What are the risks associated with NFTs? Beginner's guide


For creators, investors, and marketplaces alike, NFT laws remain ambiguous. Read this article to learn about the various legal risks associated with NFTs.

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The rise of NFTs


Nonfungible token (NFT) sales have skyrocketed in 2021. The NFT market was worth around $20 billion in 2021 and is expected to double by 2025. This spectacular growth was unanticipated at the start of 2021, when they were only used by a small group of digital artists and cryptocurrency enthusiasts — the decentralized finance (DeFi) space and NFTs grew in isolation.


Many businesses of various types are issuing NFTs to increase brand awareness. The widespread adoption has aided the rise of NFTs in sports, such as in the case of NBA Top Shot, in the gaming industry, via the Metaverse, and in fintech, such as Visa's acquisition of one rare CryptoPunk.


Sotheby's sold Larva Labs' rare CryptoPunk #7523 for $11.8 million in June 2021. Christie's, another well-known auction house, paid $69,346,250 for Beeple's NFT Everydays: The First 5000 Days.


The unexpected and sensational evolution of these digital assets has alarmed regulators who must deal with the legal issues that come with NFTs.


Continue reading to learn about the risks and challenges of NFTs, the issues associated with NFTs, whether NFTs are risky investments, and the legal implications of nonfungible tokens. Please keep in mind, however, that the information in this article does not constitute legal advice, and you should seek legal counsel through official channels.


An NFT is a digital cryptographic method of proving ownership and authenticity of an underlying asset. Nonfungible tokens prove ownership of artworks or other valuable items by using unique identification codes and metadata to differentiate them from one another.


They are nonfungible because they are indivisible, unique, and irreplaceable and can be anything from asset ownership certification, intellectual property rights, academic title, artwork, music composition, gaming, or utility — the list is endless.


NFTs, like cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), are timestamped and stored in open and permissionless blockchains. Smart contracts that assign ownership and manage transferability are used to create NFTs.

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Because they can establish and define the terms of the sale through source code, smart contracts may be an essential part of the legal agreement between the buyer and seller of an NFT. As a result, both parties can specify how interactions with the content can take place, for example, or stipulate that access to the underlying asset can only take place after payment is received.


NFT risks vs. opportunities


The growing interest in NFTs as a new asset class, as well as their ability to generate multiple revenue streams, are particularly enticing prospects for creators and investors. However, these new opportunities necessitate caution on the part of businesses in order to avoid unavoidable regulatory consequences.


Likewise, ordinary digital creators, sellers, and buyers must be aware of the risks involved in creating and trading such assets.


To mitigate these risks, buyers should think about what they're buying, ensure that related smart contracts accurately reflect the terms and rights they want to acquire, and only trade NFTs on reputable exchanges.


While the trade of NFTs is commonly regarded as the same strain of cryptocurrency, the market faces legislative issues with NFTs that cross multiple areas of law.


Many different legal scopes should be considered by NFT participants, including NFT privacy issues, security risks, copyright and intellectual property ownership, and Anti-Money Laundering (AML).


In general, issuers and service providers will be regulated in the local jurisdictions where the NFT is sold. However, due to the inherent global nature of these digital assets, a multi-jurisdictional assessment is usually required.


Legal issues and risks around NFTs


One of the first legal cases involving NFTs involved British art collector Amir Soleymani, who filed a claim against marketplace Nifty Gateway in the United Kingdom High Court over Beeple's NFT Abundance auction. Nifty Gateway froze Soleymani's assets after he refused to pay for a different edition of the artwork he had bid on.


Nonfungible tokens are not currently explicitly regulated, and the Soleymani case shows that the NFT market is still evolving alongside its legal and regulatory issues.


The International Organization for the Financial Action Task Force (FATF), which establishes the Anti-Money Laundering and Combating the Financing of Terrorism and Proliferation (CFT) standards, classifies NFTs as "crypto-collectibles" distinct from cryptocurrencies and virtual assets.


The FATF does, however, recommend that the nature of the nonfungible token be considered on a case-by-case basis, with a focus on its nature and practical function. The primary distinction is whether they are regarded as payments or as investments.


In this section, we highlight the most common legal considerations that are still undefined and awaiting resolution.


Copyright, intellectual property rights, ownership rights


The main issue for an NFT buyer is determining what rights they are purchasing. The seller can still retain ownership of the nonfungible token on sale. A video of a slam-dunk by famous basketball player LeBron James is a good example.


The video was released as part of a limited-edition NBA highlight clip collectible. Top Shot NFTs is a market where NBA fans can buy and sell collectibles. However, the NBA owns the copyright, and reproduction of any purchased item is subject to the NBA's licensing terms.


Sellers, on the other hand, should be careful not to give up unintentional rights and keep all terms as simple as possible to avoid potential purchaser claims of misrepresentation of the rights on offer.


As previously stated, smart contracts are an essential component of the NFT agreement. As we would read the fine print of a contract, we should pay close attention to the coding embedded in the NFT, such as royalties or commission on future resale of the token.


