NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT

JUNE 2021 NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT The market for non-fungible tokens (NFTs), or cryptoassets representing proof of title to a unique digital version of an underlying asset, has soared. In the sports and digital arts sectors, recent NFT issuances have sold out in seconds, netting their creators millions.

Subject to limitations in any relevant jurisdiction, NFTs have the potential to facilitate new revenue streams by establishing new forms of digital property, act as new channels for businesses and digital creators to reach customers, fans, and audiences and/or enable the monetisation of physical assets.

While NFT issuance is growing rapidly globally, the legal and regulatory treatment of NFTs continues to evolve. We have been advising clients on NFTs in various jurisdictions. In this briefing, we share our experience to demystify NFTs and consider some of the key risks, and how the tokens are regulated across some key financial centres. NBA Top Shot The National Basketball Association's What are NFTs? NFTs have gained traction to date in the (NBA) Top Shot, is a -based digital space but also have the potential An NFT is a digital asset whose online platform hosted by Dapper Labs to digitise unique physical assets, such as uniqueness and ownership can be for basketball fans to purchase and physical artwork, in theory allowing these demonstrated and verified using trade highlights of NBA sporting assets to be bought, sold and traded distributed ledger technology (DLT). NFTs history (or "Moments") through NFTs more efficiently. In principle, all physical can be used to create a tokenised proof intended to act as virtual trading cards. assets could be tokenised either as of title to a unique digital version of an Moments are minted (i.e. created) on fungible or non-fungible tokens. Many underlying digital asset (such as images, the underlying blockchain platform, businesses have successfully tokenised a videos or other digital content) or physical but are graphically displayed as digital range of assets including iconic images, asset (such as paintings, sculptures or cubes containing the video highlight athletic highlights, entertainment and other tangible assets). in the online marketplace. sports memorabilia, event tickets, music albums, artwork, famous Tweets, internet When someone “mints” an NFT, they memes, gaming and e-sports digital create a unique digital version of the work content, unique sportswear and other as a data file using blockchain, or another collectibles using NFTs. type of DLT. Once minted, NFTs cannot be edited or deleted, and can be viewed publicly and freely traded with verifiable How do NFTs generate security of exclusive ownership and revenue? transaction traceability. An NFT issuance NFTs can enable the efficient may consist of a single NFT, or may commercialisation of unique assets that involve thousands or millions of tokens. are otherwise difficult to sell or prove ownership of, as well as the creation of Each NFT is unique. In contrast, most entirely new digital product lines and other cryptoassets, are fungible, i.e. each revenue streams. token is interchangeable with and indistinguishable from another As with many other digital assets, some NFTs offer the ability to "fractionalise" Some NFTs incorporate smart contracts ownership of the underlying asset, i.e. to which specify and automate certain rights split ownership so that each purchaser of and obligations of the buyer and seller, for an NFT benefits from the underlying asset example, to provide that the NFT creator in proportion to the fraction they own, receives a percentage of the transaction which can enable new ownership proceeds every time the NFT is sold on. structures that proponents assert have

2 CLIFFORD CHANCE NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT the potential to democratise ownership of The sale of those NFTs creates a whole Buying Myself Back: assets that have traditionally been viewed new revenue stream. The provenance of A Model for Redistribution as inaccessible. However, other NFTs the underlying digital asset is assured by are indivisible. the NFT. Model Emily Ratajkowski recently sold an NFT called "Buying Myself Back: Transaction structures for minting and An artist could also sell an NFT linked to A Model for Redistribution" for selling NFTs vary. Many NFT creators are a digital version of a physical asset (e.g. US$140,000. Her NFT is linked to a "crypto natives" with DLT expertise who an image or video of a painting or photograph of herself standing in front issue the NFT themselves and also create sculpture) to one buyer, while selling the of a painting by artist Richard Prince of or own the underlying artwork or other physical work itself to another buyer as a photo of herself – for which she was asset to which the NFT is linked. Where an additional opportunity to profit. NFTs paid US$150 at the time. Her NFT the content creator/owner is not native to have opened the door to artists and served two purposes – (1) to take the crypto space (e.g. a celebrity, content producers further commercialising back control of her own image, musician, athlete or sports club or other their work in a digital environment, by which she believes Prince had business), a third party may issue the NFT providing an infrastructure in which value exploited; and (2) to generate on behalf of the content creator/owner. can be ascribed to a digital 'copy' of a revenue. The purchasers of her The third party may also provide the work due to the uniqueness of that copy. NFT will not receive a physical copy underlying technology platform for minting of the photograph. and selling the NFTs, or another platform Commercialisation of provider may be involved. Revenue physical assets sharing models between the various While NFTs have been mostly linked to participants differ considerably and digital assets to date, fine art, luxury should be carefully considered. goods and other physical assets have the potential to be linked to NFTs. This Commercialisation of digital assets ensures the provenance of the underlying A digital asset, such as a significant asset but can also assist with increasing tweet, a video file or digital photograph, liquidity. Considering the collectible wine can be linked to a finite number of NFTs. investment market for example, NFTs may

