NFT's (Non-Fungible Tokens) - Risks, Regulation and The Law (2024)

Overview

Table of Contents

• What are NFT’s?
• What does Fungibility mean?
• NFTs are Built on Blockchain Technology.
• NFT Collectability.
• Demand for NFT's.
• NFT Risks
• Types of NFT Fraud.
• Are NFT's Legal and What Issues Exist Around Them?
• FATF Guidance / Financial NFT Regulation.
• NFT Compliance and the Importance of Taking the Correct Approach.

What are NFT’s?

The emergence of NFT’s around 2017 and their surge in popularity in 2021 has sparked lengthy discussions about both their importance as products to be invested in and the risks associated with them.

NFT is short for non-fungible token. A non-fungible token is a type of digital token and cryptoasset associated with the blockchain, which acts as a digital certificate of authenticity. All kinds of digital objects can be bought and sold as NFT’s, including images, music, videos, books, virtual land and even tweets.

The thinking behind NFT’s is that they act as a unique digital signature in the same way as, for example, a painting has the signature of the artist somewhere on the canvas. The Mona Lisa painting, for example, is an original piece of art. It cannot be swapped for something similar such as a Mona Lisa painting from a gift shop. It will not hold the same value.

The NFT is proof of authenticity on the blockchain, commonly the Ethereum blockchain, which is the digital record of transactions. The blockchain works as a list or ledger, storing information such as:

• proof of ownership - who owns the digital asset.
• when it was purchased.
• when it was sold and to whom it was sold.

These records cannot be forged because the record of information is maintained by thousands of computers and nodes around the world on a public ledger. This ensures authenticity and scarcity.

Digital artwork in particular has attracted widespread attention. The art has a digital token attached to it which verifies it as the original. While the digital image can be replicated, the token cannot. Only one person can own the token.

The increasing popularity of, and interest in, NFT’s is evidenced by some of the high-profile sales of digital art in recent years. The first ever tweet by Jack Dorsey, the co-founder of social media platform Twitter, sold for USD $2.9 million. CryptoPunks, a collection of 10,000 collectable characters, has been the subject of frenzied trading, with established art auction houses Christie’s and Sotheby’s selling them at online auction.

Even musicians have joined the trend and started seeing them as a sellable commodity. Singer-songwriter The Weeknd sold his first collection of art and unreleased music NFT’s for USD$2 million, and Steve Aoki in collaboration with 3D visual artist Antoni Tudisco sold the NFT to 36-second-long clip ‘Hairy’ for $888,888.88 to the former CEO of T-Mobile. It is clear that NFT’s have started to permeate the pop culture in a number of ways.

In order to comprehend the appeal of NFT’s and how they work, it is important to understand the idea of fungibility.

What does Fungibility mean?

If something is fungible, it means it is replaceable. A fungible item, therefore, can be substituted or exchanged with another item that is identical or has the same value. For example, a £20 note is the same as any other £20 note and can be exchanged for such a note or, for example, for four £5 notes or 20 one-pound coins. This is the same for cryptocurrency - one bitcoin can be exchanged for another.

An NFT, being a non-fungible token, does not work in this way. Every NFT is a unique series of numbers stored on the blockchain ledger and cannot be substituted for something else.

NFTs are Built on Blockchain Technology.

It is important to understand how a Non Fungible Token is actually created. An artist creates a digital good - an image, video or anything that lives in the online world.

The artist would then create a token on a blockchain that supports smart contracts, such as Ethereum, Cardano and Solana. This token would hold within it information about the digital goods that are being sold. This information includes, for example, the token name, token symbol and a unique hash that proves the authenticity of the NFT.

The digital goods are not stored inside the token itself. The token stores only attributes relating to them. The NFT will point to where the file can be found. Once the token is created, the artist can sell it to someone else and that person will be the new owner of it.

As such, the information held on the blockchain will include who owns the original asset, who it was sold to and when it was sold.

It is, therefore, possible to prove who owns the NFT at any time and trace its prior-ownership history. As this information is on the blockchain, it is encrypted, ensuring its authenticity and the NFT’s scarcity. Hence, an NFT is a token that acts as a digital certificate of authenticity.

