What are digital assets?
There is no settled definition of digital assets. But a good starting point is the description used by the Financial Markets Law Committee:
“… The term digital asset is an umbrella term that…extends to a wide array of items of value, including social media accounts, online bank accounts, photography, software applications, databases, logos, illustrations, animations, audio-visual media, presentations, spreadsheets, cryptocurrencies and DLT tokens, digital paintings, electronic documents, electronic mail, and websites.
“The term digital asset includes established and innovative technology, as well as established technology being used in wholly new ways for novel purposes.”
So taking the definition at its widest, digital assets have existed for as long as people have been recording and processing information in digital form. It potentially includes everyday things like email accounts or digital photographs.
Many of these more established digital assets are, arguably, already protected and have a reasonably settled status under English law. The creator of a digital database, or a writer of software code, already benefits from intellectual property rights.
In recent years the scope of what constitutes digital assets, and the way that the term is used, has become blurred. The term is increasingly used to refer to items which are created, stored, and traded via digital means, such as cryptocurrency and NFTs, commonly known as crypto assets.
This note focusses specifically on crypto assets. Whilst the legal issues which arise in relation to digital assets can apply in a much wider context, crypto assets generally have a greater barrier to entry in terms of understanding the issues around them. The novel way in which they are created, stored and traded means they do not necessarily fit easily into commercial and legal norms developed over the last few hundred years.
What are crypoassets?
The FCA defines cryptoassets as “cryptographically secured digital representations of value or contractual rights that use some type of distributed ledger technology (DLT) and can be transferred, stored or traded electronically.”
It then further breaks them down into:
- regulated tokens (assets / investments which fall within the FCA’s regulatory perimeter); and
- unregulated tokens (those that do not).
Many of the most widely-known crypoassets are unregulated tokens, including Bitcoin and other cryptocurrencies.
The above is a good working definition for legal and regulatory purposes, but it doesn’t help in understanding what cryptoassets are in a more practical sense. In order to do that, we need to consider distributed ledger technology, which underpins the creation, storage and transfer of cryptoassets.
Distributed ledger technology (DLT)
A detailed technical explanation of DLT is beyond the scope of this note.
Perhaps the best way to approach this is to look at the key characteristics of a DLT system:
- At its core is a distributed ledger. This is, essentially, a shared database.
- The ledger is decentralised across a network. There is no individual central administrator or authority which maintains the database or controls updates being made.
- The ledger is distributed - there is no one true original of the ledger. It is spread across different devices (or nodes) in different geographic locations which are connected through a peer to peer network (rather than a connected central system).
- Each node replicates and maintains an identical version of the ledger.
- Generally all participants in the system can, subject to having the correct digital key, review information on the ledger.
- In order to update (or write) the ledger, an update has to be initiated in accordance with the protocols which have been established for that particular DLT system.
- The data contained in the update is transmitted to the various nodes and an automatic consensus algorithm is used across the nodes to verify how the ledger should be updated. Once the consensus has been determined, each node updates its copy of the ledger in the same way.
- Once this update has taken place, the relevant entry on the ledger is protected cryptographically and – in theory (and, to date, in practice) - cannot be amended.
The most widely known example of DLT is the blockchain.
Blockchain and DLT are not exactly the same – blockchain technology is one example of a distributed ledger where, as the name suggests, the data is stored in a chain of blocks (with each new block containing information referring back to the preceding block and forming a chain).
Where it all started
At this point it is worth reflecting on the origin of cryptoassets and distributed ledger technology. The generally accepted starting point is the publication of the Bitcoin White Paper on 31 October 2008 by Satoshi Nakamoto (whoever he / she / they / it are….).
Bitcoin, and the blockchain / DLT technology underpinning it, was originally conceived as an electronic cash system, an alternative medium of exchange to fiat currency to facilitate virtual transactions. It was not conceived as an investment asset in and of itself.
The intention was to remove the need for a trusted third party (a bank or equivalent financial institution) to facilitate electronic transactions, enabling these to be dealt with in a frictionless and more efficient manner and to avoid manipulation of value by a trusted third party, such as a central bank currency devaluation.
