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NFTs Are Hot, But Patchwork of Laws, Rules Needs Watching

April 6, 2021, 8:00 AM

Non-fungible tokens, known as NFTs, have become the latest craze in the digital asset space. Leveraging the same blockchain technology that powers popular virtual currencies such as Bitcoin and Ether, issuers are creating digital assets intended to serve as unique electronic certificates of ownership of intangible digital assets, such as digital art, music, sports memorabilia, or of tangible real-world collectibles.

Like traditional virtual assets, NFTs are digital tokens primarily issued on public, or decentralized, blockchains. They can be bought and sold in peer-to-peer transactions or through physical or decentralized platforms. They are often designed as so-called “smart contracts” that are programmed to automatically perform certain functions, such as forwarding a portion of each resale price to the original artist.

Transactions in NFTs are validated through a consensus mechanism that helps to ensure that each NFT is authentic and not an unauthorized copy. Unlike traditional virtual assets, however, each NFT contains unique information and cannot be directly substituted on a like-kind basis with other NFTs, as can Bitcoin with other Bitcoin or, in the real world, dollars for dollars.

NFTs can be electronically traded in a game by the participants first assigning a value to an NFT and exchanging like-valued NFTs for one another.

A Regulatory Patchwork and Unclear Laws

Collectors are buying and reselling NFTs with a fury. From a market capitalization of $41 million as recently as 2018, NFTs grew to a market capitalization of at least $338 million in 2020 and are on pace to substantially exceed that amount this year.

Most recently, individual NFTs have exchanged hands at staggering prices: An NFT reflecting a digital art collage by the digital artist Mike Winkelmann (more commonly known as Beeple) sold at the Christie’s auction house for $69 million on March 11; Twitter founder Jack Dorsey’s first tweet sold as an NFT in mid-March 2020 for $2.9 million; while an NFT highlight card featuring a dunk by LeBron James recently sold for $200,000.

Dapper Labs, a blockchain-based “experiences” design company and creator of the CryptoKitties collectibles digital game, recently raised $250 million and currently values itself at $2 billion attributable to the popularity of the TopShot digital collectibles game that the National Basketball Association recently created in partnership with it.

As with virtual assets, however, the laws governing NFTs are not always clear. Purchasers may not always be receiving what they think they are buying, and both purchasers and original artists may have fuzzy recourse when their expectations regarding what they thought they were purchasing or linking to an NFT turn out not to reflect reality.

No U.S. regulator has to date formally asserted jurisdiction over NFTs, although many different domestic regulators assert oversight over different aspects of digital assets—from the Financial Crimes Enforcement Network of the Department of the Treasury, to many states’ money transmitters’ authorities, as well as the Commodity Futures Trading Commission and the Securities and Exchange Commission.

This may change, however, as the popularity of NFTs continues to expand and disputes more frequently arise among issuers, purchasers, and artists over the actual rights that are conveyed, or if fraud or theft occurs more often in connection with these new-type digital assets; or should market prices for NFTs collapse.

Inevitably, the Internal Revenue Service and state and local tax authorities will also weigh in on the nature of NFTs and tax liabilities that may arise in connection with transactions involving these new forms of digital assets.

Considerations for Investors

Because NFTs are not standardized, each NFT represents something unique, and purchasers must understand fully what that something is and what rights are associated with that something.

Today, purchasers of NFTs may not be as fully knowledgeable of what they are buying as they should be, and artists may not fully understand what rights they are conveying when they contract with an issuer to associate their digital asset with an NFT. As a result, there are likely many issues of commercial law, let alone copyright and intellectual property law, that will need to be sorted out over time.

Additionally, like other virtual assets, there are unique security issues involved in the holding of NFTs. Typically, NFTs are ultimately held in a wallet associated with a blockchain that is secured through use of a private key (e.g., a security code). If the private key is lost or stolen, the NFT may also be irretrievably lost or stolen, as would be the case with the loss of a private key associated with a wallet holding Bitcoin or Ether.

Just recently, the NFT marketplace Nifty Gateway purportedly was hacked, and at least three holders of accounts there claimed their NFTs were stolen and/or payment details accessible through their accounts were used to purchase other NFTs illicitly. Although Nifty Gateway subsequently released a statement that it had seen “no indication of compromise of the Nifty Gateway platform,” the claimed incident serves as a warning on the potential vulnerability of intermediaries holding NFTs for investors and raises questions regarding potential liability.

For now, considerations of regulatory and legal issues regarding NFTs are taking a backseat to their dramatic popularity. However, it is likely not too long before regulators and private litigants begin asserting their theories in this new frontier of digital assets.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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Author Information

Gary DeWaal is special counsel at Katten and chairs the firm’s Financial Markets and Regulation practice. He has helped train international regulators and others on matters of derivatives regulation and virtual assets and was for many years senior managing director/group general counsel with one of the world’s largest exchange-traded derivatives brokers. He is a former senior trial attorney at the Commodity Futures Trading Commission’s Division of Enforcement.

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