Until quite recently only physical collectable items such as paintings, football shirts or land held value. Digital assets, due to their availability of being duplicated online easily, were not treated as ‘assets’. However, this has changed with NFTs as blockchains guarantee their authenticity.
Although NFTs have experienced a significant downturn since their peak in spring 2022, data from Statista shows that by 2027 the value of the NFT market will reach $3.2 billion, with estimate 19.31 million NFT users.
What are NFTs?
While an NFT stands for a non-fungible token, this brief description is not entirely self-explanatory. The ‘non-fungible’ means that it is not replaceable, indicating that each NFT contains a unique series of numbers that cannot be substituted with something else. So it is a digital token and crypto asset linked to the blockchain, serving as a digital certificate of authenticity. The blockchain functions as a public list, recording information such as when that digital asset was purchased, by whom, who currently owns it and when it was sold and to whom.
Authenticity is ensured through the way this information is recorded: thousands of computers and nodes worldwide maintaining the records on a public ledger, making it virtually impossible to forge or alter.
NFTs can represent any kind of digital object, from an art piece to virtual land or digital pets to even scents. Therefore, this technology offers limitless opportunities for creators, enabling anyone to tokenise and commercialise virtually anything.
So far, Beeple’s Everydays: The First 5000 Days has not only become the most expensive NFT sale ever at Christie’s online auction (was sold for $69.3 million), but also popularised the term ‘NFT’ in households.
How NFTs are Created?
Short answer is: minting. But what is minting?
The creator initiates the process by selecting the format of their NFT. Any multimedia file, such as a painting, photo or a video can be used. Then the creator would produce a token on a blockchain that supports smart contracts like Ethereum. This token will contain the information about the digital asset.
The value of the NFT is then determined by its uniqueness.
Sometimes creators prefer to create several copies of their digital asset with different versions and categorise some as more ‘exclusive’. In such instances, it is important for the creator to decide how many identical copies the creator wants to produce because these copies will be included within the NFT’s blockchain and become fixed. Due to their irreplaceability, the NFT becomes immune to any modification. Once the token is created, the creator will be able to sell the NFT and, ownership will change.
This is what the minting process is.
During every ownership change, the transfer is recorded on the blockchain, allowing for continuous tracking of ownership. Additionally, since this information is stored on the blockchain, it is encrypted therefore, legitimate.
Where to Buy?
NFTs can be listed for sale on various global online marketplaces, but there are mainly two types of markets for buying NFTs: centralised and decentralised markets. The former allows potential purchasers to sign up and fund their account through their credit or debit cards. The latter requires purchasers to have their wallet compatible with the blockchain the NFT was created on.
Despite the boundless creativity opportunities that NFTs offer, their authenticity and boost they have provided to digital asset trading; NFTs also come with certain risks.
Risks Attached and Fraudulent Practices
For those involved in creating, investing or trading NFTs, there are currently no legal protections in place.
An incident that occurred in 2021 serves as a notable example of the risks associated with investing in NFTs. Although the monies were returned in the end, a hacker managed to scam a British collector into purchasing a fake Banksy for $336,000 (£244,000).
Investors should remain vigilant against not only fake sellers but also against fraudulent platforms that falsely claim to offer authentic NFT. These platforms are designed to extract credit card information from investors. Not only that, but there is also the risk of sleepminting, that is falling victim to phishing attacks that can deplete digital wallets. These are several of risks attached to NFTs for being unregulated.
Furthermore, despite being a relatively new concept, NFTs have already become a vehicle for various fraudulent activities. One prevalent scheme involves tokenisation. This occurs where the digital token representing ownership of an artist’s work is created without permission.
Wash trading is another concept where users manipulate transactions by trading with themselves to inflate demand for specific NFT so consequently the value is boosted artificially, or insider trading where individuals exploit private information to profit.
NFTs, unlike than traditional assets, allow for more subjective pricing as factors such as age or condition, which typically influence the pricing of a traditional art, do not apply. This aspect eases money laundering as criminals can set the NFT price according to the amount they need to launder.
Last but not least, as NFT transactions are conducted with little supervision, sanctioned individuals may continue trading through dealing with their NFTs without being detected.
So are NFTs Legal?
NFTs provide authenticity and are trackable, but as mentioned they come with certain risks and can facilitate fraudulent activities. So, what is their legal status?
The short answer is that the exact status of NFTs has yet to be officially decided and there is a lack of clarity as to whether they can be described as a security according to Financial Conduct Authority guidance. This unclarity and absence of specific laws raise further legal issues for consideration.
Firstly, although NFTs are stored on a blockchain which is trackable and contains information about the digital asset’s location, the digital asset itself could be deleted or hacked. As a consequence, for instance, the most expensive NFT that was sold for approximately $69 million could end up being worth nothing. Not only does the ‘investment’ vanish, but the current status also fails to address what rights an investor would have.
Secondly, given that NFTs can change ownership, royalties can be paid to creators each time a transaction takes. Smart contracts written for NFTs provide the basis for the payment of these royalties. However, there is little regulation covering smart contacts.
Thirdly, the protection of personal data requires clarification, considering that blockchains are immune to modification. Therefore, it is not possible to amend or erase personal data linked to the blockchain.
Fourthly, buyers should be made aware that they do not own the copyright of their NFT rather, it belongs to the creator. Hence, it is crucial that buyers conduct thorough due diligence when investing in or buying an NFT so they understand every aspect of an NFT. The complexity further increases when questions such as ‘whether minting grants legal ownership’ come into consideration.
And finally, there is the issue of taxation. Further, although it might be anticipated that profits and losses associated with NFT’s would be subject to capital gains tax, and that NFTs would be regarded as assets for taxation purposes, the official position has yet to be confirmed.
In conclusion, the status of NFTs remains in a state of flux, with significant legal and regulatory uncertainties surrounding their classification and oversight. While currently NFTs are not subject to specific regulations, there is a potential for states or international bodies to impose legal obligations, such as "know-your-client" checks and anti-money laundering compliance requirements. The lack of official oversight and clarity on whether NFTs can be categorised as securities according to Financial Conduct Authority guidance further contributes to the current regulatory vacuum surrounding NFTs.
Despite recent fluctuations in the NFT market, projections indicate sustained growth. The rise of new virtual assets and the demand for them, coupled with the current lack of comprehensive regulation, present substantial challenges for stakeholders in these evolving markets.
