Whether we’re talking about startups, pharmaceuticals or non-fungible tokens – known as NFTs – rapid growth comes with risk. That does not mean that rapid growth is inherently bad. But if you’re considering an investment that’s gaining popularity at breakneck speed, it’s wise to proceed with caution, or at least cautious optimism.
An NFT is a digital asset (cryptocurrency) that is often linked to some kind of artistic collectible, such as music, artwork or a video. They are a fun, tangible way to own crypto, but their recent rise in popularity has been accompanied by consumer fraud, money laundering, cyber security breaches and other types of criminal activity. As a result of this rapid growth – and the amount of money exchanged – law enforcement and regulators are increasingly paying attention to NFTs.
What is the Federal Government’s position on NFTs?
For now, the US government is determined not determined on its guidelines regarding NFTs. In March, President Joe Biden’s executive order directed federal agencies to identify problems with cryptocurrencies and decide how to regulate this burgeoning market. Yet neither he nor the executive order even mentioned NFTs.
When it comes to regulating the NFT market, federal agencies have largely adopted a wait-and-see approach. While this may give the market a Wild West appeal at the moment, it also paves the way for myriad regulatory and enforcement risks in the not-so-distant future.
Regulations against money laundering
Under federal law, any business that exchanges “value that replaces currency” must comply with anti-money laundering regulations. However, whether or not NFTs fall into that category is currently not entirely clear. A February report by the US Treasury Department’s Financial Crimes Enforcement Network (FinCEN) suggested that this classification can applies to certain NFT exchanges. But it also distinguished between “collectible” NFTs, such as those linked to works of art, and NFTs used for investment purposes, with only the latter slated for regulation.
However, that does not mean that “art NFTs” do not pose a risk of money laundering. In fact, the FinCEN report described the risk of “self-laundering,” where criminals “buy” NFTs they already own with dirty money. In fact, digital art is particularly vulnerable to money laundering because owners can quickly move these assets without the costs or regulations associated with physical shipments.
What about the SEC?
The Securities and Exchange Commission (SEC) is still unsure whether NFTs should be classified as securities (and therefore fall under the Securities Act of 1933), but SEC Commissioner Hester Peirce warns that some situations are likely to require greater scrutiny than others. In particular, she points to fractional NFTs, where several buyers buy parts of a single high-value NFT.
Long story short, the US government hasn’t quite figured out how to deal with this new technology, or its unprecedented rise in popularity. But the risks surrounding NFTs should not be underestimated. NFTs can be a great way to diversify, but caution is key.
Watch out for NFT scams
You can buy NFTs through legitimate marketplaces, such as OpenSea and Coinbase. But that does not necessarily mean that NFT itself is legitimate.
It is disturbingly easy for fraudsters to create fakes or copies of a seller’s artwork, and trick investors into buying an NFT that the fraudster has no right to sell. And since blockchain transactions are irreversible, the cheated investor cannot get their money back, even if the token they bought was fake.
It is also easy for fraudsters to unethically increase the price of an NFT through a process called wash trade. This happens when the owner quickly sells and buys from fake accounts, increasing the price with each transaction. Since the NFT’s price is based on demand, a fraudster could buy an NFT for $100 and sell it to another account for $1000, instantly increasing the NFT’s value to $1000, for example.
Potential for big rewards = Potential for big risks
As assets go, NFTs are highly volatile and illiquid. Prices change by the minute and it is extremely common for a buyer to buy an NFT for $100 and have it lose almost all of its value almost instantly. The opposite can also be true, of course…but that’s the nature of a volatile investment. Combine this volatility with illiquidity (you need a willing buyer if you want to sell) and you have a very risky investment. Of course, big risks can lead to big rewards.
Investors should seek experienced legal counsel before diving in
Currently, the future of NFTs – and the prohibitions, regulations and risks surrounding them – remains somewhat unclear. But one thing is clear: if you want to invest in NFTs, it is crucial to educate yourself about this burgeoning market and how to reduce your risk. Moreover, this education should not be a once-and-done affair. We are likely to see more regulations and upgrades to counter the many risks, and staying current with these trends is critical to a favorable investment outcome. If you are looking to invest a significant amount of money in NFTs, it is in your best interest to consult with an attorney experienced in this emerging technology.
Over the next few months, our series will continue NFTs: What to look for, how to protect yourself and investor tipswill discuss NFTs as they relate to:
- Company law and securities
- The cannabis industry
- Make money from digital assets in bankruptcy
- Intellectual property rights
- Estate planning
- Taxes and regulatory issues