Written evidence submitted by Alex Preda

 

Evidence on NFTs uses and speculation, prepared for the UK Parliament

 

The evidence presented here has been gathered within the Economic and Social Research Council-funded research project ‘Professional Hybridisations and Epistemic Practices of Cryptocapital. An Ethnographic Investigation of Cryptoasset Firms’, based at King’s Business School, King’s College London.

 

I am the principal investigator on this project. To date, together with my team, we have interviewed 279 professionals from the crypto and blockchain industry in the UK, the US, Hong Kong, Tokyo, Shanghai, Beijing, and Shenzhen. We have interviewed software engineers, finance professionals, project managers, venture capitalists, analysts and managers active in the crypto and blockchain space, including professionals involved with NFTs and collectors of NFTs. We have participated in over 20 professional conferences with finance professionals, investors, analysts and managers active in this space, in the UK, US, and Hong Kong. The following insights are based on the evidence and testimonials gathered on the ground.

 

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

 

In summary, UK NFT regulation would need to take into account their triple function, as identifiers of digital objects, as identifiers of digital persons, and as instruments of ownership and use rights. In view of this triple functionality, it cannot be said that light touch regulation is sufficient. NFTs should be at least legally acknowledged as digital identity tokens similar with digital signatures. This is especially important with regard to metaverse construction, where digital identity authentication will play a key role. The reasons are formulated in the following.

 

Non-fungible tokens (NFTs) can be defined as unique digital identifiers of a digital object or of an actor in the blockchain space. Such digital identifiers are created and transacted within distributed ledgers, on what are called layer two blockchain applications. Transactions in NFTs are paid in digital assets generated on layer one protocols (mostly in Ethereum). NFTs can be associated with ownership and use rights of a transacted digital object, without being limited to that. Conceiving NFTs as a security does not adequately capture their nature, as NFTs are unique digital identifiers that can, but do not automatically confer ownership rights. A useful analogy here is as follows: pieces of clothing, such as a shirt, are sold with a tag specifying size, brand, etc. We usually remove the tag from a shirt after having bought it. An NFT is a digital tag attached to a digital object or to a digital identity, a tag that cannot be removed. The NFT (a) authenticates the object or the identity in question and (b) can confer ownership or use rights. (a) and (b) can be joint functions of an NFT, but not necessarily so. However, (b) cannot work without (a), while (a) can work without (b).

 

Hence, when talking about sufficient regulation, we need to distinguish between (1) regulating identity (similar with how digital signatures have been regulated two decades ago) and (2) regulating transactions in NFTs.

 

When we buy a piece of clothing such as a shirt, we usually buy it with a tag attached to it, which we will remove later. However, we do not buy and sell the tag separately as a unique identifier of the shirt and as conferring ownership rights over the shirt. When transacting unique digital objects, however, buying and selling the tag means buying and selling the object it is attached to.

 

NFT applications can be seen as commercial and non-commercial. Commercial applications include, but are not limited to, transactions of digital art, digital collectibles, transactions within digital game environments, royalties collections on digital cultural products (e.g., music, literature, journalism), digital ticketing (e.g., for concerts), supply chain authentication of products, and metaverse construction. Non-commercial applications can include digital document authentications (e.g., digital college diplomas) and authentication-cum-preservation of historic digital documents (e.g., digital photographs of historical events), limiting thus the possibilities of forgery or manipulation.

 

NFT regulation is regarded as challenging and a number of jurisdictions have left it unregulated yet (e.g., MICA in the EU). The challenges stem from: (1) current NFT uses; (2) their triple role as authenticating instrument for personal identities, for objects, and as transaction instruments; (3) the necessity to separate intellectual property (IP) rights from ownership rights, as NFTs can be related to both.

