Introduction
Issues and solutions
Comment
In the art world, a non-fungible token (NFT) has a place that is better defined than in the financial services sector. In the former, it can be described as a digital or computer-generated artistic expression with blockchain technology (or distributed ledger technology) as its backbone, enabling identification of ownership and its attribution to a particular person. From a banking and economic perspective, however, the role of NFTs is still developing, and there are open-ended questions. Specifically, the question is whether an NFT is genuinely an asset (and therefore can serve as collateral), or whether it is a modern-day regurgitation of the so-called "tulip-mania" occurrence of the 1600s, namely the phenomenon of a financial bubble in which the value of an asset appreciates exponentially due to perception rather than its intrinsic value.
There are some very interesting parallels between how NFTs operate and the tulip-mania occurrence:
- They both have ardent and visible backers and supporters that have captured the spotlight and led to an exponential increase in interest among the masses and therefore in their values.
- Neither has any perceptible tangible value that is apparent on the face of it.
- Both appear to be accompanied with a mass hysteria that has accelerated adoption (ie, purchases), and both have been accompanied with equally sudden depreciations in value.
- Neither can seem to shake off the presumption of speculation surrounding them.
Notably, financial sector experts will point to the lack of a widely accepted valuation mechanism for NFTs and possible regulatory moves to classify NFTs as "unregistered securities" as key factors hindering acceptability of NFTs as an asset class. Unlike other asset classes, the inability to restrict the transfer of an NFT also detracts from its acceptability as collateral for borrowings by way of conventional security forms, such as a pledge or lien. Even among niche financial sector participants that apprise and lend against the security of artworks, there do not appear to be any reports in the public domain on loans provided by traditional financial institutions against the security of NFTs.
However, there appear to be some online marketplaces and platforms that provide decentralised finance solutions through a peer-to-peer lending model where the creator or owner of an NFT may offer it as collateral to raise financing.
Financial sector participants are now increasingly subject to data privacy and protection regulations, which require them to put in place robust technological measures to prevent data breaches and leakage. Some of these data protection mechanisms can also dovetail into protecting or locking down digital assets, which would enable them to have features analogous to conventional assets classes – this would make it possible to provide NFTs as collateral for borrowings from traditional financial institutions as well.
The presence of regulations that recognise NFTs as an asset class (and not as a security or commodity to be traded on a stock exchange) would also be a good start to promote its acceptability as a financial asset. This would need to be accompanied with clarity from the perspective of valuation and taxation. Any regulation on NFT-based lending would need to consider risks around enforcement and invoking or sale of collateral in the case of any default.
Aside from their unfortunate common traits with the tulip-mania occurrence, and despite the criticism that they have garnered due to environmental concerns because of energy usage by the blockchain networks supporting NFTs, it does appear that NFTs provide a genuine technological solution for the financial market sector. It would be good to foster their development through appropriate regulation rather than dismiss them as a speculative device that must be kept away from financial market stakeholders.
For further information on this topic please contact Aditya Bhargava, Mithila Bhati or Sristi Yadav at Phoenix Legal by telephone (+91 22 4340 8500) or email ([emailprotected], [emailprotected] or [emailprotected]). The Phoenix Legal website can be accessed at www.phoenixlegal.in.
