Written evidence submitted by Dr Matthew Robert Shillito

Response to the Call for Evidence: NFTs and the Blockchain

Biography

Dr Matthew Shillito is a Lecturer in Law at the University of Liverpool. His research identifies and develops issues and themes in the areas of financial and dark web crime, with a particular focus on how the law regulates the use and abuse of digital currencies. In September 2016, he completed his PhD thesis, entitled ‘Criminal abuse of non-traditional payment methods: A comparative analysis of the application of anti-money laundering and counter-terrorist financing frameworks in the UK, US, and Australia’. The thesis specifically focussed on how the law was developing in each jurisdiction to tackle the emerging threat of Bitcoin and other digital currencies. Dr Shillito is developing a book on this area, in light of developments since his thesis was completed. He also has a meaningful body of publications and conference presentations focussing on legal issues surrounding the use of crypto-assets, and in 2016/17 through a joint N8 funded research project with Greater Manchester Police and colleagues at other academic institutions, helped to develop a handbook for the Metropolitan Police on how to deal with cryptocurrencies uncovered during the course of criminal investigations. Dr Shillito teaches an undergraduate ‘Banking Law’ course to circa 250+ students and has developed several lectures on cryptocurrencies, which have a particular focus on a range of different crypto-assets and the risks they present to consumers due to the lack of regulation and protection in the area. Further, he teaches ‘Crime & the Dark Web’ and will be introducing a cryptocurrency focussed postgraduate module ‘Law and the Regulation of Blockchain & Cryptocurrencies’ in 2023.

Topic 1: Is the UK’s light-touch NFT regulation sufficient?

The UK government appears to be stuck in a bind when it comes to regulating the cryptoassets sector. Its approach, evidenced through publications, consultations, and press releases, is to seek to strike an appropriate balance between providing the sector sufficient freedom to innovate whilst also mitigating risks to consumers and the economy through the introduction of regulation. This has bourn some fruit, for example, expansion of the anti-money laundering regime, and of FCA advertising rules on financial products, such that they cover cryptoassets. But overall progress has been slow, given cryptoassets have been in circulation for over a decade, and the UK government began consulting on issues surrounding them over seven years ago. This malaise is particularly true in relation to the response to Non-Fungible Tokens (NFTs), perhaps because other crypto areas have demanded a more pressing response.

Whilst it is not uncommon for the law to lag behind in terms of regulating technological developments, owing to the fact it takes a while for the full range of risks to emerge such that they can be tackled effectively, it is surprising that there is still so little oversight of NFTs in the UK. NFTs have been in circulation for quite some time[1] and whilst they have yet to reach any kind of mass adoption, the risks they pose are widely known e.g., they can be used to facilitate fraud or other illicit activities, can pose risks to consumers, and are susceptible to significant loss in value. In recent years, their usage has increased, with sports teams, transnational companies, and celebrities minting their own NFTs. Indeed, the UK government has also announced its intention to mint an NFT.[2] Whilst it is difficult to say with any certainty that this will increase usage of NFTs, it will certainly raise awareness and increase the potential ‘investor base’, to that end it is all the more perplexing that the aforementioned risks have not been addressed with regulation, particularly given that it should have little impact on the main benefits NFTs can offer (as will be discussed below).

Given that the focus of NFTs is on secure ‘ownership’, then it is hard to argue for anything other than a cautious approach as the costs associated with increased regulation should make the space safer, and in turn help it to reach a wider user-base.

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

For the purposes of this question, a ‘vulnerable person’ should be construed wider than its usual legal meaning, that is someone who is a minor or who for physical or mental reasons is unable to look after themselves or their finances. As well as this, ‘vulnerable’ should also cover anyone that engages with NFTs that are either:

a)      Ill-informed as to how NFTs and the wider crypto-sector work; or

b)      Duped / scammed into investing in the sector by promise of easy or guaranteed return on investment;

Such wide coverage is important as it is not uncommon for individuals to purchase NFTs as a result of their favourite sports team, artist, musician, brand or celebrity releasing a token, despite that individual having a lack of knowledge of the sector.

