Written evidence submitted by Outlier Ventures

DCMS Committee Inquiry - Non-fungible tokens (NFTs) and the blockchain

Summary

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

The UK’s light-touch regulatory framework for NFTs does not impose strict rules or regulations but NFTs are not unregulated. Sources such as the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 and Financial Services and Markets Act 2000 (“FSMA”) apply. A principles-based, market-making regulatory design logic is appropriate for capturing NFTs within the existing framework while addressing their unique characteristics and not stifling their use cases.

Further legislative and regulatory responses are needed in regards to NFTs in the UK. These include:

●        Clarification of the NFTs’ legal mode of existence through the valuable contributions of legal scholarship by the UK Jurisdiction Taskforce[1] and the Law Commission of England and Wales.[2]

●        Guidance on the issuance of NFTs from a regulatory standpoint.

●        Guidance on NFT taxation by the HMRC with regard to taxable entities (creator, purchaser/reseller, marketplace, etc.) and how tax shall be calculated. Many countries, including the UK, have no legislation or official guidance on NFT taxation. It is necessary for clear guidelines to be established in order to provide legal certainty in this area.

●        Clear regulatory guidance on the operations of centralised third parties (NFT marketplaces) dealing with NFTs towards users.

●        Classifying NFT-related businesses and establishing relevant guidelines to protect users.

●        Guidance on the classification of virtual goods and NFTs by the UK Intellectual Property Office.

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

NFTs can present certain vulnerabilities for individuals unfamiliar with the technology, particularly regarding unethical practices such as scams, fraud, or unintended relinquishment of control over underlying assets. The limited market size of NFTs also renders it susceptible to price manipulation. To mitigate risks, regulatory authorities must address the legal clarifications of the mode of existence of NFTs and undertake proactive measures to support the integrity of the market, including the implementation of sensible anti-fraud measures and providing guidance and education for consumers.

3. Do blockchains offer security to British investors?

NFTs and blockchain technology offer security to British consumers and investors through various features such as cryptography, decentralisation, and transparency. Cryptography ensures that transactions recorded on the blockchain are secure and tamper-proof. Decentralisation eliminates the risk of a central point of control being exploited by nefarious actors and improves the transparency of transactions. Smart contracts streamline the contract execution process and minimise human error. Overall, these features provide additional protection and integrity for transactions, trade, and ownership, making blockchain a desirable choice for consumers.

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

NFTs offer various benefits to individuals and society such as proof of ownership, authenticity, and transparency. NFTs enable individuals to establish clear ownership of digital assets, safeguarding them from exploitation by third parties and enabling fair compensation for their contributions. They can also authenticate assets, products and individuals, protect against counterfeiting or fraud and provide a level of transparency and economic security that traditional marketplaces can't provide. NFTs also allow individuals for greater control over their own data, reducing dependence on intermediaries and minimising the risk of misuse of personal data by large tech companies.

Full Response

1. Introduction

On November 4, 2022, the Digital, Culture, Media and Sport Committee launched an inquiry into Non-Fungible Tokens (“NFTs”) “and the wider blockchain” in an attempt to estimate the benefits that NFTs “and the blockchain” could contribute to the economy of the UK and “consider whether NFT investors, especially vulnerable speculators, are put at risk by the market”.

Outlier Ventures is the world’s largest Web3 Accelerator with over 185 investments in early-stage startups across a range of industry verticals developing the foundations of the next Internet paradigm. Founded in 2014 and based ever since in the United Kingdom, Outlier Ventures has a unique vantage point and carries a deep understanding of the fluctuating trends of blockchain- and AI-based technological applications that disrupt the way finance, technology and culture intersect. As such, it is our experience in the space that render us well-placed to provide insights into the consultation launched by the Digital, Culture, Media and Sport Committee.

