A short history of the short history of NFT
Over the last two years, Non-Fungible Tokens (NFT) seemed to be everywhere. Their (yet incomplete) success story began as a new means of either representing physical artworks or being digital art itself, which attracted a new community of collectors. Those collectors, on the one hand, were knowledgeable of the technical background of tokens, i.e. their issuance on a decentralised ledger, such as the blockchain. On the other hand, and basically for the same reason, this community of collectors had previously profited from the significant increase of value of virtual currencies, such as the Bitcoin, and were actively seeking to invest their newly acquired wealth without leaving the crypto ecosystem. With NFT, which are traded on marketplaces such as OpenSea, they could do so.
Others started using NFT in different contexts. The online gaming industry as well as operators of metaverse applications soon found that it would be beneficial for them to make rare collectibles fungible and create trading venues within their gaming or metaverse universe. These NFT issuers were soon joined by blue chip companies and renowned artists that, sometimes, used NFT as promotional tools (via Airdrops or access to special auctions and sales) or put more emphasis on NFT’s ability to create tamper-proof evidence of almost everything (such as tokenised carbon credits or certificates of authenticity).
The wide range of tokens and their use cases may have been the reason why BaFin did not act hastily (see our blog post from 2021) and waited until March 2023 to publish their views on whether and how NFT are regulated. BaFin’s approach is important for two reasons: First, because Germany has been at the forefront of crypto regulation over the last years, with the introduction of DLT-based securities in 2021 and the explicit statutory recognition of crypto-assets as a financial instrument for licensing purposes in the end of 2020. Secondly, Germany is a large market so that soliciting NFT to German investors must comply with the German legal framework, in some cases even when done so on a cross-border basis.
Issuers should, therefore, avoid falling within one or more of the German categories of “securities”, “investment products” or “financial instruments” that are addressed in the new BaFin guidance:
- If the NFT qualifies as “security” or “investment product” its issuance may trigger prospectus requirements.
- If the NFT qualifies as a financial instrument (which entails, among others, crypto-assets and investment products), providing related services may trigger a license requirement as investment firm and AML/KYC obligations.
Non-compliance with regulatory requirements may in individual cases result in criminal charges or administrative fine as well as in civil law claims.
Qualification as securities
In order to qualify as a “security”, a token must be transferable, sufficiently standardised and represent rights similar to shares or bonds, such as dividend, interest and/or voting rights. BaFin has confirmed in its guidance that it is not aware of any NFT that would qualify as securities yet (!), as they usually do not represent rights similar to those represented by shares or bonds. Furthermore, NFT are intended to represent unique items and, therefore, not to be standardised and replaceable with other NFT of the same class (with the notable exemption that fractioned NFT may be standardised).
However, BaFin confirms its “substance over form” approach. A unique Token ID (such as in the ERC-721 standard) is not sufficient to rule out that different tokens represent the same right and are therefore standardised.
Qualification as investment product (Vermögensanlage)
Since 2012, Germany has a specific legal regime for investment products in place, that neither fall within the category of securities nor are otherwise regulated: the German Capital Investment Act (VermAnlG). This act is intended to cover grey market alternative investment products, such as direct investments in shipping containers or in subordinate loans. However, the very broad definitions may – according to BaFin – also be met by some NFT.
These “investment products” are typically more than just a good that one hopes to buy low and sell high. Elements that can constitute an investment product are, in BaFin’s view, a right to participate in distributions or the obligation of the issuer to sell the NFT on a secondary market and distribute the profit to the initial purchaser of the NFT.
A prospectus may nonetheless not be required if less than 20 NFT are minted per issuance (de-minimis-threshold). BaFin does, however, not provide any additional guidance on the calculation of the de-minimis-threshold. In particular, it remains unclear whether consecutive minting processes qualify as one or more issuances and whether this safe harbour would be available for NFT collections.
However, even where an issuance qualifies for the de-minimis-threshold, it should be noted that the provision of services in relation to the NFT may still constitute a licensable business activity under the German Banking or Investment Firms Acts, as investment products are considered to be financial instruments.
