Although ‘Non-Fungible Tokens’ (“NFTs”) have been around for some time, their popularity and value have reached extraordinary heights in recent months. Christie's auction house recently sold its first piece of NFT-linked digital art - a collage of images by digital artist Beeple, for $69 million.
This briefing looks at three of the many legal issues raised by NFTs:
- Is an NFT a financial instrument within the EU (Markets in Financial Instruments) Regulations 2017 (“MiFID”)?
- Is an NFT a "virtual asset" for the purposes of the Criminal Justice (Money Laundering and Terrorist Financing) Act 2010 (the "AML Act"); and
- Does the EU Commission’s Proposal for a Regulation of the European Parliament and of the Council on Markets in Crypto-assets and amending Directive (EU) 2019/193 (the “MICA Proposal”) apply to NFTs?
What are NFTs?
NFTs are pieces of digital content supported by blockchain, the “digital ledger” underpinning cryptocurrencies such as Bitcoin and Ethereum. Each NFT has a unique digital ID, meaning that they are not interchangeable. Although NFTs have been around for some time, the popularity and value of some NFTs has recently soared due to: (i) their exclusive nature; (ii) the growing acceptance of cryptocurrency and (iii) significant advances in blockchain technology.
When an individual mints an NFT, a file is created on the blockchain network over which the creator has proprietary rights. While this file cannot be copied, edited or deleted, it can still be accessed widely across the internet and is capable of being viewed, listened to or saved by anyone who wants to do so. While this may seem like a major drawback, the more widely an NFT is shared, the more likely it is to attract interest and thus increase in value.
Supported by blockchain, NFTs have transformed digital works of art, music, videos and other collectibles into unique, verifiable assets that can be bought and sold online with ease. While digital art has emerged as one of the more popular forms of NFT, in practice any piece of digital content can be “minted”, including songs, photographs, videos, memes and even digital avatars. Twitter CEO Jack Dorsey recently converted his first Tweet into an NFT and is in the process of auctioning it off for charity. In early March 2021, Kings of Leon released their new album in the form of an NFT, becoming the first band ever to do so.
How can investors purchase NFTs?
Investors can buy NFTs on a small number of online platforms including ‘Opensea’ and ‘SuperRare’. Unsurprisingly, NFTs cannot be purchased using fiat currency. The vast majority of NFTs are Ethereum-based, meaning that prospective buyers will need to set up an account with a cryptocurrency exchange and acquire the cryptocurrency Ethereum if they wish to make a purchase.
When an NFT is sold through an online platform in what is referred to as a ‘primary market transaction’, the platform usually receives a commission for facilitating the sale, ranging from anywhere between 3 - 15% of the total purchase price. Interestingly, creators of NFTs are also entitled to a percentage of all resale revenues. If, for example, a primary purchaser decides to resell an NFT photograph for €50,000, the original creator will be entitled to as much as 10% (€5,000) of the resale price.
Is an NFT a MiFID financial instrument?
MiFID regulates the provision of certain types of activities in connection with a “financial instrument”. Falling with the definition of a “financial instrument” under MiFID also has implications for the application of other financial services related legislation, such as EMIR and the Markets Abuse Regulation.
Of the various types of financial instruments listed in MiFID II, “transferable securities” appear most relevant to NFTs. It is, however, unlikely that an NFT will constitute a “transferable security”. To fall within that definition, an NFT must be belong to a class of securities and to form such a class, the tokens in the class must be fungible with each other.
In any particular case, however, it may be necessary to carry out an analysis of the relevant token to determine whether it is, in fact, non-fungible for the purposes of MiFID.
Is an NFT a virtual asset for the purposes of the AML Act?
Recent amendments to the Criminal Justice (Money Laundering and Terrorist Financing) Act 2010 (the “AML Act”) mean that a person that provides certain services with respect to virtual assets (a (virtual asset service provider or “VASP”) will, once the AML Act is commenced, be a designated person for the purposes of that Act, and must register as such with the Central Bank of Ireland (the “CBI”).
