Non-Fungible Tokens (NFTs) is an innovative application of blockchain and smart contracts. NFT features intelligence, non-homogeneity, and non-tampering with a standard introduced by ERC-721 (Ethereum Request for Comments 721). As a decentralized digital ownership certificate of virtual or physical assets, it is widely recognized as one of the core pillars of the Metaverse.
NFT digital assets are becoming increasingly popular in the international market in recent years. According to a report released by NonFungible Corporation on its website (Nonfungible.com), the transaction size of NFT reached $17.6 billion in 2021, a 210-fold increase from $82 million in 2020.
NFTs show potential value in enriching the digital economic model and promoting cultural and creative industry development. However, they also involve many endogenous financial risks such as fraud, money laundering, illegal fundraising, and infringement of intellectual property rights.
To protect consumers’ legitimate rights and interests, maintain a healthy industrial ecosystem, and prevent systemic financial risks, Chinese regulators and related industry associations have promulgated Proposals on Preventing Financial NFT-involved Risks, Guidelines for the Compliance Operation of Issuing NFT Digital Collections, Compliance Evaluation Guidelines for Digital Collections, and Notice on Further Preventing and Dealing with Hype Risks of Virtual Currency Transactions.
There appeared also China’s first law judgment on NFTs: 2022 (Zhejiang Province) 0192 Civil Case First Appeal No. 1008. On April 20, 2022, the Hangzhou Internet Court held a public hearing of the case in which Qice Company, the plaintiff, sued a technology company, the defendant, for infringing on the right of communication through an information network. The Court ruled that the defendant shall immediately delete Panghu Vaccination NFTs posted on the platform involved, and compensate Qice Company for economic losses and reasonable expenses totalling ¥4,000.
Overall, China’s current NFT-related policies are made by drawing on the prior regulation experience of P2P platforms, which embodies the principles of integrity and innovation, prudent supervision, and orderly innovation:
NFTs are allowed to play a positive role in promoting industrial digitalization and developing the development of cultural and creative industries in scenarios such as Metaverse, while not crossing the rudimentary compliance redlines of prohibiting coinization, securitization, and financialization.
How to Ensure the Orderly Development of NFT and Other Digital Assets?
How to promote the orderly development of NFT products, the Metaverse, and the digital economy through regulation and innovation is a dire challenge for the global legal fraternity.
Similar to China's continuously improving NFT-related rules, the United States has issued Executive Order 14067, Ensuring Responsible Development of Digital Assets, Framework for Responsible Development of Digital Assets, Responsible Financial Innovation Act, and other normative documents.
These documents, with security and development at the core, aimed to protect consumers, investors, and businesses, to maintain the US dollar-centered global financial system, and to further consolidate the leadership of the United States in digital asset innovation. The responsible Financial Innovation Act, for example, released on March 9 this year, highlighted six key policy goals of the U.S. government (as shown in Table 1).
Table 1. Six Key Policy Goals of the U.S. Government
Goal 1 Protect consumers, investors, and businesses in the United States
Goal 2 Protect United States and global financial stability and mitigate systemic risk
Goal 3 Mitigate the illicit finance and national security risks posed by misuse of digital assets
Goal 4 Promote access to safe and affordable financial services.
Goal 5 Support technological advances that promote responsible development and use of digital assets.
Goal 6 Reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets
To implement these key policy goals, the Department of Treasury, Department of Commerce, Department of Homeland Security, and other authorities have worked together under the coordination of the Assistant to the President for National Security Affairs (APNSA) and the Assistant to the President for Economic Policy (APEP) to develop digital assets in a safe, orderly, and responsible manner. They submitted multiple reports and finally unveiled the first-ever comprehensive Framework for the Responsible Development of Digital Assets on September 16, which outlined a detailed and complete set of development initiatives and policy recommendations.
Framework for Responsible Development of Digital Assets
(Source: White House website)
The Framework clearly states that the policy purposes are to protect consumers and investors, to ensure financial stability and security, and to encourage responsible technological innovation and development. The U.S. government and its law enforcement agencies will hence strengthen investigations and law enforcement actions against illegal activities related to digital assets. On the one hand, they will continue to use existing regulatory tools to crack down on illegal activities that abuse digital assets, especially those involving NFT financialization and securitization; on the other hand, they will continue to monitor the development of digital assets and financial risks and assess the gap between existing legal supervision and practical needs to innovate regulation.
