To NFT or Not To NFT
By: Claus Skaaning
Tags: Nft, Nft Collectibles, Tokenization, Blockchain, Security Token

Fear and Loathing in the Tokenization Industry

As a respectable member of the highly compliant and regulated security token industry, it is annoying and frightening to see the explosion of interest in NFTs. My company, DigiShares, gets many inbound requests every week from asset managers and real estate developers, wanting to tokenize their assets in the regular and regulated manner. but, surprisingly (or perhaps not so surprisingly), we are receiving more and more requests to represent real assets with NFTs!

Up until now, we have scoffed at the concept and attempted to dissuade these confused clients from using NFTs, and instead to use regulated and compliant security tokens for their projects. These tokens are securities and fully regulated, by definition. With a security token, there would be no (or certainly less) uncertainty or risk of legal implications in the future.

However, our hostility has slowly worn down and we have been forced to consider, multiple times, whether there is actually real value in the concept of NFTs and whether they can in some way enrich the security token ecosystem. We are all expecting millennials to increasingly adopt crypto and longer-term security tokens but, while my teenage daughters know nothing about security tokens and find the concept utterly boring, they actually have heard of NFTs — and not through me (the house specialist)!

NFTs are in the eye of the beholder

Even if, from an industry perspective, NFTs really don’t offer much that’s new, they cannot be overlooked from a marketing perspective. Even the most fanatical supporter of security tokens will have to admit that NFTs currently sell out better than many security tokens. As a way to cope, some members of the tokenization community have adopted NFTs into the narrative of security tokens. After all, it is a way to represent property rights with tokens and, in many cases, it will most likely provide a security (even though the NFT community currently ignores this).

Let’s consider real estate NFT projects. Several real estate projects, which should rightfully have been tokenized, have instead been fractionalized and represented by a set of uniquely numbered NFTs. The NFTs have been offered for sale on NFT marketplaces and have typically sold out quite fast (too fast, in my view!).

The devil is in the details, but the details are often missing. How is the NFT legally associated with the real estate project? Is it linked to the title or deed? Is it linked to a share in the SPV owning the real estate project? How are profits calculated and distributed to NFT holders? How can anyone think it’s not a security? Wouldn’t it be much better, in terms of investor safety, to sell tokenized shares, rather than a profit share guarantee defined in a contract that is linked to an NFT? Where is the contract and can investors review it? (Quite often, the underlying contract that legally ties the NFTs to the property isn’t even visible to investors.) So much for investor protection.

One might suspect that issuers of NFTs don’t really care about the legal side of things. It certainly seems like it. However, they may be forced to take it very seriously in the future, once their local FSA comes cracking down on their project [1], [2], [3]. Many of them are selling securities at amounts that would normally require a prospectus; they don’t make sufficient KYC and AML checks; they don’t sufficiently enforce transfer restrictions; they allow trading on unregulated crypto exchanges, etc, etc, etc.

Finally, one might ask — are these securities dressed up as NFTs even true NFTs? NFTs are, by definition, not able to be reissued (https://docs.waves.tech/en/blockchain/token/non-fungible-token). What happens if you lose your NFT and, consequently, your profit and voting rights in an NFT’d property? Who will receive the profits? Can the old NFT be frozen and a new NFT re-issued, effectively rendering the NFT into something else?!? No, because then it wouldn’t be an NFT anymore?!? In addition to this, the link from the NFT to the underlying asset can also break, rendering the token itself useless [4].

So, how do we move forward from here? Why not embrace NFTs and help influence that they be treated as regulated and compliant tokens? In cases where real assets, such as real estate, are tokenized using NFTs, the NFTs will most likely become securities and should be regarded as such from the start. Obviously, this means that all normal securities regulation has to be adhered to when using NFTs. Investors have to be KYC’d and only regulated security token exchanges will be able to trade these NFTs. Investor protection will then be much higher. Who is in a better position to do this than us existing tokenization service providers? No one! Let’s teach the NFT community how legal and compliant tokenization should be done!

To summarize: some NFTs are utility tokens, while others are security tokens. Almost all NFTs today pretend to be utility tokens, even though many are not. This will lead to many legal issues in the future. The security token industry can help the NFT industry become compliant.

NFTs are non-fungible, but a security token can be non-fungible too! The widespread ERC-1400 security token protocol supports non-fungible tokens (e.g. numbered shares). So, NFTs can be issued using, for instance, ERC-1400. For security tokens to be compliant, it is critical that they support transfer restrictions. This seems to be supported in some NFT protocols but not in others, so someone should develop a protocol that merges the properties of NFTs and security token protocols, to create a safe and compliant protocol for “security NFTs”: NFTs that support transfer restrictions and are re-issuable.

References:

(1) Comment by SEC Commissioner Hester Pierce during the recent Security Token Summit 2021 (37:00–39:00 min. range): if someone wants to place numerous NFTs into one basket and sell F-NFTs, or take one NFT and sell shards, then “you better be careful you’re not creating something that’s an investment product, that is, a security”: watch here.

(2) NFTs are Interesting but Fractionalized Non-Fungible Tokens (F-NFTs) May Present Even More Challenging Legal Issues (here).

(3) NFT — Legal Token Classification (here).

(4) Yes, Your NFTs Can Go Missing — Here’s What You Can Do About It (here).