NFTs: modern day “tulip-mania” or genuine asset class? — Commentary

Intro­duc­tion
Issues and solu­tions
Com­ment

Intro­duc­tion

In the art world, a non-fun­gi­ble token (NFT) has a place that is bet­ter defined than in the finan­cial ser­vices sec­tor. In the for­mer, it can be described as a dig­i­tal or com­put­er-gen­er­at­ed artis­tic expres­sion with blockchain tech­nol­o­gy (or dis­trib­uted ledger tech­nol­o­gy) as its back­bone, enabling iden­ti­fi­ca­tion of own­er­ship and its attri­bu­tion to a par­tic­u­lar per­son. From a bank­ing and eco­nom­ic per­spec­tive, how­ev­er, the role of NFTs is still devel­op­ing, and there are open-end­ed ques­tions. Specif­i­cal­ly, the ques­tion is whether an NFT is gen­uine­ly an asset (and there­fore can serve as col­lat­er­al), or whether it is a mod­ern-day regur­gi­ta­tion of the so-called “tulip-mania” occur­rence of the 1600s, name­ly the phe­nom­e­non of a finan­cial bub­ble in which the val­ue of an asset appre­ci­ates expo­nen­tial­ly due to per­cep­tion rather than its intrin­sic value.

There are some very inter­est­ing par­al­lels between how NFTs oper­ate and the tulip-mania occurrence:

• They both have ardent and vis­i­ble back­ers and sup­port­ers that have cap­tured the spot­light and led to an expo­nen­tial increase in inter­est among the mass­es and there­fore in their values.
• Nei­ther has any per­cep­ti­ble tan­gi­ble val­ue that is appar­ent on the face of it.
• Both appear to be accom­pa­nied with a mass hys­te­ria that has accel­er­at­ed adop­tion (ie, pur­chas­es), and both have been accom­pa­nied with equal­ly sud­den depre­ci­a­tions in value.
• Nei­ther can seem to shake off the pre­sump­tion of spec­u­la­tion sur­round­ing them.

Issues and solutions 

Notably, finan­cial sec­tor experts will point to the lack of a wide­ly accept­ed val­u­a­tion mech­a­nism for NFTs and pos­si­ble reg­u­la­to­ry moves to clas­si­fy NFTs as “unreg­is­tered secu­ri­ties” as key fac­tors hin­der­ing accept­abil­i­ty of NFTs as an asset class. Unlike oth­er asset class­es, the inabil­i­ty to restrict the trans­fer of an NFT also detracts from its accept­abil­i­ty as col­lat­er­al for bor­row­ings by way of con­ven­tion­al secu­ri­ty forms, such as a pledge or lien. Even among niche finan­cial sec­tor par­tic­i­pants that apprise and lend against the secu­ri­ty of art­works, there do not appear to be any reports in the pub­lic domain on loans pro­vid­ed by tra­di­tion­al finan­cial insti­tu­tions against the secu­ri­ty of NFTs.

How­ev­er, there appear to be some online mar­ket­places and plat­forms that pro­vide decen­tralised finance solu­tions through a peer-to-peer lend­ing mod­el where the cre­ator or own­er of an NFT may offer it as col­lat­er­al to raise financing.

Finan­cial sec­tor par­tic­i­pants are now increas­ing­ly sub­ject to data pri­va­cy and pro­tec­tion reg­u­la­tions, which require them to put in place robust tech­no­log­i­cal mea­sures to pre­vent data breach­es and leak­age. Some of these data pro­tec­tion mech­a­nisms can also dove­tail into pro­tect­ing or lock­ing down dig­i­tal assets, which would enable them to have fea­tures anal­o­gous to con­ven­tion­al assets class­es – this would make it pos­si­ble to pro­vide NFTs as col­lat­er­al for bor­row­ings from tra­di­tion­al finan­cial insti­tu­tions as well.

The pres­ence of reg­u­la­tions that recog­nise NFTs as an asset class (and not as a secu­ri­ty or com­mod­i­ty to be trad­ed on a stock exchange) would also be a good start to pro­mote its accept­abil­i­ty as a finan­cial asset. This would need to be accom­pa­nied with clar­i­ty from the per­spec­tive of val­u­a­tion and tax­a­tion. Any reg­u­la­tion on NFT-based lend­ing would need to con­sid­er risks around enforce­ment and invok­ing or sale of col­lat­er­al in the case of any default.

Com­ment

Aside from their unfor­tu­nate com­mon traits with the tulip-mania occur­rence, and despite the crit­i­cism that they have gar­nered due to envi­ron­men­tal con­cerns because of ener­gy usage by the blockchain net­works sup­port­ing NFTs, it does appear that NFTs pro­vide a gen­uine tech­no­log­i­cal solu­tion for the finan­cial mar­ket sec­tor. It would be good to fos­ter their devel­op­ment through appro­pri­ate reg­u­la­tion rather than dis­miss them as a spec­u­la­tive device that must be kept away from finan­cial mar­ket stakeholders.

For fur­ther infor­ma­tion on this top­ic please con­tact Aditya Bhar­ga­va, Mith­ila Bhati or Sristi Yadav at Phoenix Legal by tele­phone (+91 22 4340 8500) or email ([email pro­tect­ed], [email pro­tect­ed] or [email pro­tect­ed]). The Phoenix Legal web­site can be accessed at www.phoenixlegal.in.