Glossary • Blockchain is one type of DLT in • Non-fungible token (NFT) which the data is set out and built up An NFT is a unique cryptoasset that in successive blocks, where each new represents rights to an underlying block of data verifies the content of ‘tokenised’, often digital asset, which the previous block. It is known for is created and transferred using DLT. being the technology underlying This contrasts with many existing , but has been integrated into cryptoassets, including many other transaction and asset like Bitcoin, which are fungible types. Most NFTs are minted on the or interchangeable. blockchain. • Smart contract • Cryptoasset A smart contract is commonly defined A digital asset created using as an agreement written in computer cryptography. Cryptocurrencies are code with automated performance. a subset of cryptoassets with Smart contracts are automatable and money-like functionality. The term enforceable either by legal enforcement token is often used synonymously of rights and obligations (though they with cryptoasset. may not always amount to legal contracts) or via tamper-proof • Distributed ledger technology (DLT) execution of computer code. DLT is a decentralised peer-to-peer data storage system where • Token participating computers (known as A token is a digital entry on a DLT nodes) hold and maintain identical register or other digital infrastructure copies of the ledger. Data integrity is where a person is recorded as owning achieved through public-private key a unit or other entitlement. Tokens cryptography, so that an individual may represent a permission to control node cannot tamper with the a resource native to the DLT platform, information recorded in the ledger by rights granted to the holder, or a “real rewriting the transaction. world” asset. The latter is commonly referred to as the "tokenisation" of underlying assets.

CLIFFORD CHANCE 3 NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT reduce the risk of counterfeiting and for NFTs develops and regulation substitution by linking individual bottles of evolves, regulated firms may seek to wine to a unique NFT (e.g. by way of a offer specialist intermediary services to QR code) that proves provenance, history help the market develop. of ownership and provides a record of how and where the wine has been Asking the right questions stored. A secure physical storage facility Understanding the legal and regulatory is likely to be a key component of any issues is critical before deciding whether structure. As such, collectible wines can to issue, purchase or deal in NFTs. Here be virtually traded more easily while are some questions to consider: showing proof-of-ownership and proof-of- value. However, in the short term, liquidity Are there any licensing may be more limited as investors will requirements? need to be comfortable with the Most jurisdictions do not yet have technology and the operator of the legislation or regulations specifically platform, as well as the issues around applicable to NFTs, but a host of existing secure and effective storage that typically regulations may still apply. This will accompany collectible wine. depend on: Royalty collection as a • the token's characteristics and payment model features; Some NFTs are coded to incorporate • the activities performed in respect of smart contracts that can be programmed such token; and to include the automatic allocation of a portion of the amount paid by an NFT • the territorial scope of the particular purchaser to the original owner/issuer of regulatory framework. the NFT, thus giving the original owner an For example, in the UK, the Money ability to realise the benefits of the Laundering Regulations 2017 define secondary marketplace by way of cryptoassets as "a cryptographically "royalty" payments. Ratajkowski's NFT, secured digital representation of value or for example, is understood to generate contractual rights that uses a form of DLT a payment for her every time that it and can be transferred, stored or traded is resold. electronically", and set out activities that, when performed in respect of Who is interested? cryptoassets, trigger a registration • Potential issuers: as NFTs may requirement. Where NFTs meet this represent either digital or physical definition, exchanging them for cash or underlying assets, they open up huge other cryptoassets or making opportunities for monetisation in the arrangements for others to do so, would creative sector. Although most NFT trigger a registration requirement. Where activity has been seen in the creative, an NFT does not qualify as a cryptoasset, sports, gaming and fashion sectors, we for example because it does not anticipate issuances across the broader represent value or contractual rights, retail sector. the regime does not apply to it.

