Written evidence submitted by Professor Andrea Baronchelli

 

Andrea Baronchelli is a Professor of Mathematics at City University of London, Token Economy theme lead at The Alan Turing Institute, and Research Associate at the UCL Centre for Blockchain Technologies (CBT). He specialises in quantifying human dynamics in decentralised socio-technical systems, with a focus on blockchain ecosystems and social media. His work has appeared in a wide range of journals including Science, PNAS and Nature Human Behaviour, and has been recognized by the 2019 “Young Scientist Award for Socio and Econophysics” of the German Physical Society.

 

Prof. Baronchelli created and leads the Token Economy theme at The Alan Turing Institute. He is author of pioneering articles on the cryptocurrency market [1,2], the blockchain ecosystem [3], and the dynamics of dark web marketplaces [4,5]. In 2021, he coordinated the first scientific paper analysing the overall structure of the NFT market [6], which has been downloaded more than 150,000 times so far and was broadly covered by the press. Prof. Baronchelli analysis of the NFT space has continued also in 2022 [7], and he is regularly invited to comment on NFTs by the media, with past appearances including BBC News, BBC World Service's Newsday programme, BBC Money Talk, The Times, Vice, Reasons to be Cheerful podcast, etc.

 

Prof. Baronchelli is currently PI of the project “Self-organized patterns of (de)centralisation in the Bitcoin blockchain” at The Alan Turing Institute funded by PayPal with a gift of $340,000, and part of the IRIS Academic Coalition, a research group dedicated to understanding infodemics and promoting healthy information ecosystems led by some of the world’s leading academic institutions (PI for the £600,000 funded to City). Previously, he was PI of a UKRI COVID-19 Rapid Response Call grant on “COVID-19: Monitoring the effects of the pandemic on illicit online trade” (ES/V00400X/1), which analysed illicit trade on dark web marketplaces during the pandemic (£272,813), and of a KTP grant on urban mobility (£278,074).

 

 

 

 

Is the UK’s light-touch NFT regulation sufficient? 

 

  1. Currently most NFTs cannot be categorised as security token nor e-money tokens. As such, they are mostly unregulated in the UK.
  2. Most prominent benefits of a more articulate NFT regulation include limiting money laundering and protecting NFT buyers from scams. Know Your Customer (KYC) and Anti Money Laundering (AML) regulations are currently in place for the crypto businesses, including firms involved with exchange tokens (such as Bitcoin). These businesses must comply with the same AML regulations as banks and financial services. The FCA is the AML/KYC regulator of UK crypto businesses.
  3. AML rules for Art Market participants exist but have proven ineffective to contrast illicit activities around NFT collections.
  4. The absence of regulation for NFTs has encouraged wash trading, a form of market manipulation in which a set of (colluding) users trade the same asset to create artificial activity. Wash trading usually correlates with a concentrated market, where few players generate most of the volume, as it is the case for the NFT market [6]. Recent analyses estimate a lower bound for wash trading of $3.4 billion artificial volume [8].
  5. Overall, a tighter regulation for NFT trading, incorporating at least some of the AML/KYC rules in place for cryptocurrencies, would promote a safer space for NFT creators and buyers.

 

 

What are the potential harms to vulnerable people of NFT speculation? 

 

  1. The NFT market has experienced huge volatility in 2021 and 2022. Number of sales and exchanged volume are currently at a minimum over the last 12 months. See Figure 1.

Chart

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Figure 1: NFT sales (red) and sales USD value (white) over the 12 months preceding Dec 15, 2022. Data from https://nonfungible.com/market-tracker.

 

  1. A pernicious type of scam for the vulnerable / non-expert buyer is the so-called “rug pull”. Creators of an NFT collection generate attention on their product through the involvement of one or more celebrities and/or a well-crafted social media campaign. After the price has been driven up by the first, the scammer creators sell, and the price falls dramatically, often even to zero.
  2. A second frequent scam associate to NFT trading is the NFT creator/seller lacking rights on the associated object. The NFT is essentially a contract associating an object, such as a digital image or a physical good, to a creator and an owner. However, there’s no obvious way to verify that the information registered in the contract are accurate. The scam, at the expenses of buyers in good faith, is associating the NFT to an object that was not created and/or is not owned in any form by the NFT creator. For example, one could create an NFT associated with, and claiming ownership of, the Big Ben, and sell it to a naïve buyer.

 

 

Do blockchains offer security to British investors? 

