The upcoming EU Crypto Asset Regulation (MiCA)– are NFTs to be regulated like crypto?

Initial proposals by EU institutions seemed to make it clear that NFTs were to be excluded from the upcoming MiCA Regulation. However, recent statements by an EU official indicate that the exemption may not provide much relief for NFT stakeholders since they may need to pass through the eye of a needle to not be covered by the proposed regulation’s wide-reaching requirements.

Background

In the 2021 issue of Setterwalls’ FinTech Report we focused on the European Commission’s new legislative proposal on crypto-assets, the Markets in Crypto-Assets Regulation (“MiCA”) [1], which was adopted on 24 September 2020.[2] As mentioned in the report, the Commission’s intent is to provide for a competitive EU financial sector that gives consumers access to innovative financial products, while ensuring consumer protection. Furthermore, being the first regulatory framework at EU level for crypto-assets, the purpose is to bring further financial stability and clarity within the EU, while still allowing innovation and fostering the attractiveness of the crypto-asset sector.

The latest update on the legislative process is that the Council presidency and the European Parliament on June 30^th ,2022, reached a provisional agreement on the MiCA proposal, announced on a press release by the Council.[3] Although the official text of the MiCA will have to wait until the formal approval process is completed, the press release revealed, albeit general, some of the terms of the agreement. These have been extensively discussed among crypto enthusiasts since the declaration.

One of the terms that was revealed is the exclusion of non-fungible tokens (“NFTs”) from the scope of the MiCA. In contrast to regular cryptocurrencies, NFTs do not merely represent a business in the crypto-asset market, but also a type of art and legitimate ownership. However, recent announcements and analyses indicates that the assurance of the exclusion of NFTs may not tell the whole truth.

NFTs and MiCA – a mixed message

In the official press release it was stated that “Non-fungible tokens (NFTs), i. e. digital assets representing real objects like art, music and videos, will be excluded from the scope of the upcoming regulation, except if they fall under existing crypto-asset categories.”.[4] However, despite this unambiguous statement in the press release, statements by an EU official and adviser for technological innovation at the European Commission, Peter Kerstens, has brought doubt to the extent of the exclusion. At the Korea Blockchain Week in August, Mr Kerstens remarked that the EU regulators have “a very narrow view of what is an NFT”. This comment has led to numerous speculations among stakeholders on the crypto market regarding the potential regulation of NFTs. Hence, in lack of the official and final text of the MiCA, there is a great uncertainty whether and to what extent NFTs will be covered by the new rules on crypto and whether the carve-out of NFTs, as declared in the press release, only might provide a scant relief for NFT stakeholders from MiCA’s onerous rules[5].[6]

NFTs today and tomorrow

The Market

NFTs have turned extremely popular in the crypto universe over the last years. NFTs are blockchain-based unique digital assets that are versatile, and where transactions are recorded and transparent. These qualities have led to numerous possibilities for the use of NFTs. For instance, an NFT linked to a digital artwork can ensure the buyer that the purchase relates to an authorised copy of the artwork, or a company could sell an NFT and link it to a virtual representation of a physical object. The NFT will, somewhat simplified, act like a digital certificate of authenticity for said objects. This contrasts with many existing crypto-assets, including cryptocurrencies like Bitcoin, which are fungible or interchangeable. Although NFTs have been around since 2014, they are becoming an increasingly popular way to purchase and sell digital artwork. For example, since November 2017 the staggering amount of $174 million has been spent on NFTs.[7]

Current regulatory environment

NFTs are currently not explicitly regulated in the EU. A national financial supervisory authority would have to make an assessment in each individual case on how to categorize an NFT, based on the specific features of the relevant NFT, and then assess whether the NFT falls under any current financial market regime (rules to consider would for instance be e-money and payment services regimes, MiFID II[8]  and prospectuses rules).

NFT collections – especially in limbo?

Although the press release stated that NFTs will be excluded from the scope of the MiCA Regulation if they do not fall under existing crypto-asset categories, Mr Kerstens’ abovementioned remarks implies that only a few NFT-assets will in practice benefit from such exemption. Mr Kerstens explained his statement by adding that “If a token is issued as a collection or as a series – even though the issuer may call it an NFT and even though each individual token in that series may be unique – it’s not considered to be an NFT, so the requirements will apply.”[9]

The Council’s press release statement refers to “digital assets that represent real objects such as art, music and video”. Depending on the final definition of NFTs in the MiCA, NFTs which do not qualify as such could then be subject to the new regulation. According to Kersten, NFTs that have originated out of a collection, where each one of the NFTs are unique, may not be considered as an exempt NFT under the definition in MiCA and the provisions therein will apply. An example of such NFT collections are NFTs issued in multiple copies and representing rights to different types of performances,[10] such as the Bored Ape Yacht Club which is one of the most popular and valuable NFT collections in the world. This specific collection is made up of 10,000 unique non-fungible tokens on the Ethereum blockchain depicting ape avatars with various characteristics.[11]

This reveals the challenges (due to the versatile and complex structure of NFTs) as well as points to the importance, to define the concept of NFT as precise as possible. Hence, the breadth of the definition of an NFT in the MiCA will play an important role when determining the scope of the MiCA in relation to NFTs.

