ELP Podcast Series - Non-Fungible Tokens (NFTs):Understanding the Basics

 While nowadays one keeps hearing about cryptocurrency, the concepts of non-fungible tokens and smart contracts have also become quite popular. But there remains a lot of ambiguity as regards what exactly are NFTs and Smart contracts, how do they actually work and how are they practically used and applied in the real world? Only once these fundamental questions are answered, can someone truly attempt to rationalize about the taxation and regulatory framework governing these technologies. 

Keeping this in mind, in this part of the podcast, we will delve on the technology behind Non-Fungible Token or what is commonly known as NFTs, which will help in contextually understand the recent taxation introduced by the Indian Government on Virtual Digital Assets, as also, the possible regulatory framework which one can imagine may apply to this technology in the future. 

In the second part of this podcast, we will use the same lens to examine the concept of Smart Contracts, the application of smart contracts and the potential complications that could arise when the existing legal framework is sought to be applied to this technology.

Transcript

INTRODUCTION:

Hello everyone, I welcome you all to today’s edition of ELP’s podcast on NFTs and Smart Contracts. In today’s podcast, we will discuss on the technology and various use cases of NFTs. 

In parallel to the crypto currency buzz, NFTs – more commonly known as non-fungible tokens are making their own space in the virtual world. A lot is spoken and heard about NFTs, especially amongst celebrities, but there remains a lot of ambiguity on what exactly is an NFT, how does it work and what are the various use cases of it? 

In addition to this, a new concept of Smart Contracts is evolving rapidly under blockchain technology. So, NFTs and Smart Contracts which are making their own space in the digital world are still alien concepts to many of us.  With the Government of India now proposing to levy Income tax on income earned from transfer of “virtual digital assets” -VDAs- which also includes an NFT, it will be critical to understand the various aspects of NFTs. It is equally important to understand how smart contracts could be covered within the ambit of a VDA. 

In this background, we thought it would be important to take a step back and understand the exact nature and functionalities of NFTs. So, in today’s podcast, ­­­­we will throw light on conceptual and fundamental aspects of NFTs.   

NON-FUNGIBLE TOKENS:

Question 1: What exactly is a Non-Fungible Token and how does it work, what are people exactly purchasing when they purchase an NFT?

Traditionally, ownership of things has been in physical form. Today, NFTs have changed that traditional mindset of owning things physically. NFTs are an exciting new way of owning things in a digital format – which is fully secure and registered in your name – that cannot be changed unless permissioned by the owner.   

So, in essence an NFT is a type of digital token or asset. Non-fungibility means that it can't be changed whenever it is created. It means that you can't split it up and it necessarily must be distinguishable from something else. So, NFT is a token that you own that doesn't change throughout time.   

It is important to understand how regulations will affect NFT’s it is first important to comprehend the technicalities behind an NFT and how it works. What exactly is a NFT?:

However, before doing that, it is important to take a step back, to understand blockchain. Blockchain is a form of Distributed Ledger Technology (DLT) and is essentially a decentralized and trust less system that can be shared and viewed by all users. Let me simplify this by saying that blockchain is a technology by which transactions - which may be in the form of any information or code or token or number are secured through the process of verifying/validating them in the network through the process of cryptography. For a detailed understanding of blockchain technology, you can also listen to our recent podcast on “Unfolding blockchain technology and derivation of cryptocurrency”. 

NFT's are just a piece of code or data that is owned by an individual or address on a blockchain. This piece of data can be bought and sold to different individuals or addresses.

This data is verified on a blockchain, so one can check the owner history of the NFT. So, it's important to know what you are buying when you buy an NFT. You are buying a piece of data that points to a server that hosts an image or video – which we all see or call as an NFT. But it is important to note that NFT is not the image of a particular item, but it's the specific piece of data or a code representing an image – that you own on the blockchain.  

So, the unique selling point of a NFT is that the code representing the image/video can never be changed – though it can be transferred. When one says that the code cannot be changed – it means that it is permanently registered on the blockchain and therefore it cannot be manipulated. 