• Investors: NFTs make establishing Regulatory regimes vary significantly provenance and traceability of assets globally, so it will be necessary to analyse much easier, making assets such as the regulatory position in each jurisdiction digital works of art easier to buy, sell where the NFT is issued, marketed and and trade and broadening access to where key participants are based. new asset classes. Are there any tax implications? • Financial institutions: Trading in NFTs Whilst tax authorities globally have made could one day be facilitated or engaged progress in considering and issuing in by financial firms (acting as guidance on the taxation of intermediaries or on their own behalf), cryptocurrencies, the tax treatment of mirroring the role they play in markets other cryptoassets, including NFTs, for more conventional forms of remains unclear. Most jurisdictions investments or property. As the market consider cryptoassets to be property for

4 CLIFFORD CHANCE NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT tax purposes, but, without detailed Given all of this complexity, coupled with legislation or guidance, their precise tax the decentralised and anonymous nature treatment requires consideration of of cryptoassets, we expect that a existing tax rules and an attempt to fit a significant proportion of transactions given cryptoasset within the most involving NFTs and other cryptoassets appropriate regime. This means looking at remain unreported and untaxed. Tax a variety of factors including the nature of compliance and evasion risks with the cryptoasset, what it represents, its respect to NFTs and other cryptoassets intended use and whether any analogies have largely remained unexplored to date. can be drawn from the relevant jurisdiction's existing approach (if any) However, cryptoassets in general are to taxation of cryptocurrencies. This can becoming more mainstream, and NFTs in give rise to considerable complexity particular are very much in the public eye and uncertainty. by virtue of being associated with celebrities, sports teams and The exercise becomes particularly eye-watering sale prices. The OECD is challenging when considering NFTs. developing proposals around effective By way of example, if I sell my NFT to reporting and information exchange for you, questions will need to be asked to cryptoassets, potentially making ascertain the tax treatment, such as: exchange platforms responsible for • What exactly is being sold and why? compliance in addition to taxpayers. Is it the underlying asset (and if so, is Tax, and tax compliance, is therefore that underlying asset an intangible likely to become more complex for those asset, a financial instrument, a physical issuing and arranging NFTs. asset, or something else), is it certain limited rights in the underlying asset, or Are there any resale are such rights so limited that the asset rights implications? being sold amounts to no more than In the UK and the EU, the Artist’s Resale the NFT itself? Capital gains taxes, Right (ARR) ensures that creators of income taxes, VAT/sales taxes and/or original pieces of physical artwork receive transfer taxes may be relevant a small percentage of the sale price depending on the answers. whenever their work is resold by qualifying intermediaries, for example by • If the sale falls within deemed market way of auction or dealership. ARR is value rules, how do we go about unlikely to apply to artwork sold by way of valuing the NFT in a potentially illiquid NFTs and so creators may be concerned market when it is supposed to that NFTs offer a way to avoid ARR. represent something unique, and may in fact merely confer the One of the benefits of NFTs issued on status of owning the NFT itself without DLT platforms that utilise smart contracts any meaningful rights in an is that the commission process can be underlying asset? automated. By incorporating royalty obligations in the smart contract that • Which jurisdiction(s) get to claim taxing accompanies the NFT, artists can ensure rights? Are NFTs located where the that they have similar protection to that beneficial owner of the NFT is resident, provided by ARR. as is generally the approach taken with respect to cryptocurrencies, or might In jurisdictions where the law does not they be located in the jurisdiction of the recognise resale rights relating to creative underlying asset (and is it works and contractual provisions have straightforward to work out where that traditionally given an alternative recourse, is if the underlying asset itself is digital)? smart contracts that automate royalty payments could help bypass such • What happens if the underlying asset is limitations. later hacked, duplicated, counterfeited, destroyed or deleted, or the link However, some NFT marketplaces only between the NFT and the underlying function on specific types of DLT, which asset is broken? Will the purchaser be means that automated royalty payments able to claim a loss for tax purposes? might only take place when the NFT is

