Here’s a terrifying thought: The U.S. government still doesn’t really know how to regulate the $2.5 trillion crypto market. It’s not that the laws don’t exist, or that Congress is uninterested in digital assets – it’s more that there’s a lack of consensus on how to apply existing regulations to an industry that seems to mutate every few weeks.
This feature is part of CoinDesk’s “Policy Week,” a forum for discussing how regulators are reckoning with crypto (and vice versa).
This is a pattern that has repeated itself over crypto’s decade-long history. Back in 2017, crypto’s hottest trend was the ICO, or initial coin offering. In the way that a traditional company might issue new shares of stock to the public through an initial public offering, crypto companies were trying to issue new cryptocurrencies as a kind of fundraising mechanism. Eventually, the Securities and Exchange Commission decided ICOs amounted to unregistered securities offerings. If it looks like a security and walks like a security, it’s probably a security.
Today, Congress faces similar challenges at the murky intersection of existing policy and new tech. Do DAOs count as companies? Which crypto companies get to register as federal banks? And should the Federal Reserve issue its own digital currency to keep up?
So far, non-fungible tokens (NFT) haven’t figured in the conversations.
Where stocks and conventional cryptocurrencies are “fungible,” in the sense that any one asset can be exchanged for another of equal value (e.g., a dollar is always worth exactly as much as another dollar), NFTs are unique tokens attached to media files. They’ve proven especially handy for monetizing digital art: Turning a single image file into 100 NFTs is like printing 100 copies of a physical work. Rather than being interchangeable, each token is effectively stamped with its own number.
But as with ICOs, NFTs pose their own unique regulatory risks. Dapper Labs, the company behind the runaway NBA Top Shot NFT franchise, was hit with a class-action lawsuit over alleged violations of securities laws. And even SEC Commissioner Hester Peirce, who has cultivated a reputation as one of the country’s most crypto-friendly regulators, has said that certain frameworks for selling NFTs could get investors into trouble with the law.
Olta Andoni, chief legal officer for an NFT company called Nifty’s, identified a few major areas in which NFTs might be considered securities under existing regulations.
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“The most straightforward way that I think is going to be super-dangerous is fractionalizing, which means that you allow for multiple investors to buy portions of [an] NFT,” she said. There’s a way in which buying a slice of an NFT is a little like buying a slice of a company, i.e., a share. It’s becoming an increasingly common practice thanks to the popularity of programs like PartyBid and Fractional.
Lucky for us, there’s already plenty of legal precedent here. Per the Howey Test – a multi-part rubric for determining whether or not something qualifies as an investment contract – a security is defined as an investment in a “common enterprise” with the expectation that someone else is going to make your investment go up.
Stocks fit the bill because shareholders expect their company to become more valuable over time, thanks to the efforts of its employees.
“I think [fractionalized NFTs] are more at risk because you have a user or individual that is investing money in a common enterprise,” explained Andoni.
Speaking with CoinDesk over the phone, Hester Peirce concurred. “If you take something and you slice it up, and you sell slices of that thing whether it’s NFT or something else, then that could very much start to look like a security,” she explained.
Andoni said there’s an added danger for developers who issue a collection of NFTs but retain ownership over a certain amount. In that case, the NFTs start to resemble shares in a company. When the founders have a majority stake, there’s a vested interest in making the price go up.
Larva Labs, the New York-based company behind CryptoPunks, is maybe the most prominent example of this approach. One of the company’s co-founders has said the team reserved 1,000 NFTs for themselves ahead of the public launch back in 2017. CryptoPunks are now the most valuable NFTs in the world, and the Ethereum wallet with the most tokens appears to be controlled by Larva Labs.
This past summer, a story in The Hollywood Reporter revealed that United Talent Agency had signed Larva Labs’s three major NFT projects (CryptoPunks, Autoglyphs and Meebits) “for representation across film, TV, video games, publishing and licensing.” All signs point to a burgeoning CryptoPunks media empire, with Larva Labs at the helm.
This is complicated by the idea that while NFTs can be a vehicle for speculation, they’re also defined by the media with which they’re associated. There’s an argument to be made that crypto-backed ownership of a song, image or video can provide psychic benefits that stocks can’t.
Lewis Cohen, an attorney at tech-focused firm DLx Law, framed that idea in terms of “consumptive interest.” What are you actually getting when you buy an NFT?
“With many NFTs it’s important to understand what the actual consumptive interest is, whether it is the enjoyment of knowing your special relationship to an artwork, to be able to identify yourself publicly as having been the one person who purchased this artwork, or something else,” said Cohen. “But that’s not always clear.”
Last week, I asked Hester Peirce about CryptoPunks specifically.
CryptoPunks is a collection of 10,000 unique images tied to NFTs. If Larva Labs is effectively a majority shareholder of these 10,000 slices of IP, and it is working out movie and video game deals with UTA in an effort to increase the value of that IP, does CryptoPunks end up functioning like an investment contract?
Peirce demurred, but her refusal to answer the question was itself somewhat revealing. Here’s what she said, in full:
I mean, I’m gonna not weigh in on that, because I have Coy [Garrison, counsel to Commissioner Peirce] standing and looking at me and telling me that I shouldn’t. But I think there are a lot of – I mean, you’re raising an interesting scenario. And I think this is why people need to be very careful.
My advice to people is, look at your facts and circumstances, set them down on a piece of paper and then read it with the eyes of an SEC lawyer. And make sure that you get someone to think about getting the advice that you need before you walk down the road.
But maybe the better question is whether the SEC would even care about NFTs, in practice. Between crypto-fueled ransomware gangs, carbon-hungry bitcoin mining companies, and a stablecoin industry backed by shadow banks, regulators probably have bigger concerns in the realm of digital assets.
Andoni thinks the SEC doesn’t have the resources to go after every NFT project toeing the line between token and investment contract, but admitted things could change.
“I think someone is watching. I don’t think that they’re gonna be letting all these projects go easily because some are just, like, this close to becoming a security,” she said. “I’m still so optimistic about the NFT space. I just hope that we’re not gonna ruin it.”
Investment schemes come and go, but the threat of regulation is forever. NFTs became a major market about a year ago – stablecoins have been around for nearly a decade, and the White House has only just started thinking about reining them in. For now, it’s not entirely clear what constitutes a legal NFT drop.
“Our doors are open, people can come talk to us,” said Peirce on the question of noncompliant NFTs. “It’s just, unfortunately, part of the landscape because we don’t have clarity right now.”