The following are key potential harms to vulnerable people of speculating in NFTs:

• Financial loss - The most obvious harm to individuals is the potential loss of value on their investment. As with all investments NFTs can fluctuate in price and there is no guarantee of a profit. Indeed, significant losses have been witnessed during 2022 as NFTs continue to crash in value.[3] This is particularly troublesome where an individual has been induced to invest due to the potential for high returns, security of storage, or where the possibility for financial loss has not been appreciated. There is also an issue here of ‘good faith’ creation i.e., it is not a given that a sports team for instance has any interest in long term viability of their NFT beyond its initial sale, which can leave supporter / the investor particularly exposed to price loss.
• Fraud – There are instances of fraud in the NFT market which can result in financial loss for investors, as well as reducing their likelihood to continue engaging in the sector. For instance, the developer of Mutant Ape Yacht Club (itself an imitation of a successful NFT collection.- Mutant Ape Planet) has been arrested and charged with defrauding investors of $2.9m in a ‘rug pull scheme’.[4] The issue here is twofold, that NFTs can imitate more successful ones and dupe individuals into speculating in the hope that they will also gain in value, but most importantly that bad actors are operating in the area and attempting to defraud good faith investors. CryptoZoo, an NFT based game owned by the celebrity Logan Paul has also been found to have facilitated the defrauding of its users, with 6 individuals losing in excess of $600,000.[5] Troubling because of the reach celebrities can bring to the sector and thus the wide potential for criminal abuse. Individuals may also be tricked into buying an NFT that has little value, or into releasing a valuable NFT for little money.
• Inclusivity – If NFTs gain mass adoption, they could potentially exclude vulnerable people from engaging in certain types of art / investing. It is not a given that the wider populous can access and understand the NFT marketplace and so consideration needs to be given as to 1) how to make the space more inclusive; 2) the cultural impact NFTs have; and 3) how individuals are protected once they are there.
• General Crypto Transactional Risks – buying and selling NFTs necessitates individuals engage with cryptocurrencies as a means of payment and that brings with it its own risks, namely around loss of value, failure of a cryptocurrency, and scams. This is particularly true if an individual does not subsequently cash out back into fiat currency. The risk here is particularly exacerbated as you can have a very knowledgeable art dealer wanting to engage in the sector, who potentially can also be inexperienced in cryptocurrency transactions / security making them exceptionally vulnerable. For instance, the collector may have no real interest in NFTs beyond their favourite artist releasing a new art piece in this form.
• Psychological harm / loss of confidence – perhaps the most troubling harm to vulnerable people speculating in NFTs is the psychological harm / loss of confidence that a bad investment experience can cause, whether that be due to financial loss, fraud, or other negative experiences. It could also lead to overspending when chasing profit. This coupled with predatory lending / ease of lending through crypto financial service providers e.g., Celsius, Block-Fi etc can expose individuals to unnecessary and excessive financial risk.
• Lost time / effort for creatives – from a different perspective vulnerable creatives may invest significant time and effort creating NFTs because of promised returns but they may not reap those rewards either because of a lack of a suitable market or due to fraud. It therefore poses a particular risk to less well known artists.

In light of the above, it is therefore imperative that policy makers to consider the impact of NFT speculation on the ‘vulnerable’ and regulate to protect them.

Topic 3: Do blockchains offer security to British investors?

Blockchains *can* offer security to British investors, but this is reliant on good practice and to an extent on the good fortune of not being the victim of crime (either from within the ecosystem or from malicious outside actors attacking the particular blockchain). To this extent, any security afforded by blockchains is limited by the human utilising it, as well as any weaknesses in its design and implementation.

Fundamentally, blockchains have a few key features that make them attractive to British investors in terms of security:

• Cryptography – Strong cryptography is used to secure data on the blockchain and protect the privacy of users, ensuring the integrity of the whole ecosystem.
• Immutability – once data is written, it cannot be altered or deleted.
• Consensus – all network participants have a say in the state of a given blockchain, data is recorded based on majority consensus, and as such this makes it hard to manipulate.
• Decentralisation – as they have no central authority or server, then they are harder to attack.