Outlier Ventures has played a vital role in supporting the sustainable growth of the UK's NFT market as a leading global open metaverse accelerator and will continue to assume a leadership position in this market. The foundation of Outlier Ventures'  its operation is the Open Metaverse thesis[3], which refers to open-source technologies that create a common operating system for an open metaverse, acting as a mediator between hardware, application software, and users. Digital assets such as NFTs, with their open-source properties and on-chain transferability, are useful tools for entrepreneurs and architects and embody important Web3 principles such as user-centricity, decentralisation, and transparency. Many of the companies in Outlier Ventures' portfolio work with NFTs or provide necessary infrastructure for NFT use, influencing the growth, profitability, and usability of the UK NFT market. With UK-based start-ups representing over 30% of successful applicants to our Accelerator Programmes, our vantage point is locked into the evolution of the UK market. Due to the current regulations and uncertainty surrounding digital assets in the UK, many Web3 business founders choose to relocate their businesses to jurisdictions that are more favourable towards digital assets. This decision is not only made by UK-based founders, but also by international founders who originally considered the UK due to its stability and reputation, but changed their minds upon learning about the challenges surrounding digital assets in the country.

Having conducted a series of discussions with members of the Outlier Ventures network, including NFT entrepreneurs, policy analysts and market experts, Outlier Ventures is pleased to submit its response to this consultation.

We have included a summary of our response to the consultation at the beginning of our submission. Additionally, we have expanded upon the summarised answers in a more detailed manner in the following sections. We have chosen to respond to the questions posed by the Committee in the following way: Section 2 (“Overview of the regulation of NFTs in the UK”) addresses the question pertaining to any additional regulatory measures that may be necessary for the UK in the future, addressing the first question of the consultation. Section 3, 4, 5, 6 and 7 address the remaining three questions concerning the potential benefits and harms of the NFT market.

2. Overview of the regulation of NFTs in the UK

This section will address Question 1: Is the UK’s light-touch NFT regulation sufficient?

In the UK, the regulatory framework for NFTs is considered light-touch, meaning that it does not elect the imposition of a strict set of rules or regulations on NFTs and their use. However, NFTs are not unregulated; sources of regulation which are most relevant to the issuance and distribution of NFTs do exist and are being developed on a regular basis, in an attempt to keep up with the ever-evolving nature of financial markets and their respective regulatory presuppositions.[4]

There are two main sources of national financial regulation that apply to NFTs: 1) The  Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (“MLRs”); and 2) The Financial Services and Markets Act 2000 (“FSMA”), along with the following implementing acts: i) The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”); and ii) The Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (“FPO”).

Under the MLRs and the regulatory guidance so far provided by the Financial Conduct Authority (FCA), NFTs meet the definition of an asset which is “cryptographically secured” as NFTs entail “... a form of distributed ledger technology” capable of being “transferred, stored or traded electronically”. In addition, NFT issuers and distributors, and generally NFT market participants, are likely to be within scope of the MLRs if they provide exchange and/or custodial services to customers with regard to NFTs.

Under the RAO, NFTs with features similar to security tokens will be deemed specified investments and thus businesses carrying out deals involving NFTs will be acting as principals in need of an FCA authorisation.

In a speech given on April 4,2022, John Glen MP, the Economic Secretary at the time, announced that the government would consider regulating a wider range of digital asset-related activities. The then Economic Secretary emphasised the importance of the legal landscape in this effort stating that English law and the UK’S legal system would assist in “making the UK an attractive hub for all things digital and for new technologies more generally”.[5]

To serve as a foundation for DLT and digital assets, a legal system must offer clarity and certainty.

