April 2022

NFTs: the future, a craze or a risky business?

Written by Jon Prentice on Monday 4 April, 2022

Unless you have been living under a rock for the past 12 months, you will probably be aware of the latest phenomenon taking the digital world by storm; non-fungible tokens, or as they are more popularly known, NFTs.

While NFTs have been around for a number of years, they have only really shot to prominence in the past 12 months, with their popularity booming amongst casual collectors and investors alike. In 2021, an NFT named ‘Everydays: The First 5000 Days’ was auctioned at Christie’s and sold for $69 million, making it the most expensive NFT of all time.[1]

More recently a raft of celebrities has started to jump onboard the trend, with sports stars Lionel Messi, Serena Williams and Steph Curry, K-Pop group BTS, musicians Justin Bieber, Snoop Dogg and actors Reece Witherspoon and Eva Longoria just a few to back the blockchain technology. So, what are NFTs and why the sudden popularity?

What are NFTs?

NFTs are unique digital tokens that are used to represent an asset. The term ‘non-fungible’ refers to the asset being unique, with the token element referring to ownership of the asset being stored on a digital, decentralised ledger known as blockchain technology, for example Ethereum blockchain. The blockchain records ownership in a similar way to if you owned a unique physical piece of artwork. Where Bitcoin has been likened to a digital answer to currency, NFTs have been hailed as the digital answer to collectibles.

NFTs have two primary uses:

The first is for the token to act as verification for the authenticity of a non-fungible item, utilising the decentralised ledger technology of the Ethereum blockchain. This would allow for collectable items, such as sports memorabilia or artwork, to be sold with a verifiable audit trail.

The second and more controversial type of NFT is where the token is a representation of the underlying item, but does not confer exclusive ownership, or often any ownership rights. A good example of this is the ‘NBA Top Shot’ market, where the NBA has created a market for NFTs representing clips from basketball games, which can then be traded with other users but do not confer any ownership rights over the clip itself. This market is not dissimilar to collectable physical sports cards, just with clips rather than static images, and are traded purely for their collectable value, with some tokens trading for as much as USD 280,000.[2]

Once an NFT is acquired, its usage can be likened to traditional trading cards, artwork or other collectibles. They can be kept as memorabilia or as long-term investments; traded with other NFT dealers or collectors; or sold for cryptocurrency or real-world fiat currency.

The risks associated with NFTs

Much like most things in life, there are risks associated to NFTs. These risks apply to buyers, sellers and authorities alike.

For buyers, they have to ensure that the NFT they are buying is genuine and from a legitimate seller. Sellers have to be aware that NFTs are the target of forgers and hackers. Similar to a physical piece of art, fraudsters may create a forgery of an NFT and sell it off as an original. In addition, both buyers and sellers have to be aware of the potential risk of hackers using sophisticated techniques to compromise NFT marketplaces or personal accounts and transfer assets to their own accounts before selling them on.

One major criticism NFTs have come in for is that essentially anybody can ‘right click and save’ the NFT itself, therefore creating a JPEG copy for themselves. Whilst this still does not provide ownership of that NFT, and you may still be the subject of copyright laws for saving them and using them, it has led to many people questioning whether they are worth the amount paid for them. It has also opened up a pathway for criminals to sell off forgeries, copies or imitations as originals.

The surge in popularity of NFTs could also exacerbate existing money laundering and financial crime concerns. NFTs are often purchased via cryptocurrencies, and it has been well documented the money laundering risks that crypto poses. Criminals will often exploit cryptocurrencies in order to obscure the source of proceeds of crime and, like the exploitation of real-world assets, criminals will often create, buy and sell NFTs so that they can add additional layers to the money laundering process. This can make it more difficult to monitor and trace the movement of criminal’s proceeds for compliance professionals and investigators. However, this has not stopped authorities from taking action against NFT owners.

In February 2022, in a first of its kind, HM Revenue and Customs (HMRC) seized three NFTs ‘as part of a probe into a suspected VAT fraud involving 250 alleged fake companies’.[3] Having received a court order, HMRC seized the three NFTs that are yet to be valued, alongside £5000 worth of crypto assets. Nick Sharp, deputy director economic crime, said the first seizure of an NFT ‘serves as a warning to anyone who thinks they can use crypto assets to hide money from HMRC’.

Whilst the seizure was a first of its kind, it is important to note that the underlying methods criminals use to obtain digital assets such as NFTs are fairly traditional, as explained by Thomas Cattee, head of white-collar crime at Gherson Solicitors:

Although HMRC’s seizure of an NFT in a fraud case has caught headlines due to the novel nature of this new technology, if you examine closely under the bonnet many of the other highlighted aspects - hidden identities, false addresses, pre-paid phones, false invoice - demonstrate that this was just a classic fraud with a twist.

Of course, any new technology will of course bring new methods to commit old offences. And these methods will always be jumped upon by those inclined to commit fraud. As such, as this new technology develops it is key that regulation keeps up. Regulating the NFT art market for AML purposes for example is a good start. [4]

Another risk to take into consideration when discussing NFTs is the impact that the minting and sourcing process has on the environment. The authentication process using blockchain technology takes heavy toll on the environment, and with a large majority of NFTs being sold in exchange for cryptocurrencies – also often coming with their own sizeable mining impact – the tokens come with a substantial environmental footprint. In November 2021, French artist Joanie Lemercier sold six artworks via an NFT, and in doing so he calculated that minting his work on blockchain consumed more electricity in 10 seconds than his whole art studio had consumed over the previous two years, not taking into consideration the electricity consumed to mine the $3,325 in the ether for which the NFT was sold.^[5]

With NFTs being a relatively new phenomenon, they are currently not specifically regulated in most jurisdictions, however many activities surrounding cryptoassets (which may include an NFT depending on its features) could fall within existing regulatory frameworks. Most recently, Singapore’s central bank has said that it will not be regulating the booming NFT industry anytime soon. MAS Senior Minister Tharman Shanmugaratnam stated that ’The MAS does not and cannot possibly regulate all things or products that people choose to invest their money in.[6]

Are NFTs a fad or the future?

That’s the million-dollar question! Or as it currently stands, the $25 billion question, as that is the current value of the NFT market. In 2021, NFT sales soared to approximately $24.9 billion, a huge rise from the previous year when sales totalled just an estimated $94.9 million. However, it is important to note that these are only estimates as transactions conducted ‘off chain’, such as sales of NFTs at auction houses, are often not included in the data,[7] so the true figure could be much higher. But will NFTs head down the same path as Bitcoin, becoming a mainstream success and going from strength to strength (mostly), or will they fade into obscurity like Myspace (remember that)?

Whilst only time will tell if the NFT boom will continue, one expectation is that the technology behind them will prove to be valuable for years to come. The authentication element of NFTs could prove a time, cost and confusion saving measure for authenticating transactions for individuals and companies alike.

What are NFTs?

The risks associated with NFTs

Are NFTs a fad or the future?

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