Aug 2, 2022

15 min read

A Closer Look at NFT Regulation: What Does Our Future Hold?

In the past few years, NFTs have become a household name. For many, they have introduced an innovative new avenue for expression online, investment, access to exclusive benefits, and so much more. For other people, NFT is a buzzword which connotes confusion and sometimes even frustration, possibly due to fear of something new and misunderstanding. Either way, there is clearly a market for NFTs, not only due to the stir they induce, but also the empirically explosive sales volume they saw in 2021.

However, those who are cautious and critical of NFTs are not totally unfounded in their feelings. NFTs and associated markets are still very much a new frontier with new challenges. For example, determining NFT worth is a complex task and must be made more clear for users. It is likely that uncertainties such as this contribute to misunderstanding of NFTs and the resulting intimidation. It would be to the benefit of the NFT market to create clarity for potential users.

Regulation is one of the greatest tools at hand in tackling the problems that plague NFTs. While the government is instrumental in regulation, it is somewhat lacking in terms of NFT guidance, legal definitions, and general lawmaking. It is important then that the government stays ahead of these challenges, not only to cultivate this market, but also to curtail problems like crime. Private actors within the NFT community have also played a large role, especially in light of these government deficiencies. It is crucial not only to understand the issues at hand, but also for the public and private sectors to complement one another in order to create comprehensive NFT regulation.

Understanding NFTs and Their Benefits

NFTs (non-fungible tokens) are unique, verifiable tokens on a blockchain which give creators and artists a way to publish their work, distinctively prove it is theirs, track ownership, and create scarcity. An example of an NFT might come in the form of tickets to a concert sold as one. One of their most famous iterations are PFP-NFTs (profile picture NFTs), by which investors could then use this art to identify themselves anonymously online with the associated blockchain-backed value.

A prime example of this was when Twitter began offering verification borders to prove the authenticity of NFT avatars being used. They could technically be “copied” but would not have the verified hexagonal border. For a lot of people who don’t understand, PFP-NFTs represent several things: status within the community, access to said community, monetary worth, stored value, creation of a recognizable brand with anonymity, commercial rights to the NFT, and simply fun. They are far more than a fad which can be copy and pasted and deserve acknowledgement.

The Largely Untapped Market and Upside Potential

NFTs have swooped in very quickly and recently, with a market value now of billions due to widespread adoption, trends, and popularity (such as celebrity purchases). While having been in existence for nearly a decade now, it is only recently that they have seen a fantastic boom in creation, sales volume, and adoption. They are nothing else if not new, exciting, and very cutting-edge, with the great potential for monetary gain. With the recent influx of money and interest into NFTs, they can’t be ignored. However, they have also been greatly mocked and maligned as a fad which will pop and leave nothing for their owners. The only shred of truth to this is that they are still relatively new and do present challenges which must be addressed and regulated.

The Main Issues and Private Regulation

The overarching factor which needs to be handled by regulation in NFTs is still about verifying their value, rarity, and authenticity. More specifically are concerns not only about protecting against nefarious actors, such as those seeking to duplicate the original works of others, but on the positive side, regulating to demystify NFTs. Informed investors will be able to take better advantage of NFTs and will thus promote future prosperity in what seems to be a market which has not yet seen its full potential. Regulation is also needed to protect the new market from pitfalls such as bubbles, to nurture it and tap into this potentially lucrative investment instrument. Many times, the private sector has proven to be a very efficient actor in regulating issues facing society, be it economically or otherwise. The government is an undeniable part of proper regulation, but private companies also seem to have a more vested interest in self-regulation and therefore are needed to complement, at times slow and inefficient, government action.

Determining NFT Worth

Despite NFTs being backed by blockchain, their underlying values are still threatened. Due to the increasing release rate of NFTs, value is becoming based on rarity. Duplication through transformation of data is another factor to consider. Therefore, NFT owners need to be able to determine the true worth of an NFT.

One example of a private company attempting to regulate this is Pastel Network, a blockchain protocol, adaptable to any native layer-1 blockchain and layer-2 DApp, used to measure the relative rareness and guarantee the authenticity of an NFT, including duplicate detection. It has filled the void in the market with a simple way for users to identify the rarity of an asset so that average users can understand and do so. It uses an NFT fingerprint vector and then the algorithm compares it to a database for duplication. A rareness score protects original NFTs from similar designs. Pastel seeks to be a “game changer”, which proves the drive of private actors to regulate the market.

