Can NFTs be considered securities?

Bloomberg reported that the Securities and Exchange Commission (SEC) is investigating NFTs, raising concerns about why SEC is interested in a non-fungible asset. But two reasons prompted this – the first is to determine NFT asset class, and the second is to expose any foul plays masterminded through NFTs. With numerous marketplaces set up and sales for NFTs booming – with a total market value of $23 billion, according to DappRadar, it is not hard to decipher why SEC is interested in NFTs. Parts of the concern are whether NFTs are used to raise money for investments like traditional securities and whether NFTs are counted as securities.

Additionally, there is a debate on whether or not fractional NFTs – an NFT broken into different units where multiple partners can own the asset, will be considered securities. Fractional NFTs witnessed tremendous growth in 2021 with a total market capitalization of $212.6 million, an amount in the fiscal budget of the U.S Terrorism and Financial Intelligence department. However, whether NFTs or specifically fractional NFTs can be considered securities is debated among NFT enthusiasts and lawyers. It will also be intriguing to see whether NFTs can be considered equity or debt securities or even labeled as investments.

Understanding what NFTs are

Non-fungible tokens are unique tokens that can’t be replaced with something else. To understand this, think of a $100 bill. You can exchange this bill for five $20 bills. These five $20 bills still round up to $100. Thus, the $100 bill is a fungible asset. However, a non-fungible token is unique and can’t be changed. For instance, a piece of art can’t be swapped or changed. Otherwise, you will have a different piece of art. 

Bitcoin is a fungible asset, while tokenized music is not. A token has perceived value, which may not be money. On blockchain technology, tokens represent unique assets like videos, music, in-game assets, painting, virtual land, etc. You can trade NFTs peer-to-peer on NFT marketplaces. There are fractional NFTs owned by many and a royalty mechanism for people to gain value.

But can we consider NFTs – some pieces of art, as securities?

SEC’s eyes have been on initial coin offerings (ICOs) – a form of a digital asset since 2017; recent attention is on NFTs and the legal issues of their funding. However, there is no enforcement against NFT creators or marketplace owners, but there is a need to clarify whether NFT will is regarded as securities.  

But what is security? Understanding the Howey test

Securities Act of 1993 and the Securities Exchange Act of 1934 shed light on security. Under the act, the law does not include digital assets or NFTs. There is no sanction or regulation of NFTs despite the probe of the SEC on NFTs lately. However, understanding what makes up security could be traced back to Supreme Court through a court case in 1946, SEC v. W.J. Howey Co. This court case led to four tests that determined whether an investment is a security, which includes

1. Investment of money

2. Investment in a common enterprise

3. Investment of money with a reasonable expectation of profits

4. Investment of money to be derived from the efforts of others – entrepreneurial efforts

Considering this test, it is understandable why ICO of tokens to fund blockchain projects is considered a security, much to the chagrin of entrepreneurs claiming tokens are utility tokens and labeling them as commodities. This is because people invest money, and the money is used for blockchain projects – enterprise, people invest because they believe the project will succeed. The success depends on the founders' efforts.   

However, whether NFTs fall into this category remains a mystery. But from the Howey test, we understand some NFTs (fractional NFTs come to mind) to be selling a share of a property, which a group of investors will own, expected to make profits, and maintain and run them.

But why are NFTs not securities?

It could be surprising if we say NFTs are not securities. However, they fail to meet the third condition of the Howey test – because NFTs are not investments, except for those calling it so to scam people. Generally, NFTs creators mint assets, create awareness and sell them as products.

However, many NFTs rise in value due to rarity and increase in demand, but these are products traded by the creators and not investments. Additionally, there is no certainty between buyers and creators that the value of the NFT will increase, setting NFTs apart from investment.

Are there other reasons why NFTs are not securities?

Reasons NFTs are not considered securities include:

We cannot consider NFTs as debt securities – there is no resemblance with loans or bonds

If we cannot consider NFTs as debt securities, they can’t be hybrid securities as well

We cannot consider NFTs derivatives as they are simple for such because they do not represent underlying securities

But if we cannot consider NFTs debt securities, can they be considered equity securities? This question is better answered by still putting NFT to the Howey test. Like NVIDIA shares, NFTs are:

NFTs represent ownership

External market forces determine their values

We expected their values to rise

Some players perceive NFT as good investments

However, meeting the criteria doesn’t make NFT equity security because they are just art. This is also the current position of the SEC and disqualifies it to have failed the Howey test.

Are there cases in the NFT space under the radar of the SEC? Understanding fractional NFTs

Fractionalized NFTs (F-NFTs) utilize fractionalization to split NFTs into smaller units for many to partner and own. Like a company’s ‘shares,’ fractional NFTs grant owners portions of the NFTs, providing affordability to own otherwise costly assets. An example of fractional NFTs is Logan Paul's fractional NFT, allowing collectors to access and co-own the rarest NFTs minted on Liquid Marketplace. Another example is Dibb's marketplace buying expensive physical sports collectibles and fractionalizing them to represent fractional ownership. This marketplace even attracted funding from Amazon.

However, other NFTs might fall under securities through their revenue distribution for current holders. Examples are Buzzed Bear and Lazy Lions, granting governance rights to ownership. These projects permitted profit redistribution from sales to current holders. Also, Buzzed Bears allow partners to hibernate bears to increase values. More so, the Buzzed Bears organizers promise to sell merchandise to fill a DAO controlled by holders – these points to securities, and it may not be long before SEC regulates fractional NFTs.

Conclusion

NFTs are far from considered securities because each NFT is unique, differentiating non-fungible from fungible tokens. However, tokenizing shares of stocks will be counted as securities. In the long run, there are chances that sharding and creation of F-NFTs representing other types of assets will result when the market matures.