NFT’s: What are they, English Regulations, and Dispute Resolution
This article will define Non Fungible Tokens under English law and offer you an overview of the current English regulations on NFTs, legal risks, and how you should protect yourself as an artist, auction house, or investor against these legal risks.
In this article we will look at the following:
· What are NFTs?
· UK Regulation on NFTs
· The legal risks
· How to protect yourself
What are NFTs?
Non Fungible Tokens or (NFTs) are digital assets that represent real world objects such as art, music, videos and in-game items.
A NFT is sold online with cryptocurrency. NFTs run on the Ethereum blockchain and enable the tokenization of any data.
Each token is pegged to a different identifier, unique to the owner and must be whole, unlike fungible tokens that can be divisible and you can send fractions of a token, such as Bitcoin which is a fungible token that can be divided up into smaller parts which are completely interchangeable.
NFTs allow you to include metadata about an asset, providing details and adding information about the ownership.
It is this information that makes them special and unique because it has its own unique metadata which can never be replicated or replaced for another.
This enables NFTs to be easily applied and integrated into other ecosystems.
A NFT exists on the blockchain to record proof of ownership of the person holding it, the digital files on the blockchain show the ownership of a unique piece of digital content. In principle, any digital content such as artworks, videos, tweets, video games, and music can be minted into a NFT.
The main difference between traditional works of art and those sold using NFTs is that NFT works of art are either created through a digital medium or are a digital image of a physical work such as a sculpture.
The scope of NFT’s however arguably extends beyond virtual works to tangible assets in the physical world.
There are numerous crypto start-ups waiting to tokenise concert and football tickets, real estate, and other high-value unique assets.
NFTs continue to evolve and therefore new forms will continue to emerge. For example, Nike has recently patented a system called “Cryptokicks” which allows a customer to acquire a virtual version of a shoe hence tying an NFT to a physical object.
Cryptokicks will also have the ability to create variations which in turn can be created into physical shoes.
Another example of how NFTs are being securitised is the first release of a Album (“When You See Yourself”) as a NFT by the Kings of Leon, the bands tokens will allow fans to unlock special perks to include limited edition vinyl and front row seats to future concerts.
The use of the NFT has allowed the music to bring better value to the fans and improve the relationship to their audience, which is an example of how NFTs are a valuable way to engage with target audiences.
Unlike fungible tokens such as Bitcoin, NFTs are non-fungible. Non-fungible tokens are not interchangeable, they are unique in existence ie they only exist once on the blockchain.
Fungible tokens like Bitcoin exist in larger numbers but in the same form ie they do not differ in content from other fungible tokens of the same nature.
Regulation of NFTs in the UK
The legal status of NFTs in the UK is uncertain. It is not clear how minting a digital token on the blockchain ledger can grant someone legal ownership of a physical or digital asset.
For the blockchain to be viewed as a reliable record of ownership for artwork, accuracy has to be guaranteed of the information entered onto the blockchain.
Many online places trading in NFTs have struggled to verify those selling artworks claimed to be authentic.
In the EU the draft Markets in Crypto assets Regulation proposed provisions that could regulate some NFT related activity. In the UK, the proposed regulations are unlikely to apply however, consideration is required as to how an NFT value is determined and sold and marketed in the open market.
Furthermore, due to the fifth Anti-Money Laundering Directive, NFT sales may raise money laundering compliance considerations also.
The Financial Conduct Authority (FCA) published guidance in 2019 that describes crypto assets into three categories, namely, e-money tokens, security tokens and unregulated tokens.
Crypto assets that are categorised as either e-money tokens or security tokens are under the FCA regulations and therefore classed as controlled activities requiring FCA authorisation.
Based on current FCA guidelines NFTs would be classed as unregulated tokens.
However, if the NFT had characteristics that were similar to e-money or security tokens then the classification of the NFT may vary and therefore analysis must be undertaken on a case by case basis with references to the structure and nature of the NFT.
Furthermore, as mentioned above, businesses that undertake crypto asset activities may be required to register with the FCA for money laundering supervision, even if the crypto asset are NFTs to ensure compliance with Anti Money laundering and anti-terrorist financing regulations.
With regard to ownership, it is difficult to ascertain the precise rights a NFT owner holds over the physical asset without reading the token’s code.
As an owner of the NFT, it is unclear whether you only have the right to sell it or other rights which may include copyrights or the ability to use it as security for a loan.
The Ethereum blockchain (on which most NFTs are run) smart contract capabilities have increasingly created new digital rights.
For example, every time a NFT is resold, its artist is rewarded with royalty payments in addition to governance rights in a future platform.
Through NFTs, it is possible for ownership of a digital asset to be fractionalised such that users are able to trade shares on secondary markets.
In the UK, ownership or entitlement to income or shares in future profits may necessitate regulation of the particular NFT under the Financial Conduct Authority (FCA) because it would be regarded as a security.
The UK tax law currently does not cover NFTs. HMRC has not published any detailed guidance in regards to the tax liabilities of NFT owners.
It is likely that NFTs would be treated as taxable assets for capital gains and inheritance tax purposes.
The current HMRC guidance on crypto-assets focuses on the trading of fungible tokens such as Bitcoin, Ether, and Litecoin and barely talks about NFTs.
HMRC places fungible tokens within the jurisdiction/residence of the beneficial owner for tax purposes. It is yet to be revealed whether HMRC will have a similar view in regards to NFTs especially those, unlike fungible tokens, that are attached to physical assets whose location can be traced.