The Reed Smith Guide to the Metaverse - 2nd Edition

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As NFTs continue to surge in popularity, questions swirl around their legal and regulatory status. For some NFTs there is lingering uncertainty on issues such as the ownership rights they convey to the buyer, whether the NFT can qualify as “property” under applicable legal frameworks, and which consumer-protection principles should apply to the sale and purchase of the NFT.

Autores: Hagen Rooke

With NFTs being structured in an increasingly complex manner, an additional question that now commonly arises is whether the NFT qualifies as a regulated financial product under the laws governing its issuance and distribution. In their purest form, NFTs represent unique items such as collectibles or pieces of art that are not intended to be a financial product, notwithstanding that they may represent an attractive investment opportunity (as is the case of many non-financial real-world items). But when NFTs give their holder the right to income streams or to a share in an underlying portfolio of investment assets, the NFT potentially transforms into a regulated financial product. With the increasingly exotic structuring of rights attaching to NFTs, the conventional industry perception that NFTs are unregulated products is gradually eroding.

Use cases for NFTs with complex tokenomics abound. Such NFTs are, for example, integrated into play-to-earn gaming platforms, where they may represent avatars or other in-game items that can be used to generate income for the holder. NFTs may also be minted as an on-chain representation of a unique real-world asset that a decentralized autonomous organization (DAO) wishes to invest in, thus giving the DAO participants collective exposure to the value of that asset. A further noteworthy development is the emergence of platforms that issue NFTs that give their holders rights to a share of royalties generated by underlying music catalogues. In some cases, payments made to holders of the NFT may be automated via smart contract, for example where the NFT is issued on the Ethereum blockchain using the ERC-721 or ERC-1155 standard, both of which have proven popular in the NFT space.

Financial regulatory frameworks around the world generally function in a technology-neutral manner – i.e., they apply to digital tokens that have features of financial products irrespective of how the token is labelled or presented, and regardless of whether the token is offered or supported by a company that does not otherwise operate in the financial sector. Accordingly, a token – whether fungible or non-fungible – that gives the holder ownership or control rights in a business or portfolio of assets, or which entitles the holder to certain income or revenue streams, may qualify as a regulated product such as a security or a unit in a collective investment scheme. In determining which regulatory frameworks to consider, the relevant jurisdictions are usually those where the NFT is issued and those where users are located.

Determining whether an NFT is a regulated product is important because the issuance, offering, marketing and distribution of such a product will typically give rise to a raft of requirements that apply in the financial services sector, and non-compliance with these is usually an offence. These may include, for example, a requirement for the issuer and distributors of the NFT to be licensed or approved by the relevant regulator(s) and to comply with ongoing conduct-of-business requirements (e.g., in relation to disclosure of information to purchasers of the NFT, fitness and properness of personnel involved in running the NFT offering, etc.). Establishing and maintaining frameworks to ensure compliance with these requirements typically requires a high degree of specialism and significant human and financial resource. While an NFT offering may be run within the confines of exemptions and may thus avoid regulation, typically such exemptions will only allow the offering to be directed at sophisticated investors in the wholesale markets and will not enable any offering to the retail public.

Key takeaways
  • NFTs are increasingly complex, and questions arise about whether they qualify as a regulated financial product.
  • In some cases it may be possible to avoid an NFT qualifying as a security or other regulated product.
  • Regulators are increasingly focused on how to approach the supervision of decentralized finance.
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