When Blockchain Meets Regulation: A Tale of NFTs, SEC and Unseen Chains

A vintage courtroom scene infused with a modern touch: a gavel, a written regulation document, and a non-fungible token, all illuminated by golden ambient light. Add a hint of dark shadows to reflect the unseen chains of regulation, blending the old-world charm with an edgy techno aura.

In what seems to be a first for the U.S. Securities and Exchange Commission (SEC), a non-fungible token (NFT) has been classified as a security. This incident highlights the inherent complications when innovators attempt to transition from an unregulated frontier to a regulated sphere, possibly unaware of potential pitfalls.Preston Byrne, an advisor for software and fintech companies, contends that these missteps are remarkably easier to make given the potency of the cryptocurrency technology.

What amplifies this is the nature of cryptocurrencies, especially smart contract variety such as Ethereum, that permits capturing detailed flows of actions and events—a phenomenon recognized as a state machine with money. This setup could simulate virtually any process performed by a financial technology stack, thus eliminating the need for a human authenticator. This leads to understated assumptions regarding the role of “legal”, which penetrates all layers of the transactions.

Herein lies the irony: while crypto projects are birthed free, they are bound by invisible chains. So, while the act of hashing a proof-of-work genesis block may not be a regulated activity anywhere globally, what happens next, such as creating incentives to attract new users, could bear regulatory significance. This was recently evident in the case of Tornado Cash.

The crypto community expressed widespread dissent against supposed attempts to censor code and subdue open-source developers. Despite the presumption of innocence, post-instantiation development might be something developers of Tornado Cash could reluctantly look back on.

Another emerging pattern in the face of regulatory crackdowns is the recharacterization of specific crypto-asset securities as NFTs. L.A.-based entertainment company, Impact Theory, bore the brunt of the SEC recently for its issuance of “NFTs”. The offering’s appeal was based on promises of high return values – a fact not lost on users of the project’s Discord who compared investments to early stakes in giant conglomerates like Disney.

The SEC’s Howey Test, which distinguishes transactions and offerings based on their substance rather than labels, serves a reminder here. It posits that if a non-fungible token is sold with the same expectations and manners as a fungible token, it can expect to share the same regulatory scrutiny.

The broader caveat is that this could be a common regulatory pitfall for nascent or otherwise legitimate projects, adding incremental functionality to appease users. Despite the allure of “state machines with money” like blockchains, developers must remember that the unstoppable law pays no heed to the blockchain. Operating the machine as a going concern requires understanding that various regulatory regimes apply to different layers, a necessity to navigate the legal space aptly. Just as a utility token could draw regulatory attention, so could a non-fungible token, even if its data structure indeed makes it non-fungible. Exercise discretion is the message for the wise.

Source: Coindesk

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