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Centro LAW Guest Series: Are non-fungible tokens (NFTs) a unique investment opportunity?

"Invest in what you understand. Just because there is an NFT boom does not mean that every NFT is valuable." Today, we're talking to Morgan Deane, a Zurich-based blockchain thought leader and finance and legal expert, who shares his view on the NFT gold rush. We'll delve into how NFTs work and address questions such as what does ownership include? What are the legal implications and things to consider? And, are investments safe?

NFTs are the current digital gold rush in the crypto-assets world. Since they represent unique items such as art, collectibles, and intellectual property, they have the game-changer potential for these asset classes. Record auction prices for art NFTs have fueled collectors' and investors' interest and digitally unique value-holding investments could mean the farewell of the middleman in art and collectibles transactions.

Thanks, Morgan, for taking the time to have a chat with Centro LAW. What is your field of expertise, and can you tell us more about NFTs?

I'm a lawyer by profession, but my career has taken me in a slightly different direction, and I am now the CEO of a Swiss-based International broker-dealer. I have spent my entire career in banking & finance, focusing on investment banking and capital markets. Over the past years, I have, in a private capacity, been actively involved in blockchain and cryptocurrency as I firmly believe this will be the future of commerce and society. While there are many amazing possibilities on the horizon, I find myself particularly drawn to NFTs. In their simplest form, they represent digital proof of ownership for unique items like art, fine wines, etc. But the disruptive impact of these tokens is not understood by everyone. They enable creators and entrepreneurs to generate new revenue streams that were not possible before, while, on the flip side, they create a whole new range of asset classes for people to access and invest in. We will enter a world where people can adopt an entrepreneurial mindset to almost anything they do. They can transact directly with others in a safe, transparent, and cost-effective way.

Which are the use cases for NFTS? How can you buy and sell NFTs?

NFTs are only limited by the creator's ability to conceive something of value. However, suppose we step back and take a high-level view of the developments. In that case, we can see that the significant use cases are for assets that, before NFTs, were not divisible and were challenging to transfer: art, collectibles like classic cars or rare wines, and ownership of intellectual property such as song royalties.

Art collectors may wish to own valuable art pieces but may not want to own a particular piece outright. Tokenizing art allows fractional ownership, which enables several collectors to pool together on an investment. Each investor can sell their token to someone else without needing other investors' agreement and moving the physical piece itself. Furthermore, the transparent and fraud-proof nature of blockchain allows the token holders to benefit from owning the art while agreeing to have the work held in custody by someone with the capacity to do so, e.g., an art gallery or a museum. Even passive revenues that museums generate for viewing the art can be turned into a revenue stream for the owners.

NFTs of song royalties have an extra dimension when considering how blockchain can revolutionize the tracking of royalty payments themselves. Not only can the token holder quickly transfer ownership, but blockchain technology can track and ensure that the payments linked to the token are made. Placing these approaches side by side would mean that the NFT holding the copyright, and enforcement of that copyright, can be brought together for the first time.

Buying and selling NFTs is currently done on marketplaces suitable for lower value, higher volume items  – examples include Superrare and OpenSea. However, we are at the very early stages of building the market infrastructure around NFTs. Platforms that work for lower value items or NBA player cards will not be the right environment for highly valued assets. I would envisage that private blockchain-based marketplaces will be created to meet the needs of high net worth participants incorporating considerations like confidentiality.

Another likely use case that falls slightly outside the points above would be that NFTs can become the gold standard for proof of authenticity. Counterfeit goods severely damage some industries. We may see luxury goods and brands adopt NFTs so that high-value products can be traced back to their original source. This won't necessarily feed into the NFT marketplaces I mentioned, but it would create certainty about luxury items' value and provenance. And, in turn, add real value to the customer experience and trust.

Can you outline the legal implications of NFTs? What does ownership include? How is authenticity proved?

One of the biggest advantages of NFTs is that they enable anyone to create value. But that is also one of its most significant risks. It means that vast numbers of people with little or no legal knowledge enter a world that requires so many scenarios to be considered.

