Against the backdrop of the Football Index scandal in the UK or the Robinhood/Gamestop case in the US, policymakers have raised legitimate concerns about new tools available to individuals to speculate at large scale on various types of assets. The UK Parliament’s Digital, Culture, Media and Sport (DCMS) Committee has correctly identified that some Non Fungible Tokens (NFTs) have followed a similar trajectory as a bubble formed between the 3rd quarter of 2020 and the 1st of quarter 2022, before a krach wiped out billions of dollars of value globally. Early January 2023, the DCMS Committee called for evidence on whether the lack of NFT regulation in the UK exposes individuals to potential harms.

The call for evidence focused on financial utility – more specifically on speculation-, but it is critical to consider other use-cases to envisage a balanced regulatory framework : NFTs, as applications of the blockchain technology, may have benefits to individuals and society that should not be ignored. These potential benefits must be put in perspective with the need for basic regulations to better protect NFT owners, irrespectively of whether the tokens were purchased as speculation instruments or to fulfil other types of utility.

The examples mentioned in introduction show that regulators can fail to protect users in two different ways: Football Index was a failure to supervise products or assets (there were, in fact, no assets) whilst Gamestop was partly attributed to a failure to supervise an intermediary, Robinhood, a trading platform. Regulation of the underlying assets does not guaranty users’ protection as evidenced by the heavy regulations pertaining to the Gamestop stocks. The same reasoning can be applied to situations where policymakers conclude that underlying assets do not require specific regulations ; significant risks can exist higher-up the value chain. This is important background for the discussion on NFTs because there is a general misconception about the disintermediating merits of blockchain-based applications. NFT ecosystems are extremely complex and often involve numerous stakeholders which can represent single points of failure. Therefore, the debate around potential NFT regulations should not only focus on underlying assets but must cover the entire value chains from NFT issuers to end-users.

As of today, these value chains sit in the regulators blindspot – not only in the UK but almost everywhere in the world. At the core of the issue is the lack of classification of NFTs as assets: are they securities? Are they commodities? or are they equivalent of physical assets like cars, furniture or artwork? For these asset classes, policymakers have either established regulatory frameworks covering the value chains, or they have concluded that a light-touch was justified. However, no existing asset class seems broad enough to capture the versatility of [non fungible] tokens (though Tax authorities did form a view on a classification within a broader asset class). For this reason, only considering NFTs as financial assets would likely be a dead-end for regulators. But the Finance frameworks can prove useful : the long history of scandals that led to supervision of the finance industry gives a hint of what could go wrong. Despite the blockchain technology mitigating some of the risks, NFT ecosystems sometimes evidence similar flaws : intermediary/counterparty risk, valuation risk and liquidity risk, all of which can be exacerbated as a result of complex engineering that very much resembles financial structuring, using tools that fall under the umbrella of Decentralized Finance (DeFi).

There is no doubt that the vast majority of the players in the NFT space act in good faith, yet a number of risks are ignored and they are ultimately borne by end-users. These risks are generally known to industry insiders – albeit there was no reason to quantify them during the bull market. And they are rarely clearly laid out to users, nor were they clearly explained to Venture Capitalists who poured hundreds of millions into the ecosystem on the back of buzzwords. Those who have been on the receiving-end of VC investments may be best-in-class, but they have sometimes struggled to hire employees quickly enough to keep pace with meteoric growth ; so there is still a lot of fake-it-until-you-make-it-communication. This is part of any successful entrepreneurial journey, but rarely with so much value at stake. On the bright side, the companies that survive the current “crypto-winter” will do so because they actually add value for their users ; so they should create jobs and pay taxes in the long term, which is also creating value for society.

Policymakers in different jurisdictions may form different opinions about the appropriate balance between job creations and consumer protection but an informed debate about NFT regulations seems necessary rather sooner than later. This should contribute to establishing a climate of confidence between issuers, custodians, market-places and end-users, but also to create a favourable business environment where NFT players can invest and hire employees without fearing competition from new-comers dumping flawed products (or obvious scams) that could damage the reputation of the entire industry.

