Bates Research | 06-01-22
Non-Fungible Tokens: a Beginner’s Perspective
by Managing Director Brandi Reynolds, CAMS-Audit and Consultant John Ashley, CIPP/US, CRCMP.
We've all heard of Non-Fungible Tokens (NFTs) by now, and when this term comes up in the news or a talk with friends, there is no shortage of opinions. But what actually is an NFT?
An NFT is a unique digital identifier that cannot be copied, substituted, or subdivided, that is recorded in a blockchain, and that is used to certify authenticity and ownership of a specific digital asset and specific rights relating to it. This digital asset is usually an image, audio, or video file. The NFT is not the asset itself, rather, it is a one-of-a-kind digital marker assigned to the asset as code stored within the blockchain. NFTs are themselves considered to be digital assets.
An NFT is linked to a digital identity which is then linked to an owner or owners. NFTs are used to create verifiable digital scarcity of a digital object as well as a verifiable digital ownership trail. As such, NFTs function like virtual versions of physical collectibles, such as paintings, books, or baseball cards. NFTs can also store more esoteric information, such as experiences. For example, an NFT could represent attending a particular concert or other event on a specific date and/or time. NFTs can also be used in conjunction with the trading of physical items as well.
How Does It Work?
NFTs are stored on a blockchain, meaning they are individual tokens with additional information stored in them. As they have value, they can be bought and sold, and, like other types of art, their value is determined by market demand.
However, this does not mean that there is only one NFT for each digital asset on the market. In a similar way to artists issuing print runs of original pieces, NFT copies are still important parts of the blockchain, but they can’t substitute for the original.
The NFT links the owner to the original marker, and this makes the NFT “exclusive.”
Where Are They Sold?
Currently, NFTs can be purchased on a variety of digital platforms, and the choice depends on what you want to buy. Transactions can occur in cryptocurrency exchanges or in online marketplaces like OpenSea. Also, some physical-item auction houses have recently started offering NFTs.
What Are the Risks?
There are many risks associated with NFTs, one of the biggest being the volatility associated with NFTs. Prices are largely determined by uniqueness, creativity and scarcity. However, there is still significant uncertainty surrounding NFT price determination, as there are no universal standards in place. Additionally, fraud is a significant risk for the sale and purchase of NFTs. This can take the form of NFT projects which are set up as scams, or through the use of stolen or fraudulently acquired NFTs.
What Is Driving the NFT Market?
Digital scarcity: Back in the days when music was primarily bought and sold on vinyl, cassette, and CD, it was easy to prove you owned an official copy of a song or album. Now that most media is consumed online, it has become easier to copy and distribute content over the internet, often without any recognition for the original creator. Since NFTs are based on blockchain technology, an immutable record of ownership can be clearly identified.
Fair compensation for creators: The ability for Internet users to download, copy and distribute digital audio, video, and image content has meant that creators of original content often cannot fully reap the benefits of their work.
According to a report released on March 19, 2021, by DataProt, pirated videos are viewed more than 230 billion times per year, resulting in annual losses of between $40 billion and $97.1 billion. Although governments, regulators and distributors have attempted to put in place various strategies to stem piracy, their attempts have been unsuccessful and piracy activity continues. Unlike traditional distribution networks, blockchain technology has the potential to slow down this phenomenon. Creators can set commissions on all sales of their works and all transactions are recorded.
For example, the artist known as Beeple sold a piece titled “CROSSROAD” for $ 66,666.66 in October 2020, which then resold in 2021 for $ 6.6 million. Despite the change in ownership, Beeple earned a 10% commission on each sale and will continue to earn a commission each time the NFT is resold.
The Possibilities Seem Endless
Well-known brands and major companies are also seeing the appeal of NFTs. Taco Bell, for examples, sold NFTs of GIFs and taco images, with many designs being purchased almost immediately after being announced. Each token contained a $500 gift card that the owner could spend in-store. Today, TacoCards are selling on the secondary market, some for over $3,000.
Even tweets on Twitter can fetch a high value as an NFT. Jack Dorsey, co-founder of Twitter, sold his first tweet for nearly $3 million. The possibilities seem endless, which stimulates creativity.
What the Future Holds
Regulatory uncertainty around NFTs and cryptocurrency in general creates a significant hurdle in the way of mass adoption.
Despite the uncertainties, Nadya Ivanova, Chief Operating Officer of BNP Paribas-affiliated research firm L’Atelier, sees “huge potential in the future of NFTs. A correction is inevitable, she said, but ultimately the market will continue to grow and "NFTs may become the underlying asset of the entire virtual economy, expanding far beyond just digital art and collectibles."
How Bates Group Helps
While there’s no specific guidance on whether non-fungible tokens (NFTs) constitute a virtual currency or other regulated activity, regulators and legislators are scrutinizing virtual currency and digital closely now. Most NFTs involve art or intellectual property. In 2021, FinCen specifically issued a notice concerning AML, the Arts & Antiquities Market and illicit activity under the AML Act. (Source: FinCEN Notice on Antiquities and Art (FIN-2021-NTC2)
Bates Managing Director Brandi Reynolds notes that "with the potential for money laundering and OFAC risks associated with NFT marketplaces, it is prudent for those operating in the space to have a risk-based AML program in place." Bates can create a best-in-class AML compliance program which will meet best practices, regulator and financial partner expectations, tailored specifically to your business model. We also design and implement controls to detect and prevent fraud, money laundering, and other forms of illegal activity.
Call or email Bates today to discuss how we can help protect your NFT firm or program.
Brandi B. Reynolds, CAMS-Audit, Managing Director, AML & Compliance
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