Non-Fungible Tokens (NFTs) as Art Loan Collateral

Digital art, represented by NFTs (non-fungible tokens), made a spectacular hit in March with Christie’s auction sale of a collage by digital artist Beeple valued at $ 69.3 million (in ether).[1] The buyer is the founder of an NFT fund in Singapore. To get acquainted with the phenomenon, NFTs have been condemned as a scam based on a blockchain hype and advocated as a means of improving the economic standing of struggling non-celebrity artists[2]or announced as a sign that the ‘Metaverse’ depicted in Neal Stephenson’s 1992 novel Snow Crash is fast becoming a reality. Regardless of the varying responses to NFTs, it seems inevitable that financial institution lenders will be approached by customers looking to set up newly minted NFT-linked art collections as collateral.

Real world art loans are mostly made up of revolving lines of credit with works of creative visual art serving as collateral. These loans use a number of techniques to mitigate the art world’s persistent problems through authentication, changes in market value, the need to maintain a first priority security interest in the artwork, and the risk of theft or loss of victims. In the past, given the affluence and often outstanding identity of the borrowers under these credit facilities, the risk of default on these loans was generally considered to be relatively low.

In order for institutional lenders to have a sufficient level of comfort to consider issuing NFT-secured loans, a number of real-world techniques for evaluating loan renewal applications need to be reconsidered and somehow considered. These considerations include ways of managing origins and authenticity risks, regular assessments to monitor changes in value, perfecting security interests, and insuring against theft or loss.

To begin with AuthenticationReal-world certifications are of little use. By definition, an NFT is a unique “crypto asset”. However, this does not mean that every NFT is a unique work of art. In fact, multiple NFTs can be sold based on a single work, just as a real world artist can authorize to sign a limited number or prints of an original work.[3] To authenticate an NFT, the artist can include an electronic signature in the software code that forms the basis of the NFT.[4] It is also important to remember that an NFT is not the digital work of art itself, but a crypto-asset that consists of a “smart contract” based on a particular blockchain that “references” the asset it is in may be a JPEG or some other image file or video recording. Many NFTs do not hold ownership of the underlying work and do not transfer copyright, although they may contain rights to display non-commercial online. In the case of the sale of Cristie’s Beeple, the artwork itself was transferred to the buyer in the form of a JPEG of the collage artwork.[5] Tokens generally provide some sort of verifiable provenance of only the NFT itself, not the underlying artwork. An NFT can also impose license conditions on the NFT buyer, e.g. B. a license fee of 10%, which is to be paid to the artist for future resales of the NFT with profit. The specific “bundle of rights” and obligations conferred by an NFT must be analyzed by a lender with specificity.

Second, Assessments of NFT assets is likely to be challenging given the volatility of prices in the crypto environment. This is offset by the possibility that rapidly growing secondary markets for trading NFTs can help set a “market price”.

Third, in terms of Perfection of a Security Interest For NFT collateral, a lender can opt for perfection by treating an NFT as “Generally Intangible” under a local Uniform Commercial Code (UCC) ordinance and filing a UCC-1 Funding Statement. When a proposed borrower contacts a lender on the internet or on a blockchain, it can be difficult to determine the exact location of a debtor for the purposes of a UCC filing. In addition, the enforcement of a security interest that can only be perfected by filing is less secure: Since an NFT only lives in a blockchain, in which the guiding principle is: “Code is law”, an irreversible transmission in the chain by the borrower himself if this is done in a security agreement breach may result in a crypto asset being out of the reach of a traditional UCC foreclosure of general intangible assets. (The terms used here have their common meanings in most of the local provisions of UCC Articles 2, 8 and 9.) In addition, a security interest that is only perfected by filing is subject to a security interest that is perfected by “control”, as explained below.

Under Articles 8 and 9 of the UCC, lenders have other options to perfect and enforce a security interest in an NFT, using techniques originally developed for securities and more recently applied to cryptocurrency and other digital assets. For example, the lender could register the crypto-asset on behalf of the lender as part of a security agreement, but this is often unacceptable to borrowers.

