How to Stay in Compliance
Snežana Gebauer is a partner and Chris Walsh is a manager at a global consulting firm StoneTurn.
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Without a doubt, 2021 was the year when the crypto market made its biggest strides, reaching an estimated $3 trillion. It was also the year that non-fungible tokens (NFTs) gained massive popularity. After Mike “Beeple” Winkelmann sold an NFT Christies Auction for $69 million Artists, investors, brands, celebrities and many others helped generate interest in NFTs. NFT revenue reached $17.7 billion in 2021 and they are considered disruptors of many industries.
The recent crypto meltdown also impacted NFT sales, and the prices of popular NFTs have fallen sharply over the past few weeks. Some argue that NFTs will survive this crypto crash because they are a unique digital asset class.
What makes NFTs different from other digital assets? They are tokens built on the blockchain and their underlying assets can be digital or physical. The blockchain guarantees its origin, transmission and record of ownership. In addition to the digital artwork that has made NFTs mainstream, NFTs can be used for custom music, video clips, gifts, tweets and more.
NFTs can also act like membership cards or tickets, providing access to events, exclusive merchandise and special discounts, and serving as digital keys to online spaces where holders can connect with each other. NFT owners can add value beyond simple ownership, and creators have a vector to build a highly engaged community around their brands. As an asset class in its own right, NFTs are likely to have a significant impact on the world of art, photography, music and other creative fields.
Given the huge profit potential from trading these assets, NFTs have attracted the attention of regulators and opened a debate over whether NFTs are securities and whether financial regulations designed for tradable financial assets should apply to NFTs.
And so begins regulatory enforcement.
On June 1, 2022, prosecutors in the Southern District of New York charged and arrested Nathaniel Chastain, a former product manager for the online marketplace Open sea. OpenSea claims to be the world’s first and largest Web3 marketplace for NFTs and crypto collectibles.
According to the indictment, Chastain was tasked with selecting NFTs to appear on OpenSea’s home page. OpenSea kept this homepage selection confidential until it went live, as a listing on the main page often resulted in a price jump for both the featured NFT and NFTs from the same creator. Chastain secretly bought an NFT just before OpenSea featured the piece on the front page of its website. As soon as these NFTs appeared on the main page, he reportedly sold them “at a profit of two to five times their original purchase price”. Chastain now faces a wire fraud case and a money laundering case related to an insider trading scheme involving NFTs.
Does this case mean that NFTs should be treated as securities? Or is insider trading an illegal practice that should be prosecuted regardless of the asset? These latest allegations seem to indicate that it no longer matters whether insider trading takes place on the exchange or on the blockchain.
If NFTs are treated as securities, how do securities laws affect NFTs? Whether or not a particular NFT qualifies as a security depends heavily on the purpose for which it was created and how it is marketed to buyers. When an NFT is marketed and sold as a static asset, such as a photo with a certificate of authenticity, it is less likely to be considered security. However, if the NFT is sold with the assumption or intention of making a profit, it may very well be classified as a security.
As this debate develops over the treatment of NFTs as securities, it is important for NFT preparers to assume that securities laws apply to them.
Exchange platforms that host NFTs for sale and distribution should proceed with caution: if they facilitate the trading of NFTs that qualify as securities, the NFT exchange platform could be viewed as operating an unregistered securities exchange, which would be the case of being sanctioned Securities and Exchange Commission (SEC).
To mitigate risk, companies that issue NFTs or facilitate trading in NFTs should implement NFT trading policies or proactively evaluate their existing policies and practices in a manner similar to how publicly traded companies mitigate the risks of insider trading. The NFT Trading Policies should remind employees that non-public information regarding the establishment or promotion of an NFT is confidential information and should be treated as such.
Companies may consider banning some or all employees from purchasing NFTs, at least for a period after initial introduction. They might also consider extending the ban to family members and relevant third parties. In addition to implementing a policy, companies must regularly train and communicate with their employees to ensure active awareness and compliance.
To stay ahead of the looming regulation and regulatory activity, any NFT creator, investor or trading platform should take a conservative stance and turn to publicly traded companies for best practices. While it may be daunting to get started, implementing coherent policies is a critical step in mitigating the risks associated with insider trading.
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Learn more:
– Regulatory scrutiny ramps up as crypto becomes risk to financial stability – report
– Top NFT collections surge in price after the Federal Reserve’s latest rate hike
– Ex-OpenSea boss arrested for NFT insider trading
– NFT insider trading on OpenSea highlights the benefits of decentralization
– “NFTs may be new, but this criminal scheme is not”: Ex-OpenSea boss arrested for NFT insider trading
– The right side of crypto regulation: Institutions must avoid Thucydides’ trap
– Crypto exchanges Hotbit and Bitfinex are facing regulatory headwinds
– Former Coinbase exec pleads not guilty to referral fraud charges