Blockchains and NFTs

To appreciate the risks and opportunities of NFTs, explaining what they are in reasonably intelligible terms seems an important first step. This always implies a risk of oversimplification. For most people – hopefully not too many NFT owners -, “NFT” is synonymous of unique digital images that are “stored on the blockchain” which is a guarantee of transparency about its uniqueness and ownership. Such description is inappropriate for many reasons; primarily because the practical reality of the blockchain backbone is not straightforward. Blockchain is not a piece of hardware; it is just way to record information (e.g the creation of - or a transaction on- tokens), block after block, to constitute a digital ledger that cannot be altered once a block is validated. It would be exaggerated to claim that anyone could set up a blockchain, but there is virtually no limit to the number of different blockchains that can be created. The best-known examples of blockchains such as Bitcoin or Ethereum are public and decentralized, but private blockchains exist and can be controlled by single authorities - typically for business solutions. Decentralization makes the ledger more secure but less efficient so applications are less scalable. There is a cap on the number of blocks that can be added over a certain period of time and a limit to the amount of information that can be stored in a block. To go around capacity constraints, some tokens would simply include the address of a server storing voluminous information, e.g a high-definition image. The amount of data that can be stored on-chain, directly or indirectly, varies across blockchains but the vast majority of NFTs are built combining on-chain and off-chain information. On-chain and off-chain can mean different things for different people, and all types of hybrid solutions can be envisaged. For this reason, discussions with or between specialists can be confusing.

A non fungible token is unique by nature : it has a unique ID on the blockchain, irrespectively of the image or other metadata it is associated with. Most times, the image merely facilitates the mental representation of the token and of its uniqueness (or limited supply when the image is the same as other NFTs except for a serial number visible on the picture). Like any product or service, an NFT’s value is driven by its [marginal] utility for a given user ; the metadata can only activate some of the utility. For a [non fungible] token, utility is fundamentally underpinned by a right. It can be as abstract as a right to belong to an exclusive club - a value driver for Bored Apes Yacht Club NFTs or “digital fashion” NFTs for example; just as anything rare is expensive if it is sufficiently well marketed (see Adam Smith's Diamond-Water paradox). It can also be a right to vote (e.g tokens issued by true Decentralized Autonomous Organisations), a right to attend an event, a right to enter an e-sports tournament (i.e gaming utility)… or it can be a right to earn a yield or make a profit upon resale (i.e financial utility). It can be a combination of multiple rights, leading to multi-dimensional utility. For example, tokens combining gaming utility and financial utility -a model called Play-to-Earn- have been hugely successful ; entire ecosystems have been built around them (e.g data platforms, financing and farming organisations called Guilds which in turn issued tokens…). The blockchain technology proves that one owns the token, and thus is entitled to the right(s). Establishing the link between a token and the right(s) underpinning its value is key to analyse the strengths and weaknesses of each project, starting from the NFT issuer and including all the stakeholders affecting utility.

Additional complexity lies in the fact that the number of dimensions of a token’s utility can evolve overtime. Consider a fictional token granting access an event : the access right expires once the event is finished, so utility – and thus value – drops. But if organisers decide, one year later, to give access to exclusive content or to another event to whoever owns a token, this adds utility and thus adds value. Utility of the token may drop to zero but, so long as the blockchain continues to be accessible, someone could always come up with a new use-case adding marginal value. Capturing the issue of speculation in the NFT sector is challenging for two reasons :

• speculators can bet on an increase in a specific right’s value (i.e more people will compete for the benefit of the right) but they can also bet on new rights being attached as the project matures which demonstrates a true belief in the team running the project. If policymakers consider that the latter is more acceptable than the former, establishing anti-speculation measures may be impossible;
• there will always be an argument to say that is too early to conclude that value as been destroyed if the tokens still exist because new utility can be found. This is the fundamental difference with Ponzi schemes. That said, as much value can be destroyed if new use-cases never materialize.

Instead of focusing on speculation, the onus should probably be placed on the true ownership of the tokens and transparent information about risks ; common themes in the highly-intermediated and highly-regulated finance industry.

Intermediary and counterparty risk

A corporate loan contract is a good Finance analogy for NFTs: the legal documentation does not only establish a right to receive a contractual return, but also lays out how securities are implemented over a collateral (if any) which may reference other contracts, who is responsible for enforcing these securities, what triggers such event, how and when cash flows between the borrower and the lender, whether there are restrictions to the transferability of the loan from a lender to a third-party… most steps involving actions of one or more parties. At a high level, the promise of the blockchain technology is to cut the middlemen and therefore the need for their supervision (on top of other benefits such as cost- and time- savings). However, the practical reality of disintermediation is not always clear in the NFT sector.

