NFT Laws and Regulation

The value of a non-fungible token (NFT) is determined by its uniqueness, in that it can't be replaced by an identical token.

NFTs consist of programme code and typically take the form of one or more smart contracts.

It's the smart contract of the NFT that contains the details of the underlying digital or physical asset to which the NFT relates, as well as the rules and rights associated with the NFT (e.g. who owns it, how it can be transferred, what exactly the NFT is, and perhaps a royalty).

Sometimes the NFT exists on a platform that is governed by the additional terms of a contract.

Note, an NFT can simply be a token that contains additional data or attributes that prevent it from being interchangeable with other tokens.  Or it may simply be a key that allows you to exercise rights through a smart contract. In this case, the NFT only has value in a smart contract. 

Legal nature of NFTs

In the case of tangible things, there are two forms of ownership: ownership of the physical thing itself and, sometimes, ownership of intellectual property (IP) rights over it.

Courts are willing to recognize that NFTs may be a type of property whose ownership rights exist quite separately from intellectual property rights:

• Singapore Court recognises non-fungible tokens as property
• English court recognises NFTs as "propert"

If the issuer of an NFT only provides a licence to the IP contained in the NFT, this may reduce perceived scarcity and therefore value. Providing ownership rights may increase perceived value and help to create a secondary market for the sale of NFTs.

Rights in underlying assets

If the underlying asset/thing is:

• Digital, there is usually a link to a digital file on an off-chain server or a digital file stored In the NFT itself.
• Physical asset/thing, then there is no way to use a reference to the physical world. Therefore, most NFTs linked to physical assets/things still rely on QR codes or, more simply, company records that capture the link between the NFT and the physical asset/thing.

Unless otherwise provided for in a contract, the owner of an NFT may find that they have no rights to the underlying asset/thing at all. The rights to the underlying thing will be determined, for example, in the case of a work of art, by the normal principles of IP rights.

NFTs as a regulated security

The decision as to whether an non-fungible token is a regulated security is important because the issuance, offering, marketing or distribution of such a security may, depending on the jurisdiction, give rise to requirements that apply to the financial services sector and non-compliance with these requirements is generally an offence.

In the US, the list of regulated securities is set out in the US Securities Act of 1933. Obviously, tokens and cryptocurrencies are not included in this list. However, the list ends with the term ‘investment contract’, which the US. Supreme Court has defined as a generic term that encompasses other assets that have similar characteristics and function as securities.

US position

In the seminal US. Supreme Court case, SEC vs. Howey, the court gave a four-part substance-form test for determining what constitutes an investment contract (and therefore a security):

• An investment of money.
• In a common enterprise
• With the expectation of profit.
• Derived through the efforts of others.

Subsequent US case law has also explained when an instrument that is not a security can become one.

An asset that is not a security may be packaged, sold or offered in such a way that investors have a reasonable expectation of profiting from the efforts of others (i.e., in such a way as to form an investment contract).

In April 2019, the SEC staff issued the ‘Framework for the Analysis of the “Investment Contract” for Digital Assets’. The Framework addresses the third and fourth items of the Howey test - the existence of a reasonable expectation of profits derived from the efforts of others.

Mere appreciation in value as a result of market forces can't result in an asset being recognised as a security, but appreciation in value as a result of management efforts falls within the scope of Howey.

The answer to the question of whether an NFT is a security depends on the facts and circumstances. 

• If an NFT simply represents ownership of an item, such as a digital Penguin, a video clip, or a collectible video game, it is probably not a security.
• However, if the NFT is advertised as a speculative investment accompanied by the promoter's speculation that the value of the token will increase as a result of the issuer's or promoter's actions, then the NFT may well be considered an investment contract and therefore a security.

If a token were to be considered a security under US law, each sale of the token would be required to either register with the SEC or be made pursuant to an exemption from registration under US securities laws. Any platform, exchange or similar marketplace will also need to consider whether it needs to register with the SEC.

‘’Fractionalized‘’ NFTs

The concept of ‘fractionalized’ NFTs almost certainly falls under the securities laws in the United States. A fractionalized NFT exists where the NFT itself is held in one place and other, separate, tokens are issued that collectively represent ownership of the NFT.

Europe: MiCA

The new regulation is known as the Markets in Cryptoassets Regulation (MiCA). MiCA will apply to persons involved in the issuance of crypto-assets and crypto-asset related services that are not regulated by other European legislation. MiCA will establish rules in relation to:

• Transparency and disclosure requirements for the issuance and admission to trading of cryptoassets.
• Authorisation and supervision of cryptoasset service providers and issuers.
• Activities, organisation and governance of asset-linked token and e-money token issuers and cryptoasset service providers.
• Consumer protection.
• Preventing market abuse and ensuring the integrity of cryptoasset markets.