The more simple cases are when a token represents ownership of a single digital or physical asset. As part of that, the token owner receives the original digital file or physical item. Presuming that buyer and seller both understand that the item is unique, will not be duplicated, and that the file or item being transferred is complete, this is reasonably straightforward. However, even that requires legal input to ensure that everyone understands the expectations.

NFTs become much more opaque when we move into digital art and music. There is a big disconnect between what people think they are buying and what they are actually buying. Some NFTs have been sold without including the transfer of the original file. Other NFTs purport to transfer ownership of a particular song, but the token only allows the owner to a limited edition recording in legal terms. The complete ownership of the music and its rights, such as rights to royalties, is not always handed over. The general public overlooks that an NFT will be whatever the creator says it is. Each NFT carries legal risks, and these must be clearly understood at the outset.

If you are buying something in the analog world, you would ensure that you understand what you are getting, and there would be a contractual arrangement setting this out. In the NFT world, the token will represent your ownership of the asset you are buying, and therefore it is your legal contract. The entry on the blockchain will merely say you own the token. What the token represents is up to the buyer to clarify. Caveat emptor is very applicable to NFTs. 

With NFTs, illiquid assets become liquid. Are they financial instruments?

The risk of people who lack legal knowledge being empowered to create NFTs can lead to issues. The regulatory classification of an NFT will depend on the jurisdiction you operate in. But as a rule of thumb, and contrary to what many NFT advocates think, an NFT can most certainly be a security. Again, it depends on the interactions of the creator and the buyer. If the NFT relates to a unique item purchased by an enthusiast who personally wants the item, it would likely fall outside the definition of a security. However, if the NFT relates to an asset that the purchaser buys because they expect a future profit, mainly if it is based on the creator's performance or where they are being given an ongoing revenue stream, then this would need much closer examination. There is no one size fits all approach, so creators and buyers need to tread carefully here.

NFTs are a recent phenomenon in decentralized and unregulated marketplaces. Which are the risks for investors?

The beauty of decentralized marketplaces, either for NFTs or other financial products, is that you are entirely in control of your activities. You don't require anyone to give you permission to interact with the marketplace and the lack of a middleman allows you to benefit financially. However, with this freedom comes the responsibility that you have no recourse if something goes wrong. This can result from something beyond your control, e.g., hacking, or a simple case of human error, e.g., sending tokens to the wrong address. There is a possibility that you can lose all of your money or assets. This sector is still in its infancy, and investors need to exercise caution when engaging with platforms. Getting advice from someone who understands decentralized marketplaces is an essential first step before moving in this direction.

In general, what advice would you have for wealth owners interested in investing in NFTs?

Invest in what you understand. Just because there is an NFT boom does not mean that every NFT is valuable. Your investment decision should be based on the token's underlying asset.

Engage an advisor who understands NFTs and investments. This space will develop quickly, and platforms will be created much more suitable for certain investors. An advisor who understands these options is essential.

Be 100% clear on what the token you are buying actually represents. Investment decisions are made on whether the asset itself will appreciate in value or whether it can generate recurring revenue. For either of these, you need to own the asset or the intellectual property outright. The token must clearly include this. 

Storage of the asset is essential in two ways: Firstly, the NFT needs to be securely stored in an offline wallet with security measures around the private keys. You can do this yourself, or you can have someone professionally do it on your behalf. As mentioned above, an advisor who understands how security in blockchain works is essential. Storage of the physical asset also needs to be thought through. Often the token may specify who holds the assets and under which conditions. This is important because the NFT will only be as valuable as the asset behind it. If the physical asset management is not correctly clarified as part of the token creation, it can cause significant problems.    

About Morgan Deane

Morgan Deane is the CEO of a Swiss-based broker-dealer. Originally an international lawyer, he has worked with some of the world's most prominent financial institutions throughout his career.

He is an advisor, mentor and angel investor in early-stage companies focusing on blockchain and cryptocurrency-related ventures in his private capacity. Morgan is a member of the Forbes Finance Council, a regular speaker, and a thought leader in disruptive technologies and innovation. He holds B.A, M.A, LL.B & LL.M degrees and is a U.S. Attorney, admitted to the Federal and Supreme Court (New York).

26-05-2021

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