NFT Royalty Dilemma

Introduction

The NFT space has been shrouded in controversy recently. The ongoing debate on creator royalties and whether marketplaces should enforce them or not is one of the most critical and consequential discussions to have taken place in the sector. With more and more marketplaces coming out with announcements regarding the approach they would take when it comes to creator royalties, it is crucial to analyse how these decisions could affect the future of NFTs. 

NFTs were initially branded as the solution to two of the biggest problems in the digital asset space. Firstly, NFTs gave individuals the ability to buy and sell digital assets that they own in an easily verifiable way through blockchain technology. Secondly, artists could also now be compensated for their art not only through their primary sales but also through royalties levied on all secondary sales of their NFTs. Soon the vision of a digital art renaissance made possible by NFTs brought in thousands of artists and gathered the attention of the mainstream. The NFT space flourished and did over $2 Billion in primary sales and over $40 Billion in secondary market sales overall. 

However, the future of this space is highly uncertain as, over the last few months, we have seen the emergence of several marketplaces that do not enforce the payment of creator royalties. These marketplaces allow traders to buy and sell NFTs without paying out royalties to their creators. People are starting to realise that creator royalties are challenging to enforce on a smart contract level without severely altering what ownership of these assets means. The NFT industry is at a crossroads, and it is crucial to be fully aware of the options ahead as they could have a long-lasting impact on whether NFTs can fulfil their original promises of artist empowerment and actual digital ownership. 

Why Royalties Matter?

Creator royalties were (and to an extent still are) the most significant driving force attracting artists to the Web3 space. Numerous artists were able to build strong communities around their NFT collections. They have not only been able to gain recognition for their artistic talents but have also been compensated fairly for the growth in value of their creations. There are some estimates that close to $1.8B in royalties have been paid out to artists on Ethereum alone. Yuga Labs alone has earned more than $147M in royalties, and numerous other smaller artists have made sizable amounts of money through royalties. Moreover, it’s not just the artists that have benefited from royalties. Huge brands like Tiffany, Adidas, Dolce & Gabbana, etc., have embraced Web3, and Nike alone has received close to $100m just from royalties from their NFT collections. 

The NFT space would be a fraction of what it is today if it weren’t for royalties. Royalties do a great job of aligning creators and collectors in growing NFT projects and communities together. There is also a serious argument that royalties-enabled revenue streams allow for cheaper minting costs, reducing the initial entry barrier to these communities. Royalties can significantly impact the growth of NFT projects and have been a massive reason for the success and continued growth of so many NFT projects in the space. 

Enforceability of Royalties

However, there is a fundamental technical problem in all of this. It’s a common misconception that royalties are enforced on the smart contract level and that it is solely up to the creator to decide whether or not to include royalties for their NFT projects. However, in reality, things are very different. Currently, it is entirely up to the marketplaces where these NFTs are sold to decide whether or not they want to honour the royalties specified by the creators. 

(Source)

To understand why let’s first look at what goes on under the hood when a new NFT collection is created.

NFT 101

The most common token standard for NFTs on Ethereum currently is the ERC-721. A token standard is simply a common set of attributes and functions that anyone wishing to launch a token should build or provide for. Think of it as a common template that all tokens belonging to that category must follow. This standard allows for functionality like transferring tokens from one account to another, getting the current token balance of an account, getting the owner of a specific token, and also the total supply of the token available on the network. Besides this, it also provides for the functionality to approve that tokens from an account can be moved by a third-party account. 

ERC-721 NFTs are created by coding smart contracts that follow the basic template and implement all of the functionality specified in the ERC-721 standard. Once the basic template is followed, the creators can program extra functionality and set rules for how the NFTs interact with other smart contracts. 

One standard function in ERC-721 is the ‘transferFrom’ function which basically allows the transfer of these NFTs between two addresses (holders). Whenever an NFT needs to be transferred, the transferFrom function is called, which runs a series of checks before executing the transfer. For a successful transfer to take place, the first thing checked is if it is the actual owner who is calling the function or if it is a smart contract that the owner has approved to transfer the NFT. If the above check passes, the token balances of the sender and receivers are updated, and the token owner address is changed from the senders to the receiver. 

As you may have noticed, this transferFrom function allows transfers to be initiated by the actual owner of the NFT as well as any smart contract the owner has approved. This is what enables NFTs to be sold through marketplaces. The marketplace smart contracts ask for approvals from the owner of the NFT to be able to conduct the transfers. Once the marketplace’s order book finds a match required to conduct a sale, the marketplace is able to transfer the NFT from the seller to the buyer. It then calls another separate function that transfers the funds from the buyer to the seller. In this function, the marketplace calculates the stipulated creator royalty, deducts the royalty from the sale, and then sends the royalty to the creator. At any given time, a marketplace could simply stop distributing the royalties and continue to operate in the same way as before. 

