Metaverse make-up

Blockchain and the contribution of cryptocurrency to the metaverse

In the metaverse, blockchain is seen as a critical technology to the expansion of a decentralised infrastructure that includes an independent digital economy within the metaverse. Blockchain-based non-fungible tokens (NFTs) also create the potential to empower a player through the possibility of owning in-game assets that are – as termed by Newzoo - "persistent". Specifically, NFTs create a way to "stamp" digital content with authenticity, authorship and ownership. Video games companies could use NFTs to sell official digital merchandise or individuals could create the tokens for user-generated content to allow the authorship (or co-authorship for collaborations) of such items to be tracked.

NFTs and blockchain

Blockchain and smart contracts have emerged as major disruptive technologies in recent years, and cryptocurrencies, NFTs and other digital assets are fast gaining mainstream acceptance.

Blockchain is best described as a decentralised digital platform or database for securely storing information and recording transactions. Those records are protected by powerful cryptography and are almost entirely immutable. Blockchain was originally created as the software "infrastructure" for a decentralised digital currency, available to anyone and operated by its users without the involvement of banks or other financial institutions. Applications of blockchain have since diversified widely, but cryptocurrencies and tokens remain one of the major uses of this technology. Cryptocurrency tokens or coins carry financial value but blockchain also enables the creation of a digital token that represents something unique and specific. All transactions using that token can be logged, making it possible to trace the provenance and history of the underlying asset over time, and as it changes hands.

NFTs are a relatively recent phenomenon and draw on that functionality to create unique tokens that represent a specific digital asset. NFTs are not simply tokens – they typically also incorporate coding that fixes how interactions with the content can take place. The coding itself is also locked on to the blockchain, and self-executes – known as a "smart contract".

For example, the smart contract may provide that access to the underlying asset is only permitted following receipt of payment or that the original creator of the digital asset receives a payment whenever the NFT is sold on. There are, accordingly, two sets of interactions with the NFT that will be logged – ownership of the token itself and interactions on the terms of the related smart contracts. Most NFTs are built and held on the Ethereum blockchain, which was specifically created as an infrastructure for smart contracts.

Cryptocurrency in the metaverse

The use of NFTs enables digital content to be stamped as unique, thereby creating scarcity (and therefore enhanced value) around metaverse content that would otherwise be infinitely copiable and infinitely available. At face value, this may seem no different than when in-game items are noted as "rare" in games-as-a-service models like Destiny 2 or Outriders. However, the notable difference with NFTs is that real-world value can be attributed to them and provide an additional level of authenticity. For example, just as a football shirt worn by a player in a World Cup final has monetary value for collectors, so NFTs make it possible to purchase and own the skin worn by an esports player when they won a major tournament, with a blockchain log of its provenance.

This "captured value", in the form of the NFT, could also give rise to potential new monetisation models such as peer-to-peer marketplaces where value fluctuates. Official peer-to-peer marketplaces would assist in reducing the need for what are considered "black marketplaces" (for example, e-commerce platforms facilitating the illegal sale of in-game items or currency) and additional royalties could be charged on subsequent sales of items. Newzoo notes that:

… the long-term implications of NFTs are exciting to consider for games, the metaverse, and esports."

Furthermore, Newzoo highlights the potential for NFTs carried on an open blockchain to facilitate the portability of in-game assets across into other games or worlds within the wider metaverse – not currently possible between closed gaming worlds. It notes that this:

... aligns closely with the metaverse ideal of identity and ownership that exists games, not just inside individual game silos."

In addition to supporting the intra-metaverse economy, NFTs also enable value that is created in the metaverse to be exported into the real-world economy, which has not previously been possible. Given the increasing interest and values for some NFTs in recent real-world auctions, this could operate as a further boost for metaverse growth. As Newzoo notes:

The surge of interest in NFTs is sowing the seeds for the metaverse foundation and evolution."

Digital assets: legal status and issues

While there is no English law that regulates blockchain technology, the legal status of blockchain-based digital assets was given a boost when the UK Jurisdiction Taskforce announced that crypto-assets can be a form of legal property under English law and smart contracts are capable of forming enforceable contracts. There is also a growing body of case law that has further clarified the rights that attach to these digital assets, including ownership and whether – and where – a holder can obtain legal remedies.

NFTs have characteristics that give rise to complex legal questions. While NFTs themselves are unique and cannot be counterfeited, as a matter of law they do not prove ownership of either the underlying asset or, necessarily, any of the rights (for example, copyright) associated with it. Creation of an NFT is not a formal registration in the legal sense, such as registered intellectual property (IP) rights like patents or trade marks. Instead, the holder has a tokenised version of that asset (that is, metadata). What a holder owns will depend on the coding or smart contracts that make up the NFT. For example, an NFT may define how a holder is permitted to use a particular asset (for example, a song or artwork), or may require a payment to be made to the artist whenever the NFT is traded, or accessed, etc.

