Written evidence submitted by Artclear Limited

A, Introduction

This document sets out evidence submitted by Artclear Limited to the DCMS Committee (The Committee) in response to its call for evidence related to its inquiry into NFTs and the Blockchain.

Artclear is a business that offers “Trustworthy Data Infrastructure” to support the global market in physical art. Our origins lie in the field of financial infrastructure, including securities settlements and payments.  Our founders have held senior positions at Euroclear, which operates Crest, the UK’s securities settlement system, and CLS, which settles global inter-bank foreign exchange transactions, as well as served on advisory committees at the Bank of England, the ECB and various financial services industry bodies.

In our business, Trustworthy Data means data that can be verifiably linked to both its subject and its source. The subject is always a specific physical instance of a work of art. This could be an original painting, one of an edition of prints, or a reproduction.  We have developed a technology, in partnership with Hewlett Packard Inc, which lets us distinguish between physical artworks with forensic certainty- that is, with less than a one in a billion chance of a false reading.

The source of the data is context specific. In the case of Artclear Certificates of Authenticity, our initial product, the source is an artist who has created a new work. Later we will add other data providers such as authenticators of existing works; art shipping and storage businesses and financial services providers. 

An important part of our model is that we use non-fungible tokens to represent de-facto legal proof of ownership of a given physical work, and operational proof of ownership rights to data in our platform concerning that work. NFTs provide a technical container that can make these claims and rights secure, rivalrous and transferable between owners of an artwork.  However, NFT technology provides only part of the solution we require, and we have invested significant effort into the processes by which we define rights both legally and operationally prior to investing them into NFTs, and thereby giving the tokens real-world meaning that is independent of Artclear.

Our use of NFT technology in a tightly defined operational capacity within our business model, coupled with our observation of the NFT bubble that inflated and then deflated while we have been working on setting up our business and building our platform, have given us certain insights into the strengths and weaknesses of NFTs which we believe may be of interest to The Committee and which form the basis for our evidence.

Angus Scott, Chief Executive

B. Summary of Our Evidence

1. Is the UK’s light touch NFT regulation sufficient?

We address this question through three lenses: NFT technology; products built using NFT technology; and the conduct of business of firms supporting NFT related products. We conclude:

a)      It would not be appropriate to regulate NFT technology independently of the uses to which it is put, which may vary widely.

b)      There may be a case for regulation of NFT based products. Any such regulation should, in general, be specific to the business context of the product -a financial product in NFT form should be regulated differently to an event ticket- and should align with existing regulation for equivalent products offered in non-NFT formats.

However, NFTs derive their value from their relationships to things that exist independently of themselves and give rise to practical and legal pitfalls. To the extent participants in NFT markets are not aware of these pitfalls, it may be beneficial to require enhanced disclosure of the rights contained within an NFT. 

c)      Although most NFT based products are not financial instruments, the fact that NFTs can be priced and traded electronically means that they share some features with financial products such as securities. This has led to the development of an eco-system of firms providing support services, such as exchanges and custodians, which resemble their financial services namesakes. It has also led to the development of business practices that are prohibited by financial regulation, such as market manipulation or co-mingling of client and firm assets. There is a case for equivalent regulation of these practices in the NFT world.

However, consistent with the first bullet above, the mere use of NFT technology by a firm should not bring it within the scope of a future regulatory regime.

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

The combination of poorly defined property and contractual rights, mispricing through market manipulation and risk from poorly run service providers exposes participants in NFT markets to the risk of losses that they may not be comfortable to sustain.

3. Do blockchains offer security to British investors?

Blockchains appear to be secure in the important but limited sense that the major protocols, despite operating in a completely open, permissionless environment for several years, have not been compromised, meaning the data contained within them remain reliable.

However, they have displayed security vulnerabilities in their interfaces to the external world, for example, in terms of the robustness of the legal and operational links between blockchain data and external-world assets or data, or the security of the cryptographic keys needed to prove ownership of specific data objects on a blockchain.

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

Although NFT technology can be used to create instruments of speculation, it has much broader potential applications that may prove beneficial, if used appropriately, in spheres such as rights management, data notarization, asset lifecycle management and digital identity.

Speculation itself has a role to play within markets, potentially bringing in new information and improving liquidity, although it may be harmful where it dominates the core function of markets as mechanisms for resource allocation.  Since a speculative transaction can only be distinguished from an “allocative” transaction by the motivation of the parties involved, it can be difficult to determine the prevalence of speculation within a given market.

