Partner Nicola McKinney explores how regulatory plans for cryptoassets may impact the UK financial market.
Nicola’s comments were published in eprivateclient, 21 April 2023, and can be found here.
“Non-fungible tokens, or NFTs, are now one of the more visible forms of digital asset, due in large part to attention-grabbing headlines in the media about NFTs in the art world, such as the record-breaking $69 million Beeple sale. Notwithstanding that NFTs have been embraced by the art market and might now be viewed by some as a mainstream investment, in the UK they remain largely unregulated save to the extent that they fall within the existing framework.
“Fundamental legal questions about digital assets are still being tested and established, at the same time as regulators are attempting to categorise and risk-assess them. For example, the question of whether NFTs are deemed as property remains to be categorically determined in the English courts. While service of certain legal documents has been permitted by NFT (by airdrop into digital wallets), at present there have only been interim decisions that there is a ‘realistically arguable case’ that this is so.
“The essential features of an NFT are also still open for debate. Again, there are non-final decisions in the English courts which consider that an NFT confers digital ownership rights in a unique asset, and is an item in itself which is separate from the underlying ‘real world’ object that it represents. This delineation is considered by some commentators as intrinsic, with the joint Chancery and Commercial Bar Associations’ response to the Law Commission consultation on digital assets stressing the importance of this distinction. However, this is not necessarily taken for granted, as the Law Commission itself appears to consider that the relationship between the NFT and the object might be determined by market participants.
“This potential variability and the lack of consensus and legal definitions make NFTs all the more difficult to regulate as there is not yet any specific regulation of NFTs. What investors and dealers in NFTs will be interested in establishing is whether a particular NFT is governed by existing frameworks, bearing in mind that different tokens may hold different qualitative characteristics.
“The potential regulatory regimes which are likely to come into frame for most businesses including in the art world, include the FCA regulations and licencing requirements for promoting regulated; the FCA’s company registration requirements under its anti-money laundering remit; and marketing and advertising, under the purview of the Advertising Standards Agency.
“The FCA, under guidance issued on cryptoassets, has indicated that it is the specific characteristics of an NFT which ultimately determines what kind of crypto asset it might constitute (exchange token, e-money or security token), and whether it accordingly may fall within an existing class of regulated financial products, for example relating to promoting specified investments or collective investment schemes.
“Although commodity-linked tokens could be structured as NFTs and consequently fall within collective investment scheme regulations, most NFTs are currently unlikely to be regulated, although the FCA has very recently indicated that it may extend its regime. Meanwhile the FCA guidance appears to envisage scope for divergent types of NFT, and so largely avoids categoric determination of whether NFTs are subject to existing financial services promotion regulation.
“The FCA also supervises UK cryptoasset businesses in relation to anti-money laundering regulations, and requires cryptoasset businesses offering certain services to be registered. NFTs are broadly recognised as cryptoassets (as they rely on distributed ledger technology to record and store data), and so the exact nature of a company’s services will need to be scrutinised if it intends to deal in NFTs, as to whether it must seek to be registered. Whether registration is necessary, art market participants are also required to adhere to anti-money laundering rules that apply to trade or intermediate transactions in works of art above a certain value, supervised by HMRC. While the question of whether an NFT constitutes a work of art has often relied on the Treasury definition, which excludes digital art, this may well change.
“Firms selling NFTs should also take account of ASA advertising requirements, and financial services firms may have broader obligations to consider under the Principles for Business.
“The lack of NFT-specific regulation may stem from a recognition that some of the risks posed are not new or unique. For example, English court cases show that NFTs are vulnerable in the same way as other electronically held assets or data, in particular to theft after a successful hack.
“Increased regulatory scrutiny and action may well be seen in the context of anti-money laundering efforts, as certain features of NFTs can be exploited to launder the proceeds of crime. For example, the potential for extreme price volatility and high sale prices makes NFTs attractive to ‘wash trading’ sales where the value of the product is artificially driven up, with an interested party involved on both sides of a transaction. Cryptoassets, including NFTs, are transacted in a highly visible way (as they are recorded on the blockchain), however the identity of those behind the transactions can remain anonymous. Requirements for those offering services that will allow for scrutiny of those individuals are therefore likely to become more stringent.
“NFTs may be an attractive and exciting proposition for some, but particularly for businesses great care will need to be taken not to fall foul of existing regulation if the intention is to promote or trade NFTs. The absence of dedicated regulations, where applicability can be easily ascertained, means that expert help is likely to be sought, or dealing in NFTs may be avoided altogether.”
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