 

Regulation of NFTs should take into account both commercial and non-commercial uses, as well as each of the specific contexts in which they are used. For instance, NFTs have been tied to the recent emergence of digital art as a sui generis domain of collection and investment. Previously, digital art was more difficult to collect because it could be infinitely replicated (e.g., by hacking and replicating the software code that generated it). The use of NFTs as unique identifiers for digital art remove the problem and during 2021 and 2022 large auction houses (e.g., Sothebys) have auctioned digital art tied to NFTs. At about the same time, during the last two years, technology companies such as Samsung and LG have developed technologies for displaying digital art (e.g., the Frame screen developed by Samsung). Currently, platforms such as OpenSea work as marketplaces for digital art too, outside the regulated sphere, but they have been associated with price volatility, manipulations, hacks, and AML issues. A regulation of NFTs as authenticating and ownership instruments could help institutionalise digital art markets as a domain where collectors and auction houses engage and invest more regularly. At the same time, an institutionalised digital art market will have to acknowledge the separation between intellectual property rights and ownership rights, as NFTs could play a role in both (some digital artists are known only by their artistic online personae).

 

Similarly, in supply chains, NFTs can be used in conjunction with QR holographic technologies to track the origin of components and authenticating them. The way in which the technology works is that unique QR holographic codes (that are difficult to forge) are attached to physical components (e.g., products of origin) and linked one-to-one to NFTs, making it possible to authenticate a component alongside the chain. Acknowledging NFTs as authenticating instruments would contribute solving problems witnessed by supply chains when it comes to following the origin of components and authenticating them.

 

During the last two years, NFT-based transactions in digital collectibles within and outside game environments (e.g., memes, series of digital objects, game-specific objects) have greatly expanded and been characterised by significant price volatility. Such transactions take place both in-game (the play-to-earn model) and outside games. NFTs used for collectibles are probably more difficult to regulate. Similarly with digital art, regulation would require separating intellectual property of a unique object from ownership of that object. NFTs can play a role in both.

 

As digitalisation advances, it is to be expected that NFTs will be used more and more as digital authenticating instruments outside the commercial sphere. Here regulation acknowledging them will be necessary, similar with that for digital signatures from two decades ago.

 

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

 

We have to distinguish here between harm through fraud and harm through speculation. Harm through fraud can include but is not limited to hacking of wallets and exploitation of vulnerabilities in smart contracts. Harm through speculation does not necessarily imply harm through fraud. It can include (1) losses stemming from high volatility in the prices of NFT-linked digital assets, (2) over-exposure to such assets, and/ or (3) aggressive promotion primarily through social media. Potential for NFT speculation can be identified in the first place within the commercial domains of digital art and collectibles. We have to acknowledge that the audiences for these domains are different: collectors, galleries, and auction houses engaging with digital art are expected to possess expert knowledge and/ or have the resources to hire experts. They are less likely to be seen as vulnerable. Buyers of digital art on platforms such as OpenSea are more exposed to losses stemming from price volatility and/ or fraud and manipulation. The most likely potential harms for vulnerable audiences can be identified within the domain of in-game and outside game collectibles. Prices for which such digital objects trade are highly volatile and after a short period of ebullience the market for previously very popular games such as Axie Infinity has collapsed. Audiences for digital collectibles are more likely to be young and less well off; losses stemming from investments in digital collectibles are therefore more likely to have a higher impact on their finances. However, it has to be emphasised here that we lack statistical data about the engagement of UK audiences with such collectibles. The data we have indicate that this engagement has been very popular in East Asia over the past two years. Collectibles have been popular with younger audiences in South Korea and Hong Kong, while play-to-earn games have been popular in developing economies such as the Philippines.

 

  1. Do blockchains offer security to British investors?

 

To summarise, the answer is yes, albeit the security offered is never perfect and also depends on the type of blockchain.

 

The question of security is taken in this context as a high degree of trust in the capabilities of a chain and its components to withstand attacks and hacks, protecting thus the digital assets of investors from malicious attacks. This does not include aspects of personal security such as safekeeping of the private key to one’s wallet, which is a matter of individual responsibility. It is also different from aspects of security related to trust in the character of individual actors, groups, or companies involved in transactions or operating exchanges.

