Written evidence submitted by UK Finance

 

Overview of inquiry

The inquiry opened on 3 November 2022.

 

DCMS is inviting written evidence on the following questions:

 

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

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

3)  Do blockchains offer security to British investors?

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

 

 

Introduction

UK Finance is the collective voice for the banking and finance industry. Representing more than 300 firms across the industry, we act to enhance competitiveness, support customers and facilitate innovation.

 

Executive summary

 

 

 

Points of clarification on the scope of this consultation

A non-fungible token (NFT) is a basic building block of computer code that creates a unique digital representation of a digital or physical asset and is recorded on a blockchain. NFTs are a broad class of digital asset (that is, there are different types of NFT) and can represent a variety of underlying assets, from virtual playing cards and art/digital art, to tokenised loans – all of which will likely require different treatment and would have different implications for regulatory purposes.

NFT’s can:

 

An NFT that provides rights to real estate and an NFT that provides rights to digital artwork are inherently different. The NFT wrapper aspect might be similar, providing evidence of ownership, but the underlying assets may or may not be within the perimeter of regulation. In particular, some members believe that an NFT that evidences rights to a financial asset ought be treated differently compared to an NFT evidencing rights to a non-financial asset. We strongly recommend the application of the same activity, same risk, same regulation principle to avoid regulatory arbitrage to the extent possible and to protect consumers.

 

It is not immediately clear whether the focus of this inquiry relates to the digital ‘wrapper’ (the NFT) that represents the rights to something, the asset or service that the digital “wrapper” is referencing, or both. This is an important distinction; many members believe that regulation (and more specifically financial regulation such as that covering financial promotions) should be aligned to the underlying asset/service rather than the NFT “wrapper” (that is to say, in line with the current regulatory regime).

 

Similarly, some members were unclear as to whether the consultation is focused on blockchain[1] as a type of Distributed Ledger Technology (DLT), or whether the intention had been to consider DLT more generally. Therefore, comments in this response on blockchain will, unless stated otherwise, also apply to DLT more generally.

 

Finally, whilst the inquiry appears to focus on NFT speculation and harm, it should be noted that NFTs are not automatically speculative in nature. While some NFTs have been bought for speculation purposes, it is important to acknowledge that NFTs can be used for a large number of use cases that may not even involve trading in an organised market (electronic inventories, unique identification, access to services, etc.). This is in line with our earlier point that regulation of NFTs (where it is required) shouldn’t be homogenous but should reflect what the NFT provides rights to.

 

Other developments

 

We are conscious that there are other notable pieces of work underway at present that intersect with this area which DCMS will be mindful of. For example, the new legal statement on digital securities expected from the UKJT and the Law Commission consultation on Digital Assets. While the DCMS consultation is specific to NFTs, we also hope that contemporaneous outputs from elsewhere can be factored into the final outputs.

 

At this stage, we would also like to flag some work we have been doing in this area with our members and the law firm CMS. We are producing a report on NFTs, covering: (1) a general taxonomy and description of the market, (2) NFT use cases, opportunities and risks, and, (3) the legal and regulatory principles for tokens. We are currently working on updated drafts, with a scheduled publication date of Jan/Feb 2023. We would be very pleased to discuss these reports with you further.

 

 

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

 

As noted above, NFTs can cover a wide spectrum of use cases which should be taken into consideration when evaluating the regulation of these products/markets. The breadth and complexity, coupled with the desire to not impose burdensome regulation on markets currently outside of the regulatory perimeter such as art sold at auction houses, has led EU regulators to consider NFTs regulation outside of MICA. It would be sensible to strike the right balance and only impose new regulation where it is needed, for example to account for any new risks created by the tech and the way of transacting when using DLT (i.e. immutability of transactions which may conclude in a very short period of time). We strongly suggest leveraging what exists such as conduct and customer protection rules, such as those requiring a fair description of products and disclosure of rights conferred, fair promotion and marketing, application of existing practices related to safe custody/safeguarding of assets, etc.

 

Many UK Finance members believe that a better approach to categorising NFTs would be one underpinned by the principles of "same activity, same risk, same regulatory outcome". For example, as previously stated, the categorisation of NFTs might be better determined by looking at the intent, rights and attributes of the NFT, as well as its potential to emulate the risks and characteristics of a financial instrument.

 

Members believe that it may not be appropriate for all types of NFTs or indeed digital tokens to fall within the regulatory perimeter. Any proposed future UK regulation would therefore need to clearly specify the criteria by which the perimeter was defined. A proportionate approach, with a degree of flexibility to take into account potential risk factors (such as the potential for the NFT to become systemically significant) is seen to be a sensible approach.

 

Members have some different views on the exact approach that might be taken to regulating NFTs at this point. Some members feel that targeted, streamlined rules could be helpful in ensuring transparency, market integrity and safe custody of NFTs. For example, two members were of the view that a model centred around consumer protections might be a sensible approach, ensuring there is an immutable record of the rights conferred on the token-holder by the relevant NFT, that those rights are clearly and truthfully disclosed to any potential buyers so they know exactly what they have ownership of (i.e. do they actually own the IP or not?) and that token-holders know whether those rights are transferrable or not. In addition, where NFTs are traded in a multilateral, organised setting, some basic rules around customer protection such as those related to the trading and third-party custody of those instruments could be beneficial.

 


Other members cautioned against the introduction of a regulatory regime for NFTs too soon. As it is not yet clear what the most appropriate policy or regulatory response would be to NFTs, regulating too soon could have the effect of stifling growth and innovation.