In the case of NFTs, some people may have bought them for speculative reasons, whereas others may derive utility from their ownership of NFTs. As more robust uses of NFT technology are increasingly developed, the intrinsic utility experienced by NFT holders is likely to increase relative to the speculative utility.  It is therefore likely to be difficult to limit speculation without also reducing the possibilities for this intrinsic utility.

We therefore do not believe that speculation, per-se, should be an object of regulatory concern.

C. Our Submission of Evidence

1. Is the UK’s light touch NFT regulation sufficient?

We address this question from three points of view: the technology used to create NFTs; the products created using NFT technology; and the conduct of the businesses servicing these products. 

a)      Regulation of NFT technology

We do not believe that technology can or should be regulated.

In the first place, the methods and data structures that instantiate the concept of an NFT are specific to the blockchain protocol being used and may be subject to change and development over time.  It may be difficult to draft a regulation that is generic enough to cover different ways of delivering equivalent outcomes but does not unintentionally restrict future innovations.

Secondly, it is not obvious why a non-fungible token should receive different treatment to a fungible token. Both fungible and non-fungible tokens are applications of methodologies contained within blockchain protocols.  They have different characteristics, but in essence both enable a peer-to-peer data network to recognise and control “title” (in an operational sense, not necessarily in a legal sense) in unique data objects.

Finally, in equivalent spheres such as financial services, regulators are explicitly technology neutral. To the extent that they concern themselves with technology choices, it is in the context of the Conduct of Business of the firms they oversee, and the oversight is typically focussed on ensuring that factors such as resilience and security provide appropriate levels of protection to customer assets, rather than to the underlying technology used. 

b)      Regulation of NFT Based Products

In its consultation paper on Digital Assets, published in July 2022, the Law Commission stated its opinion that a blockchain token such as an NFT could be considered property under English law.  However, an NFT is simply a unique code that is stored on a blockchain.  It has no intrinsic meaning and to the extent it is used to represent claims over objects or rights that exist outside of the blockchain (“rights”) the linkages between the NFT and the rights must be defined by and established by the NFT issuers. 

An NFT may offer its owner property rights over another thing, such as digital data or a physical object, or rights to participate in some benefit such as a VIP event. The rights conferred by an NFT give rise to an implicit or explicit legal contract between the issuer of the NFT and its current holder. It is the nature and strength of these contracts that define the utility of an NFT and hence ultimately enables people to value it. As such, these contracts should be the focus for any evaluation of the adequacy of existing regulation

As a starting point, we believe that use of NFT technology in a particular business context should not over-ride existing regulation relevant to that context. For example, a financial instrument that used NFT technology to record its ownership should be regulated in the same way as an equivalent instrument that used different technology to record ownership.  If a situation arose whereby use of NFT technology allowed an issuer to circumvent existing regulation that would otherwise apply, there is clearly a strong case to modify the existing regulation to close this loophole.  Equally, an instrument should not be subject to increased regulation just because it uses NFT technology.  For example, an NFT that represents a digital ticket to a sporting event should be covered by the same consumer protection regulation as any other ticketing format used for similar events.

However, there may be certain practical or legal pitfalls that arise from the use of one thing to represent rights in relation to another thing including:

1. The thing that is owned must be uniquely identifiable and easily distinguishable from copies, editions, reproductions or fakes.  If not, the NFT may lose both practical utility and financial value.
2. Any claim of title embedded within the NFT must be robust and provable, even if the object existed prior to the creation of the NFT
3. If someone sells an NFT giving title to an object to one person, and then sells the object itself to a second person, the NFT holder may have a claim against the person that sold them the NFT but is unlikely to be able to claim the object from its new owner. Managing this risk, which is similar to settlement risk in financial markets, is an operational matter that requires its own service infrastructure.
4. A similar issue may arise with respect to an NFT that contained a license to use copyrighted material. If the copyright owner sold the copyright to a third party, that person would not necessarily be obliged to maintain the license, since they would not have been party to the contract granting it, which would devalue the NFT through no fault of the NFT holder.
5. Digital data is not property. Many NFTs purport to represent “ownership” rights over data such as a digital image. However, the only way in which true property rights can be established in digital data is through intellectual property frameworks such as copyright and related licensing regimes. Often the data “owned” by the purchaser of the NFT is stored at a public URL on, for example, the IPFS. In practice, unless the NFT contains an explicit copyright license, the rights of the NFT owner may be no different from those of anyone else who accessed the data via the URL.
6. Rights embodied in an NFT may not be transferable when the NFT is sold. An NFT may represent a contract between its issuer and its purchaser to grant benefits to the purchaser. However, if it is sold in a secondary market, the new purchaser has no direct contractual relationship with the issuer of NFT. Normally, a third party cannot enforce the terms of a contract to which they are not party. This raises the possibility that an NFT issuer could disclaim any obligations promised in the NFT when it is sold unless, the contract explicitly recognises future purchasers of the NFT as a class of third parties whose rights are to be protected.

