Science & Tech Spotlight: Non-Fungible Tokens (NFTs)

by James · October 22, 2022

Table of Contents

Why this matters

Revenues from NFTs could exceed $130 billion by 2030, and NFTs can help advance the digital economy. But despite media attention and celebrity endorsements, they are poorly understood and the current market is subject to speculation and fraud. Also, a lack of NFT expertise in the federal workforce makes it difficult to deal with statutory and regulatory challenges.

The technology

What is it? A non-fungible token (NFT) is a digital identifier, similar to a certificate of ownership, that represents a digital or physical asset. Generally, a non-fungible asset is unique and cannot be exchanged for others. An NFT, like an original painting, has its own unique value. In contrast, fungible assets are interchangeable, such as dollar bills or units of a cryptocurrency.

The most widespread use of the technology is currently for digital collectibles, such as the NFT for a digital collage that sold for $69.3 million in March 2021. The use of NFTs for other applications is emerging (see Fig. 1). For example, NFTs can enable a decentralized marketplace for music or other creative work, allowing creators to collect revenue for digital assets directly and automatically, rather than through a third party.

Figure 1. Examples of common and new digital and physical NFT applications.

How does it work? NFTs generally rely on the following technologies:

ONE blockchain is a decentralized digital ledger that uses cryptography – such as encryption of data – to improve the security and duration of transactions.
An NFT marketplace is a website where one can create, sell and buy NFTs – like other online platforms that allow users to do business with each other.
ONE digital wallet is a contactless payment application that can store payment methods, identification cards, NFTs and more.

To create, or “mint,” an NFT, the creator uploads a digital file, such as a photo, image, or piece of music, to a marketplace. The marketplace runs a code to create a unique identifier – the NFT – and adds it to a blockchain, which verifies, stores and tracks it. Once created, the NFT can be sold, destroyed or kept as a record indicating ownership. Typically, buyers buy NFTs with digital currency, but legal tender, other assets or credit can also be used.

Most NFTs are not the asset itself. In the case of a physical asset, they represent ownership of the asset. For digital assets, they represent ownership of the unique code associated with or associated with the asset’s metadata – information about the asset, such as its creation date, size or where it is stored on the internet. In the case of a digital image, others may be able to view the asset or even download a copy, but the NFT proves which digital image is the original and can, along with other information, show who owns the NFT.

NFTs rely on smart contracts – computer code that automatically executes a transaction when set conditions are met. For example, a smart contract may stipulate that the original creator will receive a percentage of all subsequent sales of the NFT.

How ripe is it? NFTs were first created in 2014 for digital photos, but interest in them increased in 2021. One company estimated that 360,000 people had 2.7 million NFTs between February and November 2021. According to a market research company, the NFT market size was 50, 1 billion in 2021 and could reach $130 billion or more by 2030, largely due to growing demand for decentralized marketplaces and digital collectibles.

Some researchers suggest that current NFT buyers are primarily interested in reselling NFTs at a profit. As with collectibles such as first edition books and sports cards, rarity and popularity can drive the value of NFTs for collectibles.

NFTs can also offer opportunities to a wider group of artists and creators. For example, they can help artists sell their work without relying on a third party, such as a gallery. The decentralized marketplace can allow artists to take full advantage of their art and interact directly with buyers worldwide. And it can allow buyers to support artists’ free expression and autonomy.

Other NFT applications are emerging. For example, some researchers suggest that storing electronic health records as NFTs could give patients more control over who has access to their data and when or how to share it. One company uses NFTs to track and monitor consent for clinical trials. Individuals will be able to track and monitor their consent agreements in real time across various data sources. The company states that this will give individuals control over their personal information and allow flexibility to manage their consent. The company also believes that it will increase efficiency by reducing redundancy and the need for human involvement.

What are some concerns? Areas of concern with current NFT use may affect public trust and may hinder their expansion into new areas. Some users of the technology have bought collectibles of NFTs with the goal of making money, but like other investments, NFTs come with financial risk and have shown volatile prices. Cryptocurrency, which has fluctuated in value, is often used to purchase and set a value for NFTs and can exacerbate this volatility. NFTs are subject to artificial price manipulation, such as celebrity endorsements and illegal activities. For example, NFT owners can set up multiple digital wallets to sell NFTs to themselves, thereby inflating an NFT’s perceived value.

The federal government and private industry have also identified concerns related to NFTs. In March 2022, the President issued Executive Order 14,067 aimed at developing a comprehensive government approach to managing the risks and harnessing the potential benefits of digital assets and their underlying technology. Additionally, in March 2022, the Department of Justice charged two people in an alleged $1 million fraud scheme after they promised an NFT fundraiser to investors, then transferred all the money raised without making the fund available. At least one insurance company is considering options to cover fraud and other NFT-specific risks. Furthermore, some government organizations are considering how to protect and inform consumers about NFT risks. In April 2022, the Joint Chiefs of Global Tax Enforcement issued a bulletin on how to recognize money laundering and other illicit uses.

NFTs can also pose a risk to privacy. For example, without proper security measures, the assets in a person’s digital wallet could be publicly visible, which could reveal identifiable information. Users may also receive unwanted or illegal NFTs, such as NFTs linked to obscene content, because some transactions do not require recipient approval.

Another concern is the federal government’s longstanding difficulty in hiring and retaining a highly skilled science and technology workforce. Some researchers suggest that sufficient expertise can help inform policymakers as they consider what actions, if any, are necessary to regulate NFTs.

Possibilities

Decentralization. NFT creators and buyers can interact and set the terms of their transactions without the involvement of third parties, which can allow creators to keep a larger share of profits.
Digital economy. NFT applications can improve the efficiency of the digital economy. For example, they can facilitate the processing of records, help companies attract start-up funding and help match fundraisers with donors.

Challenges

Investment risk. Like other investments, NFTs come with financial risk and may have price volatility. Additionally, when individuals purchase NFTs on the Internet, they may not be warned of the risks as they would be for a traditional investment.
Illegal activities. Criminals can take advantage of users through fraudulent activity to steal NFTs or the assets used to purchase them. Smart contracts can pose similar cybersecurity risks.
Privacy. NFT information on distributed digital ledgers and in digital wallets may be publicly visible and reveal personally identifiable information.
Lack of federal expertise. NFTs are rapidly evolving. Many in the federal workforce may not understand current and emerging applications across various sectors, which can make it more difficult to identify and address statutory and legal challenges.

Policy context and questions

What, if anything, can policymakers do to better protect individuals or entities using NFTs, including through the use of regulatory or criminal enforcement mechanisms?
How can policymakers improve the expertise of the federal workforce to manage the use of NFTs and clarify the applicability of current statutory and regulatory frameworks for current and future NFT use?

For more information, contact Karen Howard at 202-512-6888 or [email protected].