 

These are not the only approaches, and many members agreed that consumer protections remain an important facet. We reiterate our overarching view that we should look through to the underlying asset to determine the need for regulation. To the extent there were non-financial risks that needed to be addressed (IP, tax, AML and property rights), some members feel that these could be addressed by extending existing legislation. For example, NFTs that provide rights to digital artwork fall outside the existing AML regime for dealers in high-value works of art, which is limited to physical paintings, sculptures, etc (see the relevant definition of ‘work of art’ at Value Added Tax Act 1994 as amended, Section 21 Clause 6).

 

As NFTs are simply the digital representation of ownership of a digital or physical asset, then from a policy perspective it makes sense that UK consumers should benefit from the protections they otherwise would have if they were to buy or sell the equivalent real-world asset. In that respect, members pointed to consumer protections in existing legislation which may capture the sale and purchase of some NFTs, such as implied terms into B2C sale contracts and cooling off rights. However, the adequacy of those consumer protections when applied to NFTs (both in terms of extent and coverage) is still far from certain, and a careful, independent, analysis of existing consumer protections would need to be undertaken to understand whether further amendments to legislation might be needed, including the adequacy of existing financial services legislation.

 

Finally, members noted that a prescriptive rules-based approach to consumer protections might not be appropriate due to the unique and varied nature of NFTs. A more outcomes- and conduct- focused set of guidance to govern the way NFTs are sold and traded might be more appropriate at this stage.

 

In terms of opportunities for further regulation, our understanding is that NFTs (or most NFTs) will likely fall under the definition of a ‘cryptoasset’ as defined in amendments to the Financial Services and Markets Bill proposed in October 2022 (albeit, it is acknowledged that such amendments are still subject to further negotiation in the legislative process and HM Treasury would also need to take steps to make changes to the Financial Promotions Order). This proposed amendment defines a cryptoasset as “any cryptographically secured digital representation of value or contractual rights that: (a) can be transferred, stored or traded electronically, and (b) that uses technology supporting the recording or storage of data (which may include distributed ledger technology)”. All NFTs will be a “cryptographically secured digital representation and meet requirements of (b). Most NFTs will be a “representation of value or contractual rights”. By way of example, a tokenised share would represent the share and the contractual rights associated with that share. Most NFTs should meet the requirements of (a), including identity (or soulbound) NFTs, as they will be capable of being stored electronically (and may also be capable of being transferred). Though most NFTs may fall in to the cryptoasset definition depending on the finalised text of the legislation, we again make the point that the different underlying assets will likely warrant different treatment strategies.

We can and should learn from the experiences in other jurisdictions. The potential difficulties of categorising tokens that fall outside or inside the regulatory perimeter and the impact of this categorisation on NFTs can be seen in the EU’s approach. The regulators in the UK have the benefit of being able to analyse the approach taken by the EU in MiCA; taking the opportunity to pursue a new or different approach. We would recommend that the approach is nuanced, taking into account the broad family of digital assets but does not deviate from existing and well tested standards and practices.


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

 

a)   Collections often offer ‘presales’ or ‘white-list for early buyers, which often involves joining forums where prospective buyers are subject to high-pressure sales tactics.

b)   Advertisements offering significant returns on investments, where these returns cannot be guaranteed.

c)   Schemes offering ‘passive incomes’ but are based on the influx of funds from new participants akin to Ponzi schemes.

d)   Fake ‘sales volume’ tickers have been observed which start at a set number (circa 2 thirds of artifacts), and then a rapid count to the maximum limit of artifacts available applying an undue sense of urgency to the purchase as the items will sell out.

e)   Advertising is increasingly using fake/celebrity/influencer endorsements, one influencer categorically denied involvement.

f)     Redaction/Editing of previous promotion material to lower the benefits indicated before the sale.

g)   Prizes are offered akin to lotteries, and charitable donations are referenced which remain unverified.

h)   Some collections infringe on Copyright/Trademarks

i)     Another consideration is that there is not always transparent pricing, including for transaction costs of purchasing, such as ‘gas’ fees (eg Ethereum NFTs).

j)     NFTs may potentially be copied or replicated and it may be difficult in today’s market for consumers to to evidence proof of ownership.

 

j) There is a knowledge gap with many consumers who may not understand what they are buying exactly or the correct process for transferring ownership of their NFT after buying/selling it.

 

3)  Do blockchains offer security to British investors?

 

Members were not clear on what specifically was being asked in this question. In generic terms, blockchains are not more or less secure than other technologies, it is a question of how they are being used and the standards they follow regarding resilience, cybersecurity and governance.

 

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

 


 

 

 

 

Finally, UK Finance made a submission to TSC on cryptoassets in 2022. We have included here some of our high level points as they may be pertinent.

a)      Many of the current proposed rule changes are being undertaken in a patchwork way, with industry often being pulled in different and competing directions by regulators. One future example relates to the proposed additional powers of the Bank of England in the cryptoasset space for systemic providers, and how this will sit alongside/overlap with the role of the FCA;

b)      without clear transparency on roles, responsibilities and priorities, this landscape could become more confusing;

c)      there are concerns regarding the technical skills and level of knowledge of regulators in this space given the emerging complexity and need for differing approaches to regulation;

d)      any standards and regulatory decisions should take into consideration the role of different participants in the digital currency ecosystem and how their risks may vary to that of a typical bank;

e)      regarding the wider cryptoassets space, regulation should strike the right balance in relation to the DLT technology that underpins cryptoassets generally; and

f)        due to the lack of regulation of NFTs as a speculative investment, it can be unclear to consumers what is a genuine opportunity.

 

 

 

If you have any questions relating to this response, please contact Rhiannon Butterfield (Principal, Payments and Innovation)


[1] The Blockchain is a type of Distributed Ledger Technology (DLT) where transaction records are kept in the ledger as a chain of blocks, like a long list of records. As each block is linked and cryptographically secure, earlier blocks in the chain are unchangeable.