Nevertheless, the creation or ownership of an NFT might help to prove authorship or ownership/co-ownership of the underlying asset and its chain of title (if assigned). As with all blockchain-logged data, the key is to be able to show that the data that was locked into the database was true, correct, or original in the first place.

At the moment, there are various dangers regarding the misuse of NFTs as there is no requirement to prove ownership of a digital asset when creating one. There may be opportunities for third parties to misappropriate digital content by creating an NFT and proclaiming it to be their IP. There are examples of such activity happening in the digital space already. Although untested, there is a growing opinion that the mere creation of an NFT (entering metadata onto the blockchain) would not constitute an IP infringement. However, that is not to say that other acts occurring before the creation of an NFT (for example, uploading the infringing content to a server) or the sale and/or subsequent use of an NFT would not infringe a right holder's IP rights, subject to the facts surrounding such circumstances.

Regulating digital assets and NFTs

The regulation in this area has tended to be technology agnostic. The fifth Money Laundering Directive imposes anti-money laundering requirements on virtual currency exchanges and custodian wallet providers, but beyond that, digital assets, including NFTs, are not specifically regulated.

However, as with any token, the features of an NFT or the activities that are being undertaken in connection with it could trigger regulation if they correspond to regulated activity. While exchange tokens and utility tokens will typically fall outside the regulatory perimeter, security tokens (which exhibit features of traditional investment instruments such as stocks and shares in a company or units in an investment trust) will fall within it.

The key will be to check the rights that a particular NFT carries and to ensure that it is structured in such a way as to avoid corresponding to a regulated instrument, such as e-money or a stablecoin. NFTs remain a nascent concept, with scope for wide variation and innovation, but, generally speaking, the focus is on creating a tradable asset rather than a financial share in the value of that asset. (In some contexts, purchasing an IP right, such as a patent, that carries the right to a revenue stream, such as annual royalty payments, has been considered to be a business purchase but IP transfers are not considered to be regulated financial services activity.)

Green credentials?

The carbon footprint of Bitcoin and other cryptocurrencies has been making headlines recently. Video game businesses are increasingly conscious of their green credentials and, happily, there is good news. As noted, most NFTs are created on the Ethereum blockchain. The high energy demand of Bitcoin and Ethereum is driven by the "proof of work" model used to validate transactions on the network.

Ethereum has discussed moving across to the far less energy-intensive proof of stake (PoS) model for some time. This requires miners to hold an investment of the relevant cryptocurrency as proof of their goodwill and from which penalties can be taken if they act badly. Typically, miners' ability to mine is proportionate to their stake, so it is increased by greater investment in the coin, not by purchasing more processing power and the energy to run it. In a PoS system, the more powerful miners hold more of the currency so the security of the system is protected by their correspondingly greater disincentives to attack it. It is not clear when Ethereum will make the switch to PoS, but its carbon footprint should be significantly improved when that change is made.

Ethereum is a public, open-source system that anyone can use – a characteristic that has fed into its popularity and wide use for NFT creation. It is possible to build private blockchains that have much simpler validation models and far lower energy consumption, but the logic of such systems includes controlling access and they are neither open source nor universally accessible. This kind of private NFT infrastructure would need to be built as an integrated part of the metaverse, with access controlled in parallel to access to the platform.

Decentralised ownership

As Newzoo emphasises:

Decentralised ownership is sowing the seeds of a new era of gaming, where players will be able to own, collect, and trade their items outside of games and across games."

While it is still a technology in its early adolescence and has environmental concerns in the short term, the potential of blockchain is undeniable in the context of the metaverse. The closer one gets to the real world the closer regulatory institutions will start looking at such systems and there may be regulatory concerns regarding metaverse marketplaces giving rise to real-world profits. We have already seen with the recent "loot box" debate in games spreading around the world that regulators have concerns around video games mechanics mirroring those in the gambling industry. NFTs on their own may not be the root of this concern but may inevitably contribute to it as game developers adapt monetisation mechanics to the technology and this gives rise to further scrutiny from regulators.

Authors

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Catherine Hammon Digital Transformation Knowledge Lawyer Head of Advisory Knowledge, UK catherine.hammon@osborneclarke.com +44 207 105 7438

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Ian McKenzie Associate Director, UK ian.mckenzie@osborneclarke.com +44 20 7105 7558