In essence, the copyright holder is the person or company who owns all rights and can prevent an NFT publication, amendment, distribution, or showcase of the work unless exclusive rights are granted to another person or entity.


If the contract terms are violated, NFT marketplaces reserve the right to freeze users' assets or delete their accounts — including any artwork — without warning.


Privacy and data protection laws


Data protection laws, particularly within the framework of the EU's General Data Protection Regulation, tend to give individuals the "right to be forgotten," as well as the ability to rectify or even erase their data from both public and private businesses.


Because of the immutability of blockchain technology, this privilege may be impossible to exercise or difficult to implement. As a result, nonfungible tokens containing personal data may violate data protection laws.


Money laundering


NFT platforms are being scrutinized more closely in terms of AML regulation. Concerns that bad actors may use NFTs to circumvent laws such as AML are growing as the value of NFTs rises.


Given that crypto provides decent anonymity to both sellers and buyers, ill-intentioned actors may be able to use NFTs to launder money more easily than traditional channels. NFT marketplaces must be aware of such risks and respond quickly, as well as ensure compliance with the relevant regulatory framework.


Security


NFTs, as a relatively new technology, do not yet provide adequate security to protect their users and investors. Cyber-hacking and asset theft can jeopardize NFT security. NFT security risks are real because NFT marketplaces are centralized and hosted on the servers of third-party websites.


While unfortunately common in the cryptocurrency and digital spaces, heists by impersonators are difficult to prevent under the law. Since the significant increase in the value of NFTs, the number of bad actors impersonating platforms, exchanges, influencers, or wallets to steal users' data and access their assets has increased.


Platforms such as Nifty Gateway control the private keys to all assets. As a result, hackers may exploit vulnerabilities, jeopardize platform security, and steal large amounts of NFT.


Estate and succession planning


Estate and asset succession, like cryptocurrency, must be carefully considered by NFT owners. The only way to ensure that future beneficiaries have access to private keys, passcodes, and other security settings is to ensure that they have access to them.


Involving third-party legal counsel is an option. However, blockchains must devise simple methods for successors to access digitally stored assets without the use of intermediaries.


Environmental impact of NFTs


One of the main issues that many investors have with nonfungible tokens is that they can be bad for the environment, and there are legal steps that can be taken to legally prevent problems for businesses that are tied to inefficient energy-related NFTs.


Environmental issues are rising to the top of the corporate agenda, particularly in terms of government-backed policies. As a result, NFT-related businesses should comply with such policies by making public disclosures on their websites and providing pre-agreement documentation.


Recently, the EU proposed a contentious regulation aimed at restricting the use of proof-of-work (PoW) blockchains due to environmental concerns, which would have inevitably impacted the NFT market. The law was, however, rejected by the European Parliament, much to the relief of the cryptocurrency community.


Risk of fraud


Despite blockchain technology's immutability, transparency, and time-stamped ownership properties, the risk of fraud persists across the market because all of these properties are only valuable after the data is encoded in the blockchain.


In essence, existing data cannot be forged, but any malicious actor can embed false data in the blockchain. For example, they could mint a replica of an NFT that does not belong to them without the permission of the creator.


Notable is the case of a phony Banksy who raised $1 million in ETH through NFT sales last year. Before investing a large sum of money in an asset, it is always prudent to conduct additional and thorough research into the NFT's history and storage.


Taxation aspects


Is it possible to profit from NFTs? The straightforward answer is yes. However, given the risks, legal and tax implications, you must decide whether NFTs are worthwhile and have a future.


As with cryptocurrencies, the law has been slow to catch up with the legal issues and taxation of NFTs, leaving a somewhat gray area in determining where NFTs fall within the framework of tax purposes.


NFTs tax treatment for creators vs. investors


Because taxes and related regulations differ from country to country, NFT creators and investors should become acquainted with local laws. NFTs are taxed everywhere, and the terms and amounts owed vary depending on the nature of the business. Are you the NFT's artist or investor?


To put it simply, the creation of an NFT is not a taxable event. It's a different story when it comes to selling it as a regular business or investment.


The NFT creator would be taxed on the settlement received if he or she sold the digital asset for ETH on one of the available marketplaces. If the creator immediately converts the ETH received into any fiat currency, a taxable event as capital gains/loss occurs.


If the sale occurs after one year, for example, the taxable amount is different and is calculated in accordance with the tax laws of the local jurisdiction. According to some, when an asset is held for a longer period of time, taxes are usually expected to be lower.


The purchaser who buys the NFT for ETH, on the other hand, will have to accept capital gains or losses depending on whether the value of ETH has increased or decreased since it was purchased.


The future of the NFT regulatory landscape


The current legal framework is not suited to the rapidly evolving cryptocurrency environment or the rapid rise of NFTs.


These types of digital assets are expected to be used more frequently in everyday life — from the Metaverse virtual existence to real-world applications such as identification or academic certificates — which means that any future regulation will have a significant impact on how they are used. Regulators will be responsible for balancing NFT laws without impeding innovation and adoption.

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