the Law Commission recognises that English law presents a barrier to such adoption, describing the current law governing trade documents as "archaic, inefficient and wholly unsuited to an increasingly digitalised world".  In particular, the possession problem means that as electronic trade documents currently cannot be possessed, they cannot function in the same way as their paper counterpart.

Parties have developed contractual workarounds to this problem using multipartite agreements. However, such contract-based electronic trade documents are only binding on those parties that have contracted with each other. By contrast, possession of a paper trade document gives proprietary rights which are enforceable "against the world".

To address this problem, on 16 March 2022 and following an earlier consultation, the Law Commission recommended changes to the law to enable certain electronic trade documents to have "the same effect as the equivalent paper trade document".  It proposed a Bill which would recognise that a person can possess qualifying electronic trade documents that meet certain criteria. Although the Bill is technology neutral, certain of these conditions appear well suited to the application of NFTs. For example, the requirements that:

  • the document is identifiable from any copies.  NFTs are unique, distinguishable assets, which can be verified on the blockchain, enabling digital verification of the true document as well as its transfer to the person exercising its control
  • the integrity of the document is protected from unauthorised alteration. The recording of transactions on the blockchain enables a tamper-proof history of previous transactions.

The above is of course a simplification; international trade involves complex supply chain procedures and regulations. However if the Law Commission's Bill were to be adopted, it could help pave the way for the use of NFTs and DLT to help digitise and reduce fraud in paper-based trade.

Legal and regulatory considerations

As with the Liechtenstein container model, the underlying legal and regulatory issues relevant to the asset themselves will continue to apply. These might include IP considerations, advertising regulation and consumer regulation, for example. NFT businesses will also need to carefully consider whether the arrangements are in-scope of UK financial services legislation, including on anti-money laundering, financial promotions, and in the case of asset tokenisation, collective investment arrangements.

Overall, NFTs could offer wide-ranging utility for an array of innovative real asset use cases, with practical benefits beyond efficiency improvements. Addressing the existing uncertainties under English law would help realise their full potential.

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