It is our view that law needs to underpin all trade and financial transactions, providing market participants and governments with certainty about the conduct of business in a safe and sound environment. The dominance of English law as the foundational layer for a plethora of businesses and transactions is indisputable.[6]

The legislative origins of the UK financial services regulation law can be traced back to the birth of free markets in Britain. Under the pressure of the social, financial and technological advancements of the time, statutes, grounded in the tradition of Merchant Law, created the belief “that commerce is a domain of private transactions”, a sociopolitical ethos that has inspired relevant legislative responses and is reflected in the design logic of the UK’s regulatory architecture.[7]

If we consider the inherently global nature of digital assets, and particularly NFTs, the traditional regulator’s dilemma of balancing domestic financial stability with the international, globalised competitiveness of the national economy is rendered obsolete in light of the transformational dynamics of the digital economy and its underlying assets and technology. NFTs have the potential to commoditise and assetise, in a broad sense, all aspects of social and financial life in ways that were previously unimaginable. It is necessary for regulatory frameworks to be adaptable and address the unique characteristics of NFTs without stifling their ever-expanding use cases.

Thus a principles-based, market-making regulatory design logic is appropriate to grosso modo capture NFTs within the existing framework. The analytical leverage of this explanation becomes evident when considering the migration velocity of digital asset and blockchain projects across multiple jurisdictions in search of the most favourable regime for conducting business. Company founders and innovators tend to reject rigid and inflexible regulatory techniques and abide by the most accommodative and hospitable legal environments, while those techniques create jurisdictions susceptible to regulatory arbitrage, the opposite of the intended effect. This is a common problem in jurisdictions with rules-based approaches, where short-sighted rulemaking amputates competitiveness and innovation and fuels regulatory arbitrage. In a field where exponential innovation is the norm, rules should be able to adapt to the  technology.

If the UK seeks to promote innovation and foster growth, then the question of competitiveness versus stability should be reversed: Can the UK achieve stability without being competitive?                                         

3. The evolving landscape of NFTs in the UK

Section 3, 4, 5, 6 and 7 will address the following questions:

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

Question 3: Do blockchains offer security to British investors?

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

It is anticipated that the non-fungible token (NFT) market will experience robust growth in the forthcoming years[8], with the UK market specifically predicted to exhibit a compound annual growth rate of 34.5% from 2023 to 2028[9]. This projection is made in spite of the current downturn in activity, prices, and volume in the NFT market due to an adverse macroeconomic climate. Despite the challenging market conditions, there has been a diversification of NFT use cases and categories, as demonstrated by sales activity and venture capital funding[10], with the scope of NFTs extending beyond collectibles and art to include a range of applications such as sports, music, content, gaming, utility, fashion, and luxury. Notably, gaming, utility (e.g. access passes or subscriptions) and community-oriented NFT projects have received significant investment, and it is expected that this trend will continue as younger demographics and pioneering startups enter the market[11].

4. Distinguishing between NFTs and speculative practices

Non-fungible tokens (NFTs) garnered significant popularity in 2021, with at least $44.2 billion worth of cryptocurrency being spent on NFT marketplaces and collections, a significant increase from the previous year's $106 million[12]. While the heightened attention to NFTs may have contributed to an influx of speculators entering the space, it is important to note that NFTs, as a technology, do not inherently promote speculation. They should not be viewed as financial instruments that users invest in with a pure speculative intention of higher monetary returns, but rather as utility-based assets, products, or services that offer some form of benefit in exchange for user participation. While speculation does exist within this realm, it is often driven by the complex and innovative features of the technology, which can obscure consumer behaviour and encourage retail users to trade due to the ease and reduced friction the technology provides. The unfamiliar opportunities of digital assets to new users, such as "whitelists" that guarantee the ability to purchase a product over other consumers, can lead to excitement, such as the phenomenon of "flipping," which involves the rapid buying and selling for marginal profit. This can result in price volatility and, in the absence of regulation and education, can contribute to speculative tendencies that may ultimately be used for fraudulent and exploitative purposes. However, these practices should not obscure the fact that NFTs are more comprehensible in regards to their proprietary and consumptive features as well as the trade of goods rather than their purely speculative nature. The latter is supported by the outlined diversification of NFT use cases in point 2.

