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Freshfields TQ

Technology quotient - the ability of an individual, team or organization to harness the power of technology

| 4 minutes read

Non-fungible tokens – a case for German or European financial regulation?

Non-fungible tokens (NFTs) have recently gained significant public attention. In March 2021, the auction house Christie’s sold a digital artwork named 'Everyday: The First 5000 Days (2021)' for $69.3m. The artwork, created by Mike Winkelmann alias 'Beeple', exists only as a digital picture file (in the .jpeg format). The winning bidder not only acquired the artwork but also a unique token, which digitally represents the ownership or copyright in the artwork. The underlying transaction was registered on a distributed ledger. The registration of the unique token at the public key (the 'address') of the winning bidder provides evidence of the assignment of the unique token to the bidder, and, therefore, a type of 'ownership' or 'copyright' in the digital artwork.

The use of fungible vs. non-fungible tokens

Its uniqueness renders a token non-fungible. This distinguishes NFTs from most other tokens that are created to be fungible or 'interchangeable'. For instance, two different bitcoin tokens are interchangeable. This serves their intended purpose as a means of exchange or payment, therefore resembling the fungibility of physical money such as coins.

The use of NFTs is not limited to representing unique digital assets. NFTs may also represent unique physical assets, such as paintings, sculptures, gemstones or vintage cars. The 'tokenisation of everything' is, however, still in its infancy. Only a few countries have so far established bespoke rules that provide for legal certainty. The most notable example is Liechtenstein, which established a law regarding the civil and supervisory framework for the tokenisation of rights in physical assets (Token- und VT-Dienstleister-Gesetz; TVTG) in 2019.

No EU or German regulatory guidance available

NFTs are a relatively new phenomenon and regulators have usually not yet given guidance on how and whether NFTs fall within the perimeters of existing regulation. However, the global standard-setter in relation to AML, the Financial Action Task Force (FATF), seems to recognise that NFTs may create the risk of money laundering or terrorist financing (ML/TF) so that there is a reason to regulate them.

In its March 2021 draft guidance for a risk-based approach to virtual assets and virtual asset service providers (VASPs), the FATF proposes to amend the definition of 'virtual assets' (VAs) in a way that items or tokens, that 'on their face do not appear to constitute VAs [but] may in fact be VAs that enable the transfer or exchange of value or facilitate ML/TF. Secondary markets also exist in both the securities and commodities sectors for 'goods and services' that are fungible and transferable. For example, users can develop and purchase certain virtual items that act as a store of value and in fact accrue value or worth and that can be sold for value in the VA space'. This explanation can be applied to NFTs that undoubtedly can accrue worth and that can be sold for value in the VA space.

Status under German financial regulation

Germany has a long-standing tradition of including virtual currencies into the scope of financial regulation. For example, in 2020 when transposing the fifth AML Directive (AMLD5), the German legislator established a definition of 'crypto-asset' under the German Banking Act (KWG) that covers tokens that not only serve as a means of payment or exchange but also serve 'investment purposes'. This aims to cover (fungible) 'security tokens' but may – according to its wording – also cover non-fungible tokens, since the holder of an NFT can participate in the increase of the token value by selling it (eg at an auction house like Christie’s).

Whether NFTs are covered by the KWG is, however, not entirely certain. The definitions of AMLD5 and KWG also require that the tokens can be 'transferred, stored and traded electronically'. 'Tradability' may imply that fungibility is needed. Similarly, BaFin would require 'tradability' or 'negotiability' (in German: handelbar, ie literally 'tradable') of a token to treat it as a 'security' under the EU prospectus regulation. For that purpose, tradability requires 'a minimum level of standardisation' and that the tokens must be comparable with each other in the sense of a 'class'. On the other hand, the AMLD5 definition, which was originally established by EBA’s 2014 opinion on virtual currencies, does not explicitly require fungibility for virtual currencies (although it may be assumed, based on the fact that virtual currencies must, as a means of payment and exchange, always be fungible). A clarification by BaFin would be highly welcome.

By being non-fungible, NFTs should not qualify as 'tradable securities' under the EU prospectus regulation. However, it may be possible to design NFTs in a way so that they qualify as investment products under the German Capital Investment Act (VermAnlG). This law governs the public offering of 'grey market' investment products, including certain direct investments. Direct investments are governed by the VermAnlG if an interest payment, a repayment of invested capital or a cash settlement is promised or envisaged in exchange for an investment of capital. Whether NFTs fall within that definition will depend on the individual token. The mere acquisition of an NFT with the pure expectation of being able to sell it for a higher price to a third party should, however, usually not fall within the scope of the VermAnlG.

Future regulation under MiCA

In September 2020, the European Commission published a proposal for a regulation on markets in crypto-assets (MiCA) that will (once adopted) govern the regulatory status of crypto assets and replace applicable EU member state rules.

The proposed definition for crypto-assets being 'a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology' includes NFTs so that MiCA will generally apply to NFTs. However, issuers of 'crypto-assets that are unique and not fungible with other crypto-assets' – which would cover NFTs – are not required to publish a prospectus-like 'crypto-asset white paper'. Against the background that any public offering of an NFT would necessarily result in only one transaction, requiring a white paper would also appear disproportionate.

While proponents of NFTs argue that 'tokenising everything' will open the door for myriad new asset classes, NFTs are at the moment still a niche product and the current regulatory uncertainty is further limiting their use. Nonetheless, there is significant potential beyond the art market and MiCA should provide for a harmonised regulatory framework in the future also for the use of NFTs.


fintech, europe, blockchain, cryptocurrency, financial crime