Investing Smart

It is also this issue of ascertaining the true value and rarity of an NFT that hinders the NFT market from reaching greater heights of profitability. One of the downsides of the recent NFT boom is overhyping and a lack of understanding of the asset by investors, creating a bubble like that of the dot-com era. Proper valuation research of this relatively new and complex investment is necessary to learn from the mistakes of the dot-com bubble and be more than just a hype. Investors need a process by which to research the value of NFTs and provide them with better understanding. Many people invest based on hearsay or trends because NFTs are unlike other investments which provide fundamentals. NFTs instead rely on more complex factors such as rarity. Also, the need for investors to be very aware of social media news can be a challenge for them. NFT trackers like the Delta app make it easier for investors by refining criteria to the users choosing, such as finding types of collections. Actions like these will regulate the overwhelming need by investors to rely on rarity, thus assuaging price uncertainty and smoothing out large price fluctuations. Another example of a private player regulating the field.

The very popular “Bored Bunny” NFT project was hyped by celebrities such as Floyd Mayweather. However, investors lost $20.7 million due to deception by the team.

Other Valuation Factors

It is not only the rarity of NFTs which investors must be able to derive in order to invest properly. Other aspects which need to be made more clear for investors include:

Utility

This involves the potential usefulness an NFT offers to the owner. The more privileges, access, or uses the NFT holds, the greater value it has. An example of utility in an NFT could be in the form of video game assets. How tangible the utility is in the real world amplifies the value. The ability for an NFT to be used in different applications is another aspect of utility, although it is an area which could be better managed. For example, due to a lack of a large-scale ecosystem, 90% of NFT game players play only one game. Developers like Dapper Labs and Engin, who are working to resolve this, could potentially unlock a huge market for NFTs, their utility, and the gaming industry.

Community

In order for an NFT project’s value to shine, it needs the support of a strong community. A project which has the backing of a passionate and vocal community adds trust and engagement to it, such as an active and dedicated discord. Community is also important to establish confidence, communication, and transparency in a project.

Partnerships

Value can also be built into an NFT through partnerships with reputable brands, such as tickets to a professional sports event in the form of an NFT. This in turn adds utility to the NFT for the owner and legitimacy to the project.

Mission

An NFT project needs a mission, otherwise it is aimless and detracts from its value. There must be a purpose or a need which is met in order to create value. Creators need to find a way to interest others by branding towards and targeting a specific audience. An example of this would be the Taco Bell “Transformative Tacos”, a series of NFTs which began at $1.79 and now range close to $200,000. 0.01% of future sales goes to the Taco Bell Foundation and Live Más Scholarship. Taco Bell made use of the increasingly virtual marketplace in a way which was organic to its business while working towards a noble mission. Customers find value in purpose-driven brands with a social impact. This is especially true of younger generations if it is done through virtual means like NFTs. It’s even better if an NFT can engage, build, and reward its customer base.

The Team

The backgrounds and credentials of the team behind an NFT project are important value indicators too. Much like a résumé is important to determine the skills of an individual, knowing these features of a core team correlates to the value of the project. Learning about the team, such as through social media, can highlight their levels of passion, community engagement, character, and past NFT experiences, all of which impact the value of a project accordingly. Referring back to the “Bored Bunny” NFT, if investors had known the core team behind it better, they might have realized that the team had a history of fraudulent projects.

Project Roadmap

An added facet of value found in having community engagement is the advantage of being able to communicate the timeline and stages which a project passes through, either projected or as they develop. This also ties into the value provided by having a mission. The clearer and more detailed a project roadmap is, and the more it lays out its recipe for success, the more value it possesses.

The Artist

Since the value of an NFT is largely tied to scarcity and rarity, the artist’s reputation and status are major factors in determining how special, invaluable, and important the art behind the NFT is. More value is added if an artist has established a unique brand with a strong fan base through their own style. Things like social media presence and on-chain IDs, to create a smart contract for the artist and a verification of the artwork, also help the artist stand out. Above all, the artist needs many, if not all, of the preceding factors to push their art to NFT status.