CLIFFORD CHANCE 5 NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT traded through the same platform it was marketplace or platform offers to ensure The Nyan Cat meme issued on. Selecting the right platform is that the creator is not ceding more rights The minting of an NFT linked to the therefore a key commercial decision for to purchasers than expected. Nyan Cat meme provides an example the issuer to ensure it can enforce its of a content producer commercialising royalties, together with inclusion of While certain cryptoassets have been their work via an NFT drop (the act of appropriate restrictions around resale. recognised as qualifying as "property" offering the NFT for purchase). Similarly, analysis of the legal recognition (rights "in rem") in some jurisdictions, the The author of the original Nyan Cat and enforceability of smart contracts in question of whether an NFT would be meme minted a single NFT of a each relevant jurisdiction is a crucial step. recognised by the courts as proof of legal remastered version of the Nyan Cat title to a digital version of the asset to meme. This NFT was purchased for What is the ownership status? which it is linked remains open. around US$590,000 following a The purchaser of an NFT owns the token Technically, the holder of an NFT simply bidding war on the crypto art platform, itself, which is a record of ownership of has a unique set of numbers which Foundation. The purchaser of the NFT the unique digital version of the underlying amount to a token in their wallet, thereby acquired the token, which is a record work, so that when the NFT is transferred granting the holder the ability to decide of ownership of the unique digital to someone else, the underlying digital where or to whom the NFT should be version of the meme. However, the version of the work is transferred with it. transferred. Arguably, this creates factual copyright in the original meme was An NFT does not (unless stated control of the linked asset in a way akin retained by its creator. otherwise) represent copyright ownership to property rights. The logic is that when of the underlying asset. Copyright to the something like a picture, sound or text is underlying work, or property rights in attached to the NFT, the token proves respect of a physical underlying asset, that the digital copy of the underlying would only be transferred where work is an authentic copy of the specifically agreed (and validly assigned). original work. In most of the NFT issuances to date, there has been a clear intention not to However, as discussed above, the NFT create ownership interests in the does not necessarily transfer copyright underlying asset. In this respect, and therefore the scope of an NFT purchasing an NFT is the same as buyer's enforcement rights is unclear. purchasing a physical work of art, which This poses the question of whether the rarely involves an assignment of copyright NFT owner can require the original in the artwork. creator to take steps against someone who has created unauthorised versions of By virtue of retaining the copyright in an the underlying content, and, if that underlying work, the original creator of an counterfeiter in turn created a counterfeit NFT retains the exclusive right to do NFT, who would or could take action. It certain acts in relation to the underlying also raises the question of what action work which are restricted by copyright, can be taken by the purchaser of an NFT namely the right to make additional where the creator subsequently issues copies, distribute, display or sell the work more versions of the NFT, thus increasing to someone else. The purchaser of the the availability of the asset (and therefore, NFT receives the token and, typically, in principle, reducing its market value). the rights to use the unique digital version of the work for personal use and resell Are there anti-money laundering that copy of the work. (AML) concerns? Physical artwork has been used as a tool The scope of a purchaser's usage rights for money laundering, given the potential with respect to an NFT are determined by for anonymous purchases of high value the conditions or licence terms attached artworks to be made. However, to the acquisition of the applicable NFT, its effectiveness is limited as physical art which will vary from token to token. The can be hard and expensive to transport creator of the NFT or marketplace where and store. To the extent that NFTs are it is acquired could therefore implement developed that provide an actual more permissive licence terms enabling ownership interest in artwork, they would the buyer of an NFT broader rights to offer the benefits of purchasing physical exploit the unique digital version of the art while resolving the problems of work acquired in connection with the physical transportation and storage and respective NFT. Equally, creators should therefore could represent serious be mindful of the licence terms that any AML concerns.

6 CLIFFORD CHANCE NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT The Financial Action Task Force (FATF), relies on proof-of-work validation, is the global standard setter in relation to computationally intensive and requires a AML, has recognised that NFTs may large amount of energy. This type of create opportunities for money laundering validation is similar to the mining or or terrorist financing and has called for creation of new , which further regulation, so we are likely to see Cambridge University recently found international developments in this space consumed more energy than the entire in the coming months. country of Argentina on an annual basis. Validating NFT transactions will continue Whether NFTs fall within the scope of to consume significant amounts of energy existing AML regulation will depend on until more sustainable data centres and local implementations of FATF guidance validation techniques are created at large in relevant jurisdictions and the specific scale. There is ongoing work around characteristics of the NFT in question. migrating Ethereum from "proof-of-work" See page 8 onwards for highlights of the to "proof- of-stake" validation, which is considerations across key global anticipated to considerably decrease the financial centres. amount of energy required for validation. However, proof-of-stake validation raises What are the practical separate network operation concerns, considerations? which may impact the overall anticipated Data and storage reduction in energy consumption, NFTs are hosted on a DLT platform, including in relation to security, fairness, which typically does not enable storage of and transaction redundancy. Alternative large files, such as digital assets. As a platforms may offer issuers more result, the NFT and its underlying digital sustainable solutions today. This will asset are typically connected to each be a key consideration for potential other via a link. If the digital asset is issuers, advisers and purchasers who stored on a conventional server, there is a are focussed on reducing their risk that the file could be changed or environmental impact. deleted, or the server could shut down, hence breaking the link between the Reputational risks asset and its corresponding NFT. Brand reputation is key for entities who Certainty of the reliability and security of have worked hard to build close ties with the link and the server hosting the digital their fans, followers and supporters. asset is essential. A more robust The reputational benefits of being alternative is a distributed, decentralised associated with a nascent technology storage system, but these are yet to be need to be balanced against the risks widely adopted. such technologies inherently bring. If an issuer's NFTs or tokens significantly Litigation risk reduce in value, there is a great risk of The usual risk of misrepresentation when brand devaluation. Equally, the issuer's selling digital assets will apply to NFTs. brand could be affected by issues with NFT issuers need to be clear with the platform used to sell and trade purchasers about the risk of market the NFT, which may, in extreme volatility leading to a complete loss in circumstances, render the value for them. Whether NFT owners NFT worthless. have any rights in relation to the underlying asset in such a case NFT issuers should also consider the risk remains to be seen. of reputational damage by issuing NFTs on platforms that have a negative Environmental cost environmental impact, as set out above. The execution and validation of NFT transactions on a blockchain, particularly under the Ethereum blockchain which