 

In order to answer this question, we have to take into account that there is a manifold of chains (estimated over 1,000) with four major types (public, private, hybrid, and consortium), and with a variety of protocols. We have identified 34 major chains and 68 protocols being developed. A protocol is an automated decision mechanism used in validating actions within a chain. The discrepancy between the number of chains and the number of protocols is due to the fact that we can have layer one and layer two protocols—that is, we can have a protocol for a chain generating a digital asset (such as Ethereum or Bitcoin) and additional protocols for layer two applications, built on layer one chains. A majority of these protocols (but not all) are variations on proof of work (PoW) and proof of stake (PoS), respectively. Generally, PoW protocols are considered to be more decentralised and offering more security than PoS protocols, which are more centralised and hence more prone to attacks. More centralised protocols have less nodes, and if a node is successfully attacked, then the security of the chain will be compromised. A more decentralised chain will be resilient to such attacks. It is to be noted here that the Bitcoin chain, which runs on PoW, has never been hacked. There is a trade-off here between security and energy consumption, though it has to be said that PoW protocols are transitioning toward green energy.

 

The question of security cannot be answered without considering the type of chain and the protocols they use. It is safe to say that consortium and private blockchains offer higher security compared with public and hybrid chains. At the same time, consortium and private chains have higher entry barriers for investors, so that there is a trade-off between security and barriers to entry. It is also safe to say that decentralised, PoW protocols offer more security compared with more centralised, PoS ones.

 

A second aspect of security is related to the smart contracts used on different protocols. Smart contracts consist of software code that automate the execution of transactions (which are not reversible on chain). If a smart contract has flaws, it will be prone to attacks. Hence, smart contracts have to be audited one by one in order to evaluate their safety. This is done by specialised audit firms.

 

To answer the question about security: yes, blockchains do offer security to British investors, but with qualifications, depending on the degree of centralisation of the chain and the audit of the code employed in smart contracts.

 

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

 

There are at least four benefits: the institutionalisation of new types of markets, for instance in digital art. Until recently digital art has been difficult and costly to collect, display, authenticate, and trade. NFTs can contribute to the institutionalisation of digital art, of markets therein, and to maintaining UK’s and London’s status as a major art centre. They can also encourage new types of collectors and popularise digital art with younger generations. We have seen recently galleries and auction houses include mid-priced, NFT-linked digital art in their holdings. As far as we can see, markets in digital art are presently more developed in East Asia than in the UK, as evidenced by the development of display technologies, auctioning of digital art, gallery activity, digital art fairs, and collector engagement. Institutionalisation of digital art markets in the UK (with the corresponding regulation) can be seen as beneficial to the UK art environment, artists, and audiences.

 

Another domain where NFTs can be beneficial is royalties collection on artistic works—including here music, digital art, or literary works. NFTs can facilitate both circulation and traceability of digital cultural products and thus contribute to improving revenue streams for artists. As in the case discussed above, this would require regulating the separation of IP rights from ownership rights, as well as regulating digital authentication in a manner similar with the legal recognition of digital signatures from two decades ago.

 

A further domain where society can definitely benefit from NFTs is the preservation of collective digital memory. Digital memories (e.g., photos, newspaper articles, books) can be easily altered and nowadays there are AI tools that allow deepfakes of digital artefacts such as photographs. Preserving digital memories on chain, authenticated with NFTs can serve as a useful counter-measure to manipulation of digital memories.

 

Another domain to be mentioned here is the legal one, in which NFTs can be used to authenticate legal digital evidence. It is unavoidable that digital evidence will be used more and more in courts of law, and will be in need of authentication. NFTs can be a useful instrument and can evolve into standards of authenticity used in legal cases. This will be especially beneficial if we think of the potential tampering with and manipulation of digital evidence, which NFTs make next to impossible.

 

 

Alex Preda, King’s College London

 

 

 

 

 

 

 

 

5