How to Stay in Compliance

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How to Stay in Compliance
Source: AdobeStock / Chad McDermott

Snežana Gebauer is partner and Chris Walsh is manager at global advisory firm StoneTurn.
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Without a doubt, 2021 was the year when the crypto market made its biggest strides, reaching an estimated USD 3 trillion. This was also the year when non-fungible tokens (NFTs) gained huge popularity. After Mike “Beeple” Winkelmann sells an NFT at Christie’s Auctioned for USD 69 million, artists, investors, brands, celebrities and many others helped fuel interest in NFTs. NFT sales will reach USD 17.7 billion in 2021, and they are considered to be disruptors of many industries.

The latest crypto crash has also affected NFT sales, and the prices of popular NFTs have fallen in recent weeks. Some argue that NFTs will endure this crypto crash because they are a unique digital asset class.

What makes NFTs different from other digital assets? These are tokens that rely on the blockchain, and whose underlying assets can be digital or physical. The blockchain guarantees their provenance, transfer and record keeping of ownership. In addition to digital artwork, which has made NFTs mainstream, NFTs can be used to own music, video clips, gifts, tweets and more.

NFTs can also function like membership cards or tickets, providing access to events, exclusive merchandise and special discounts, as well as serving as digital keys to online spaces where holders can connect with each other. NFT holders can leverage value beyond simple ownership, and creators have a vector to build a highly engaged community around their brands. As an asset class in their own right, NFTs are likely to have a significant impact on the worlds of art, photography, music and other creative fields.

Given the enormous profit potential that comes from trading these assets, NFTs have received the attention of regulators, starting a debate about whether NFTs are securities and whether financial regulations designed for tradable financial assets should apply to NFTs .

And so begins regulatory enforcement.

On June 1, 2022, prosecutors in New York’s Southern District charged and arrested Nathaniel Chastain, a former product manager at the online marketplace. OpenSea. OpenSea claims to be the world’s first and largest Web3 marketplace for NFTs and crypto collectibles.

According to the indictment, Chastain was tasked with selecting NFTs to appear on OpenSea’s homepage. OpenSea kept those homepage picks confidential until they were made available, as a homepage listing often translates to an increase in price for both the featured NFT, as well as NFTs made by the same creator. Chastain would secretly buy an NFT just before OpenSea featured the piece on the front page of its website. Once those NFTs hit the main sheet, he would allegedly sell them “at a profit of two to five times his initial purchase price.” Chastain now faces one count of wire fraud and one count of money laundering, in connection with a scheme to commit insider trading in NFTs.

Does this case suggest that NFTs should be treated as securities? Or is insider trading an illegal practice that should be prosecuted regardless of the asset? These recent charges seem to indicate that it no longer matters whether insider trading occurs on the stock market or the blockchain.

If NFTs are treated as securities, how will securities laws affect NFTs? Whether or not a particular NFT is considered a security will largely depend on the purpose for which it was created and how it is marketed to buyers. If an NFT is marketed and sold as a static asset, such as a photograph with a certificate of authenticity, it is less likely to be considered a security. However, if the NFT is sold with the assumption or intent to return a profit, it may very well be categorized as a security.

While this debate about the treatment of NFTs as securities develops, it is important for creators of NFTs to operate under the assumption that securities laws apply to them.

Exchanges that host NFTs for sale and distribution should proceed with caution: if they facilitate the trading of NFTs that are considered a security, the NFT exchange may be deemed to be operating an unregistered securities exchange, a behavior sanctioned by the Securities and Exchange Commission (SEC).

To mitigate risks, companies that issue NFTs or facilitate the trading of NFTs should implement NFT trading policies, or proactively assess their existing policies and practices in a similar way that public companies mitigate insider trading risks. The NFT trading policies should remind employees that non-public information about the launch or promotion of an NFT is confidential information and should be treated as such.

Companies may consider banning some or all employees from purchasing NFTs, at least for a period after the initial launch. They may also consider extending the ban to family members and relevant third parties. In addition to implementing a policy, companies must regularly train and communicate with employees to ensure active awareness and compliance.

To stay ahead of looming regulation and regulatory activity, NFT creators, investors or trading platforms need to take a conservative position and look to public companies for best practices. While it may feel daunting to begin with, implementing coherent policies is a critical step to take in mitigating risks related to insider trading.

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Learn more:
– Regulatory Scrutiny Increases as Crypto Becomes Financial Stability Risk – Report
– Top NFT collections rise in price after latest US Fed hike

– Ex-OpenSea chief arrested for NFT insider trading
– NFT Insider Trading on OpenSea Highlights Benefits of Decentralization

– ‘NFTs may be new, but this criminal scheme isn’t’: Ex-OpenSea chief arrested for NFT insider trading
– The right side of cryptoregulation: institutions must avoid Thucydides’ trap

– Crypto Exchanges Hotbit and Bitfinex Face Regulatory Headwinds
– Former Coinbase executive pleads not guilty to pay fraud charges

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