The United States Securities and Exchange Commission (SEC), for example, officially announced as early as May this year (May 3, 2022) that by nearly doubling the size of its Crypto Assets and Cyber Unit, the SEC would be better equipped to police wrongdoing in the crypto markets while continuing to identify disclosure and control issues with respect to cybersecurity. However, it did not impose much punishment for many cases directly against NFTs.
Meanwhile, the SEC repeatedly issued investigation letters, asking NFT creators and trading platforms to provide information on how they use and trade NFTs, especially regarding so-called Fractional NFTs (F-NFTs). F-NFT, as the name suggests, is a fragment of a single NFT without uniqueness. Therefore, unlike non-homogeneous NFTs, it may be recognized as a security by the Howey Test and then included in SEC supervision.
The World's First Insider Trading Case Involving NFT Platform: Telecommunication Fraud and Money Laundering
As another key law enforcement agency to ensure responsible digital asset innovation, the U.S. Department of Justice (DOJ) focuses on how to prevent NFT and trading platforms from being used for fraud, money laundering, and other traditional financial crimes.
The DOJ has successively filed the world’s first telecommunication fraud and money laundering case involving inside information of an NFT platform (USA v. Nathaniel Chastain), the world's first telecommunication fraud case involving the abuse of inside information of cryptocurrency platforms (USA v. Ishan Wahi et al.), and many other landmark cases since June of this year.
In USA v. Nathaniel Chastain, the DOJ prosecuted Nathaniel Chastain, a former product manager of OpenSea, the world's largest NFT trading platform, for telecommunication fraud and money laundering.
According to the indictment, Chastain, as a product manager for OpenSea at the time, was responsible for selecting certain NFTs to be featured on OpenSea's homepage. He was obliged to keep these products confidential before the official launch, and not use inside information to engage in transactions. According to the DOJ's investigation, between approximately June and September 2021, Chastain purchased dozens of NFTs shortly before they (or other NFTs made by the same creator) were featured on OpenSea's homepage and, shortly after they were featured, sold them for profit.
For example, Chastain took advantage of the inside information obtained through his position to buy The Brawl 2, an NFT that would be displayed on the OpenSea homepage, through an anonymous account. He then sold them at a high price, twice that of the purchase, for profit on August 2, 2021.
In making these purchases and sales, the government alleges Chastain "misappropriated OpenSea's confidential business information," namely knowledge of which NFTs would be featured on OpenSea's homepage, and in so doing, committed telecommunication fraud in violation of 18 U.S.C. §1343. The government further alleges that to conceal his involvement in buying and selling the featured NFTs, Chastain transferred funds through anonymous Ethereum blockchain accounts and new Ethereum accounts without any prior history, and in so doing, committed money laundering in violation of 18 U.S.C. §1956(a)(1)(B)(i). If convicted, the defendant could not only be fined and have all property gains from the criminal acts confiscated, but also lose his freedom and face a maximum penalty of 20 years in prison.
In response to this case, Damian Williams, U.S. Attorney, clearly states:
NFT might be new, but illegal activities involving NFT were not new. “As alleged, Nathaniel Chastain has betrayed OpenSea by using its confidential business information to make money for himself.” As a law enforcement agency, his office was committed to fighting insider trading “whether it occurs on the stock market or the blockchain.”
The DOJ’s investigation of Chastain, the SEC’s law enforcement undertakings, and a series of regulatory documents issued by the Biden administration fully illustrate that the U.S. government is utilizing policies to severely punish illegal financial activities and to strictly prevent the illegal financialization and securitization of NFTs and other digital assets.
Chinese companies planning to enter the Web 3.0 industry or the global metaverse market should not only strive to decode domestic and foreign policy orientations, but also to improve internal compliance systems as per the priorities of regulatory enforcement to reduce compliance risks.
First, they should carefully evaluate the internal compliance system to ensure compliance with relevant regulatory requirements, such as the Digital Collection Compliance Evaluation Guidelines of China and the Evaluation of Corporate Compliance Programs of the U.S.
Second, to avoid inadvertently issuing NFTs and other data assets as securities to the public, they should check whether such digital assets have the characteristics of securities and explicitly prohibit fragmenting NFTs.
Finally, platform companies promoting NFT transactions need to strictly implement regulatory requirements such as Know Your Customer (KYC) and Anti-Money Laundering (AML) with pre-listing screening and real-time transaction monitoring to fulfil the required due diligence obligation.