What do NFTs need? More clarity and compliance
Originally written 2021–03–16
The crypto space prefers to ask for forgiveness rather than permission. The space moves so fast you can miss the boat if you wait for the governments to move and give you a response. However, it might not be the best approach to charge into making a lot of money without doing some due diligence.
Once first money was made with ICOs, people jumped onto the bandwagon trying to make the big bucks. A few years after the DAO’s ICO the SEC started cracking down on a number of ICOs that were unregistered securities. BitClave, Enigma, Unikrn were all charged, had to return the funds to their investors and pay multi-million dollar penalties. Getting rich quick is a good way to get broke.
Now the Non-Fungible Tokens (NFTs) are all the rage, and only time will tell if the governments will crack down on some of them or not. In general, it might be best to be prepared for the worst, even if it won’t come.
Categories of NFTs
NFTs are a rather broad term when it comes to cryptos. It really only describes how the tokens function — rather than dealing with a number of fungible coins you can easily add together, you have something that’s unique and non-divisible. What those NFTs represent are a different matter.
Currently, art NFTs seem to be in-vogue. I’ve written about the idea of physical art tied to NFTs in 2015, but seems these days digital art NFTs are more popular.
In a similar vein, selling Tweets is rather popular, and even get meta:
In general, we could add these kind of things to a category of “broad copyright and miscellaneous assets”, since I really don’t know how to classify this otherwise…
The most prominent NFTs from a few years back were the CryptoKitties. The genesis kitty sold for $100k back in 2017, and these days you can buy them for a few hundred to a few thousand dollars a pop. Also interestingly enough, CryptoKitties did talk with the regulators about whether their collectibles would be securities and got an explicit statement that they were not.
You could also have NFTs representing something like Real Estate. There have been a few ICOs in this space already, so all you would need to change is having a singular owner rather than many to have yourself an NFT.
These should cover most of the “asset classes” when it comes to NFTs, but I’m sure we’ll have more in the future.
NFTs and copyright issues
While NFTs may be used for some interesting things, they will grind up against the meatspace’s laws sooner than later.
While it’s nice to sell your art as an NFT, what are you selling really? Are you selling a license to use that piece of art? Its copyright? Are you also parting with its moral rights? Are you selling a right to the copy of the art, or to the original? What jurisdiction is the sale governed under?
All of those and more are important things to consider. Once again CryptoKitties are a good example of what to do — they define their Terms of Use clearly. For example, what you buy when you purchase a CryptoKitty is a “limited, worldwide, non-exclusive, non-transferable license to use, copy, and display the Art for your Purchased Kitty”, but you may not modify the art, use it to sell third party products, etc.
The legal agreement might also be very important when buying other kinds of assets. What does it mean to buy a Tweet? Does it give you the right to delete it? If you could edit it, does it give you the right to edit it to whatever you want? How often can you request that Tweet to be edited? Do you get an API access to change it whenever you want? Can you rent out the Tweet to other people to make it say whatever they want? If the edit is offensive or breaks the law, who gets in trouble for it? All of those and more are important things to consider when putting a $2.5M bid on a Tweet…
The NFT marketplaces also seem to take a very laissez-faire approach to their listings. OpenSea for example listed a number of pixel paintings that the person listing might not have had the permission to sell. It doesn’t take long browsing on Rarible to find some art that might be potentially infringing on a trademark or a copyright:
Of course it’s not impossible that such NFTs did get the proper permissions to use the copyrighted characters or trademarks in those images, but I would do my due diligence before listing or buying such tokens just to be sure.
While I’m an opponent of the nigh-perpetual copyright brought about in part thanks to Disney and its “Mickey Mouse Protection Act”, disregarding the law might not be the best strategy to change it…
NFTs, crime and speculation
Since we’re dealing with art, we might also soon be dealing with the industry’s less savoury side — tax evasion and money laundering.
Criminals do enjoy using stolen pieces of art as collateral, or use them to launder money. While there is no example of NFTs being involved in anything like that, it’s not something unimaginable. If the infinitely traceable world of Bitcoin can still be used for illegal activities, it wouldn’t be long before someone tries that with an NFT.
Rich people using crypto art as a new scheme to avoid paying taxes would also be in the realm of possibility. You could use the same tricks as you have in the art world (drive up the price of a piece of art, increase the value of your entire collection, donate some of it to charities to get tax deductions, etc.):
If you thought people didn’t understand Bitcoin, then importing the creative accounting practices from the art world into NFTs will be beyond ludicrous for most people.
It seems we are already entering the area where people speculate on NFT art with Metapurse’s B.20, a fungible token backed by a collection of NFTs that increased in value after purchasing the $69.3M Beeple piece of art. It seems the market is prime for speculation, appreciation, and everything else.
NFTs and compliance
Since we are dealing with such large sums of money, people speculating on the price of those tokens and so on, we are getting dangerously close to the area of securities, anti-money laundering regulations and all the other fun things related to compliance.
While it doesn’t appear that buying and selling art in the US would fall under any explicit AML laws just yet, that might not be the case under EU law. Things might differ when dealing with NFTs representing real estate, copyright, collectibles or the like understandably.
It might be advisable for NFT auction houses to at least try applying some basic KYC, AML checks and be proactive about their compliance and reporting requirements. From what I’ve seen, not a lot of places even verify people’s identities. Nifty does do phone check and credit card check, while Rarible only appears to require an anonymous Ethereum wallet to be connected to get started, while their verification process is focused more on someone’s digital rather than actual identity (asking for things like Twitter and Instagram, rather than a real name).
There might be a similar need to establish an NFT provenance to curtail their use in illegal activities. It might not be so important now when such various art NFTs are sold for the first time, but for secondary markets you might want to see even some basic due diligence be put in place.
Of course, this is not to say that all NFT transactions would require a full background check. Low-value transactions might still be done anonymously without an issue in most jurisdictions, but you would expect anyone buying or selling NTS above say, $10k to require some KYC check. Similarly once a token is sold for that amount you would want to comply with FATF Travel Rules and verify the identity of all owners of that piece of art.
Conclusions
- NFTs are a very hot market right now, which encourages people to get rich quick without regard to compliance
- It is likely that the recent large trades of NFTs will attract regulator attention
- It would be advisable for NFT auction houses to look into performing KYC, AML checks on high-value transactions and be proactive about compliance
- NFTs need clearer legal agreements as to what exactly is being sold (NFT auction houses might want to offer a few standard templates of the agreements)
- NFTs already appeal to speculators, they might soon become some weird financial instruments and apply even further scrutiny from security regulations if they are used like securities
- It seems that CryptoKitties is still the most proactive NFT company in the space, even 3 years later