CLIFFORD CHANCE 7 NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT A GLOBAL ISSUE: of non-fungible cryptoassets will not be required to publish a white paper. WHAT ARE THE REGULATORS DOING? Germany NFTs are available and traded globally • The German implementation of the because DLT platforms operate beyond 5th AML Directive (AMLD5) defined borders. Therefore, issuers, advisers and "crypto assets" as financial instruments purchasers of NFTs will need to consider within the meaning of the German the legal status and regulatory Banking Act (KWG). Under the KWG, frameworks across multiple jurisdictions. crypto asset means "a digital representation of value that is not There is very little global regulatory issued or guaranteed by a central bank guidance as to whether NFTs fall within or a public authority and does not the perimeter of existing regulation possess a legal status of currency or applicable to cryptoassets. money, but is accepted by natural or Most jurisdictions have not yet developed legal persons as a means of exchange regulatory frameworks specifically or payment or which can be used for applicable to NFTs, although several have investment purposes and which can be implemented or published plans to transferred, stored and traded regulate DLT or cryptoassets more electronically". The reference to being broadly. Liechtenstein is an exception, used for investment purposes is an having established a law regarding the expansion of AMLD5. As NFTs can, in civil and supervisory framework for the principle, be used for investment tokenisation of rights in physical assets, purposes given their unique (value- which would cover certain NFTs. creating) character, there are good arguments that NFTs may qualify as Some highlights of international regulatory crypto assets and therefore as financial developments across key global financial instruments under the KWG. In this centres are set out below. respect, the underlying service in relation to an NFT (i.e. brokerage or European Union (EU) trading-related activities) may trigger a • NFTs are not currently specifically licence requirement. regulated in the EU. However, the • Some NFTs may qualify as investment features of any proposed NFT issuance products under the German Capital would need to be considered alongside Investment Act, which governs the various existing regimes, including in public offerings of investment products relation to securities, electronic money that promise an interest payment, and crowdfunding, to ensure that these repayment of invested capital or a cash are not triggered. settlement in exchange for an • On 24 September 2020, the European investment of capital. Whether NFTs fall Commission published the Markets in within this definition is a question of Crypto-assets Regulation (MiCA), fact, subject to the characteristics of which proposes to regulate currently the particular token. out-of- scope cryptoassets and their service providers under a single Italy licensing regime. MiCA is anticipated to • Under the Italian implementation of take effect by 2024 and will apply to AMLD5, the definition of "virtual any person issuing or providing currency" also encompasses digital cryptoasset services across all Member representations of value which are not States, as well as any non-EU firm used as means of exchange but are seeking to trade in EU member states. held for investment purposes, as long One of the proposed obligations is that as they are transferred, stored and cryptoasset issuers would need to traded electronically. In principle, NFTs issue a prospectus-like "crypto-asset could fall within the scope of such white paper". MiCA's definition of definition and trigger AML obligations. 'crypto-assets' includes NFTs – although, as currently drafted, issuers