NFT’s can be bought on both centralised and decentralised markets:

• Centralised marketplace – this will allow you to sign up and fund your account via fiat currency, such as a credit or debit card.
• Decentralised marketplace – here you will need a wallet that is compatible with the blockchain your NFT was created on (e.g MetaMask if the NFT was created on Ethereum). MetaMask is a wallet that is built as a browser extension, and you can use it to log into decentralised marketplaces such as OpenSea. At the time of writing, most NFT’s are bought and sold with the cryptocurrency on a blockchain.

NFT Collectability.

NFT’s have changed the digital asset market. Whereas physical collectable items, such as a signed football shirt or trading card have value because they are rare and their authenticity can be proven, this was not the case with digital assets – until now. Previously, digital assets could easily be duplicated online, with there being no way of identifying who had the right to sell the asset.

Anyone could download, for example, an image. That image could not be considered rare, and it was impossible to identify clear property rights. But with ownership of the NFT able to be proved and guaranteed by the blockchain, such transparency is an important part of the appeal of NFT’s to investors.

A smart contract can be created to ensure that only one copy of a piece of digital art is made available, ensuring its scarcity and keeping its value high. The smart contract can also be created in a way that gives the artist royalties, securing the artist a cut of any future sale of the token.

Unlike how the blockchain operates with cryptocurrency, these terms that can be set for the sale of an NFT mean that a particular piece of digital art can generate an income for the artist for years to come.

Demand for NFT’s.

The process that we have just outlined regarding NFTs has prompted the recent increase in the collecting and trading of digital assets. They can be listed for sale on one of a number of global online NFT marketplaces. Such marketplaces can be easily accessed, and would-be buyers can input various criteria to narrow down the search for what they want.

With bitcoin making gains of around 300% in 2020 a new group of crypto rich investors has emerged, and these investors are looking to spend their cryptocurrency on the digital equivalent of a supercar, Picasso or Patek Philippe watch.

For those not looking to invest in the long run, NFTs offer a way to make a quick return by ‘flipping’; making profit from the rapidly-increasing value of an NFT within days or even hours.

NFT Risks.

NFT’s have certainly given a major boost to trading in digital assets and have provided more certainty and security than that which previously existed. However, despite their appeal and the advantages associated with them, involvement in NFT’s will not always be risk free.

At present, NFT’s are not subject to regulation, which means there is little or no legal protection for those who create, invest or trade in them. It should be remembered that not all platforms selling NFT’s verify the identity of the seller. Platforms face difficulties when checking that the seller is the original creator of the art, as anyone can access the digital marketplace and claim to be the creator of the digital asset for sale.

Although some platforms have now started to employ AI software to scour public blockchains and NFT platforms for identical examples of artwork - so that the artists can be alerted to any suspicious matches - the risks still remain.

One high-profile example of this was when someone sold what was falsely claimed to be a Banksy NFT for the cryptocurrency equivalent of £244,000 on the platform OpenSea. While this case did see the purchaser have most of what they paid returned, it highlighted the dangers that can be associated with NFT buying.

In addition to fake sellers, investors must also be aware of fake platforms claiming to sell genuine NFT’s. These duplicitous platforms are set up to steal would-be NFT customers’ credit card details and there is also the threat of phishing schemes and viruses draining digital wallets – a practice dubbed as ‘sleepminting’. With NFT’s being unregulated, it can be difficult to track funds. Scammers and hackers are increasingly exploiting security gaps in the rapidly-expanding marketplace to make illegal gains.

Anyone wanting to purchase an NFT’s should also be aware of the possibility of being caught in a sales frenzy bubble that sees prices rise rapidly before suddenly falling, leaving those who bought at the top of the market-facing large losses. Additionally, there is the danger of “bit rot” or “format rot”, where an image’s quality can deteriorate, file formats may no longer be opened or websites fail; leaving an NFT owner with an asset that is decreasing in value or even worthless.

Types of NFT Fraud.

Although NFT’s are a relatively new concept, they are already being used as a vessel for carrying out a number of different types of fraud. Here, we detail some of the most notable fraudulent practices that have involved NFT’s:

Tokenisation: This is the term used to describe the process of creating digital tokens that represent ownership of a real-life asset. This occurs when someone takes an artist’s work without permission and ‘mints’ it, turning it into an NFT.