It is important to understand that it is impossible to know which NFT transfers result from sales and which are merely wallets moving or consolidating their NFTs. Therefore, in its standard form, the transferFrom function is invoked without any concept of payment from the receiving party – either purchase amount or royalty. This is the primary reason why royalties are so hard to enforce. As long as the smart contract allows the holder of an NFT to send the NFT to another address freely, it’s impossible to stop a marketplace from using the same mechanism to do the transfer without honouring royalties.

Further developments in NFT standards like the EIP-2981 only served as decentralised mechanisms to retrieve royalty payment information for NFTs to enable universal support for royalty payments across all NFT marketplaces. However, the new standards still do not provide any mechanism for enforcing such royalties and leave the royalty payouts to the sole discretion of the marketplaces. Therefore the issue remains that it is inherently challenging to enforce royalties without some level of centralization and trust in marketplaces to ensure the payment of royalties while keeping all the basic expected functionality. 

(Source: Twitter)

Even if royalty payments were enforceable on-chain, there would still be loopholes around them. It wouldn’t take long for people to start facilitating sales consisting of two independent transactions – one facilitating the sale of the NFT for a minimal amount, thereby minimising the amount of royalty paid, and the other a seemingly unrelated transaction that sends the rest of the sale amount independently. Beeple’s example of “gifting” NFTs and getting a “gift” in another transaction in return is another loophole that is going to be impossible to solve. It could be possible to implement a fee to be charged on every transfer of an NFT, but that would make it unnecessarily expensive for collectors to move their NFTs between their own wallets and undermine the idea of actual ownership of these assets. This makes it clear that NFT royalties are, in a way, impossible to enforce on-chain while allowing for basic functionality like transferring the NFT between wallets freely. Therefore, it comes down to the marketplaces and the actual traders to take a stand on whether they want to respect the royalties that the creator of the NFT had set initially. 

The Shift Towards Zero Royalty

Until quite recently, most significant marketplaces like Opensea and Magic Eden chose to honour creator royalties. However, this changed when marketplaces like X2Y2 announced that they would let buyers select the amount of royalty they would like to contribute to the projects. This made it much cheaper to buy NFTs on platforms like X2Y2 as most people chose not to pay the 5-10% royalty that would’ve been charged on other trading platforms. The reason cited for this switch by X2Y2 was the fact that several dominant marketplace aggregators were planning to launch similar functionality and that they had to adapt to stay on top of market movements.

The launch of Sudoswap, an AMM-style marketplace, played another significant role in eliminating creator royalties. Sudoswap differs from Opensea and other major marketplaces as it allows users to sell their NFTs without having to find a buyer for them. Sellers can directly swap their NFTs for ETH and vice versa. They interact solely with a liquidity pool and have no direct trades between buyers and sellers. While Sudoswap was disadvantageous for creators as it did not enforce royalties, it was great for traders who benefited greatly from the instant liquidity and significantly lower fees. Sudoswaps biggest strength was its efficiency, and not honouring royalties made it even more attractive to active NFT traders. 

A similar story played out in the Solana ecosystem. Smaller platforms like Solanart, Yaww, and Hadeswap moved to the zero-royalty camp and subsequently gained significant market share. Magic Eden, the biggest marketplace on Solana, initially took the creators’ side and continued to enforce royalties. However, as their market share continued to fall, they went on the offensive against the marketplaces that were gaining market share by not honouring creator royalties. In mid-September, they rolled out MetaShield, a tool that helped creators to track NFTs traded on marketplaces that bypassed creator royalties and take defensive actions like altering the NFT metadata, putting a specific flag on it, or even blurring the image in the NFT.

(Source: Magic Eden)

Magic Eden’s move received a lot of backlash from the Solana NFT community. While this move firmly put Magic Eden on the side of the creators, it also raised some serious questions about the actual ownership of these assets as creators could still exert control over the NFTs after their sales, and many viewed such a move as a threat to decentralisation. There were genuine concerns about how such tools could be misused, and the fact that blurring or altering NFT metadata could punish innocent and unsuspecting buyers was highlighted by the community. In the end, Metashield got minimal usage and did almost nothing for Magic Eden, which continued to lose market share to its competitors. This loss in market share ultimately drove Magic Eden to make royalties optional on its platforms as well, thus becoming the largest NFT marketplace on Solana to do so.  