MiCA did not apply to unique and non-fungible tokens, whose value is derived from the unique characteristics of each cryptoasset and the utility it provides to the token holder.

However, European co-legislators recognised that such crypto-assets could be traded on markets and accumulated speculatively. They agreed that unless they are readily fungible and the relative value of one crypto-asset to another, each unique, can't be determined by comparison with an existing market or equivalent asset, the extent to which they can be used financially is limited.

The features of the asset in question should determine its qualification rather than its designation as an issuer. 

In particular, the issuance of cryptoassets in the form of non-fungible tokens in a large series or collection should be considered an indicator of their fungibility. The assets or rights represented must also be unique and not fungible for a cryptoasset to be considered unique and not fungible. MiCA should also apply to cryptoassets that appear to be unique and not fungible, but whose actual features or features related to actual use make them either fungible or not unique. 

Eighteen months after MiCA comes into force, the European Commission will be required to submit a report assessing the opportunities and potential ways to regulate NFTs, so some or all of these may be explicitly included over time. 

AML and KYC requirements

The Financial Action Task Force (FATF) Recommendations apply to virtual assets and virtual asset service providers. They define a virtual asset as a digital representation of value that can be traded or transferred digitally and used for payment or investment purposes. According to the FATF, NFTs that are digital assets that are unique rather than fungible, and that are used in practice as collectibles rather than as payment or investment instruments, are generally not considered virtual assets.

However, it is important to consider the specific nature and characteristics of an NFT and its function in practice, as the FATF Standards may apply to them, regardless of the description used. Some tokens may in practice be used for payment or investment purposes. Other NFTs are digital representations of other financial assets already covered by the FATF Standards, such as securities.

It is important to consider the application of the FATF Standards in each country in which a service provider operates, as they may adjust the definition or interpret it more broadly. In the UK, for example, the relevant term is “cryptoasset” but doesn't expressly include or exclude NFTs, it is possible that NFTs could fall within its scope, at least if they represent value or contractual rights, in which case the issuer or other exchange or custodial wallet provider would need to register with the UK Financial Conduct Authority.

Sanctions and Money transmitter laws

Recent global events have highlighted the potential impact of sanctions regimes. Whether an NFT or a transaction involving an NFT will fall within the scope of such regimes (due to the nature and location of the counterparty) depends on the facts (including the parties and jurisdictions involved) and the specific sanctions regime in question. Advice on local law is required.

NFTs as commodities

NFTs, like other digital assets, have raised concerns about commodity laws in some jurisdictions. For example, the US Commodity Futures Trading Commission (CFTC) has taken a fairly firm position that virtual currencies such as bitcoin and ether are properly defined as commodities for the purposes of the US Commodity Exchange Act of 1936. A “commodity” includes all goods and wares, and all services, rights and interests for which contracts are now or hereafter made for future delivery. Forward sales of commodities fall within the broad definition of a “swap,” which is subject to regulation by the CFTC and includes numerous types of derivatives - barring applicable exceptions.

Notably, sales of non-financial commodities (which likely include many NFTs) under a forward contract are excluded from the definition of swaps if the commodity (

1. is intended for physical delivery, even if delivery or shipment is deferred; and
2. the forward contract qualifies as a commercial transaction for the sale of commodities.

This raises the question of what is meant by “physical delivery” in the context of an NFT, which may have different implications depending on whether the commodity to be delivered is the asset represented by the NFT or the NFT itself. A non-fungible token may be a forward, futures or swap even if the asset it represents isn't.

Antitrust and Competition Laws

Agreements and, in certain circumstances, unilateral conduct involving NFTs can raise a variety of antitrust issues. Generally, the most serious antitrust concerns arise from agreements between participants at the same level of trade, often referred to as “horizontal agreements”.

Examples in the context of non-fungible tokens include agreements between creators of NFTs setting the prices at which they will sell their NFTs (price fixing), limiting the types of NFTs each will (or will not) create (market allocation), or limiting the volume of NFTs produced to maintain high prices. Such agreements with respect to tokens, as in other markets, can constitute a serious antitrust violation and can result in high fines, the possibility of private damages suits, and even criminal penalties.

Agreements between participants at different levels of trade, often referred to as “vertical agreements”, may also raise concerns, but generally only if the agreement results in a significant restriction on competition.

This may occur, for example, if an important channel for distributing NFTs requires creators to refrain from using other, competing channels to distribute their tokens. Whether a vertical agreement relating to an NFT violates antitrust law generally must be determined on a case-by-case basis.