The main categories of NFTs include:
1Digital art;
2Collectibles;
3Decentralized finance (DEFI);
4Games;
5Metaverse (virtual world);
6Sports;
7Domain names;
8Trading cards.[1]
The regulation of NFTs in the United States depends on the specific rights and characteristics of NFTs. If NFTs meet the characteristics of securities, such as investment contracts, then NFTs need to be regulated by securities-related laws.
The U.S. Securities and Exchange Commission (SEC) uses the “Howey Test” to determine whether a transaction constitutes a security. The “Howey Test” includes four major conditions:
1. Whether it is suitable to adopt the PPP model;
2. The investment is for a specific cause;
3. The investment has reasonable expected benefits;
4. The expected benefits come from the efforts of a third party.
NFTs are considered to be unique digital assets, but there are also cases where they can meet the above Howey test in appearance. At this time, further judgment is needed:
1. If the sales method of NFTs is to issue them to the public and promise returns or immediate cash, then the investment attribute of the project is greater than the collection attribute.
The public’s perception is that they can circulate and cash out immediately after passively investing in NFTs, rather than investing in a unique digital collection on the blockchain as a senior collector. This kind of transaction is more like the sale of securities, so it will be identified as a security at the beginning of the sale.
2. Control over NFTs and underlying assets. When determining whether a transaction meets the fourth clause of the Howey Test (the expected benefit comes from the efforts of a third party), the NFT project party’s control over the NFT and the underlying assets also needs to be considered.
If the NFT project party retains some of its control over the NFT, such as the copyright, trademark, patent and other intellectual property rights of the NFT’s underlying works, and is able to influence the secondary market through itself, or is able to participate in activities that affect the value of the NFT, such as being responsible for the project’s network development, improvement, brand operation and promotion after the NFT is sold, the NFT holder also expects to increase the value of the NFT through the project party’s operation.
This expected benefit will basically depend entirely on the nature of the NFT project party’s transaction being more like a security than a digital collectible.
If the NFT meets the conditions of the “Howey Test”, it will be deemed a security and will be subject to securities-related laws.
On April 3, 2019, the U.S. Securities and Exchange Commission (SEC) released a framework for analyzing digital asset investment contracts based on the Howey test, providing official guidance for determining whether digital currencies are securities. The SEC believes that most digital currencies on the market currently meet the two criteria of “capital investment” and “investment in a common cause.”
For the other two criteria, the SEC pointed out that if the development of a digital currency depends on the efforts of a company or centralized entity, and the purchaser has an expectation of reasonable profit from the investment, then the digital currency is considered a security. It should be pointed out that if a digital currency is decentralized enough, has a clear application scenario, and the price change is related to the application rather than from investors’ expectations of profit, then the digital currency is not a security. The SEC has stated that Bitcoin and Ethereum are not securities.[2]
[1] Zhang Yanlai and Ye Danni: “What Can NFT Bring to Copyright Protection”, China News Publishing and Broadcasting Newspaper, December 9, 2021, p. 005.
[2] Xiao Feng, Blockchain: Distributed Business and the Future of Intelligence, CITIC Press, 2020.