Fractionalization Makes NFTs Affordable… and Big Targets for Securities Regulators

Fractionalisation of NFTs is a key development in a maturing market. These assets amount to more than just a craze for artists to sell digital art at sky-high valuations. Non-fungible tokens are also being used in sophisticated ways such as collateral for lending products.

Divvying up ownership of NFTs enables more people to hold a piece of the asset. Like with a lot in DeFi, it is unclear how top-tier regulators intend to regulate NFTs. However, ventures offering fractional NFTs to any investor may not have realised the regulatory vulnerability of these assets — in short, they are morphing from collectibles into securities.

You would be hard-pressed to argue how giving fractional ownership of an asset could not be classed as equity. This will no doubt trigger securities laws and enforcement in multiple jurisdictions, especially considering that Gary Gensler, the hard-charging chair of the Securities and Exchange Commission, has taken a broad view on what types of cryptocurrency offerings are defined as securities. U.S. companies offering fractionalized NFTs should school themselves on the law before regulators knock on their door.

Eye-watering Prices

NFTs have acted as an incredible awareness-raising moment for blockchain technology and DeFi. The last time crypto technology did this much marketing for the industry was the Bitcoin price boom and crash back in 2017 and 2018.

Everyday there seems to be new headlines on the latest set of NFTs valued at eye-watering prices. But this latest phenomenon is more than just a mania. If you look carefully, these instruments provide a lens into the future.

The concept of NFTs is not new. NFTs reflect the right to ownership represented in a digital format with provenance recorded on the blockchain. It’s no different to HRD diamond certificates that authenticate if a stone is a genuine diamond. This type of authentication is the same as the NFT process but the provenance of ownership is stored differently.

There is no reason why digital assets represented on the blockchain should fall outside of existing securities laws. The digital form, or token, representing an asset must have clarity, which is comparable to holding an ownership certificate.

The potential of this crypto category has not yet been realised. NFTs could provide an avenue for onboarding real-world assets with intrinsic value onto DeFi platforms. This would expand the ecosystem and build more marketplaces on blockchains where the existing rules of TradFi can be replicated and even enhanced. Yet with more marketplaces, comes more regulatory scrutiny.

There is an important distinction to be made between simply storing an asset and using it as an investment vehicle. Certificates of ownership are static rights and do not change and so custody solutions for NFTs are not necessarily subjected to securities laws. Buying a piece of a digital artwork and storing it in your crypto wallet is very different. You’re investing in an asset with the expectation that it will rise in value and you can trade it for a profit. Moreover, chances are you’re not just buying one fragment of an NFT but many that you assemble in a portfolio, just like stocks or bonds.

Idle Collateral

When aspects of an NFT become revenue and value producing, it moves into security territory covered by federal laws. The same rules apply to digital assets as if the right of ownership was being recorded in the real world. Similarly, the same definitions apply such as the Howey Test as defined by the SEC, which considers a transaction to be an investment contract, and therefore a security, if there is “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”

There is no reason why digital assets represented on the blockchain should fall outside of existing securities laws. The digital form, or token, representing an asset must have clarity, which is comparable to holding an ownership certificate.

Tokenization gives rise to fractionalization, which enables asset holders to do more with idle collateral. By breaking up a larger or more expensive asset into smaller parts, it makes the entry point accessible for more investors, which is a good thing.

Fractionalization puts a legal infrastructure in place that makes an asset a security. By breaking up an asset into smaller parts and selling those to others is effectively providing equity. These tokens can then be traded and used as collateral for lending purposes.

However, if you’re fractionalizing, and subsequently borrowing or lending against an asset and generating interest, you’ve created a financial product. Accordingly, these products should be registered as securities and subject to the same rules as if they were in the real world.

As we see in traditional markets, there are repercussions for companies and individuals dealing with unregistered securities. In a world where fiat still matters, regulators and central banks have the means to sanction the conversion of crypto or digital assets back into dollars and euros, if they are deemed to be blacklisted assets.

By having tainted assets within your wallet, not only could their value be adversely affected, but this could extend to your entire wallet. Due to the transparency of the blockchain, it is easy for regulators to blacklist wallets, which could have implications for trading and lending activity on certain crypto platforms.

By July 2021, NFT token sales hit over $100M. It’s naive to think NFTs would not be next on regulators’ agendas.

It is difficult for most people to try and understand securities laws and how they apply to their assets and even the tax liabilities they may be incurring. There is an onus on regulators to provide clarity so people have the confidence to engage in this investment class with confidence.

German regulator, BaFin, has put stakes in the ground, deeming all DLT-issued securities to fall under existing securities laws as part of the amendment to the German Banking Law in 2020. While this caused many blockchain proponents to worry, this clear direction actually gives entrepreneurs confidence to build products with regulatory certainty.

We’re already seeing coordinated regulated crackdowns on parts of the crypto market, including goliaths such as Coinbase, Uniswap and Binance. By July 2021, NFT token sales hit over $100M, according to Decrypt. It’s naive to think NFTs would not be next on regulators’ agendas.

Providing clear legal guidelines will give impetus for the industry to build issuance and trading processes that are compliant and replicable to any asset class, including NFTs.

Philipp Pieper is the co-founder of Swarm Markets, a regulated cryptocurrency exchange in Germany.