Trading NFTs – do you have regulatory obligations?
What are the legal considerations around NFTs in the UK?
With NFTs being the latest breakout stars of the asset market, more people are turning to trading and financing their NFTs (i.e., using them as collateral for loans) to strategically release capital for some other investment purpose. Whilst potentially a lucrative investment opportunity, these types of transactions fall within a regulatory grey zone that do lend themselves to risk. In this week’s newsletter our NFT Lawyer and Head of Commercial Litigation, Margherita Barbagallo goes through the current legal framework and how to effectively reduce risks for those interested in NFT trading.
Are NFTs regulated?
Broadly speaking, no. To date, NFTs are not explicitly captured by any legislation in the UK, or globally for that matter. However, they could become subject to regulation if they begin to function more like securities or other regulated products. If an asset falls under a regulated product, the transacting party is required to comply with the same regulatory obligations as investment and financial services firms. Whilst there is not yet any activity inherent in NFT sales that would qualify an NFT seller as a ‘financial institution’, there are proposed regulatory changes currently being consulted on in the UK, including extending the scope of the financial regime to apply to currently out-of-scope cryptoassets, which might impact NFTs.
Are NFTs cryptoassets?
NFTs are unique cryptoassets. Generally, there are three categories of cryptoassets:
i. Security tokens: the digital form of traditional investments such as shares, bonds, or other securitised assets;
ii. E-money tokens: tokens that are ‘electronic money’ (i.e., digital currency like cryptocurrencies backed by fiat currency); and
iii. Unregulated tokens: tokens that do not fall under the above categories (e.g., activities converting cryptoassets to other cryptoassets or cash into cryptoassets).
The majority of NFTs will be unregulated tokens. Conversely, categories (i) and (ii) will be regulated by the Financial Conduct Authority (FCA), where there are licensing requirements and ongoing business reporting obligations (such as submitting reports on the transactions and information on the buyer and seller). If regulated, a business will also be caught by the provisions of The Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (the Regulations), the breach of which is a criminal offence.
Are NFTs securities?
The question as to whether NFTs are securities does not have a straightforward answer. Ultimately, it depends on the purpose or the use of the NFT.
In traditional art finance, when the sale of an artwork is fractionalised to create shares that are traded in a secondary market and provide liquidity, then the transaction will be captured by securities laws. Similarly, fractionalizing an NFT (i.e., where multiple investors buy portions of an NFT) to provide trading and liquidity would likely qualify as securities and fall under FCA regulation.
Other obligations?
Whilst NFTs are not directly captured under the UK’s financial licensing regime, they do fall within its anti-money laundering (AML) regime. Firms in the UK transacting with cryptoassets have obligatory duties to counter money laundering, such as carrying out Client Due Diligence (CDD) to verify the identity of the purchaser and to verify the source of the funds used for the purchase prior to the transaction.
Further, since 10 January 2022, the EU’s AML Directive (EU) 2018/843 (5th AML Directive) became applicable to traders or intermediaries involved in the purchase or sale of a work of art for more than €10,000. Whilst the 5th AML Directive does not set out whether NFTs would be considered as works of art, it would be prudent to proceed as though they were where the underlying asset is an artwork, whether digital or otherwise.
What is the future of NFT regulation?
It remains to be seen whether the regulatory regime will be expanded to explicitly include NFTs (beyond fractionalised NFTs), but it is one to monitor.
In the meantime, players in the NFT market should continue to bear in mind the purpose of any NFT transaction. If the transaction is intended as an investment with the expectation of making profits, then regulators may conclude that it will be subject to financial regulation.
For advice on NFT transactions and how best to protect your interests, please get in touch by scheduling a discovery call with Margherita Barbagallo, Head of Commercial Litigation.
Head of Commercial Litigation
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