The surge in the NFT market is characterized by the rise of unique digital assets distinct from fungible tokens, which are interchangeable. Examples like CryptoPunks and CryptoKitties have showcased the potential of NFTs, with certain virtual items fetching substantial sums. NFTs provide a means to establish ownership and authenticity for digital art, transforming it into valuable collectibles. This trend has led to significant sales within the NFT market, indicating a growing interest in owning and showcasing digital assets. The appeal lies in proving ownership to an unlimited audience, a feature unique to digital collectibles (Trevisi, 2022).
The foundation of NFTs can be traced back to Ethereum, a distributed ledger that is both public and permissionless. Ethereum laid the groundwork for tokenization, which allows investors to transact a range of ownership and access rights, licenses, and royalty claims through a distributed ledger, providing an alternative to traditional paper-based exchanges. Tokenized ownership can encompass both tangible and digital possessions, enabling investors to exchange claims linked to physical assets such as real estate, fine art, collectibles, and limited-edition items, as well as exclusively digital artworks (Barbereau, 2022).
Transferring a token involves updating the distributed ledger’s transaction history. NFTs represent unique value, ideal for claims related to rare items and bespoke creations. Unlike fungible tokens, NFTs have distinct metadata, making each token unique. Their value remains stable as they are linked to different assets. Tokenized claims gained traction in 2017 with CryptoKitties, causing Ethereum network congestion. In 2020, there was a surge in fractional ownership demand for luxury assets, notably in art, facilitated by platforms like Masterworks and Acquicent, offering liquidity alternatives (Kazakina 2020;Garbers-von Boehm, 2022).
Further, recent case-law on NFTs use, their legal nature and, particularly their collateralization, showcases the need for a more nuanced approach in MiCAR to ensure legal certainty and investor protection in light of the increasing financialization of NFTs.1 NFT ownership’s legal definition and rights depend on the specific contractual framework. However, debates persist over applying conventional civil law principles to NFT ownership, especially in jurisdictions with Roman law traditions, where ownership traditionally pertains to physical objects.2
Considering the legitimacy of offering security interests in NFTs, it is crucial to acknowledge that the effectiveness of such interests depends on the legal framework provided by applicable law. Legal certainty is a foundational requirement for the widespread adoption of Distributed Ledger Technology (DLT) systems in financial transactions, as any ambiguity could erode trust in the system, impacting its overall value,3 especially considering that due to any potential ambiguity of legal consequences, e.g. when the court does not recognize any rights of the NFT holder in the underlying asset, investors may incur unforeseen losses (Takanashi , 2020).
To tackle these concerns, UNIDROIT and the European Law Institute (ELI) propose that for a secured creditor to acquire a security interest in digital assets, control must be granted,4 namely the ability to (a) exclude others, (b) to obtain all the benefit from the digital asset, and (c) to transfer these abilities to another person.5 However, concerns include jurisdictional differences in treating digital assets and their underlying real-world assets, and issues of good faith acquisition, especially with NFTs linked to undelivered physical assets.6
When determining the applicable law to security interests over NFTs, private international law considerations become pivotal since an element of internationality is nearly always inherent in these transactions. Principle 3(4) of ELI’s Principles on the Use of Digital Assets as Security offers some guidance, by providing that: “If the digital asset to be used as security represents a real-world asset, tangible or intangible, the question of whether and under which conditions a security interest created in the digital asset would also result in the creation of a security interest in the underlying real-world asset is to be determined by reference to the ordinary conflict of laws rules governing the proprietary aspects with respect to that real-world asset.” Such an approach which upholds the lex rei sitae rule, namely the law of the country where the asset is located, arguably strikes a balance between legal certainty and the facilitation of utilizing assets created by new technologies. This principle, however, appears to be effective only when the ledger operates within the same jurisdiction as the asset’s physical location, while the creditor is situated elsewhere. However, in practice, the ledger functions in a jurisdiction distinct from the one where the asset represented by the digital token is situated. In such circumstances, it becomes necessary to contemplate an applicable law governing that digital token, which is distinct from the one governing the proprietary aspects of the underlying asset. Considering that distinguishing which national law should apply to NFTs can be challenging, as a first step, it may be necessary to establish a specialized rule of private international law, under which, the applicable law for NFTs, would be determined by the jurisdiction where the person or company providing the DLT services is domiciled (lex societatis). This aligns with the UK High Court decision in Ion Science Ltd v Persons Unknown and others. Nevertheless, it should be noted that lex societatis may be helpful only in cases of permissioned blockchains which are under the control of a private operator, which is easy to locate. Conversely, decentralized blockchains which span several jurisdictions and lack any central authority or validation point, are difficult to be spotted on a specific location.
