Launching a DeFi protocol?
Reach out to us for regulatory consultations and compliance checks.
Decentralised Finance (DeFi) is an umbrella term for financial applications built on blockchains and distributed ledgers. As opposed to traditional financial systems which are state controlled, DeFi protocols are usually open and transnational. For this reason, they offer attractive alternatives for those who consider existing banking infrastructures opaque and centralised. These applications allow people to have control over their crypto assets by offering a suite of services such as staking, borrowing, lending, leveraging and so on. Within this broad ecosystem, there are multiple niches such as fintech, stablecoins, collateralised instruments and remittance payments.
In simple terms, NFTs do not function as mediums of exchange but as digital collectibles which carry symbolic value. Owning a “Cryptopunk” or a “Bored Ape”, for instance, signals membership of a rarefied group which has ‘made it’ in crypto. Because of this symbolic characteristic, the monetary value of most NFTs is impossible to predict. At a given point of time, it is purely a function of dominant cultural trends.
Smart contracts (coded agreements which self-execute when their initiating criteria are met) are at the heart of DeFi. Since a majority of financial functions are reducible to mathematical conditions, blockchains offer a seamless way of automating them without the need for a centralised authority such as a bank. For instance, imagine a simple contract which has been programmed to exchange token A with token B if the value of the former falls below 1$. As is clear, very complex financial applications (from derivatives to insurance) can be built by simply changing the parameters in the above example.
The key aspect of this technological infrastructure is disintermediation, i.e. users can deploy their crypto assets in any supported DeFi application without the need for state authorisation. The application itself may impose certain internal rules (lock-in periods, staking rewards etc.) based on its own tokenomics. While it is true that lack of expertise and regulatory oversight make all such systems inherently risky, it can also be argued that owing to the transparent nature of blockchains, users are free to trace the source of systemic risk (such as bad loans) and divert liquidity away from it - a freedom they hardly ever exercised with respect to traditional banking systems. Ultimately, the onus falls on the end user to research the protocol he is using and understand its pros and cons before deploying assets on them.
While considering the legal implications of NFTs, it is crucial to underscore that every ‘token’ is a representation of something. In the traditional legal sense, a registered and notarised title deed represents title to the house. In a similar fashion, a negotiable instrument represents a transferable debt payable to the bearer. Such examples tell us that ‘tokenisation’ already has a rich and variegated history which is not only recognised in, but sanctified by, the law.
With the rise of NFTs, tokenisation has simply moved into the digital realm. While the token itself is digital, it can be made to represent any real asset. For instance, the rules of title ownership in a hypothetical jurisdiction may mandate that property-registration occur on a particular blockchain once adequate consideration is transferred. Here, the NFT would merely represent ownership of a real asset which has been otherwise guaranteed and sanctified by the law. To say that NFTs themselves guarantee ownership of anything remains a dubious claim. Even in the case of digital assets, authentic NFTs are best understood as those which have been digitally signed by a recognised artist/issuer. In the cryptopunks example considered above, note that all the “unique attributes” are merely visual traits. As such, they can be (and in fact have been) easily duplicated. This implies that the “proof of ownership” a cryptopunk holder actually possesses is merely a claim to a token digitally linked to (or ‘signed by’) LarvaLabs.
As is evident from the foregoing, the most far-reaching legal consequence of NFTs lies in the world of intellectual property rights. Because of their ability to generate unique tokens, blockchains provide robust tools for digital rights management. This explains the eagerness of big brands, artists, media platforms and gaming companies, etc. to move into this space.
Having said that, there are many grey areas in which it is not possible to determine whether an NFT holder is the actual owner of an underlying asset. Instances of copyright and trademark infringement, for instance, are quite widespread in the cryptoverse. Oftentimes when an NFT project is successful, many iterations of it may be released such that they become barely distinguishable from each other. The copyright issues such projects raise need to be analysed on a case to case basis, and in light of evolving precedent. If any commercial use-rights flow from the NFT project (for instance the right to specific merchandise or access to events) then they must be carefully drafted before being promised to the NFT holder. Presently, in our view, most NFT projects do not take these challenges seriously, and therefore carry the risk of serious legal conflicts in the future.