The result of these blockchain features is security in terms of stored data, strong protection from financial crime, and transparency of assets in terms of transaction and ownership history, all of which is appealing to investors and makes blockchains good platforms for recording and verifying transactions.

However, blockchains are not fool proof, nor are they immune from attacks or other types of security breaches. Fundamentally, investors are reliant on the blockchain they are utilising having been developed in good faith to a high standard[6] and on the creator not having the ability to perform a ‘rug pull’ / exploit weaknesses in the blockchain known only to them from the design phase. They are also reliant on the security features of that blockchain to protect from external attacks. Beyond design, investors are also reliant on other users of their chosen blockchain to provide them with security given that it relies on consensus.

Investors are also reliant on their own good practice, that is to say like any system if they do not follow good practice in terms of security e.g., keeping access codes and passwords safe and having strong computer security, then they are exposed to any risks that may bring. Alongside this, use of the blockchain can be complex and can result in individuals making errors that further expose them to risk.

Furthermore, whilst the blockchain can provide security in terms of data, it does not necessarily provide any additional security in terms of the actual investment itself. Most investments that are recorded on the blockchain currently are those that relate to cryptoassets- these are exposed to significant market volatility and can fluctuate wildly in value over relatively short periods of time. Linked to this, a high proportion of crypto investments are either under regulated or not regulated at all, which can further expose investors to great risk.

Finally, difficulty can arise if a particular blockchain fails and investments are either solely recorded there or are reliant on that ecosystem to be able to operate, such that an investor could potentially lose all of their money, or at least part of it, should things go wrong.

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

The primary argument advanced in favour of NFTs is that they are a digital asset that is unique to its owner, in other words they represent a one-of-a-kind item. Though a problem with this, as many have found, is there is questionable value to this in some instances – as an example, social media users have frequently shared and changed their profile images to NFTs that have changed hands for significant value (pointing out it is theirs now too), whilst they don’t own the item it shows they can derive many of the same forms of enjoyment without the cost, especially where litigation remains unlikely or not possible. Of course, this is not true of all forms of property and investments and as such the quality of ownership can be a big appeal to utilising the blockchain and NFTs in some instances e.g., where a bank creates a bespoke record for the owner of a specific NFT.

Beyond ownership, NFT usage can provide a number of other key advantages for society:

• Accessibility – Can make it easier to buy and sell digital assets, making them available to a wider audience. They also allow for the creation and ownership of digital assets unique to NFTs. Again, taking the example of a musician, it might give them access to listeners that would have never considered them previously. Or in terms of artists, it may bring a new demographic to the field.
• Revenue – could increase revenue for creatives due to wider accessibility.
• Control – can allow creatives to have greater control over their digital assets, including setting distribution and use terms and conditions. This could make a big difference to musicians for instance who usually rely on ‘middlemen’ who then control contractual terms and take a large percentage of the sale price.
• Transparency – as discussed elsewhere, blockchains and NFTs are incredibly useful in terms of transparency meaning investors and individuals can see full transaction and ownership history. This means that individuals can feel more secure in their purchase / investment and have a full picture of its history. This should also assist in preventing fraud through for instance counterfeiting of goods.

Whilst each of the above are potential benefits to society of NFT usage, they are not a given. NFTs have the potential to be less accessible due to barriers to entry, notably around knowledge. If that is true, they may result in less revenue, and if that is the case then increased control and transparency might come at too much of a cost. Particularly, given as noted in the preceding section that they can still be attacked / manipulated by criminals.

So, at this stage, the benefits are yet to be realised / proven, yet the risks outlined in other sections are very much tangible. In that sense, it seems clear that regulation is needed, not just to negate these risks but also to help realise some of the benefits NFTs / the blockchain can afford.

Dr Matthew Robert Shillito (Lecturer in Law)

The School of Law and Social Justice, University of Liverpool