NFTs: Is the World of Finance About to go Virtual? (Pt. 2)

It’s no longer a question of “if” NFTs will drive far reaching changes through the world of finance, but more a question of exactly “when” and “how.” In part one of this series, we took a comprehensive look at NFTs, exploring what they are and their potential role in the world of finance. In part two, we’ll look at some of the risks and issues that need to be considered when evaluating the use of NFTs in wealth management and other personalized investment experiences. 

Has the NFT Bubble Already Burst?

By their very nature, non-fungible tokens represent underlying assets that are unique and whose value is highly subjective, as they are not driven by supply and demand as strongly as other more traditional commodities might be.

In addition, it is difficult to account for how many NFTs exist since anyone can create one at any given moment and offer it for sale on a marketplace. Over time, certain categories of NFTs will be defined and secondary markets will emerge (i.e., plots of land in metaverses). This makes valuation difficult and, although there have been some spectacular prices paid for individual items, the market remains volatile, with some already suggesting that the NFT bubble has burst. A key question is whether this was indeed short-term exuberance or if activity will pick up again this year to the same fervor experienced previously.

In addition to the underlying risk of NFTs in general, potential investors will need to purchase and value their NFT holdings in cryptocurrencies which are also highly volatile, as recent history has shown. Therefore, a potential investor has a two-factor risk, based on highly speculative and volatile assets.

This also raises another question regarding what will happen to the NFT records if a marketplace collapses and prevents NFT owners from retrieving their proof of ownership. Although the interoperability of blockchains is being considered, the risk remains and may not be fully appreciated. Clearly there is work to be done in clarifying the legal and regulatory guardrails around ownership to protect investors.

Security & Copyright Infringement: “Right Clicking” of Web-Linked Sites

As discussed in the last installment of this series, creating an NFT based on a digital asset is relatively straightforward using a wallet. Once the NFT is created and the transactions are on the blockchain, the assumption is that proof of ownership and right of usage are guaranteed and hacking/stealing is difficult, if not impossible. 

Although proof of ownership is guaranteed once the NFT linked to the asset is on the blockchain, it is unclear how this is validated on creation. By themselves, digital assets are easy to copy and claim as your own, which has led to an increasing number of copyright claims. This practice has been dubbed “right-clicking” as the practice involves right clicking to save the image without paying for the NFT.

In theory, tokens could be duplicated or faked if they are created on a different blockchain to the chain used by the original marketplace. Similarly, an NFT/digital token could be created for a copy of a digital asset and then sold. Proving this could be a lengthy legal process that would require authenticity provided by the platforms involved and backed up with clear legal grounds.

Financial Crime – AML

It is plausible that NFT marketplaces could potentially provide trade-based money laundering possibilities. The anonymity afforded to buyers and sellers is attractive to criminal types together with the highly speculative and subjective nature of the digital assets.

That said, the structure of NFTs allows parties to transfer digital art without incurring potential financial, regulatory, or investigative costs often related to the physical shipment of the art.

Complicating matters, NFTs are pseudonymously held, which may make them particularly vulnerable to illicit use. However, NFTs are stored on a blockchain with a unique crypto wallet address. Some crypto wallets may reveal the identity of the owner, while others only reveal a string of characters known as a “public key.”

Despite this potential, according to Chainalysis — a cyber security specialist — there is no evidence that this is already happening on a large scale. One explanation could be that the transaction volumes and values are not significant enough even though the markets have grown significantly over the last two years.

For compliance officers, NFTs pose a whole raft of novel anti-money laundering ramifications and regulations. There are many questions regarding what types of regulations should or could apply to marketplaces, private sellers or auction houses.

The current environment of confusion poses high risks for compliance professionals. The absence of sufficient guidance means that NFTs as an asset class must be regarded as an area ripe for abuse.

Environmental Concerns Regarding Blockchain Energy Usage

With global pressures on reducing the carbon emissions, blockchains and cryptocurrencies (as well as NFTs) have come under scrutiny. The mining of cryptocurrencies as well as sustaining the blockchain infrastructure is consuming a huge amount of energy. In some cases, the process uses more energy per year than some countries (for example, Bitcoin mining activity uses 91 TWh each year, which is more energy than is consumed by all of Finland). The industry is addressing this in two ways:

• One uses sustainable energy sources to generate the required amount of energy.
• The other countermeasure is for the newer blockchains to use “proof of stake” as their method of authorization versus “proof of work.” In cases where “proof of stake” is used, it is no longer required for each member to authorize the transaction (by running the complex mathematical algorithms) and therefore significantly reduces the energy consumption per transaction to just 0.1% of the original amount otherwise required in some cases.  

Of course, the sustainability concerns of the underlying technology’s energy consumption must be weighed against the economic benefits, particularly for countries that lack access to traditional centralized finance infrastructure.

Conclusion

NFTs represent a significant use case for blockchain technology and have solved some copyright and ownership problems for the digital artworld. At the same time, NFTs have spawned new markets and innovations.

Looking ahead, tokenizing non-fungible physical assets such as commercial buildings and then offering tokens representing an ownership “share” in the asset is analogous to securitization. The issue of how a physical asset is tied to a token and how that mechanism is secured is one that needs to be tackled. However, since tokens are also divisible, investors can buy small percentages of the underlying assets. This opens the opportunity to a wider market of investors and would thus increase liquidity.

The ability of even retail investors to own small percentages of, say, a building could usher in a new way to approach wealth management and promote personalization and customization of investments along ethical and environmental lines. Tokenization could even unlock trillions of dollars currently held in illiquid assets. This token-based economy and decentralized financial system will require all market participants to rethink how they transact, store, tax and regulate in a tokenized world.

One of the most far-reaching implications of the technology underlying tokens, both fungible and non-fungible, is the prospect for decentralized finance (DeFi), which rekindles and pursues the independent democratic principles espoused by the early pioneers of the internet.

The use of cryptocurrencies and smart contracts to provide financial services allows transactions to be done on a peer-to-peer basis and eliminates the need for intermediaries. Such services could include lending (where users can lend out their cryptocurrency and earn interest in minutes), receiving a loan instantly, making peer-to-peer trades without a broker, saving cryptocurrency and earning a better interest rate than provided by a traditional bank, and buying derivatives such as stock options and futures contracts.