 

  1. The answer to this question is three-layered, including investors in blockchain as a technology, investors in the blockchain industry, and investors in cryptocurrencies and NFTs.
    1. Investing in blockchain as a technology for finance and the economy. Blockchains are secure tools to store and retrieve information. As such, several financial services could in principle benefit from the Blockchain technology. A chief example is represented by the case of Central Bank Digital Currencies (CBDCs) which, despite presenting serious potential problems in terms of privacy and civil liberties [9], would represent a secure way to transact for the users. Investors in large companies that are experimenting with the blockchain are exposed to very limited additional risks.
    2. Investing in the blockchain industry. The blockchain industry plays a prominent role in the emerging Web3 economy. Many startups and medium-size companies in fintech propose potentially disruptive uses of the blockchain and/or services for the blockchain ecosystem itself. Investors in such companies need to be aware that, beyond the usual risks associated to investing in small companies, they are currently exposed also to the macro trends of the cryptocurrency market.
    3. Investing in cryptocurrencies and NFT. As mentioned above, both cryptos and NFT prices have experienced significant volatility and certainly represent highly speculative investments. While major scandals have happened, such as the recent disintegration of the FTX crypto exchange, the crypto market is certainly more mature than the NFT one, both in terms of age and regulation. The early NFT market has represented a sort of wild west for investing, exposing investors to high risks on top of the general ones associated to the overall market trend.

 

 

What are the potential benefits to individuals and society of NFT speculation?

 

  1. NFTs allow to unequivocally establish the ownership of an associated digital or physical object. As such, they have potential (i) to promote an economy around previously largely untraded digital objects, such as digital art, while protecting the rights of creators and (ii) to dramatically simplify the trade of physical objects, particularly of significant value, such as real estate.
  2. Transparency is a key benefit that NFTs offers both to individuals and the overall market, relevant to every sector where they may find, or have found, application. Firstly, transparency grants creators both recognition for their work and, if implemented in the smart contract, revenues from the resale of their creations. Secondly, transparency grants buyers a full information on the history of the purchased good, from creation and through the chain of past ownership.
  3. The art market has shown immediate appreciation for this transparency, with artists (in theory, at least) accessing an unprecedented level of protection and collectors benefitting from immediate access to the so-called “provenance” of a piece of art.
  4. Beyond digital art, NFTs have had a significant impact on the gaming industry, where smart contracts allow users to own digital artifacts and game producers to profit from the trade of these artifacts. The birth of such an economy has potential to revolutionise the gaming industry itself, with game producers who will provide free access to their ecosystems and players who can put their skills to profit in a “play to earn” model.
  5. Another industry that has clearly benefitted from NFT trade and speculations is collectibles, such as Panini stickers, which lend themselves naturally to a digital translation of the traditional physical model.
  6. Other sectors that have experimented with NFTs are the music industry, both in terms of decentralised streaming platforms (e.g. Audius) and community building, marketing, luxury (in terms of metaverse), and the companies aiming at building metaverses.
  7. Finally, interesting proposals exist to use of the NFT technology to simplify physical trade of valuable goods, such as real estate property. In this respect, if the shift from the current system to a blockchain-based database were backed by the Government, the digital ledger technology - with/and NFTs - could dramatically reduce existing frictions in the market.

 

 

References:

 

[1] Elbahrawy, A., Alessandretti, L., Kandler, A., Pastor-Satorras, R., & Baronchelli, A. (2017). Evolutionary dynamics of the cryptocurrency market. Royal Society Open Science, 4(11). doi:10.1098/rsos.170623

 

[2] Alessandretti, L., Elbahrawy, A., Aiello, L. M., & Baronchelli, A. (2018). Anticipating Cryptocurrency Prices Using Machine Learning. Complexity, 2018. doi: 10.1155/2018/8983590

 

[3] Lucchini, L., Alessandretti, L., Lepri, B., Gallo, A., & Baronchelli, A. (2020). From code to market: Network of developers and correlated returns of cryptocurrencies. Science Advances, 6(51). doi:10.1126/sciadv.abd2204

 

[4] ElBahrawy, A., Alessandretti, L., Rusnac, L., Goldsmith, D., Teytelboym, A., & Baronchelli, A. (2020). Collective dynamics of dark web marketplaces. Scientific Reports, 10(1). doi:10.1038/s41598-020-74416-y

 

[5] Nadini, M., Bracci, A., ElBahrawy, A., Gradwell, P., Teytelboym, A., & Baronchelli, A. (2022). Emergence and structure of decentralised trade networks around dark web marketplaces. Scientific Reports, 12(1). doi:10.1038/s41598-022-07492-x

 

[6] Nadini, M., Alessandretti, L., Di Giacinto, F., Martino, M., Aiello, L. M., & Baronchelli, A. (2021). Mapping the NFT revolution: market trends, trade networks, and visual features. Scientific Reports, 11(1). doi:10.1038/s41598-021-00053-8

 

[7] Mekacher, A., Bracci, A., Nadini, M., Martino, M., Alessandretti, L., Aiello, L. M., & Baronchelli, A. (n.d.). Heterogeneous rarity patterns drive price dynamics in NFT collections. Scientific Reports, 12(1). doi:10.1038/s41598-022-17922-5

 

[8] La Morgia, M., Mei, A., Mongardini, A. M., Nemmi, E. N. (2022). NFT Wash Trading in the Ethereum Blockchain. Preprint arXiv:2212.01225

 

[9] Baronchelli, A., Halaburda, H., & Teytelboym, A. (n.d.). Central bank digital currencies risk becoming a digital Leviathan. Nature Human Behaviour, 6(7), 907-909. doi: 10.1038/s41562-022-01404-9

 

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