Qualification as crypto-asset
Under German law, a crypto-asset is a regulated financial instrument and is (for licensing purposes) treated like a share or a derivative. Crypto-assets are defined as digital representations of a value that are not issued or guaranteed by any central bank or public body and do not have the legal status of a currency, but which is accepted by natural or legal persons as a means of exchange or payment by virtue of an agreement or actual practice or serves investment purposes, and which can be transmitted, stored and traded electronically.
This means that, in practice, their economic function will decide about whether the crypto-asset is regulated or not.
- According to BaFin, using (non-fragmented) NFT as means of exchange or payment hardly seems realistic for NFT because of the lack of their interchangeability.
- However, NFT may “serve investment purposes”. According to BaFin:
“The mere fact that users speculate with an NFT, i.e. can realize a profit through the purchase and subsequent sale, is not sufficient to be able to objectively assume an investment purpose for the NFT category concerned. […], it will therefore depend both on the rights associated with the tokens and on the advertising statements of the issuer or third parties commissioned with the distribution. If, for example, a particular suitability of the NFT as investment is highlighted, this could amount to a crypto-asset.”
Unfortunately, there is no further guidance as to when “rights associated with tokens” may serve investment purposes. For extrinsic tokens one may consider whether the referenced physical objects (tokenised artworks, exclusive fashion such as Hermès Birkin Bags or tokenised music instruments) have been subject to speculation. However, on the other hand, it seems questionable whether such kind of speculation is close enough to financial market trading to be subject to financial market regulation. Furthermore, whether a good is subject to extensive speculation depends on specific communities and may change over time. The latter also applies to advertising statements of the issuer or third parties. While the issuer may be silent on the suitability of the NFT as investment, secondary market intermediaries or advisors unrelated to the issuer may make such statements and it is difficult to assess why this should requalify the token as a regulated product.
In light of the remaining uncertainties, BaFin concludes that the qualification as crypto-asset will depend on the individual case. In many cases, it will therefore still be required to seek alignment with BaFin on the regulatory status of the NFT.
Additional license requirement for NFT issuers and market participants
Market participants should also avoid raising capital from a number of investors to purchase one or more NFT collectively, as this may result in the managing of a regulated “alternative investment fund”, which may be a licensable (or at least notifiable) business activity under the German Capital Investment Code.
More clarity under MiCA?
Should issuers wait with NFT issuances until MiCA enters into force?
According to the final compromise (Link) crypto-assets that are unique and not fungible with other crypto-assets are not within the scope of MiCA (Art. 2(2a) MiCA). Recitals 6a-6c of the final MiCA compromise provide some guidance that a crypto-asset is considered to be unique and not fungible:
- if its value is attributable to its unique characteristics and the utility it gives to the token holder (such as digital art and collectibles), or
- if it represents services or physical assets that are unique and not fungible (such as product guarantees or real estate).
- However, fractional parts of an NFT should not be considered unique, and issuance of an NFT in a large series or collection should be considered as an indicator of their fungibility.
- Furthermore, there are crypto-assets that may “appear unique and not fungible”, but whose de facto features or features linked to de facto uses would make them either fungible or not unique, which should be understood as a reference to the “substance over form approach”.
In particular, the rationale for excluding NFT from MiCA is that they “are not readily interchangeable and the relative value of one crypto-asset in relation to another, each being unique, cannot be ascertained by means of comparison to an existing market or equivalent asset.” This would limit the “financial use” of NFT.
It seems unclear whether BaFin has (fully) adopted this rationale in its own administrative practice. A NFT may serve investment purposes in BaFin’s view because it is advertised as a “good investment”, but in fact may not have a value that can be ascertained by means of comparison to an existing market or equivalent asset. However, in the most prominent case of “digital art NFT”, whose value can unlikely be ascertained by way of an equivalent asset, also BaFin takes the view that they do – as a rule – not qualify as financial instruments. However, while the MiCA recitals share certain similarities with the BaFin guidance, it seems well possible that there are nuances in the interpretation.