8 CLIFFORD CHANCE NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT • Some NFTs may also qualify as one or more of the existing investment products under the Italian regulatory frameworks: Consolidated Financial Act triggering 1. Where an NFT qualifies as a financial additional licensing and other instrument, a number of activities obligations. "Investment products" including the buying, selling, encompass MiFID instruments as well intermediation as well as certain as "any other form of investment of a ancillary services in respect of such financial nature". The Italian regulator financial instrument may trigger a has clarified that an 'investment of a licensing requirement as an financial nature' is one entailing all of investment firm. Additionally, any the following: (i) a capital disbursement; other related financial sector activity (ii) the expectation of a financial gain; performed in Luxembourg (e.g. and (iii) the assumption of a risk directly custody or lending of financial linked and correlated to the capital instruments) may trigger licensing disbursement. An NFT's features would requirements and create certain need to be carefully considered to see regulatory and prudential obligations. if it would meet these conditions. 2. Where an NFT qualifies as electronic Japan money, the issuer may trigger a licensing requirement as an • In Japan, while fungible tokens are electronic money institution and be regulated as security tokens or subject to ongoing obligations, cryptoassets under the financial including conduct of business rules. regulations, and dealing with them triggers certain licensing requirements, 3. The issuance of NFTs which qualify the non-fungible nature of NFTs means as units of a collective investment that they usually do not have a undertaking could trigger a licence settlement function and therefore will requirement as an undertaking not qualify as regulated cryptoassets. for collective investment for the issuer or its management company • As a result, many NFTs are not under the relevant Luxembourg specifically regulated, and dealing with investment funds and AIFM laws them does not trigger any licensing and regulations. requirements. NFTs linked to trading cards or in-game items recorded on the • Pursuant to Luxembourg's AML blockchain are most common in Japan, legislation as adapted following AMLD5 primarily because the Japanese online and relevant FATF guidance on virtual gaming market is one of the biggest assets, a virtual asset means "a digital and most mature globally. representation of value (including a virtual currency), that can be digitally • Despite not being caught by specific exchanged, or transferred, and can be financial regulations, NFTs issued as used for payment or investment in-game items do raise issues in purposes" with the exception of virtual relation to the Act Against Unjustifiable assets which constitute electronic Premiums and Misleading money or financial instruments. It is Representations and gambling crime possible that certain NFTs may fall under the Criminal Code. Therefore, within this definition. recently the Blockchain Contents Association and the Japan • Firms who are established or provide Business Association services in relation to virtual assets in have each formulated guidelines Luxembourg, including exchange, concerning NFTs. transfer, safekeeping and administration and the participation in and provision of Luxembourg financial services related to an offer of • NFTs are not currently specifically virtual assets, are subject to a regulated in Luxembourg. However, registration requirement as a virtual depending on the features and asset service provider with the purpose of an NFT, certain activities in Commission de Surveillance du Secteur respect of such NFT could fall within Financier and must comply with relevant AML obligations.

CLIFFORD CHANCE 9 NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT • Commercial activities not subject to a currency and does not possess a sector-specific regime and carried out legal status of currency or money, with a profit-making aim in Luxembourg but is accepted by natural or legal may trigger a general business persons as a means of exchange licence requirement. and which can be transferred, stored and traded electronically", the The Netherlands activities that amount to (i) • NFTs are not currently specifically exchanging virtual currencies into regulated in the Netherlands. However, cash, or vice versa, or (ii) certain activities in respect of certain safeguarding private cryptographic cryptoassets (depending on their keys on behalf of its customers to features) could fall within one or more hold, store and transfer virtual of the existing regulatory frameworks: currencies may trigger registration requirements in the Netherlands. 4. where an NFT qualifies as a financial instrument (e.g. as shares, bonds, People's Republic of units in collective investment China (PRC) schemes, or derivatives), the buying, selling, intermediation and certain • Activities relating to cryptocurrencies ancillary services in respect of such and cryptoassets are strictly regulated financial instruments may trigger a and scrutinised in the PRC. Despite the licensing requirement as an absence of a unified regulatory investment firm framework, rules in respect of (beleggingsonderneming); cryptoassets are scattered in ad hoc notices and circulars issued by the 5. where an NFT qualifies as electronic PRC financial regulators, as well as money (electronisch geld) in self-discipline organisations. The circumstances where it represents a milestone regulation in this area is the claim on the issuer for pre-paid Circular on Preventing Risks related to electronic spending power, the issuer Initial Coin Offerings (ICO) (2017) issued may trigger licensing requirements as by seven Chinese governmental an electronic money institution agencies (including the PRC's central (elektronischgeldinstelling); bank, the People's Bank of China) in 6. where an NFT qualifies as an September 2017 (the ICO Circular). investment object (beleggingsobject), The ICO Circular marked an which is defined as "an item or unprecedented regulatory clampdown object, a right to an item or object or on cryptoassets which has been a right to the full or partial return in sustained in practice; since 2017 we cash or part of the proceeds of an have seen supervisory and item or object, (…) that is acquired enforcement actions taken in respect of other than for no consideration (e.g. crypto-related activities. for payment in kind), with the • In May 2021, the National Internet prospect of a return in cash and Finance Association of China, the China where the management of the object Banking Association and the Payment is mainly carried out by someone and Clearing Association of China other than the acquirer", the offering issued a joint statement reiterating the and intermediation in respect of such position in the ICO Circular that their investment object may trigger a member institutions (including banks licensing requirement as a and payment firms) should not offer any financial service provider crypto-related services in the PRC. (financiëledienstverlener); and The statement also set out further 7. where an NFT qualifies as a specific restrictions and risk alerts, "virtual currency", which is defined in including around cryptocurrency the Dutch implementation of the exchange, investment and trading. AMLD5 as "a digital representation • However, there is no clear-cut definition of value that is not issued or of cryptocurrency or cryptoasset under guaranteed by a central bank or a the laws of the PRC and whether an public authority, is not necessarily NFT qualifies as such may require a attached to a legally established "substance over form" analysis. If NFTs

