Where next for the regulation of NFTs?

Guest post from Christina Fleming, senior associate in the commercial group at Bird & Bird

The crypto market experienced a wave of turbulence towards the end of last year as several high-profile poor practice and bad-actor events rocked the sector. But, despite the increased regulatory focus expected throughout 2023, the interest in the technology underlying non-fungible tokens (NFTs) and blockchain protocols remains strong.

One such instance of increased regulatory focus comes from Parliament’s digital, culture, media and sport (DCMS) committee. In December, it closed its call for evidence into the operation, risks, and benefits of NFTs and the wider blockchain. This is expected to be a precursor to potential regulation being brought in across the sector, along with a Treasury review also in the wings.

The DCMS announcement highlights that the boom of NFTs has led some to argue that a new, more democratic way of creating and selling assets is developing, albeit that NFT regulation in the UK is largely non-existent.

No consultation paper or policy statement has been put forward by the committee, but one of the questions posed by the inquiry is whether investors in NFTs, particularly vulnerable people, are put at risk by the NFT market and speculation on NFTs.

This issue around investor speculation is interesting. Historically NFTs have been seen in some ways as distinct from the rest of the crypto market; they are fungible in nature, in that each token is unique, and they allow creators to tokenise digital and real-world assets. The fungible nature of other digital asset classes has been seen as one of the characteristics which makes them significantly more likely to give rise to consumer protection concerns.

We could therefore see the DCMS committee considering whether fungibility is indeed a characteristic of a cryptoasset which exposes investors to higher risk, or whether NFTs are equally as risky as other fungible cryptoassets, and therefore also deserving of regulation.

The DCMS inquiry follows the recent confirmation from HM Treasury that it will bring certain cryptoassets into the scope of the UK’s financial promotion regime, which regulates the marketing of financial services and investments.

There has been some indication that for NFTs the fungibility requirement would possibly remove many NFTs from the scope of the regime. We will wait to see how this unfolds and the extent to which this aligns with the conclusions drawn by the DCMS committee.

The government has also asked the Law Commission to make recommendations for legislative reform to ensure that the law sufficiently accommodates crypto tokens and digital assets. The consultation (available here) explores principles of private property law, but does not consider the regulation of crypto tokens and other digital assets which is dealt with by HM Treasury and the Financial Conduct Authority.

With all these bodies looking at regulating the digital asset and crypto space, there is some risk that the resulting regulatory framework could become unwieldy, and contrary to the UK’s vision as “a global hub for cryptoasset technology”.

It will therefore be important for the government and regulators to be mindful of this as clarity on any proposed changes to the regulatory position unfolds.

For example, it could be that any potential harm to consumers identified by the DCMS inquiry could be sufficiently mitigated by some form of light-touch regulation around financial promotions (something that, as mentioned, HM Treasury is already looking at in relation to certain cryptoassets).

As NFTs move significantly beyond sporting highlights and cartoon punks to the tokenisation of an array of financial and non-financial digital and physical assets, there is a strong argument that a clear and cohesive regulatory framework could be well timed.

This would provide more legal certainty for participants in the eco-system to allow such participants to develop products and services with confidence of how their products and services will be treated and supervised from a regulatory perspective.

However, many players in the NFT, crypto and blockchain ecosystem feel that NFTs should not fall under financial services regulation due to the differing characteristics of NFTs to other types of crypto assets, as discussed in relation to fungibility above.

There is also understandably general concern shared by industry and regulators alike that increased regulation could stifle innovation in the space. Some are also expecting a pivot away in digital asset trading from retail focused crypto-native marketplaces to financial institution blockchain projects.

We will wait to see what’s next from the committee and the regulators.