What are NFTs and are they regulated?

The regulatory world is currently playing catch up to a new dawn of crypto assets.

Non-fungible tokens (or NFTs, as they’re more commonly known) have left regulators perplexed as they don’t seem to fit into any of the traditional forms of an asset.

The cryptocurrency world has recently been hit with more specific guidance. Whereas, the NFT industry has not been touched by regulators and NFT creators, owners, buyers and sellers may run riot against prudential actions.

What are non-fungible tokens?

On a very basic level, non-fungible tokens are assets that are digitally stored on the blockchain. 

Being non-fungible makes them different digital assets from other currencies, such as cryptocurrency. With crypto coins like bitcoin, you can easily exchange one bitcoin with another bitcoin with each other, since they have the same value. 

However, NFTs have their own unique identification codes to distinguish between them, meaning they can’t just be interchanged with one another. So while fungible assets like crypto can be used for transaction-based activities, each non-fungible token can’t. 

How are NFTs created?

On a very simplified level, NFTs are created through a process called minting. 

1. A new block is created.
2. The information published on this block is validated by an external party.
3. The information is then recorded publicly (as with every transaction in the history of the blockchain).
4. A smart contract assigns the ownership of the NFT.

NFT use cases

NFTs have so far been pieces of art and are therefore deemed digital collectables.

NFT enthusiasts and celebrities have begun their own collections, with some of the most famous NFT pieces being the NBA Top Shots and Bored Apes. But some have more functional uses, and there are regular developments for different use cases.

Why would you pay for an ‘NFT ownership’ when you can access the art online for free?

Think of NFT ownership like real-world art ownership. Sure, there are plenty of prints and copies of Picasso’s ‘Guernica’ or Van Gogh’s ‘Sunflowers.’ But only one person has the original. 

The same concept applies to NFTs. All intellectual property (IP) rights are given to the single original owner via smart contracts. Plus, with these new functional use cases, ownership of NFTs can bring other exclusive benefits.  

For example, NFT Birth Certificates have been designed. Issued to children as soon as they are born, it means that individuals can verify their identity and build a lifelong medical record on the blockchain. This would also enable medical professionals to access the right data without compromising patient confidentiality.  

NFT Regulation around the world

At present, the regulatory world is still catching up to NFTs. This means that in varying jurisdictions, NFTs fit different asset classes and could fall under certain regulations… or they could not. 

But right now, there is very little regulatory guidance for the artist, seller or NFT marketplace to follow. 

Let’s explore this a little bit further.

The UK

In the UK, there is no set regulation for NFTs. However, there are three separate forms of crypto assets, and your NFT could fall under any one of them. These are: 

1. Security tokens
2. E-money tokens
3. Unregulated tokens 

It’s fair to say that most NFTs fall under the unregulated category. In this case, as the name suggests, no regulation applies.  

But if the NFT fits the characteristics of a security token, then it will be subject to the Financial Services and Markets Act (2000). If they’re considered e-money tokens, the NFT owner will be subject to the Electronic Money Regulation (2011). Both are overseen by the Financial Conduct Authority (FCA).  

Either of these categorisations means that owners (typically businesses) would require specific authorisation by the FCA, and follow both anti-money laundering (AML) and know-your-customer (KYC) frameworks. 

The EU

In the EU, there is no specific regulation that applies to NFTs. However, they could fall under general cryptocurrency regulations, such as MiCA.

When NFTs result in sales of more than €10,000, standard anti-money laundering regulations (AML) come into play. This is likely to hit digital art collectors more than one-off curious types. If above the threshold, the seller must meet due diligence requirements, and follow the guidelines for the proper transaction records.  

Likewise, NFTs fall under the general guidance from the advertising standards agency about financial products. 

Finally, businesses must pay corporation tax on any profits above the threshold, and individuals are required to pay capital gains tax on profits. 

The US

The SEC is still determining whether NFTs are in fact being treated (and traded) like securities under a different name. Yuca Labs, the creator of the infamous Bored Ape, has been under particular analysis due to the governance rights that come with their products.  

From the SEC side, it’s about determining whether NFTs are a type of financial instrument at their core, or if they simply represent an underlying asset. 

Securities (even if they do come in a form of a virtual asset) fall under the jurisdiction of the Securities and Exchange Commission, which applies FinCen anti-money laundering requirements.  

However, no other regulatory measures have yet been implemented in the United States. 

China

While China has an outright ban on virtual currencies, they do have separate guidance for NFTs. Their code of conduct details how NFTs cannot be used as de facto securities, with no underlying trading items such as credit or precious metals. 

The code also warns against the use of virtual currencies and direct investments. This makes China the most anti-NFT jurisdiction at present, with every NFT transaction likely to be scrutinised. 

Future of the market and regulation

Right now, creators, buyers, sellers and business owners must attempt to comply with some of the messy guidance in their jurisdictions.

We expect much more clarification as the regulators catch up to blockchain technology, and all that it encompasses. Where cryptocurrency has its own set of rules, we expect to see regulatory bodies around the world bring in more specific guidance for NFTs (even as their functionality grows).  

Until then, non-compliance with current guidance could warrant heavy fines. Even social media influencer and reality TV star, Kim Kardashian, was recently fined $1.2million for false advertising in relation to NFT and cryptocurrency products.  

To stay ahead of emerging regulations, RegTech which utilises horizon scanning could be your best friend. With the ability to be alerted to what’s around the corner before it happens, CUBE’s regulatory technology uses AI and machine learning to identify the regulations that matter most to your firm.

Keep ahead of emerging regulations by speaking to CUBE.