NFTs have an image problem: they are often the focus of scams and carpet pulls. They have been accused of being harmful to the environment. And many think they are tasteless or not worth their exorbitant cost. However, they always had one saving grace: paying royalties. Royalties are why charities like UNICEF chose to sell NFTs last year.
That’s why many YouTubers like rapper Nas joined web3. Unlike an artist who sells a physical portrait in a small gallery and only makes money from the main sale, artists can expect to earn ongoing income from a portion of any future on-chain sale of that asset simply by making a Shape NFT. However, one of the main benefits of NFT is under threat, as demonstrated by SudoAMM, the marketplace launched by NFT exchange Sudoswap. In July, Sudoswap removed all royalties to bring fees down to just .0.5% per transaction, angering many NFT creators.
And artists are taking proactive steps to protect their royalties. QL, a generative NFT project co-founded by Fidenza creator Tyler Hobbs, blocked X2Y2, an NFT marketplace that allows buyers to bypass royalties. The project’s creators did this to make a statement and defend secondary royalties that benefit artists.
The rap on wrapped NFTs
Centralized NFT marketplaces like OpenSea are among the organizations that manage NFT transfers. OpenSea verifies that the transaction is genuine and facilitates the sale by taking ETH from the buyer’s wallet and delivering it to the seller. OpenSea then takes the specified percentage, up to 10%, from each sale and redistributes the funds as royalty payments to the original creator. The decentralized equivalent of OpenSea’s royalty implementation is the Ethereum Enhancement Protocol (EIP) 2981, which dictates that when the conditions of a sale are met, and the NFT is transferred, a portion of the sale must go to the creator. This part and the original creator’s wallet address are written into the smart contract code.
NFTs can be wrapped to follow different guidelines than initially intended. A wrapper acts like a box, covering everything it contains, explains blockchain developer Marissa Hudson. It’s as if the smart contract is scanning the box before deciding whether to accept or reject your transfer. To see an example of how the wrapper works, let’s assume an NFT is minted under ERC-721. This is the Ethereum token standard that NFT is creating.
It states that the owner of an NFT is the person who has the NFT in their wallet and can use it as they or he pleases. In other words, the owner and user are bound under ERC-721. But a new standard token called ERC-4907 breaks the bond between owner and user, enabling profitable NFTs. An ERC-4907 box is wrapped around ERC-721 NFTs. If this wrapped token goes through an ERC-4907-compliant smart contract, the ticket will be good even though it wasn’t originally intended.
As planned, an ERC-2981 token routed through an ERC-2981 smart contract would send a portion of the sale to the designated original artist. But someone can package the ERC-2981 token with an ERC-721 box and trade it through an ERC-721 smart contract. The intelligent contract ERC-721 would confirm this transaction and take place free of charge. Because of this, ERC-2981 can only keep on-chain royalties if all parties agree to use this standard token with the proper smart contract. Otherwise, it is essentially “ERC-2981, aka ‘Ask Kindly for Specific Royalties,’” Hudson quips.
The issue with on-chain royalties
There is a way to stop NFT wrapping, which bypasses royalties, but it would cause more problems than it solves. The ERC-721 token standard, which most NFTs adhere to, has several functions, one of which is “transfer of.” It also allows an NFT to be sold on a marketplace, regardless of whether it has royalty payments, like OpenSea, or not, like SudoAMM. The rationale behind royalty enforcement is that as long as it allows the NFT holder to send the NFT to a different address, it is impossible to prevent a marketplace from using this feature to complete the transaction,” says a blockchain author. A developer named Nicholas.
He adds that you could block this circumvention by restricting NFTs only to move when a sale occurs and not transfer them between wallets. “However, that wouldn’t solve the problem because it could just sell ETH to you for a minimal amount to bypass this mechanism and then make a larger ETH transaction out of the market.” This distinction between sales and transfers to meetings is difficult. However, Hudson says transfers happen for many reasons, for example, when a user exchanges a token between their multiple wallets.
Disabling “Transfer from” would prevent NFT from switching between wallets.
Open season on NFT royalties
Royalties are left to the markets without a good way to enforce NFTs on-chain. Despite the potential damage to artists, more NFT markets may move to a 0% licensing model to reduce costs. When the Solana DeGods-based NFT project cut its royalties, its founder bet that more markets would do the same. Five days later, Solana’s central NFT marketplace, Magic Eden, decided to make paying royalties optional on October 15, 2022.
“In a market that’s now not liquid, this solely ignites undermining wars between the fee-free and fee-free markets, each trying to squeeze liquidity out of their JPEGs,” says Goner. As more markets avoid royalties, some are making a supportive decision to support artists. One platform is Data, which commissions original digital work from aspiring creators. Data smart contracts pay artists a 15% royalty on resale, higher than OpenSea’s 10% royalty limit. Secondary markets are ‘opt-in’ for royalties.
Some follow EIP-2981, others follow royalty registration, and others, like OpenSea, do not,” Data CTO Josh Hardy told The Block. “Data has always held that artists should receive royalties, and that’s a shame. That markets are reluctant to pay royalties when this is one of the main benefits of NFT technology for artists. Data does not yet have a secondary market, but if or when we do, we will require buyers to pay royalties to the artist.”