Wash trading: Users manipulate transactions by trading with themselves or accomplices to create the illusion of high demand for an NFT, to manipulate its value or raise its profile.

Insider trading: Where individuals use knowledge not available to the public for their own financial gain.

Sleepminting: As mentioned earlier, while NFT’s are minted to a well-known artist, hackers are sometimes able to have them transferred to their wallet. This is done in a sophisticated way that does not trigger any security checks and convinces potential buyers that the hacker is entitled to sell the NFT’s that they have obtained illegally.

Money laundering: Due to NFT’s being decentralised (involving peer-to-peer transactions as opposed to using an intermediary such as banks or government institutions) and unregulated, they provide a convenient way of laundering money. Unlike traditional art, NFT’s are not subject to specific regulations that have been designed to prevent money laundering, including providing ID documents to assist in validating ownership of property.

The prices of digital art are less influenced by factors that affect the price of a traditional piece of art, such as age or condition. This means that pricing of NFT’s can be more subjective, giving criminals the opportunity to launder their money through NFT trading without arousing as much suspicion as they would if they bought more traditional assets.

Economic sanctions: The current unregulated status of NFT’s means that the buying and selling of them is – to a degree – conducted with very little supervision from the authorities. While states and individuals may have had sanctions imposed on them to prevent them trading with others, the lack of legislation relating to NFT’s may enable those subject to sanctions to trade without being detected by enforcement agencies. As with money laundering, NFT’s do create an opportunity for those looking to act illegally without attracting official attention.

Are NFT's Legal and What Issues Exist Around Them?

As mentioned, the current lack of NFT related laws or NFT regulation specifically directed at NFT’s means there are risks relating to sanctions and money laundering. This is a situation that, for now at least, leaves a number of other important legal issues to be clarified regarding NFT’s.

Some of the most significant are:

• Data Hosting and Storage of NFTs.
• NFT Royalties.
• Data Protection.
• NFT Intellectual Property Rights.
• Transacting NFT Sales.
• NFT Taxation.

Data Hosting and Storage of NFTs.

An NFT and the digital asset it represents are usually stored separately. The NFT is stored on the blockchain and contains information about where the digital asset is located. While the NFT is connected to the digital file asset via a link, the digital asset could be deleted or the server hosting it could fail or be hacked. This would make the NFT worth little or nothing – and the law has not yet addressed what rights the NFT owner would have in such a situation.

NFT Royalties.

One of the characteristics of NFTs is that royalties can be paid to the creators each time their NFT changes hands. While smart contracts written for NFTs can ensure the creator of a piece of digital art can receive royalties each time it is sold, such payments may not be automatic if the sales are not always conducted via the same platform.

A number of countries (including the US) do not recognise resale rights, meaning the creator of the art may have no legal instrument for claiming their royalties. At present, there is very little case law or regulation covering smart contracts.

Data Protection.

There is the possibility that NFT’s containing personal information may violate data protection laws. Some of these laws allow individuals to erase or amend their personal data but NFT’s are linked to the blockchain, where such activity is not possible. The issues of security and data sharing relating to NFT’s have so far received little consideration.

NFT Intellectual Property Rights.

The buyer of an NFT may mistakenly think they own the actual art associated with the NFT. But the only person with the right to copy, distribute, alter or publicly display the art is the creator of the art.

There is the possibility that a disgruntled NFT buyer may bring legal action if they feel that there was misrepresentation when they were sold the NFT, as they believed they were buying the copyright.

Every buyer needs to conduct thorough due diligence – and, if necessary, seek legal advice – to ensure they understand each and every aspect of an NFT purchasing process. The situation is made more complicated by the fact that it is at present unclear whether minting a digital token can grant legal ownership of an asset (physical or otherwise) in the UK, due to the technology of the blockchain ledger.

Transacting NFT Sales.

Although the market in NFT’s has only developed recently and differs from markets for more traditional items, sales must involve contracts that comply with the relevant consumer legislation or consumer protection at the point of sale. But even a well-drafted sales contract may present problems if disputes arise regarding any aspect of the ownership of an NFT, especially given the multinational (and relatively novel) nature of such transactions.