Question 2: Thank you for that explanation! That simplifies the concept…..but some examples of NFTs will help us understand its characteristics more clearly, so can you please help us with some examples of NFTs?

(a)       Examples of NFTs: 

Sure, now having the background on how NFTs work, lets discuss few examples of NFTs: 

1.       The sale of first tweet: Jack Dorsey, who is Twitter’s CEO, sold the very first tweet on the platform  - which was made on March 2006-  as an NFT for nearly 3 million dollars.  

2.       Another example is of a Sports Collectibles: Top Shot is an NFT marketplace where basketball fans can buy, sell, and trade NBA moments. So far, the most expensive collectible traded is LeBron James dunking against the Houston Rockets (one of the teams in NBA), which was sold for over hundreds of thousand dollars.  

3.       Another use case of NFTs is Nike’s NFT sneakers example: Back in 2019, Nike Inc applied and secured a patent that will allow them to be at the forefront of the NFT craze. Owners of virtual shoes will be able to have them manufactured in the real world. Such NFTs provide some real-world benefits as well. 

4.       In fact, a lot of FMCG companies are using NFTs as marketing strategies for their brands: For instance, Pringles had created CryptoCrisp, which the brand calls its “newest virtual NFT flavor.” One such flavor was sold for a high price of almost 2,000 Dollars. The brand had released 50 more CryptoCrisp NFTs that were created by artist Vasya Kolotusha. Another, even more curious, example is Procter & Gamble’s NFT toilet paper. While these examples may seem absurd to many, these are but a few businesses that have garnered significant attention in the media for choosing to experiment in blockchain and increase their revenues.   

NFTs by various Indian celebrities: 

5.       Sale by Mr Amitabh Bachchan: The veteran actor was probably the first from Bollywood to jump onto the NFT bandwagon. In November 2021, Mr Amitabh Bachchan sold his NFT collection for about Rs 7.18 crore. The collectable series included his father’s famous poem “Madhushala”, autographed vintage posters of himself, along with his other works. According to sources, Mr Bachchan’s Madhushala poem recital was sold for a whopping rupees 7 crores while physical posters of Sholay and other movies that were personally autographed by him were sold for about rupees 70 lakhs. In fact, very recently, the Indian GST authorities raised a demand on Mr Bachchan on sale of NFTs. He ended up paying GST @ 18% on the sale value of the NFT, even though, at present there is no clarity on applicability of GST on cryptocurrencies and NFTs, but that’s a topic for another day! 

6.       Another example of Sale is by Mr Kamal Hasan: NFT marketplace Fantico recently announced that Tamil actor Kamal Haasan had offered 100-1,000 NFTs, including customised posters, avatars, among other things. 

So, considering the above examples, there are three (3) main things that make an NFT valuable or attracts attention from purchasers/investors:  

(i)                  First is – the NFT has to be unique or rare; 

(ii)                Second is – NFT has to be popular and its ownership history – i.e whether it was ever owned by or belongs to any famous personality;  

(iii)               And the Third is – if the NFT has a benefit attached to it  

Question 3: Sure, that was quite helpful to understand on the overall functioning of NFTs. Just one more question – where and how are NFTs sold and what is the medium of exchange? 

So, NFTs are sold on NFT marketplace exchanges – these are similar to cryptocurrency exchanges or virtual currency exchanges. In fact, a lot of cryptocurrency exchanges offer NFT trade as well. To name a few famous Indian NFT marketplace platforms: WazirX, Jupiter Meta, Beyond Life, Bollycoin (famous with Bollywood stars), Nifty Gateway, Rarible and many more. The modality of sale of NFTs is different from cryptocurrencies. Typically, NFTs are auctioned on the marketplace platforms, the highest bidder of a particular NFT gets to purchase the NFT.  As regards the medium of exchange, NFTs can be purchased with flat currency (i.e our actual money) or  cryptocurrency. 

Question and conclusion: Thank you ___ for providing us with these details, they were quite insightful! Moving ahead, since we have understood the basic concept of NFTs and how they work.