Taking it a step further, Guynn has provided valuable insights into the shortcomings of private international law concerning securities ownership, which can, by analogy, be instructive for the present issue: the applicable law for creating security interests over NFTs tied to real-world assets. Specifically, the application of lex rei sitae, for bearer securities, and lex societatis, for registered securities, may not consistently produce desired outcomes especially in instances where physical securities are moved from one location to another, e.g. sub-custodians, or if an investor or secured creditor holds rights over certain assets through a single intermediary, and these assets are spread across multiple locations, the lex situs rule requires that the transfers or pledges of these securities could potentially be subject to the laws of multiple jurisdictions (PAech, 2016; Guynn, 1996). Such inconsistent results may also be produced in the context of NFTs trading as well, where an asset exists in two forms: as a digital asset on the blockchain (NFT) and as a tangible asset off the platform, such as a piece of art, real estate, or a diamond. Similarly, for example if the underlying physical asset is moved to a sub-custodian located in another jurisdiction legal certainty is undermined, since market participants are unable to determine the applicable substantive law in advance.
An additional issue which should be taken into consideration is that mismatches between these two realms may arise, especially considering that NFTs represent underlying assets which have distinct legal existence and can be transferred independently, potentially leading to inconsistencies between the digital and non-digital realms, as also shown above. In the author’s view, NFTs should be examined from two different perspectives: with regards to acquisitions and dispositions within the DLT network, the law of the network applies, which can be determined by the parties’ choice of law or by referencing the location of a central service provider. In a similar vein, the Financial Markets Law Committee (FMLC) suggests that the legal implications of transactions within a DLT setup should align with the legal system chosen by network participants—a concept known as the ‘elective situs’. This model allows DLT system participants the contractual autonomy to specify the legal framework overseeing asset ownership, transfer, and usage.7 In contrast, the law governing the right stemming from the NFT and its connection to the underlying physical asset is determined by the law applicable to the off-chain asset, which most probably is the lex sitae of the underlying asset. In order for legal certainty to be enhanced and disparities to be avoided, the parties could stipulate that the law governing the underlying asset shall serve as the governing law for the entire network, considering that a court is rather unlikely to apply any law other than the lex sitae of the underlying asset.8
Regarding the stage of insolvency, where enforceability of the security interest is ultimately assessed, conflicts may arise if the applicable insolvency law differs from the law of the blockchain network. As a result, the financing transaction may be susceptible to a claw-back, i.e. avoided under the insolvency law of the forum. Therefore, substantive laws should address whether, and under what conditions avoidance should be a feature of digital assets network frameworks, offering a well-defined solution to ensure certainty when providing security interests over NFTs. Until such a solution is reached, since it is common for the law of the place of the security provider to also govern insolvency proceedings, it could be advantageous in the interest of legal certainty, for the contracting parties to align the law of the security agreement with the relevant insolvency law.9
Custodians play a vital role in facilitating the safekeeping of high-value physical assets, which clients may use as collateral or secure interests over. In NFT-backed financing arrangements, custodians function similarly to traditional securities accounts. However, breaches by custodians can lead to third-party acquisitions, posing a significant risk to the original owner’s assets, especially in jurisdictions that recognize the acquisition of assets in good faith by third parties.