This could be made even more problematic by the fact that online marketplaces offering the ability to buy NFTs do not yet have to satisfy legal requirements to verify the identity of NFT sellers or the authenticity of the NFT’s.

NFT Taxation.

Taxation is one of the most notable areas of law that is lagging behind the development of NFT’s. The UK and other nations have little or no legislation in this regard, nor any official advice relating to NFT’s and tax. In the UK, HM Revenue and Customs (HMRC) has issued guidance relating to cryptoassets but has specified that NFT’s are classified as a separate entity.

While it can be expected that profits and losses relating to NFT’s would be liable for capital gains tax, and that the NFTs themselves would be considered assets for the purposes of other taxes – including inheritance tax – the official position has yet to be confirmed.

The jurisdiction in which the digital asset is considered to be located will also have implications regarding the relevant applicable taxes when buying and selling that asset. HMRC has clarified that, for tax purposes, cryptocurrencies are considered in terms of the jurisdiction in which the beneficial owner is resident – but it is yet to say anything on NFT’s.

FATF Guidance / Financial NFT Regulation.

While NFT’s are not specifically regulated, legal obligations may yet be imposed by states or international bodies. These may involve "know your client" checks, obligations regarding verification of what is being sold and record-keeping or other AML compliance requirements relating to money laundering, sanctions laws or the forthcoming Europe-wide Markets in Crypto-Assets Regulation (MiCAR).

The exact status of NFT’s has yet to be officially decided and there is still a lack of clarity on whether an NFT can be described as a security in accordance with Financial Conduct Authority guidance. There is currently a vacuum in terms of official oversight of NFT’s.

The need for more clarification regarding NFT’s has been recognised by the intergovernmental Financial Action Task Force (FATF). Its recent guidance has explained to regulators when and how they should identify and regulate NFT’s as virtual assets.

The FATF guidance clarifies that NFT’s are not considered virtual assets based on their general use, and the evaluation of them should be conducted on a case-by-case basis. The FATF says that they should be regulated as virtual assets when the use of them conforms to the definition of a virtual asset. Read the article FATF Guidance on NFT's.

Adding that “some NFT’s, that on their face do not appear to constitute as virtual assets may fall under the virtual asset definition if they are to be used for payment of investment purposes in practice.’’

The FATF wants to see an approach that is rooted in the actual use of NFT’s as opposed to the technology. The challenge now facing those who are involved with NFT’s is to identify which NFT’s meet the FATF functional definition of a virtual asset. If the definition is satisfied, compliance and monitoring obligations will then have to be met.

This will require a risk-based approach to be taken to prevent unwanted customer transactions and ensure any suspicious incidents are flagged up swiftly. Regulators will be expecting those involved with NFT’s to be proactive when controlling risk.

NFT Compliance and the Importance of Taking the Correct Approach.

The rise of new virtual assets, the demand for them and the current lack of comprehensive regulation means that there are issues and challenges to be faced by anyone who is involved in these rapidly-evolving markets. NFT’s are at the intersection of finance and technology. They pose compliance risks that will be new to many who have involvement with them. Managing those risks will require the devising and introduction of procedures that are capable of identifying, assessing and mitigating their effects.

The first steps would involve:

• Preparing a risk-based approach to prevent unwanted customer transactions.
• Introducing real-time alerts to minimise the time from incident to investigation to reporting.
• Reducing the potential for illicit activity, while ensuring that the user experience is not compromised.

As NFT’s continue to rise in popularity, there will be an ongoing – and possibly an increasing – expectation from regulators that those involved with them are proactively managing the risk. Such a need to develop best practices may require the assistance of those who are “up to speed’’ on all legal matters relating to this fast-moving area of finance.

Lawyers with the requisite knowledge of cryptocurrency, the blockchain and the developing and growing virtual asset markets can be of value to those who are set to face the legal issues and challenges arising from this new technology.

About Rahman Ravelli - NFT Lawyers

Rahman Ravelli is a law firm that has been at the forefront of many of the most significant cryptoassets cases that have come to court. The judgements in these cases have shaped the legal landscape for such assets. Our specialist experts in this area are ideally placed to offer advice and devise a course of action for any individual or corporate that is involved with NFT’s or is considering becoming involved.