The existence of such pitfalls means that there may be a case for additional regulation to protect the rights of NFT purchasers. Given the current limited scale of NFT related business and the difficulties of creating generalised rules that could cover the multiplicity of uses to which NFT technology may be applied, any such rules should focus on ensuring adequate and accurate disclosure of the rights obtained by purchase of a given NFT.

c)      Regulation of Businesses Servicing NFT markets

NFTs are electronically transferable instruments to which value can be ascribed. In this respect, they may resemble financial securities and it is therefore unsurprising that an eco-system of businesses has grown up around NFTs that resembles a securities trading eco-system, comprising firms such as exchanges and custodians. 

Exchanges facilitate the buying and selling of NFTs in the primary or secondary markets. They enable buyers and sellers to discover one another, and bring together data on bids, offers and trades that assist in pricing of transactions. Custodians provide safe-keeping services for the private keys that control wallets on the blockchain, addressing the risk that an individual may lose their cryptographic keys and hence control of their NFTs. In some cases, the same firms provide both exchange and custody services.

These businesses fall outside the scope of regulations such as the Financial Services and Markets Act. On one level, this makes complete sense. No-one would argue that a physical art fair should be regulated like a securities exchange, so why should a digital art market? However, the securities-like nature of some NFTs means that business practices have developed around NFT markets that are outlawed or strongly discouraged in financial markets. These may include:

• Inadequate client due diligence.
• Creating false markets through schemes such as pump and dumps or by creating wash trades between wallets controlled by the same person, at ever increasing prices. 
• Co-mingling of client assets and firm assets, meaning counterparty risks may be greater than some clients have bargained for.
• Excess leverage- some people use NFTs as collateral in highly leveraged trading strategies. These strategies may raise suitability questions for individual traders and give rise to systemic issues that create risk for other token holders, especially where the same organisation offers margin trading and custody services and asset segregation is weak. Although not specifically related to NFTs, the collapse of exchanges such as FTX, taking billions of dollars of client assets with them, highlights the risks of some service-provider business models.

Given these issues, there may be a case to extend regulation of practices such as client due diligence, market manipulation and client asset protection to firms offering trading and custody services to participants in digital markets in non-financial products.

A second category of businesses incorporates NFT technology as part of a service offering that is not focussed on asset trading, for example a digital ticket agency that used NFTs to represent tickets to events. Artclear is another example of such a business. Artclear’s use of NFT technology enables us to provide robust digital instruments representing verifiable data about specific physical works of art. However, Artclear plays no role in arranging art transactions and works through traditional players in the art market such as artists’ studios, galleries or auction houses.

We believe that such businesses should not attract additional regulation merely as a result of their use of NFT technology.  This is consistent with the principle we asserted in 1.A above, that technology should not be regulated in itself. 

2. What are the potential harms to vulnerable people of NFT speculation

As noted above, NFTs may expose purchasers to a number of risks including:

• Poorly defined or insecure property rights over an external object to which they refer.
• Weak contractual participation rights.
• Mispricing as a result of market manipulation.

In addition, businesses set up to facilitate trading in NFTs may subject their clients to counterparty risks that could lead to loss of assets.

Collectively, these problems mean that people may pay inflated prices for NFT “assets” of uncertain value, giving rise to risk of loss of the amounts paid for the NFT. Purchasers may face further risk of loss because of weak financial and operational controls at intermediaries providing access to markets.  To the extent that people see NFTs as investments and do not understand these risks, the potential losses may be more than they can afford to lose.

3. Do blockchains offer security to British Investors?

Blockchains would appear to offer security in a limited but important sense, but some of the business models and organisations built on top of them do not.

Blockchains have been successful at maintaining the integrity of a set of data within the parameters set out in their protocols. 

Blockchains are typically structured as ledgers for recording transactions in digital codes called “tokens”. Transactions transfer control over the token from one participant, represented by a cryptographic identity known as a wallet, to another. The primary innovation of blockchain is to enable the consistent, immutable maintenance of these records in a peer-to-peer network with no central governing authority. Consistent means that changes to data are applied in accordance with deterministic rules of which all participants in the network are aware. Immutable means that data cannot be changed once they have been accepted as records by the network.

The rules of a blockchain system are encapsulated in a “protocol”: a set of instructions that govern how data and transactions are to be shared between and validated by the participants in the system. Each participant individually runs software that encodes the protocol, called a node. The collective of all nodes is the blockchain network.

