Non fungible tokens, the future of horse racing: A LEGAL PERSPECTIVE

Non-Fungible Tokens (NFTs) have been a feature of the digital world for the past decade. However, it is only since 2019 that NFTs have begun to dominate the sporting industry. Specific regulatory and legal framework in the UK remains subject to continuing development to incorporate further regulation on the sale, distribution and marketing of NFTs amid growing concerns of the environmental and long- term economic sustainability as the crypto technology becomes increasingly commercialised in sport company’s structures.

At the Centre of this has been the recent development of Zed run and Maxima. The crypto technology has enabled individuals to buy, breed and race virtual horses, costing and earning fiat currencies, including up to $125,000 (£93,000) per horse sale. Such digital racing platforms developed alongside NFTs, are still in the early stages of development, resulting in many uncertainties surrounding the global legal impacts of this new class of asset. It is therefore increasingly important for businesses and individuals to understand the legal characterisation of NFTs and subsequently how they are regulated, including therefore any potential legal issues that arises when buying and selling these digital assets.

This article will explain the legal risks of NFTs in the context of horse racing, setting out potential issues that should be considered when looking to invest in NFTs. However, it is firstly worth addressing what NFTs are and why and how they are increasingly being used within horse racing.

1. What are non-fungible tokens and how do they work?

NFTs are tokens or certificates that can be used to represent ownership of unique items; in the context of horse racing, this includes digital horses and their physical copy. The value of an NFT is derived from the concept of being “non fungible”, meaning that the token, data stored on a digital ledger (blockchain), cannot be replaced due to its unique properties and therefore is not interchangeable. This contrasts with the fungible nature of crypto currency in which each unit of the currency is identical and can be interchangeable.

Most NFTs are secured on the Ethereum blockchain, which is immutable (comparable to crypto assets) meaning that no one can modify the record of ownership or recreate it by copying the ‘verification of transfers’ in the form of a new NFT. These tokens with a unique identification code are linked to an underlying digital or physical asset, meaning in the case of Zed Run and Maxima if the asset increases due to good performance in races for example, the value of the token will also increase. Many NFTs are additionally composed of software code integrated into the form of a ‘smart contract’. The smart contract contains the details of the underlying digital or physical asset that the NFT relates to, enabling buyers to have access to information regarding who has owned the horse previously, how many others there are and what price the token has been sold for in the past.

2. A new form of horse racing

The link between computer games and NFTs

A new form of horse racing has emerged with the integration of NFTs into the gaming industry like zed run, business models subsequently are becoming increasingly interested in digital betting games to benefit from NFTs. Such platforms could fundamentally from an animal welfare perspective could be considered as a win for advocacy groups such as PETA who continue to petition for preventing the use of animals for entertainment.

Zed run is a manifestation of the actual horse racing blockchain that allows users within a virtual environment to buy, sell, train, race and even win monetary prizes. The odds that a horse will win the race is based primarily upon the horses’ race history. Additional factors that are considered include the length of the race, the track location, and weather conditions. These breathing NFTs are built in such a way that they include their own unique DNA that is defined by their bloodline, Genotype and racetrack performance, which will be passed onto the next-generation zed, where owners and shareholders can buy and sell them on marketplaces such as Opensea.

A key feature of Zed Run is that the NFTs are coded to incorporate smart contracts which can be programmed to perform automatically the contractual terms that includes the allocation of a portion of the amount paid by an NFT purchaser to give the original owner or issuer of the NTS in the way of royalty payments without the requirement of an agent. The asset value of the horses, however, will increase if the horse performs well in races meaning that royalties from each transaction have the potential to be substantiated.

Digital assets backed by physical counterparts

Maxima, in partnership with the UK Harratan court stables and Larneuk Stud in Australia, is set to launch in 2022 the first racehorse NFT marketplace where anyone can own horses and earn money with real asset tokenisation, meaning digital horses are backed by their physical counterparts. Maxima proposes that “industry professionals can use the platform to improve their business’s operation efficiency, reduce risks, promote their brands, and gain access to a rich global network of stable clients”. The platform is promoted by Maxima as democratising the ownership and involvement in horse racing to enable accessibility to the market for everyone.

The tokenisation of real world-asset ownership, through a tokenised syndication system enables Maxima NFT ownership to be broken down meaning multiple users can own shares of a single NFT once the horse is certified and the creator’s authentication process of know your customer is succeeded. Junior horses will be minted and sold as NFTs, divided into a limited number of shares, however every horse is backed by its share-owners. The gamification system incorporated into Maxima, like Zed run, intends to create the experience of owning and raising a racehorse in a virtual context with the inclusion of the development in training processes and races available in the physical realm.

A significant aspect of Maxima is that the share transfers are available through the blockchain, meaning that every sale is recorded. This data Maxima, assures is publicly available enabling share-owners to view horses’ history and for buyers, price transparency without additional fees to eliminate asymmetry of information often present during transfers of ownership. Due to the link of digital assets to real horses, however, the physical horses do, have a life span. Although debate as to whether these digital horses should be granted a life span is an additional factor, legal protections of these assets when the horses die or retire is due to ensure that the holder can still earn a percentage from the royalties irrespective of the horse they bought.