A failure of a counterparty or service provider is the single most overlooked threat for NFT owners. This extends far beyond project-specific intermediaries as blockchain infrastructure, in the broad sense, is quite concentrated and not always as decentralized as generally believed - not enough to mitigate a knock-on effect when a big player fails. It is not just about identifying fraudsters and scammers in a value chain, it is also about understanding if companies can withstand operational disruptions or afford having assets frozen each time a service provider files for bankruptcy. Important considerations regarding intermediaries include:

• Blockchain (infrastructure):
  • Can anyone see/audit what’s on the blockchain?
  • Who has authority over the validation of the blocks?
  • What is the risk that the blockchain stops being operated in the medium-to-long term due to a lack sustainable business model of the stakeholders? What are the mitigants to such scenario? Is a migration possible?
• Custody / wallets (true ownership):
  • Who controls the wallet that holds the NFTs? If it’s a custodial wallet (i.e managed by a third-party platform), who has the private key to the wallet? If the platform collapses or restricts access, would the user be able to get direct control over the wallet? How?
  • Marketplaces:
    • Is the user required to make a deposit before a purchase or is the purchase directly debited from a non-custodial wallet (managed by the user) or bank account? Upon sale, does the user directly receive a payment or is the amount credited to an account on the platform? If the account is credited in cryptocurrency, where is the wallet and who controls it? In any case, is the balance of the account segregated from the platform’s own fiat or cryptocurrency?
    • How is the marketplace dealing with AML regulations?
  • Are intermediaries, if any, audited by reputable firms? Where do key intermediaries keep their cash (bank or exchange)?
• Off-chain information (if critical to utility) : can information disappear, either because the server operator fails, or because the NFT issuer stops paying?
• Are the issuer and intermediaries, if any, [expected to become] subject to laws and regulations (prudential, financial, intellectual property, …)? Is this expected to significantly impact their operational models, or business models? or even liquidity of the tokens?

Note that value chains can be partially or fully integrated as one platform can control at the same time the NFT issuance, the Blockchain operation, custodial services and the marketplace.

Valuation and liquidity

Transparency about valuation and liquidity is another area where the NFT industry is critically weak. In this sector, liquidity and valuation are two sides of the same coin as the only valuation methodology in NFT markets relies on past transactions. Even aggregating transactions on “comparable” NFTs – which can be subjective - trading volumes can be extremely low. Whilst it may not be easy to sell, one single transaction or even a listing for sale on an open market (known as the “floor” in the NFT sector) can constitute a valuation event affecting all comparable NFTs. Relying on a single price point would not be considered good practice in Finance, albeit it is less of a problem in a bull market because transaction-based valuations likely underestimate fair market value so it can be seen as a “prudent” approach. In Finance, regulations mandate professionals to disclose liquidity risk to their [retail] clients for assets that don’t trade frequently. Many NFT players would argue that information about trading volume and frequency is available on the blockchain (if public), however only few users have the technical knowledge to query a blockchain at scale and to aggregate information to from groups of comparable tokens.

Adding to the complexity of NFT liquidity, issuers can compete against their own customers to sell tokens : projects can be designed to ensure that the primary market (issuer sales) has priority over the secondary market (user sales) so that, when the market cools down, a baseline revenue is maintained. If secondary volumes disappear, transaction-based valuations are meaningless for token-holders. Hence, supply management by NFT issuers is a key source of concern in many projects. Important considerations regarding valuation and liquidity include:

• Supply & Volumes:
  • Are there market markers? More generally, is anyone paid to influence prices or volumes? Has any market participant a material influence on secondary volume?
  • How do primary volumes compare to secondary volumes? How quickly does the overall stock increase (i.e how many new tokens are brought to market each month/year)? Does the stock only increase as a result of transactions or are tokens “airdropped” as gifts, yield or rewards? What is the stock rotation?
  • If there is indication that primary volumes are more resilient than secondary volumes, is it driven by more utility of newly-issued tokens ? or is it just because users restricted to undercut the issuer?
• Valuation:
  • If price information exists, how many trades does it cover? When was the last one?
  • If valuation is expressed in a volatile currency and the assets are illiquid : is the reporting currency reflective of the end-users reference currency ?
• Selling on a marketplace: if proceeds of a sale are denominated in fungible tokens (crypto-currency), how easily can this be converted into cash?
• Yield (financial utility):
  • If yield is denominated in fungible tokens (crypto-currency), how easily can this be converted into cash?
  • Yield in form of NFTs can exacerbate the influence of demand: increasing demand can lead to increasing prices so yield value increases which increases financial utility, which contributes to the increase in prices. However, if prices start to drop due to a lack of demand, yield also decreases which can accelerate the decrease.