Other Relevant Areas for Regulation

Other risks to NFTs include things such as weaknesses in smart contract protections, digital contracts set in code to self-execute upon completion of specific conditions. An example of this would be the hack of DeFi protocol Poly Network in which $600 million in NFTs were stolen. The reason was the inadequacy of the smart contract security. Fake NFT stores selling counterfeit or even non-existent NFTs, as well as NFT creator impersonators are another issue. Also, traditional laws of property currently do little to protect intellectual property rights of NFT owners, such as buying a replica but only receiving the right to use that NFT but not the intellectual property rights. This requires regulation to secure these rights. Lastly, there is a discrepancy between whether NFTs are securities or investment contracts. All of these must be considered as well when regulating the market.

The Government’s Role and Challenges

The Lack of Regulation

Finally, While the case for private regulation is clear, the government has a distinct role in regulation as well through the power of the law. In fact, now more than ever does the government need to keep up with this asset class which is very much misunderstood, new, and lacking regulation. As governments around the world work to catch up with NFTs, without even a clear legal definition or guidance yet, it becomes apparent that an international regulatory body would be prudent. Using the United States as an example, classifying NFTs becomes difficult in this vague regulatory atmosphere because they can be linked to different assets, rights, and obligations

Legal Definitions and Guidance

The definition of commodity, like other blockchain technologies, could fit NFTs according to the Commodity Exchange Act. Definition as a security would depend on the marketing of NFTs in relation to buyer expectation of profit based on the efforts of others. “Fractional” NFTs, partial interest in an NFT, could be viewed as “investment contracts”. Security law issues would then arise, such as registration of relevant marketplaces, based on the Exchange Act. Another challenge is how metadata within the NFT, decided by the creator, determines the intellectual property rights transferred to the buyer. Buyers must be able to be made aware of the specific rights they do or do not receive upon purchase. The Financial Crimes Enforcement Network has regulatory power in the financial system to prevent criminality. Lacking comprehensive guidance at the moment, however, it is questionable whether NFTs fall under FinCEN’s jurisdiction due to the uncertainty on whether they are considered substitutes for money

Sanctions, State Laws, International Jurisdictions

From the area of potential U.S. sanctions on NFT users, The Office of Foreign Assets Controls also lacks guidance but has identified a high risk of possible violations, based on previous experience with other blockchain technologies due to the lack of transparency and decentralization. On a state level, some like New York have passed laws regarding companies associated with virtual currencies, with a list of activities such as exchanging. One solution posited by these states is to require a license or charter and post surety bonds or fund an account. The cybersecurity needs of users must also be protected by government regulation, as they are the most vulnerable to targets by cybercriminals and “account takeovers”. Finally, the international sale of NFTs is another regulation consideration, such as the moving of NFTs across other jurisdictions, such as the Markets in Crypto-Assets Regulation in the EU. Fortunately, NFTs are now being acknowledged and regulation is improving as things progress in this brave new market.

Rug-Pulls and Wash Trading

One specific NFT-related crime is known as a rug-pull. This is when an NFT project entices people to invest in it and then the developers abscond with the proceeds after leaving the project. An example of this was the “Frosties” scam. Allegedly, two crypto traders, Ethan Vinh Nguyen and Andre Marcus Quiddaoen Llacuna, advertised NFTs called “Frosties” which would grant access to many perks, such as early access to a metaverse game. However, upon selling out, they allegedly deactivated the website, abandoned the project, and transferred $1.1 million in crypto from it to their own various wallets with plans to launch other fraudulent NFTs called “Embers”. The US DOJ charged them with conspiracy to commit wire fraud and conspiracy to commit money laundering.