4.1.            The security of NFTs: the role of Trustlessness, Transparency, and Immutability

NFTs built on decentralised ledger technology, provide a secure and transparent method of recording transactions that can be beneficial for users to safely consume in the digital realm. The following features are essential for NFT technology:

4.1.1.            Cryptography

Cryptography, the practice of secure communication using mathematical algorithms to encode and decode messages, underlies the security offered to consumers through the use of blockchain technology. In the context of NFTs, cryptography is utilised to secure transactions recorded on the blockchain, making it difficult for any alterations or tampering to occur. This is achieved through the linking of each data block to the previous block, rendering retroactive modifications impossible. While the individual transactions are cryptographically protected, the open-source nature of blockchain technology allows for traceability and transaction monitoring tools that facilitate the investigation, trace, and retrieval of NFT-related crime proceeds in a manner that is much easier compared to traditional markets[13].

4.1.2.            Decentralisation

The decentralised nature of NFTs allows for the absence of a central governing entity and instead relies on a network of computers to validate and record transactions and ownership. This decentralisation renders NFTs resistant to manipulation due to the absence of a single point of control that could potentially be exploited by nefarious actors, as any attempt to alter the data stored on the blockchain would require the consensus of the network. In addition, the transparency of all transactions being recorded and publicly available on the blockchain enables users to have visibility into the status of their assets at any given time, potentially increasing consumer confidence and mitigating the risk of fraud or misrepresentation.

4.1.3.            Smart Contracts

Self-executing code known as smart contracts can streamline the contract execution process and minimise the risk of human error or fraud. Smart contracts are characterised by the incorporation of the terms of the agreement between the buyer and seller directly into lines of code. Additionally, the logic of the issued non-fungible token (NFT) and its inherent representation are embedded within the smart contract itself. Smart contracts provide an automated and transparent means of enforcing the terms of a contract, which can help to reduce the risk of disputes and ensure the smooth execution of the contract.

In summary, British consumers and investors stand to benefit from the various security features offered by blockchain technology, such as cryptography, decentralisation, and transparency. These attributes, in conjunction with the possibility of utilising applications like smart contracts and asset tracking, make blockchain a desirable choice for users to consume digitally. Overall, the use of blockchain technology and cryptography in NFTs enhances the security and transparency of transactions, providing added protection for consumers.

5. The positive impact of NFTs on individuals and society

Non-fungible tokens (NFTs) are unique digital assets that are stored on a blockchain and cannot be exchanged one-for-one with other assets. They provide significant utility through their ability to abstract and commodities the value of various types of assets, including intellectual property, user activity, relationships, cultural artefacts, real-world goods, and general consumer products within the digital sphere. NFTs offer a secure and transparent method of recording and transferring ownership of these assets, making them well-suited for a wide range of applications.

Users can capitalise on the opportunities presented by blockchain and NFTs to derive benefits[14]:

5.1.            Proof of Ownership

The immutability and transparency of NFTs on a blockchain enable individuals to establish clear ownership of a particular asset, service, or knowledge in the digital realm, which was not previously possible without relying on centralised platforms. The clear and transparent record of ownership also offers protection against unauthorised use of any asset, safeguarding users from exploitation by third parties[15]. Ordinary users often do not receive compensation for their digital activity, while third-party platforms profit from user activity and data. Additionally, it is easy for malicious users to copy and disseminate images, data, or knowledge without permission. NFTs provide a means to validate specific user activity and reward the corresponding output, data, and internet-based activities based on ownership. This can help to ensure that users are fairly compensated for their contributions and that their intellectual property is protected.

5.2.            Authenticity

NFTs, due to their unique and immutable nature, offer the ability to authenticate assets, products, and individuals, which can be beneficial for consumers who rely on provenance to assess value. Moreover, NFTs can serve as identifiers for individuals on the internet, acting as a representation of their identity on the blockchain that cannot be falsified. The use of NFTs allows for more confident consumption by enabling the verification of entities, items, and services. This can be particularly useful in industries where the authenticity of goods is of critical importance, such as the art and collectibles market. In these cases, NFTs can provide a verifiable and immutable record of ownership, provenance, and authenticity, which can enhance the value of the asset and protect against counterfeiting or fraud.

