Are Non-Fungible Tokens (NFT) regulated? What are the concerns?

The hype around NFT has subsided. It seemed as if NFT was slated for explosive growth in 2022, being named “word of the year” and hitting record high volume in January this year. But as it turns out, it was the top. Looking at Q3 2022 NFT trading volume around the top 8 chains. There is a decrease in trading volume of 76.4% from Q2 2022 to Q3 2022.

Since then, trading volume has fallen 83% from the beginning of the year, according to Footprint Analytics’ data on CoinGeco. The last few months have logged figures lower than July 2021, just before the NFT summer. Most notably, Ronin and Avalanche have dropped out of the Top 8, replaced by ImmutableX and Panini. Recent sports craze has spilled over into the NFT space, pushing Flow into the Top 3. Solana’s NFT ecosystem doubled September volume while all competitors faltered.

During this period, where the market is bearish, you will see changes. For example, in Q3, Magic Eden wins based on OpenSea dominance. Magic Eden was the only one to see growth in September, doubling its volume and dominance month-on-month, while the rest of the competition continued to slide further. Magic Eden (22%) has gained ground on OpenSea’s (60%) dominance, but it remains to be seen whether it can sustain its current momentum.

Another factor in maintaining the current momentum is adapting to the regulatory norms. There is still disagreement about how NFT should be handled, which makes it difficult to set clear regulatory norms. NFTs can now be viewed in one of three ways: as commodities, securities or intellectual property. Let’s explore each interpretation in more detail.

Raw materials

Commodities are defined by US law as reasonably exchangeable services, goods and rights, including money and interest, that are traded as commercial items. The Commodity Futures Trading Commission (CFTC) claims that cryptocurrencies such as Bitcoin and Ethereum, as well as renewable energy credits and other intangible assets, are included in the definition of commodity.

If we take NFTs, they are similar to cryptocurrencies in several ways. They can be bought and sold and are based on blockchain technology. In addition, the CFTC places more emphasis on price manipulation and commodity exchanges than it does on underlying assets and issuers. The Commodity Exchange Act (CEA) can be implemented if it is decided that NFTs should be classified as commodities. CEA’s rules on manipulative trading may apply in this situation.

Securities

Most NFTs with a single owner and only one unique asset are unlikely to be securities. However, in certain situations they can. If an NFT has security-like characteristics or otherwise satisfies the Howey test, such as when money or other form of compensation is invested with a reasonable expectation that gains will result from the efforts of others, the NFT may be subject to US securities laws. A case-by-case Howey analysis is important to determine whether a specific NFT is a security. However, NFTs may violate securities laws in the following situations, depending on the details:

• NFTs are pre-sales of digital assets intended to be used on a platform that has not yet been developed, and the proceeds of the sale go towards developing the platform;
• Digital assets can be “pooled” or “fractionalized” (for example, in the case of art, when creators pool resources and share profits, or where multiple NFTs reflect different investors’ portions of ownership of a single asset);
• NFTs are a license to a digital asset (such as a song) and a share of the revenue (eg a percentage of sales).

Intellectual property

NFTs may be covered by intellectual property rights such as copyright, design patents and trademark protection. As a result, buyers of NFTs should be aware of any associated intellectual property rights. In fact, the license that comes with many or even most NFTs only allows the NFT buyer to use, copy and display the NFT.

A clip of renowned basketball star LeBron James’ slam dunk is an excellent illustration. The video was made available as a limited edition NBA highlights video compilation. The NBA collectibles are available to buy and sell on the Top Shot NFT marketplace. The NBA still owns the copyright, and the rules of the license agreement continue to apply to the replication of all purchased items.

However, while most NFT producers place restrictions on commercial use, other authors grant NFT owners broader rights. Members of the Bored Ape Yacht Club (BAYC) have the right to use their “apes” for commercial purposes, allowing them to produce and market hats, T-shirts, mugs and other items.

Brand owners should consider how current or upcoming design patents can protect against imitation or infringement in addition to trademark and copyright protection. Because they give owners full ownership of an infringer’s profits rather than just the fraction associated with the use of the design, design patents are important intellectual property rights compared to other IP rights.

Fraud schemes

Despite being a relatively new idea, NFTs are already being used to commit a variety of frauds. Here we go over some of the most prominent NFT-related fraud schemes that have occurred:

• Tokenization– The process of producing digital tokens that reflect ownership of physical assets is known as tokenization. This happens when someone steals an artist’s creation without their consent and “mints” it to create an NFT.
• Wash trade– This is the practice of users manipulating transactions by trading with themselves or others to pretend to be in high demand for an NFT, manipulate its price or improve its visibility.
• Insider trading– The practice of using information that is not widely known for personal benefit. In recent high-profile situations, employees and managers of NFT companies and markets have engaged in behavior that could be seen as unfair or illegal. Various events generate negative press for these organisations. NFTs’ insider trading rules often prohibit buying NFTs based on secret information. Similarly, several forms of trading in NFTs by companies that aim to inappropriately manipulate the perceived price or trading volume of such NFTs are prohibited.
• Anti-money laundering– NFTs, especially high value ones, can occasionally be used to aid in money laundering. A study on how the art market helps finance terrorism and money laundering was released by the US Treasury Department. The study covered a range of topics, including the dangers of financial crime in relation to digital art and NFTs. The study discovered that the high-value art market has several inherent characteristics that can make it vulnerable to various financial crimes.

To conclude

As we can see, the market for NFTs is still growing and it will take some time before an appropriate regulatory framework for NFTs is in place. That said, governments around the world have already begun the process of developing NFT norms and standards, proving that they are seriously interested in these digital assets.

Additionally, you should be aware that the phenomenal success of NFTs will undoubtedly result in fraudulent activities. For this reason, it is becoming more and more crucial to conduct research before buying or investing in NFT collections or projects.