The AML Act defines the term “virtual asset” to mean a:
“digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes but does not include digital representations of fiat currencies, securities or other financial assets”.
This reflects the definition of virtual asset set out by the Financial Action Task Force (FATF), which is the international standard setter for AML controls. According to FATF, in its recently published draft update of its Guidance for a Risk-Based Approach – Virtual Assets and Virtual Asset Service providers, the definition of “virtual asset” is meant to be interpreted broadly. In particular, to be a virtual asset, an asset must be digital, have inherent value (rather than simply recording or representing ownership of something else), be capable of being traded or transferred and be used for payment or investment purposes. However, according to the draft guidance, the definition of VA:
“does not seek to capture the types of closed-loop items that are non-transferable, non-exchangeable, and non-fungible. Such items might include airline miles, credit card awards, or similar loyalty program rewards or points, which an individual cannot sell.”
Based on the above, while it appears some NFTs will fall outside the definition of “virtual asset”, an exact classification will again depend on the relevant factual circumstances.
If an NFT falls within the definition of “virtual asset” then, generally, a person will fall within the definition of a VASP, when providing one or more of the following services1:
- exchange between virtual assets and fiat currencies;
- exchange between one or more forms of virtual assets;
- transfer of virtual assets from one virtual asset address or account to another;
- custodian wallet provider;
- participation in, and provision of, financial services related to an issuer’s offer or sale of a virtual asset or both.
Does an NFT fall within the MICA Proposal?
The European Commission recently adopted a digital finance package, which includes the MICA Proposal, which sets out concrete legislative proposals on the regulation of crypto-assets. The MICA Proposal will apply to all crypto-assets not currently covered under existing financial services legislation (see our related briefing here).
The MICA Proposal defines the term “crypto-asset” as “a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology”. Most NFTS are likely to fall within this definition and, consequently, both issuers of NFTS and service providers will be subject to the MICA Proposal.
Issuers of NFTs
The MICA Proposal imposes a number of obligations on issuers when offering crypto-assets to the public or seeking admission of such crypto-assets to trading on a crypto-asset trading platform. While several of these will apply to issuers of in-scope NFTs, it is significant that the MICA Proposal exempts the issuer of an NFT from the obligation to publish a white paper setting out specified information on the issuer, the relevant crypto-asset and the offer to the public. The relevant exemption applies to “crypto-assets that are unique and not fungible with other crypto-assets”.
Crypto-Asset Service Providers (“CASPs”)
The MICA Proposal sets out harmonized authorisation requirements and operating conditions for CASPs, as well as specifying rules for their acquisition. It defines “crypto-asset service provider” to mean any person whose occupation or business is the provision of one or more crypto-asset services to third parties on a professional basis. It defines “crypto-asset services” to mean any of the services and activities listed below relating to any crypto-asset:
- the custody and administration of crypto-assets on behalf of third parties;
- the operation of a trading platform for crypto-assets;
- the exchange of crypto-assets for fiat currency that is legal tender;
- the exchange of crypto-assets for other crypto-assets;
- the execution of orders for crypto-assets on behalf of third parties;
- the placing of crypto-assets;
- the reception and transmission of orders for crypto-assets on behalf of third parties;
- providing advice on crypto-assets.
Consequently, once the MICA Proposal is adopted, a person providing any of the above services in relation to an NFT which is a crypto-asset will need to be authorised to do so and comply with any other requirements set out in the MICA Proposal.
As with other types of virtual/crypto assets, the legal and regulatory framework applicable to NFTs is not entirely clear, and much will depend on the characteristics of any specific NFT. While non-fungibilility will effectively exclude an NFT from being a transferable security for MIFID purposes, the position is less clear with respect to the AML Act. Moreover, an NFT that falls outside of MiFID may still be regulated under the MICA Proposal, assuming that it is adopted in its current form. While some NFT issuers and service providers may well view the prospect of regulation with a degree of antipathy, it does come with a number of advantages. In particular, regulation is likely to make NFTs more attractive to a broader range of consumers, as well as enhancing the credibility of both NFT issuers and service providers.
Also contributed by Sean Kehoe.