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Issue #5: 2021 | NFT Mania

The recent success and increasing interest of mainstream media Non-fungible tokens ("NFTs") after Christie’s auction raising USD 69 million for a digital art piece, after having started with small blockchain games such as Crypto Kitties in 2017, have made NFTs become increasingly popular.

The mechanics and legal classification of NFTs and what NFTs legally represent is still fairly ambiguous, and poor technical implementation might be confusing despite buyers spending millions of dollars on NFTs. To purchase NFTs, Bitcoin ("BTC"), Ethereum ("ETH"), etc. can be used for payment. There isn't much legal or regulatory limitation at the present moment, globally.

What are the characteristics of NFTs?

A. They do not serve as a medium of exchange for the purchase of goods and services.

B. They are not digital representations of value and are non-transferable;

C. They are non-fungible.

D. They appear to have no other purposes other than to operate as collectables;

which take the form of NFTs

Are NFTs considered as securities regulated by Monetary Authority of Singapore ("MAS")?

NFTs are not considered as securities regulated by MAS under the Securities and Futures Act ("SFA") as the aforesaid NFTs are not an “instrument representing indebtedness, with the objective of an investment approach where investors to the Platform buy a unit in the fund and way of capital gains generates the profit/income".

In Singapore at present, the analysis for NFTs under MAS may in some instances be prescribed as capital markets products, but are probably not securities in most cases under Singapore. Under Section 2(1) of the SFA, “capital market products” include any securities (which includes shares, debentures and units in a business trust), units in a collective investment scheme, derivatives contracts (which includes derivatives of shares, debentures and units in a business trust), spot foreign exchange contracts for the purposes of leveraged foreign exchange trading, and such other products.

Globally, some regulatory actions were commenced during the initial coin offering boom of 2017-2018. The USA "Howey Test" is a landmark test used in lawsuits against coin offerings to determine whether transactions are investment contracts that will be subjected to registration requirements. A common theme in both the Howey Test and the definition of a Collective Investment Scheme under the Singaporean SFA is that the degree of control is largely outside the control of the investor.

According to the Howey Test, a transaction is an investment contract if:

(i) it is a money investment;

(ii) there is an expected profit associated with the investment;

(iii) the money investment is a common enterprise;

(iv) the profit comes from the promoter’s effort.

There are currently many ways a would-be money launderer can use art to hide the illicit sources of their ill-gotten money. The NFTs world can add a few layering methods to the launderer’s repertoire. Or just another way of achieving the same goal: breaking the provenance and with minimum KYC processes.

The relative lack of know-your-customer and anti-money-laundering checks, or even no KYC checks and no restrictions on transaction amounts in the NFT sector, means that laundering via NFTs may be as simple as buying and then selling a non-fungible token. It would be effortless for illicit actors to purchase NFTs, resell them, and move the crypto into other wallets.

Although NFTs are currently facing the rising issue of money laundering, there is still no proof that money laundering through NFTs is worse than the traditional method. The traditional art world is already infamous for money laundering. Global authorities are concerned that laundering through NFTs is becoming a big problem. They are still contemplating if it will surpass the money laundering being done in the physical art world. The experts are still gathering data and conducting research on how NFTs are being used for money laundering. Still, the digital nature of the NFTs will also make it an easier target for money laundering than the traditional art world. Since art dealers are not regulated, they do not have to comply with AML/CFT regulations.

As important as the technical implementation is the question of what NFTs legally represent. This is important as it may limit what the creator or the buyer of artwork can do, which again affects the price of the NFTs being created and sold/traded.

What is Artwork?

It involves several complex questions revolving around ownership and copyright. When creating an artwork, the creator generally becomes the first copyright owner. Registration at the copyright office is unnecessary in most countries in the world, but may be advisable in some cases as it establishes a record of copyright ownership. For digital artwork, the same result can be achieved by signing the picture digitally, recording the corresponding NFT on the blockchain, and storing the high-resolution file on the InterPlanetary File System ("IPFS").

What does the NFT exactly represent? Digital ownership? Copyright? Or both?

This really depends on the artist as well as the Platform the artist uses to sell his artworks. The ownership of digital artwork is transferred when transferring the NFT itself. However, the copyright remains with the creator unless explicitly agreed otherwise.

As the first copyright owner, the artist has the exclusive right to make copies, sell and distribute the documents, prepare derivative works based on the copyrighted artworks and publicly display the artworks. The copyright gives creators the profit rights, reproduction and distribution rights/protection and right to produce derivative work. Most importantly, the right to communicate the work to the public.

Compared to copyright, ownership rights are rather limited and restricted to non-commercial use. If a creator wants to grant the owner the right to use the artwork for commercial purposes, he may either transfer the copyright or grant the owner a licence to use the artwork commercially.

It should be noted that some platforms require creators to give the Platform a licence to use the artwork for commercial and non-commercial purposes. In the Open Sea/ Rarible/ SuperRare etc marketplaces, the creator grants the Platform a worldwide, non-exclusive, royalty-free licence to use the uploaded artworks for non-commercial and commercial purposes.

When selling digital artworks to users, the creator must consider which rights he has already granted to the Platform to avoid potential conflicts. If a creator has given the Platform a non-exclusive licence to use the artwork for commercial purposes, he cannot grant an exclusive licence to the buyer anymore.

Even where the creator and buyer explicitly agree on the transfer of the copyright or granting a licence, the token does not necessarily reflect the exact terms. To ensure that all parties are always fully aware of the rights represented by the NFT, it is advisable that the NFT points to the respective terms and store the terms on the IPFS. In this case, the NFT would serve as a track record of ownership and bring more clarity to the rights represented by it.

Early Conclusion

When Cryptocurrencies first launched one of its big use cases was for illicit activities such as the Dark Web (Silk Road for example). NFTs are now having their day in the sun, but there may be a significant crackdown soon backed by KYC/AML regulations (know your customer / anti-money laundering) for NFTs that are worth valuable consideration, and it is important to distinguish between NFTs that are purely digital representations of non-digital assets, or NFTs that exist as a store of value, which will be more under the scrutiny of regulators globally.

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