Because protocols are public, anyone can examine them to identify security flaws which would allow them to change data in the network outside of the rules. Honest people might highlight issues to the development community, allowing them to be fixed quickly. Dishonest people may attempt to exploit the flaw for personal gain. The fact that no such flaws have yet been exploited with respect to the major blockchain protocols, despite several years of operation, provides a strong indication that these protocols are, in fact, secure. Of course, someone may discover a way to subvert the protocols in the future, but this applies to any system from physical vaults to legacy secure communication networks such as SWIFT, the inter-bank messaging system.

Hence, it seems reasonable to conclude that data recorded in a blockchain is secure, in the sense that they adhere to the rules of the blockchain protocol. 

However, potential weaknesses in blockchain security arise in the interfaces between blockchain data and the external world.

One set of potential security issues for investors arises from the relationship between a blockchain token and any real-world assets, goods and services to which it relates, as discussed in 1.b). above in relation to NFTs.

Similar issues arise with other types of tokens, such as certain stable coins. These instruments used algorithms contained in smart contracts in an attempt to maintain a constant value relative to some benchmark, such as the US dollar.  In practice, these algorithms proved to be flawed and the value of the tokens chimerical.  Although the methods employed by these algorithms are publicly available, arguably some people who bought the tokens did not fully understand them and so took on unexpected risks.

A third set of issues relates to the arrangements for safekeeping the cryptographic identities used to control blockchain tokens. There have been high profile cases where people have lost the keys that control these identities and hence their ability to realise any value tied up in their tokens, for example because they were stored on a computer hard drive which was accidentally thrown away. To mitigate this risk, some people use custodians that promise to store the identities in a more secure facility. However, these services give rise to operational risks if, for example, the holding facility is not as secure as promised and is hacked, and legal risks, whereby customer identities have not been legally segregated by the custody firm, exposing clients to losses on the insolvency of the custodian.

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

We believe that NFT technology may be useful in many potential applications that have nothing to do with speculation. We therefore start our answer to this question by outlining some of these applications. However, NFTs clearly offer the potential to create instruments that can be used for speculative purposes and so we also briefly address the question of whether speculation has any social or economic utility and whether there might be a case for regulatory intervention to limit it.

a)      Benefits of NFTs

We believe that, used in the right way, NFTs can develop into an open, accessible infrastructure to record and track attributes of unique things. The existence of such infrastructure has many benefits including:

1. Reducing the cost of developing and operating rights management businesses, particularly where rights are transferable, from event ticketing to asset registers;
2. Enabling a convenient mechanism for notarising data to prove its existence and content at a point in time, reducing potential for dispute or fraud;
3. Enabling assets to be tracked over an extended lifecycle, reducing risk and cost to participants in those lifecycles;
4. Protecting anonymity in the digital realm, particularly if used in conjunction with other technologies, such as verifiable credentials, which prove some defined attribute of an individual like age or nationality.

At Artclear, we use NFT technology as i) a digital notary, to secure critical data about a specific work of art that someone may need to rely on in future; ii) a mechanism to record and transfer claims of title in specific artworks; iii) a means of establishing access and editorial rights to certain data attributes concerning a specific work of art. 

This is not to say that other means of delivering these services are not available. However, the availability of NFT technology has reduced our development and roll-out cost enabling us to deploy our scarce capital on other features, such as establishing an indelible link between physical object and digital record.

b)      Speculation

Speculation arises in  any market where prices are volatile and transaction and carry costs are not prohibitive. The primary function of markets is to allocate goods and services in the real world between people today and in the future.  Markets therefore need a strong grounding in the real economy. Absent this- in other words, where speculation dominates over allocation- markets become casinos.  As J.M. Keynes wrote in the General Theory of Employment, Interest and Money: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”

Some level of speculation can be beneficial. Speculators can take contrary views to other market participants, increasing market liquidity and reducing trading costs. They can also bring information and opinions about future developments that would otherwise be lacking, improving overall price efficiency. For example, a foreign exchange market that is closed to speculators may be slow to respond to incipient inflationary risks building up in one of the currencies, resulting in the mispricing of certain transactions.

Moreover, since speculation is defined by the motivation behind a trading decision, it can be difficult to tell when it is present.  In the case of NFTs, we cannot say how far people have bought them because of the value they derived from owning them or because they hoped to profit from rising prices and we should be wary about attempting to do so since clumsy misclassification may stop people from accessing legitimate sources of utility.  It may also end up catching non-speculative activities that use NFT technology for purposes such as those outlined in 4.a) above. 

For these reasons, we do not believe that speculation, per-se, should be an object of regulatory concern.

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