NFT Regulation Looms Large, So Let's Start With the Proper Framework

By Adrian Krion, CEO of Spielworks

NFTs have passed the initial hype test of February, with monthly sales on OpenSea reaching an all-time high of $3.4 billion in August. As the market got so mind-bogglingly popular that even Martha Stewart hopped on the bandwagon, the world is sizing it for some sort of regulation or oversight, just as with other types of digital assets. But should NFTs be grouped in with Bitcoin? USDT? BCAP? On the heels of the tumultuous U.S. infrastructure bill, it’s become increasingly clear that regulators are not ready to effectively answer this question, and in the EU, legislation that may apply to some NFTs is now only in the making. Thus, it's best that the community of digital asset pioneers takes the initiative on building the foundations of the regulatory framework.

Around the world, governments have reacted differently to the rise of digital assets—primarily Bitcoin—which at their onset carried a stigma of enabling cybercrime, money laundering, and tax evasion. Historically, there are quite a few cases when authorities responded with heavy-handed measures to regulate things they deemed a threat to their power or subjects, even to extremes, such as with alcohol during Prohibition in the U.S., mullets in Iran, and blue jeans in North Korea. Now that the blockchain world is going more mainstream, it is important to make sure that such drastic regulations don’t send its promising technologies back to the fringes. 

U.S. congressional committees and government agencies deliberated over the last three to four years trying to grasp what digital assets truly meant for the global and domestic economy. This summer, with the infrastructure bill on the Senate floor, concerns emerged over how the government would regulate such assets. At one point, Congress appeared determined to even classify crypto miners as "brokers," thus requiring them to adhere to the same reporting standards as banks or brokerages.

While a blanket ban or harsh restrictions might seem like the right idea to regulators, easier to draft up than laws distinguishing all the different types of digital assets, they certainly could be harmful. A blanket ban on cryptocurrencies for payments in Nigeria, for example, could have detrimental effects to business owners who are unbanked or require remittances. And that’s cryptocurrencies—with NFTs, things are even more complicated, as they are a whole 'nother ball game.

From a regulatory standpoint, NFTs are not that easy to pinpoint. Fungible tokens can represent all kinds of different rights and liabilities, typically broken into three distinct legal categories (security, currency, and utility). NFTs can do all that too, which makes it tempting to bundle them with other crypto-assets. After all, a stablecoin capped at 10,000 units and pegged 1:1 against USD with cash is the same from the regulatory perspective as 10,000 unique NFTs representing a real-life dollar bill (at least given none of the NFTs represent the same banknote). The problem is, though, that NFTs can at least theoretically tread so much further than fungible tokens in terms of their functionality. They can have multiple utilities, such as both security and intellectual property rights. Moreover, not all NFTs should be necessarily regulated. Some NFT are like trading cards—we might as well regulate the Pokemon card market if that’s where we go. 

Governments have tried tackling this NFT regulation conundrum directly, by breaking NFTs down into separate categories of functionality, just like fungible tokens. Luxembourg, for example, categorized NFTs into three distinct types: financial instruments, electronic money, and collective investment instruments. The landlocked European state offers new possibilities on the potential direction of a communal framework to best define NFTs, it’s a step in the right direction. That said, there are innumerous other functions NFTs can theoretically have, and understanding how to evaluate revenues derived from them can get messy. This is precisely why the frameworks built into NFT marketplaces, the self-regulation efforts, effectively, are essential.

Platforms and developers minting NFTs should have a duty to very clearly define the NFTs once they've been minted, which will be critical to building the marketplace frameworks. Delineating that an NFT is a security could easily help distinguish down the road whether it requires oversight from agencies or not. Sports memorabilia NFTs, for example, should be defined differently at the minting stage to avoid being put into the same basket as NFTs with security designations. They would hardly require excessive KYC efforts along the lines of what is expected when working with traditional securities, but for NFTs classified as financial instruments, KYC should be a must.

With far too much abstraction in NFTs and their labels, there is plenty of room for misunderstanding and for higher authorities to get it wrong, but either way, the regulators will be coming sooner or later. The community of developers and marketplaces facilitating NFT trades and minting would be best served to prepare for it and differentiate between the different token functionalities, because, as we all know, blanket regulations never work.

About the Author

Adrian Krion is the founder of the Berlin-based blockchain gaming startup Spielworks, with a background in computer science and mathematics. Having started programming at age seven, he has been successfully bridging business and tech for more than 15 years, currently working on projects that connect the emerging DeFi ecosystem to the gaming world.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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