Moreover, considering the high volatility of fungible crypto-assets that may be involved in an NFT-backed financing arrangement, in conjunction with the comparatively low volatility of blue-chip artworks and luxury assets, there is a possibility of overcollateralization if the value of the lent crypto-asset decreases. However, this risk is less likely to materialize when fiat currency is borrowed. NFT-backed loans face overcollateralization risks due to volatile crypto-assets, as evidenced by the BendDAO DeFi lending protocol’s near-collapse (Chan, 2023). Illiquidity of NFTs in bear markets necessitates heavy over-collateralization, but this may still pose a risk of inadequate security.
In light of the points discussed above, it is imperative to reevaluate the approach towards NFTs as delineated in MiCAR, commencing with a reexamination of recital 10, which currently provides that “[t]his Regulation should not apply to crypto-assets that are unique and not fungible with other crypto-assets, including digital art and collectibles. [....] Such features limit the extent to which those crypto-assets can have a financial use, [...]”. Firstly, the distinction between crypto-assets encompassed by MiCAR and those deemed ‘unique’ and ‘non-fungible with other crypto-assets’ lacks clarity.10 Further, collateralization through financing agreements demonstrates that the financialization of NFTs is slowly coming to the fore. The array of legal issues arising from such financial use underscores several risks, spanning from potential unenforceability to custodian risk. This emphasizes the necessity of exploring whether NFT regulation would afford a degree of legal certainty to all parties involved. In addition, a sound regulatory approach to NFTs could prompt investors, especially those securing NFT-backed loans, to be aware of associated risks like illiquidity, volatility, unclear pricing, hacking, and fraud.11 This awareness could be facilitated through mandatory disclosures, such as NFT white papers, enabling them to make informed decisions regarding credit provision backed by NFTs, and to be prepared for potential losses.
Platforms and app providers may evolve into financial intermediaries, especially those facilitating secondary trading of fractionalized tokens, resembling asset listing with financial value. Private platforms providing terms of rights for NFT owners and fractionalized shareholders mimic collective investment functions. Fractional.art exemplifies a self-regulatory market with extensive disclaimers emphasizing buyer/investor responsibility. The fractional parts of NFTs are, in principle, under Recital 11 of MiCAR, considered fungible. However, their regulatory treatment remains unclear, given that they are only briefly mentioned in the said recital. Further clarification is needed on the fungibility of fractional NFT parts and the concept of ‘collection’. It is important to determine whether fractional ownership tokens for artwork are fungible and subject to MiCAR, especially if combining all parts reconstructs the original NFT. Fractionalization may result in identical attributes for each fraction, lacking uniqueness.12
Outside the reach of MiCAR, NFTs are likely to fall under other EU financial services regulations, such as if they are deemed to constitute a unit in a collective investment scheme (Chiu, 2022). Irrespective of that, their collateralization should be a factor that the Commission of the EU, the European Banking Authority (EBA) and the European Securities Markets Authority (ESMA) take into consideration when preparing the report on the development of markets in unique and non-fungible crypto-assets, in accordance with Article 142 of MiCAR. Specifically, it could be determined if utilizing NFTs in this manner aligns with the definition of ‘financial use’ according to MiCAR. Collateralizing NFTs can potentially blur the line between digital collectibles and financial assets capable of securing credit, whose value is rooted in the rights they confer. Furthermore, queries need to be resolved, regarding whether NFTs should be categorized as financial instruments, and the criteria for considering them fungible or unique.13 While it is stipulated that national competent authorities employ a substance over form approach in such assessments, the absence of a unified rule may result in varying interpretations14 leading to inconsistent legal treatment and regulatory arbitrage, where market participants structure their legal arrangements in a way that benefits their interests.
By the end of 2024, the EU Commission, along with ESMA and EBA, should assess the implications of granting security interests on NFTs to shape informed regulation. Their evaluation should particularly focus on the associated risks, including custodian and overcollateralization risks. This effort aims to shape regulation that ensures investors are well-informed and protected against potential risks and losses. Such an approach will not only address the issue of applicable law in cross-jurisdictional DLT transactions, which are commonplace, but also help rectify any inconsistencies in among EU countries. n