5.3.            Transparency

By offering a clear and transparent record of all transactions and interactions related to a specific asset, NFTs can provide a level of transparency and economic security that traditional, centralised marketplaces cannot. This can aid in the reduction of fraud and other forms of manipulation, leading to increased trust in the market and higher participation. Additionally, the transparency of NFTs allows consumers to easily track and understand the history of their assets or purchases, breaking down silos of centralised control in traditional marketplaces. Overall, the use of NFTs can provide legal certainty and security for consumers, enabling them to confidently transact and consume in the digital realm.

In conclusion, NFTs offer the potential to safeguard individuals from the abuse and exploitation of data by large tech companies and platforms by providing a means for individuals to control their own data and minimise the reliance on intermediaries. The Cambridge Analytica scandal[16] serves as an example of the potential for personal data collected by third-party platforms to be misused for nefarious purposes. NFTs and blockchain technology offer a means to mitigate such risks by providing a secure and transparent means of recording and transferring data ownership.

6. The Risks of an unsupervised market

The potential for non-fungible tokens (NFTs) to revolutionise digital ownership may leave individuals unfamiliar with the technology vulnerable to unethical practices. Since 2017, over $8 million in illicit funds have been laundered through NFT-based platforms, representing 0.02% of known trading activity. An additional $328.6 million (0.81%), potentially reflecting a proportion from illicit activity, originates from obfuscation services such as crypto mixers. Between July 2021 and July 2022, over $100 million worth of NFTs were also reported as stolen through scams. NFT-based services are also facing a growing threat from sanctioned entities and state-sponsored exploits, as demonstrated by the $540 million heist of the popular crypto game Axie Infinity by North Korea's Lazarus Group[17]. While crime represents a small proportion of overall NFT trading, it significantly impacts the industry's reputation and legitimate user experiences. To mitigate these reputational risks and issues, both NFT infrastructure providers, such as marketplaces, and supervisors must be proactive. It is important to note that the potential harm does not come from NFTs themselves, but rather from the unbridled application of blockchain technology in an unregulated environment.

7. Potential harms can generally be attributed to the following factors:

1. Limited market size: The limited size of the NFT market makes it vulnerable to price manipulation through practices such as wash trading, which involves the simulated buying and selling of an asset in order to artificially inflate its price or volume. These factors may create opportunities for fraudulent activities that can have consequences for unsuspecting buyers and can undermine trust in the market. In order to address these risks, it is important that regulators and market participants take steps to support the integrity and transparency of the NFT market by establishing adequate market structures.
2. Fraud: The risk of scams and fraud is present in the NFT market, as it is in any market. This risk may be particularly pronounced for individuals who are not familiar with the technology or who may be swayed by promises of high returns for low investments or who may be misled by perceived experts in the field. In order to protect against these risks, it is important for market participants to undertake enhanced due diligence and for regulatory authorities to implement rational anti-fraud measures, including sensible reporting requirements.
3. Loss of control: In certain cases, NFTs may represent ownership or control of tangible assets, such as art or real estate. It is essential that individuals fully understand the terms and conditions associated with these NFTs, as failure to do so may result in the unintended relinquishment of control over the underlying assets. It is advisable for authorities to provide guidance to ensure a thorough understanding of the implications of purchasing and holding NFTs.
4. Lack of understanding: The innovation of NFTs and associated risks may not be fully understood by many individuals, leading to uninformed purchase decisions that could result in financial losses and other harm. To protect consumers, it is important for regulators to provide guidance and education on the nature and potential risks of NFTs, and for individuals to fully educate themselves before making any purchasing decisions.

We would be happy to elaborate on any of our responses and ask that you contact:

Dino Kandiloros, Legal Associate

Leo Sprueth, NFT Market Analyst

Martin F. Saps, Content Strategy Manager

Outlier Ventures

10