10 CLIFFORD CHANCE NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT are created for fundraising, the relevant Singapore regulatory risks would be high. Likely • NFTs are not currently specifically post-issuance activity may also be regulated in Singapore. The regulatory relevant when evaluating potential risks approach has been to look beyond a in relation to any NFT. token's label and examine its • Notwithstanding the above, neither the characteristics. If such characteristics ICO Circular nor other regulations fall within an existing regulatory explicitly prohibit a PRC resident from framework, the NFT will be subject trading or investing in NFTs, but only to regulation under that remind people of the relevant risks existing framework. associated with cryptoassets. • Generally speaking, there are three types of digital tokens – security Russia tokens, payment tokens and utility • Russia has recently finalised its legal tokens. If an NFT is determined to be a framework regulating cryptoassets. It type of security token (i.e. it exhibits the does not currently specifically refer to characteristics of securities, such as NFTs, but distinguishes between: conferring or representing a legal or beneficial ownership interest in a 1. digital utility rights, defined as corporation, partnership or limited digital rights to request the: (i) liability partnership), it may be subject transfer of tangible assets; (ii) to the regulatory regime governing transfer of intellectual property securities. This may include complying rights, or (iii) carrying out of works with the offering regime for an offer of and/or provision of services; securities and the licensing 2. digital financial assets, defined requirements for dealing in securities. as digital rights including monetary • If an NFT is determined to be a type of claims, the possibility of exercising payment token (i.e. it is structured to rights under securities, the right to function as a medium of exchange as participate in the capital of a non- payment for goods or services), it may public joint-stock company, the be regulated under the Payment right to demand the transfer of Services Act 2019, which governs the certain digital securities; and provision of payment services (which 3. digital currencies, defined as a includes a "digital payment token combination of electronic data: (i) service"). Currently, the scope of contained in the information regulation for "digital payment token system; (ii) capable of being service" extends to dealing in digital offered and/or accepted as a payment tokens or facilitating the means of payment and/or an exchange of digital payment tokens. investment; and (iii) in respect of A person who carries on business in which there is no person obliged such activities triggers the licensing towards every holder of such requirements under the Payment electronic data, save for operators Services Act 2019, unless a relevant and users responsible for issuance exemption applies. and making entries to the • If an NFT is determined to be a type of information system in accordance utility token (i.e. it is used to access a with its rules. good or service and does not fall • Depending on the characteristics of a within the former two categories), particular NFT, it may fall within one of it may be unregulated. these categories, or be considered as an asset sui generis. In either case the United Arab Emirates specifics of issuance of or trading in the • The recently introduced Crypto Asset NFT and the related regulatory, legal Regulations in the UAE, issued by the and tax implications would need to be Securities and Commodities Authority analysed on a case-by-case basis, with the support of Clifford Chance, depending on the characteristics of the are designed to capture cryptoassets NFT and the underlying asset to which which are securities or are otherwise it is linked. traded on an exchange (a "regulated