What if MiCA will apply to NFTs?

As mentioned above, if an NFT has the characteristics and therefor may be categorised as one of the existing crypto-assets defined in and covered by MiCA, e.g., a collection or series of NFTs, it may be subject to the MiCA and the issuer would have to comply with the requirements set out therein. This would mean that issuers of NFT collections might be considered as crypto-asset issuers and would have to publish a white paper setting out details of the protocol used by the NFTs and would be forbidden to make outlandish promises about future value that could mislead people into buying their products.

Since a white paper is a lengthy regulatory document broadly equivalent to the prospectus drafted for securities, it may be questioned if it is feasible for an NFT issuer to publish a white paper for the creation of every singular NFT. Furthermore, this may also mean that NFT-specialized marketplaces would have to seek regulatory authorization to be crypto assets service providers, which some mean could possibly stifle the innovation in the NFT industry [12].

Final remarks

To sum up

Whether a specific NFT will be subject to MiCA or not depends on whether the NFT may be covered by one of the already proposed crypto-asset categories. However, for NFTs which cannot be “re-classified” in such way, one will have to resort to the regulations already in force and applicable to solve possible legal loopholes. Thus, the decisive factor on which regulation that will apply to NFTs will in such cases be determined by the character of the NFT as such, although most NFTs will fall outside of the scope of current financial regulations.

The main reason for NFTs, at least as a starting point, being excluded from the scope of MiCA is probably due to the very nature of NFTs which differs from a “traditional” crypto currency like Bitcoin. NFTs are first and foremost a type of art and manifestation of legitimate ownership which have however turned into a major business itself. Yet, some claim that NFTs have become more similar to cryptocurrency. This since the NFT market has been as vulnerable to securities-style rate changes, money laundering, and other illicit purposes such as wash trading, as any other crypto-asset markets[13].[14]

Considering the purposes of the MiCA Regulation, to preserve financial stability while allowing innovation and fostering the attractiveness of the crypto-asset sector, it may be questioned why NFTs should not be covered by MiCA instead of the semi-solution which the proposal seem to be offering at the moment.

The next step of the legislative process

The provisional agreement accounted for above is subject to the approval of the Council and the European Parliament before going through the formal adoption procedure. As also stated in the press release from the Council, the European Commission will be tasked to, within 18 months, prepare a comprehensive assessment and, if deemed necessary, a specific, proportionate, and horizontal legislative proposal to create a specific regime for NFTs and address the emerging risks of such new market.[15]

It will indeed be interesting to learn what emerges from the final draft of the MiCA as well as the potential legislative proposal from the Commission on NFTs, in particular how NFTs will be defined. For the time being, MiCA’s applicability on NFTs will most likely remain a hot topic which will leave issuers of, and service providers in relation to, NFTs with significant uncertainty while imposing more pressure on the EU institutions on how NFTs should be regulated in the future.

[1] Proposal for a regulation of the European Parliament and of the Council on Markets in Crypto-Assets, and amending Directive (EU) 2019/1937

[2] Setterwalls’ FinTech Report 2021, The new EU Crypto-asset legislation (“MiCA”) – are the Wild West days of Crypto about to end? p. 12-17

[3] https://www.consilium.europa.eu/en/press/press-releases/2022/06/30/digital-finance-agreement-reached-on-european-crypto-assets-regulation-mica/

[4] https://www.consilium.europa.eu/en/press/press-releases/2022/06/30/digital-finance-agreement-reached-on-european-crypto-assets-regulation-mica/

[5] https://www.crypto-news-flash.com/nfts-will-have-similar-regulatory-rules-like-crypto-under-eus-mica-law/

[6] https://www.coindesk.com/policy/2022/08/10/nft-collections-will-be-regulated-like-cryptocurrencies-under-eus-mica-law-official-says/

[7] https://www.forbes.com/advisor/in/investing/cryptocurrency/what-is-an-nft-how-do-nfts-work/

[8] Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU

[9] https://www.coindesk.com/policy/2022/08/10/nft-collections-will-be-regulated-like-cryptocurrencies-under-eus-mica-law-official-says/

[10] https://en.cryptonomist.ch/2022/07/15/micaprovisional-agreement-reached/

[11] https://www.nftgators.com/nft-collections/

[12] https://www.coindesk.com/policy/2022/08/10/nft-collections-will-be-regulated-like-cryptocurrencies-under-eus-mica-law-official-says/

[13] https://www.moonstats.com/news/nfts-to-be-regulated-like-crypto-under-mica-law-eu-official/

[14] https://www.coindesk.com/learn/what-is-nft-wash-trading/

[15] https://www.consilium.europa.eu/en/press/press-releases/2022/06/30/digital-finance-agreement-reached-on-european-crypto-assets-regulation-mica/