A lender may want to consider an approach that is currently used for loans that are backed by cryptocurrency collateral. In relation to procedures originally developed for equity securities in the indirect holding system, a lender may require a proposed borrower to place the NFT or other digital asset in a “securities account” with a “securities intermediary,” generally a bank or a Trust company, transfers. Under a three-way account control agreement (ACA) between the lender, the securities intermediary and the borrower, the securities intermediary undertakes to treat the NFT as a “financial asset” in accordance with Article 8 (meaningfully any property, including a real asset), a ” financial asset ”within the meaning of Article 8, if the securities intermediary expressly agrees). When an ACA is in place, a security interest in the account and / or the financial assets held therein may be perfected in favor of the lender if the securities intermediary agrees to perform mandates (“Claims Orders”) from the lender. without further consent ”, whereby the lender is granted“ control ”within the meaning of Articles 8 and 9. By perfecting through “control,” a secured lender generally takes precedence over all other filing-perfected security interests. Additionally, the risk of an irreversible transfer of the asset down the chain can be mitigated by the securities intermediary’s commitments in the tripartite agreement that the asset (an NFT in our example) will only be transferred in strict compliance with the provisions of the ACA.[6]

As for Loss of accident, theftand the other vicissitudes that can affect works of art, note that in the case of the $ 69.3 million Christies / Beeple sale, the “original” JPEG was stored on the blockchain rather than locked in a museum vault to be. based interplanetary file system (IPFS). The NFT itself is on an Ethereum blockchain managed by the platform that generated it for the creator of the work, and there are already reports that some other platforms have inexplicably gone from the web.[7] There are also reports of NFT art theft on a popular platform[8]and a new industry of scammers has emerged to mold and sell NFTs based on works of art in which the NFT mints themselves have no ownership interest.[9] There will likely be a need for new and expanded types of cyber insurance to cover against such eventualities. The metaverse may be closer, but the dangers inherent in the glamor and brilliance of the existing art world will no doubt find new expression in the new one.

[1] An NFT is a digital asset that is present in a blockchain. A blockchain is a digital ledger that is verified with the consent of users without the need for a trusted authority. Most digital assets, including cryptocurrencies like Bitcoin, are fungible in the sense that units representing equivalent value are widely accepted in exchange, as can five pennies for nickel. In contrast, each NFT has unique characteristics and is identified by a specific digital signature of the originator that is embedded in the underlying code. See e.g. B. “Explain: NFTs are hot. So what are they? “and The Atlantic,” What Critics Don’t Understand About NFTs “(Comparing Reviews of NFT and Traditional Artwork).

[2] CNN, “NFTs Changed The Lives Of These Digital Artists”

[3] “Digital Asset”, “Smart Contract” (as defined on page 23) and other terms relating to Blockchain-Based Assets are used as defined in the Jurisdiction Working Group of the Innovative Digital Products and Processes Subcommittee (IDDPS) of the ABA Derivatives and Futures Law Committee uses white paper, updated December 2020.

[4] The Christie’s Beeple NFT was “encrypted with the artist’s signature, which cannot be forged and clearly identified in the blockchain”. See Beeple: A Visionary Digital Artist at the Top of the NFTs | Christie’s.

[5] I would.

[6] This article does not address a number of other issues that should be considered in the context of digital asset collateral. There have been reports that tokens representing partial interests in some art-related NFTs are in some cases held by other people. Such transactions raise, among other things, a number of legal and compliance concerns regarding offers and sales of securities under US or foreign law, the regulation of stock exchanges when assets traded are considered “securities”, the regulation of investment companies, brokerage Dealer and investment advisor on regulation, tax and compliance with BSA / KYC / AML.

[7] The Atlantic, “What Critics Don’t Understand About NFTs”

[8] The Verge, “Hackers Stole NFTs from Nifty Gateway Users”

[9] ArtNet, “A collective of NFTs of masterpieces without telling the museums that owned the originals. Was it a digital art theft or a fair game? “

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