How NFT Can Be a Security

NFT and DeFi dominated the second wave of crypto market’s expansion after Initial Coin Offerings (ICO) of 2017. But what are the differences and similarities of these two markets from the regulatory point of view?

Similar to ICOs, DeFi space provided investment opportunities open to the general public without appropriate safeguards. Expectedly, there were many projects where people lost money due to fraud or unintentional failures. The regulatory arbitrage allowed founders to structure financial products without legal overheads appropriate to the level of the risk, leading to competitive but unsustainable business models. Another concern of the authorities was the compliance of this space with anti-money laundering (AML) and other illegal operations. The need for clear and fair rules here is obvious.

NFT on the other hand, positioned itself as non-financial, creative branch of crypto, empowering individual artists and collectors. Nevertheless, here and there, we read about the intentions of regulators to enter into this particular domain of crypto. Let’s find out why.

First, the broad term “regulations” is not only about investor protection and compliance laws, that constrain a “free crypto” and irritate people involved. The regulation also includes such things as taxation laws, ownership transfer and intellectual rights laws that are welcomed by the community.

The taxation and ownership rules cannot work without the legal identities of the participants, so AML and other compliance in NFT is also easy to enforce. So, the question remains only about whether NFT is an investment vehicle open to public and if so does it require investor protection rules.

NFTs are different in how they are used and there are some obvious examples where they fall under the security types. Cyprus-based Sand Vegas Casino Club has been ordered by securities regulators in two U.S. states to stop selling NFT that promise a share of profits from casinos on metaverse platforms.

The first case of NFTs that represent real estate property ownership was basically structured as an LLC in Ukraine. So other than marketing title, nothing new was there.

However, others are less obvious. The fractionalized NFT, where a single piece is fractioned and sold to multiple owners was intended to make entry barriers low for investors in expensive pieces. When the fraction holders sit and watch others promoting their NFT, it sounds like a positive Howey test.

There were also talks that EU MiCa rules could view NFT as a security because they share the same visual concept (and non-fungible enough). Meaning, holders of Crypto Punk NFTs, are considered to hold a small share of the common Crypto Punk concept enterprise.

The argument against the investment definition is based on real world analogy. Art auctions do not publish prospectus that warn people against possible drop of the art’s value. And, people wearing branded accessories, like Gucci, are not the shareholders of the company. Interesting debates ahead which we will continue to observe.