3. Potential Legal issues to be considered

3.1 Who owns the underlying asset?

A potential problem with the tokenisation of both digital and physical assets relates to part of the contract of sale in which the value of intellectual property rights on the sale of the asset is considered. A common misconception is that when an NFT is purchased the individual has additionally purchased the underlying asset that is associated with the NFT. The NFT however, is not the digital or physical horse but the metadata that ties it to their original files. As such copyrights are not transferred when the token is bought unless specified otherwise in a sale of contract, the NFT owner pertains the right for personal use only. This could lead to a potential infringement liability when individuals, unfamiliar with the legal restrictions relating to copyrights, for example make copies or display the asset publicly.

However, certain marketplaces can impose less stringent licence terms to those of the creator which can enable buyers’ broader rights in relation to use of the NFT. Further misrepresentation can occur for buyers if the seller is not the author or copyright owner of the underlying work represented by the NFT. Although the blockchain is a public recorded digital ledger that can track all transactions there is no requirement for sellers to disclose their identities meaning it is challenging for buyers to ascertain who the actual owner is of the underlying asset and subsequently receiving remedies if the asset is stolen.

3.2. Personal data

Personal data, in relation to who collects the information, processes the data and what it is used for is a fundamental consideration in commercial transactions. The EU legislation of the General Data Protection Regulation introduced in 2018 provides the right for personal data to be removed or corrected, ultimately the right to erasure.

Under Article 17 of the General Data Protection Regulation 2018 an individual has the right:

“to have their personal data removed if the personal data is no longer necessary for the purpose of an organisation originally collected or processed it”.

However, the immutable nature of the blockchain poses a potential infringement on this right, due to the erasure of information being technologically almost impossible. Therefore, this means that NFTs containing personal information would potentially violate some of the data protection principles enshrined within EU legislation. Furthermore, as stated above blockchain technology does not oblige people to disclose their identity, which makes it difficult for data subjects who believe their personal data has been misused to exercise their rights.

3.3. ESG (Environmental, Social and corporate Governance)

ESG has become an issue of priority on the corporate agenda, however, particularly Ethereum (a proof of work system) aligning with wider organisational environmental strategy is a potential issue when utilising this decentralised trading ecosystem. As explained above, existing planforms use the execution of NFT transactions on a blockchain that rely on a system called Proof of work. The process, however, is computationally intensive and requires a large amount of energy, as Cambridge university found on a study surrounding the mining and creation of Bitcoins, similar to the PoW validation system used in NFTs, the process of mining consumed more energy than the entire country of Argentina on an annual basis.

Although the exact carbon footprint of minting an NFT cannot be determined, according to Digiconomist they estimate a single Ethereum transaction has a carbon footprint of 33.4kg CO2. One alternative for the PoW system is the Proof of Stake (PoS) model as a form of lower-carbon NFTs. In comparison to PoW which relies upon computing power, PoS blockchains like Cardona rely upon hard drive storage requiring a lower amount of electricity. The exact environmental impact of horse racing NFTs are unclear, however the minting, issuing, and selling of the tokens as above requires a significant amount of energy, and therefore is currently in question as to whether NFTs meets ESG standards.

3. What’s next with regulations?

The Financial Conduct Authority (FCA) and UK legislator have not currently provided specific regulations relating to NFTs in the UK and EU. NFTs continue to be governed by the wider applications of the UK regulatory confines for crypto assets based upon the guidance provided by the FCA in 2019 that defined 3 categories of crypto- assets. However, The European Legislator at present is preparing a regulation for crypto assets that will additionally affect certain types of NFTs in the form of the Markets in Crypto-assets Regulation set to be fully operational in 2024 (the MiCA proposal).

Within the MiCA Proposal (2024), an international definition of crypto assets is provided, as a “digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology”.

The proposal intends to provide comprehensive regulation of crypto assets, including in some fact specific circumstances NFTs which are not yet covered by EU financial law by imposing disclosure and authorisation requirements on crypto asset issuers and service providers utilising blockchain technology within European markets.

4. Conclusion

To summarise, it appears that NFTs have hit a peak of inflated expectations highlighting future considerations for economic market regulations in the way of data protection, intellectual property, and ESG. Although NFTs present significant opportunities for particularly original owners and creators, they simultaneously present unique global policy and legal issues, beyond the few that have been listed here.

What the long-term impact of NFTS will have on horse racing and wider sporting industry and whether such legal risks will be resolved by incoming regulations remains to be seen. What is apparent however, is that understanding the potential obstacles in adopting NFTs is inevitable in preparing for the litigation and regulatory scrutiny that is set to follow the operationalisation of crypto assets regulations in 2024 by the EU legislator.

Market players, both business and buyers will need to take care to comply with the MiCA regulations and consider if and how this could affect their business models in relation to the utilisation of this crypto technology when looking to formulate NFTs into the future structure of horse racing.