CLIFFORD CHANCE 11 NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT commodity token). "Crypto assets" UK expressly include a DLT record serving • NFTs are not currently specifically as a representation of ownership. regulated in the UK. However, certain Therefore these regulations will only activities in respect of certain apply to the extent NFTs become cryptoassets (which may include an tradable through a digital assets NFT depending on its features) could exchange, and such NFTs are fall within one or more of the existing promoted or offered (or associated with regulatory frameworks: other financial activities conducted) within the UAE. It is unlikely in the near 1. where cryptoassets qualify as term that NFTs listing on digital assets regulated investments (such as exchanges will be practical given their shares, bonds, units in collective unique and non-fungible nature. investment schemes, or derivatives), Where an NFT is subject to a brokerage the buying, selling, intermediation arrangement or peer to peer transfer and certain ancillary services in (whether organised through an online respect of such regulated platform or not) – this is unlikely to be investments would trigger a an "exchange" to which the current licensing requirement and ongoing UAE rules are intended to apply. conduct of business obligations; Notwithstanding the above, it remains 2. where the cryptoasset qualifies as possible that activities in the UAE in electronic money in circumstances respect of NFTs (including for example, where it represents a claim on the brokerage) will be subject to AML issuer for pre-paid electronic compliance responsibilities, which spending power, the issuer will would need to be assessed depending trigger licensing requirements on the nature of the underlying asset and ongoing conduct of and the size of the transaction. business obligations; • The Abu Dhabi Global Market (ADGM), 3. under the UK's AML legislation, a growing financial free zone in the cryptoassets are defined as UAE, has become a leading regional "a cryptographically secured digital zone for virtual assets business. representation of value or The ADGM has developed its own contractual rights that uses a form regulations on "virtual assets" and it of DLT and can be transferred, licenses firms to conduct regulated stored or traded electronically", activities in respect of virtual assets and activities that amount to separately to other parts of the UAE. converting cryptoassets to other However, again, these rules are unlikely cryptoassets or cash into to apply in respect of NFTs. cryptoassets would trigger The definition of a "virtual asset" refers registration requirements. Such to a digital representation of value that regulatory requirement is also can be digitally traded and functions as triggered by intermediating or (1) a medium of exchange; and/or (2) a arranging such exchanges. unit of account; and/or (3) a store of value. Unlike the UAE rules, this does • Whether an NFT qualifies as a not expressly include a "representation cryptoasset under the UK's AML of ownership". Therefore NFTs are legislation requires careful arguably not captured. However, to the consideration, particularly if, based on extent a particular NFT is determined a its characteristics, it amounts to a constitute a virtual asset, the ADGM's representation of value or Financial Services Regulatory Authority contractual rights. only permits firms to conduct activities • There are various proposed regulatory in respect of "Accepted Virtual Assets" changes currently being consulted on – which must satisfy a number of in the UK, including around the criteria (including maturity and market regulatory perimeter applicable to cap). These criteria are unlikely to be cryptoassets and stablecoins and satisfied by NFTs. extending the scope of the financial promotions regime to apply to currently out-of-scope cryptoassets which might impact NFTs.

12 CLIFFORD CHANCE NON-FUNGIBLE TOKENS: THE GLOBAL LEGAL IMPACT US However, the situation could change – for example, if certain NFTs are actively NFTs are not currently specifically traded and come to have an regulated in the US. Thus, the legal status established value at which they can and regulatory classification of NFTs readily be converted to currency. In the under US law remains unclear. However, case of intermediaries who facilitate as with other cryptoassets, the features of NFT trading but also engage in other an NFT and how it is marketed and activities that are subject to established purchased or sold could cause an NFT to regulation, this argument may have less fall under existing US federal regulatory force. Recent changes to the Bank frameworks. The following key points Secrecy Act included in the Anti-Money should be considered: Laundering Act of 2020 (the 2020 Act) • From a US securities law perspective, amend certain definitions to include pieces of memorabilia and collectibles businesses engaged in the exchange or are not ordinarily considered to be a transmission of "currency, funds, or "security" standing alone. However, an value that substitutes for currency" as NFT marketed as a financial investment financial institutions that are subject to whose holders have been led to expect AML regulatory requirements. profits from an entrepreneurial venture • US federal regulators could also involving the NFT, or the managerial interpret anti-money laundering skills of the NFT's promoter, is more regulations governing dealings in likely to be deemed to be part of an "antiquities" or "art" to cover NFTs. "investment contract", which is a type The 2020 Act amended the Bank of "security" that is subject to US Secrecy Act's definition of "financial securities law. While no US federal institution" to include persons engaged regulator has taken enforcement action in the trade of antiquities, and directs against an NFT issuer to date, we have FinCEN to promulgate implementing seen private litigants filing civil class regulations. The 2020 Act also instructs actions against NFT issuers alleging the Treasury and other agencies to that the issuance of their NFTs perform a study of the facilitation of constituted an unregistered securities money laundering in the trade of works offering under US law. Class action of art, and report to Congress in suits can be expensive to defend January 2022 to inform the debate over even where claimants are whether to extend AML regulatory ultimately unsuccessful. requirements to art dealers. The impact • The Financial Crimes Enforcement such actions will ultimately have on Network (FinCEN) and the courts have NFTs, if any, is not known at present. yet to issue specific guidance on NFTs. • US federal sanctions laws may also be From a US anti-money laundering relevant to the issuance, purchase, and standpoint, whether an NFT can be sale of NFTs. NFT transactions can characterised as a "medium of occur between counterparties located exchange" and ultimately as a anywhere in the world. Thus, US and "convertible virtual currency" under US certain non-US persons transacting in law is not entirely clear at present. NFTs NFTs, and NFT dealers in particular, that are truly non-fungible should not should ensure compliance with be considered a medium of exchange regulations issued by the US Office of or convertible virtual currency because, Foreign Assets Control prohibiting unlike Bitcoin or other virtual currencies, business dealings with certain persons, most NFTs are not designed or as NFTs of any value could be used to intended to serve as a currency evade US sanctions. substitute or medium of exchange.

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