Another noteworthy crime in relation to NFTs is wash trading. This is the practice of someone selling themself their own NFT. It is done many times in order to create the false impression of a higher price to make it seem more appealing to unsuspecting buyers. Fortunately, companies like Chainalysis, with expertise in observing blockchain technology, are watching. They released a report which monitored and followed 110 profitable, albeit overt, instances in which NFTs that were sold back and forth at least 25 times by the same group of cryptocurrency wallets, resulting in sales of $8.9 million. However, on average, this is not very profitable, even for the most successful trader monitored (830 trades with a profit of only $8,383). Wash traders are further hindered by gas fees, the commission every Ethereum transaction takes. Unfortunately, Chainalysis suspects that keener traders would probably use different Ethereum wallets for each transaction, so this report only accounts for a fraction of wash trading. Jarod Koopman, the director of cybercrime investigations for the IRS, said that his agency does look for purposeful cases of wash trading, like the Chainalysis report, but regulations for NFT wash trading simply aren’t as clear as they are for stocks.

As of June 1, 2022, the Department of Justice made a great stride in handling NFT insider trading when it charged former OpenSea employee Nathaniel Chastain with insider trading of NFTs on said marketplace. Allegedly using anonymous accounts, and with confidential knowledge, he would buy NFTs before they were featured on the site, at which point they would grow in attention and demand. He would then resell them for huge profit. Furthermore, he did so despite agreeing to not use the information for his own benefit. What makes this case so novel is that instead of charging him with a violation of the SEC’s insider trading statute and rules, the Southern District of New York is charging him with violating the general wire fraud statute. This was likely because the government thought it would be unsuccessful if this was treated like a standard insider trading case, despite elements of insider trading theory being used in the case. This relates back to how tricky it is to define an NFT as a security. If this wire fraud approach is successful however, it could be used in the future. The SEC has been tenacious in regulating NFTs and it appears as though their strategy is to do so by defining them as securities What remains to be seen is how combative the SEC will be in regulating NFTs and how defining them as securities will stand in court. Furthermore, it is fortunate that the SEC and the Southern District of New York have joined forces to regulate the NFT market.

While it is clear that the federal government was unprepared for the rise of NFTs, both in establishing laws and guidelines as well as tackling the associated criminal elements, it is also evident that it is gaining expertise in handling them and working towards addressing the gaps in its policy. However, this is still new terrain for the government and continued regulation is required. Some responsibility needs to be placed on operators of NFT and cryptocurrency markets to impress upon the importance of maintaining confidential information and to crack down on such criminality, such as through stronger policies, procedures, and training. Since there is a shared goal, it would seem wise for companies with expertise like Chainalysis to work in conjunction with law enforcement.

The Present and Future: Finding Opportunities

2021 was no doubt an auspicious year for NFTs. However, 2022 has been quite bruising for the crypto market at large and NFTs haven’t exactly been immune to the pain, with NFT prices and accounts trading NFTs down.

Source: https://beincrypto.com/nft-marketplace-volume-12-billion-2022-lows/

Nonetheless, there is much for which to be hopeful. Much like investing in general, downturns, bear markets, and corrections are all means by which investors can enter and be part of the next boom. For NFTs in particular, it is important to remember that the market is still emerging, relatively speaking. As such, it faces problems which must be addressed, such as determining valuation, security weaknesses, and inadequate government regulation. Fortunately, like them or hate them, NFTs created a buzz in 2021 which no one could ignore, if for no other reason than the excitement they stirred. The government and the private sector have taken notice and must contend with NFTs and their associated problems, in the hopes that proper regulation will foster a more mature and sustainable NFT market. With the downturn of the broader crypto market, now is the opportune time for everyone, investors, government, and private sector alike, to at least understand the issues which require regulation in order to stay ahead of the problems.

The hope for NFTs is best exemplified by the 2022 NFT.NYC conference, expected to boast an attendance of 15,000 people who believe NFTs are the future for so many things, including art and the internet. Ticket prices to the event range from $599 and $1,999, for people to share about their enthusiasm for NFTs and the ways they can grow and improve. David Angelo, co-creator of the NFT project Naughty Giraffes, echoed the sentiment about downturns being an opportunity to invest. What’s more, Angelo reminded that the path may be long, and some may not endure it, but that doesn’t mean that long-term growth isn’t possible. He’s not alone in his long-term optimism. Other positive activity as of June 2022 includes continued investment by venture capitalists, the $8 billion dollar valuation of digital asset trading platform FalconX, and Meta’s publishing of an NFT-for-beginners guide.

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