Latest Developments  

Earlier this month Opensea, the largest NFT marketplace globally, finally broke its silence over the whole issue and added more fuel to the ongoing fire. Opensea released a repository containing several tools that allow creators to manage the operators allowed to transfer NFTs on behalf of holders. This snippet essentially blocks the transfer/sale of NFTs through the marketplaces that did not honour creator royalties. Several of Opensea’s largest competitors on Ethereum, including Sudoswap, LooksRare, and Blur.io, were mentioned on the blocklist. Opensea itself admitted that this was not a foolproof approach, but rather its purpose was to make bypassing creator fees less liquid and harder to do at scale.

This announcement brought in a wave of criticism from all ends. For starters, it angered the creators of existing NFT collections, as this announcement originally meant that Opensea wouldn’t honour royalties for their collections but rather made royalties optional. They later went back on this decision and announced that they would continue to honour the royalties of the existing collections whose smart contracts cannot be updated. 

(Source: Github)

This move was also seen as anti-competitive as it effectively blocked out several marketplaces that had gathered a significant market share by moving to optional/zero royalties. Many accused Opensea of using this as an excuse to block the growth of these other marketplaces and further cement its status as the dominant marketplace on Ethereum. Moreover, a code snippet like this severely compromises the concept of complete ownership of these digital assets as it adds new restrictions on where these assets can be traded. 

As a testimony to Opensea’s clout, X2Y2 conceded and announced that it would enforce creator royalties on all NFT collections for existing and upcoming projects. Opensea further responded by removing X2Y2 from its blocklist. Furthermore, Opensea has announced that it will discuss with its communities and has given itself a self-imposed deadline of 8th December 2022 to make a final decision on this matter. 

New Token Standards

Like ERC-721 on Ethereum, Token Metadata is the de-facto standard for NFTs on Solana and was developed by Metaplex. More than 99.9% of all NFTs on Solana follow this token standard. Token Metadata had included royalty information in its base standard from Day 1. This standard, however, faced the same issue as their Ethereum counterparts, as these NFTs could also be freely transferred between wallets. Since the start of the royalty debate, Metaplex had taken it upon itself to create a new asset class that would enforce creator royalties. 

Metaplex has said that their new asset class is the most viable solution to provide NFT creators with a reliable way to enforce royalties without compromising the collector experience. They claim to do this by introducing two new asset classes in the Token Metadata standard. These new asset classes are 1) RoyaltiesNonFungible — a new asset class that creators can use to enforce royalties, and 2) Identity — a new asset class that enables wallet linking and will support free transfers for collectors. 

NFTs minted using this new standard are “always frozen,” and the sales and transfers are blocked until they meet specific requirements. The sales of these NFTs will be restricted based on royalty enforcement validation and will be restricted to a limited number of programs (marketplaces) that respect royalties and belong to a list maintained by Metaplex. Self-transfers will be restricted to only those wallets linked via the new Identity NFTs. 

Such an implementation of NFTs makes it very hard for users to avoid paying royalties on any sales but can also have several negative impacts on the NFT space itself. It is easy to see how such a standard can bring out several legitimate questions about the ownership of such assets. One of the defining features of NFTs was how users could have actual ownership of their assets, i.e., they could buy, sell, and transfer their assets freely without relying on any centralised third parties. Furthermore, maintaining the allowlist by Metaplex of marketplaces that can facilitate sales will always bring concerns about centralization and dependence on third parties. Such an implementation severely favours the enforceability of royalties over the actual ownership of digital assets. 

The Road Ahead

There does not seem to be a way to enforce creator royalties on-chain without creating a multitude of new problems, especially around ownership and centralization. As with many other things, this, too, will end up in some compromise. I believe that this is more of a cultural debate than a technical one. Artists will have to build communities and provide enough value to their members for people to want to pay royalties. The whole discussion hinges on collective morals. NFTs as a technology can be used for various purposes, and different stakeholders will develop their own solutions for creator royalties. Royalties might be a lot more critical for some use cases, and users would be willing to compromise on having complete ownership/tradability of their NFTs. Some creators will choose to enforce (or make it hard to bypass) royalties while compromising on giving users complete control of their NFTs and would be able to pull it off if they have built strong communities around their projects. In other instances, true ownership of digital assets will be much more important than royalties, and for such NFTs, communities might not be as open to accepting stringent royalty enforcement measures. As the space grows, the artists and the communities will decide what solutions work best for them. Therefore I think that this debate will not have a single clear-cut solution but several use-case-specific solutions. I think the future holds some really exciting possibilities in this regard and I am still extremely confident in the potential of the space to not only provide significant value and utility to the consumers but also to provide the tools for the empowerment of the creators.   

Author – Sarthak Dwivedi, Research Associate, Woodstock

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