Initially, its main purpose in practice reflected this idea as a medium of exchange. The comparitech.com website published an article in April 2021 which included the following:
“When Bitcoin was first introduced in 2009, each coin was worth $0. The first known commercial transaction of the cryptocurrency was the purchase of two pizzas for 100,000 bitcoin. Today, that’s equivalent to $5.9 billion — more than the GDP of a small country (Fiji) and an astronomical amount that would make you the 108th-richest person in America.”
Clearly we are operating in a different world now, not just in terms of absolute value but where cryptocurrency is treated as an investment asset in its own right, and the DLT systems which underpinned the introduction of Bitcoin are put to much wider uses.
How does Bitcoin work?
So how does a DLT system work in practice? Bitcoin, perhaps the best known cryptoasset, is a useful case study here.
Bitcoin is operated using blockchain DLT.
The main data update, or writing, for the Bitcoin ledger occurs through a process called mining.
Miners create blocks to be added to the chain by grouping proposed Bitcoin transactions together.
To be accepted and verified by the other nodes on the Bitcoin peer to peer network, a new block also needs to contain a proof of work (which involves using large amounts of computer processing power to resolve a complex mathematical problem).
Once a block has been successfully verified, this becomes part of the blockchain – it is linked to the previous block and becomes part of the ledger.
The blockchain is a chain, rather than just a group of entirely separate blocks recorded on the same ledger, as each block on it contains information relating to the previous block.
A successful miner who creates a new block receives (amongst other things) a reward of newly created Bitcoin – this is how all Bitcoin have been created to date.
The number of newly created Bitcoin awarded per block is reducing over time. There is a finite number of 21 million Bitcoin.
What is an NFT?
NFT stands for non-fungible token. As with much of the jargon in this area, this does not have a settled legal definition.
In general terms, an NFT is a token that represents the proof of ownership of a digital asset.
Although NFTs may be issued as part of a series (so there will be a, potentially quite large but limited, number of NFTs which are substantively the same), each individual NFT is unique.
So depending on the particular NFT issue, the unique feature of a particular token may simply be an identifying number – the same principle used for limited edition issues of physical works.
How do NFTs work?
NFTs are issued, stored and transferred using DLT.
As far as individual owners of NFTs are concerned, DLTs are held in digital wallets - essentially a more user-friendly way of recording and visualising records of NFT ownership and transactions which are maintained on the relevant distributed ledger.
Underpinning each NFT is a smart contract between the issuer / transferor, and the acquirer. A smart contract is primarily based on computer code rather than anything verbal. Smart contracts can incorporate more standard contractual provisions, but it isn’t unusual to see the issue or transfer of an NFT supplemented by more conventional contractual drafting.
The smart contract is the means by which transactions involving NFTs, whether transfers or issues, are recorded on the relevant distributed ledger.
Once a smart contract has been initiated and appropriately verified on the relevant distributed ledger, it will then become self-executing.
How are NFTs used in practice?
NFTs are often, but by no means exclusively, issued in connection with artistic works (digital or physical).
But it isn’t necessarily helpful to conceptualise ownership of an NFT as a direct digital equivalent to owning a physical artwork.
Often, but not always, the motivation for acquiring an NFT connected to a piece of digital art will be entirely different to the reasons for buying a purchase of real life art – it may be related more to other rights which the holder of the NFT enjoys (or even more nebulous factors such as the status which ownership of the NFT conveys), rather than appreciation of the art in and of itself.
The digital asset which the holder of an NFT owns will be a bundle of rights which varies on a case by case basis.
Using artwork as an example, the owner of an NFT connected to an artwork may or may not acquire copyright in the underlying work depending on the terms of the particular NFT.
More generally, the variations on what owning an NFT actually means in practice are almost infinite. At one end of the spectrum, the owner of the NFT may benefit from certain tangible rights or rewards which it is able to enjoy in the real world. At the other end of the scale, acquiring an NFT may not convey any tangible benefit or utility of any kind, other than the benefit of being able to assert ownership of the particular token (and potentially trade it, for example).