[Financial] Engineering

Some blockchains allow to attach smart contracts to tokens which adds to the versatility of the technology. Smart contracts are programs that self-execute when pre-determined conditions are met. There are infinite use-cases of smart-contracts, such as collateralization of a token by another token or automated distribution of sales proceeds between several parties. Going back to the corporate loan analogy : smart contracts can encapsulate all terms and conditions (securities, covenants, timing and calculation of cashflows...) and automate cash flows or transfers of ownership. Tokenization can mitigate liquidity risks by breaking down highly illiquid assets into smaller pieces that can be traded more easily, however the addition of layers in the value chain adds to counterparty risks and valuation uncertainty. High-profile NFTs have been the objects of tokenization : for example, Beeple works auctioned in December 2020 were used as collateral of tokens called B20 in early 2021. Not all players in the NFT “structuring” market are as sophisticated as the B20 issuer ; there is a lot of DYI-type engineering (if any engineering at all) and sometimes aggressive communication focused on financial return.

Critically, one key source of value “leakage” is almost always omitted when it comes to automated distribution of value via back-to-back contracts: what constitutes a taxable profit and what constitutes a deductible charge (and in which jurisdiction) is a gray area to say the least. Entire business models could collapse following an adverse decision of tax authorities regarding accounting rules for smart contracts.

Regulators scrutiny seems all the more important outside the core of NFT ecosystems because core players, backed by blue-chip VC funds, are strongly incentivized to act in the best interest of the end-users, first and foremost out of reputation concerns. It is not necessarily the case for DeFi alchemists building NFT-backed solutions under everyone’s radar.

Very few people in the world can pretend to understand everything that is going on along those value chains and I am certainly not one of them; I am not even a trained blockchain engineer, I studied finance and management and I have worked in the Private Equity industry for the last 13 years. NFTs should be the least of my concerns. The blockchain technology has always looked compelling to me, in particular for its applications in Finance, but I only took a deep dive in 2019 when I serendipitously became a business angel to a start-up that issued gaming NFTs. Initially driven by curiosity about this NFT project - exited in 2021 -, I extensively studied NFT value-chains beyond gaming, and the economic theory underpinning NFT markets until 2022. My analysis is undoubtedly biased by my financial education and years in Private Equity: I genuinely admire entrepreneurs, I love all types of businesses... but I have seen very good companies fail. Sometimes I had to deal with the consequences of "perfect storms" in value chains. My job requires a decent understanding of contract law and most regulatory frameworks – or lack of – across various jurisdictions, which are important tools to get your head around an industry at an infancy stage, like Web3 today. I believe that I understand its potential and I definitely share the vision. Yet, I am today as ambivalent about Web3 as I was 4 years ago because, despite many billions invested by Venture Capitalists recently, two key ingredients are still critically missing in order to deliver on the vision:

• scalable decentralized blockchains supporting smart contracts, a technical hurdle;
• mass adoption of non-custodial wallets, a cultural hurdle.

Unless significant progress is made on these two fronts, Web3 seems bound to fall short of current expectations for a societal revolution, irrespectively of recent turmoil in the crypto industry. So long as practical portability and true ownership of tokens is not the norm, Web3 can merely be a technical evolution limited to relatively small niches. In these niches, there can be undeniable benefits that justify fostering innovation ; asset ownership in gaming is a good example. Yet it does not necessarily alleviate important risks. These issues, notably around custody, have unfortunately materialised in the last 6 months on another branch of the crypto-ecosystem. And there is little doubt that the NFT sector will be affected by the ripples, for example if a service provider has crypto or fiat on a bankrupt exchange or if a third-party giving utility to the tokens gets bust. It seems like financial regulators are contemplating prudential frameworks for the custodian function over other crypto-assets which would represent an important risk mitigant for NFT value chains too. But users need better information about risks, and companies need to be held accountable when they fail. Best-in-class players at all stages of the value chains should benefit from a regulatory framework that is flexible enough to allow them to grow, but prevents scandals that could damage the image of the entire sector.