Striking a Balance between Innovation and Investor Protection
Regulators are scrambling to understand emerging technologies and financial instruments like NFTs (Non-Fungible Tokens), Blockchain, and Cryptocurrencies. The current climate is understandable, to say the least, what with the unforeseen collapse of the popular crypto exchange platform FTX and the complete devaluation of coin LUNA.
Furthermore, the NFT market has crunched a whopping 97% from its all-time high. Effectively, that means that investors in the sphere almost certainly lost money. Coupled with the persistent allegations of endemic money laundering in the NFT Arts space, regulators are even more adamant about curbing the market in these areas. These are technologies that have seen a recent surge in popularity, aided by the fact that they are relatively simple to invest in.
This is a magic formula for regulators to step in. New technologies opened up new, volatile markets where the average retail investor is highly exposed, and where larger-scale institutional investments are contingent on a more robust regulatory framework.
This article explores the value of regulatory environments as well as their drawbacks while advocating for the proper philosophy of NFT Regulation – Regulate the underlying Digital Assets, not the NFTs themselves as a technology.
The Value of Regulation and Governance
Regulators have a lot to gain from this environment granted they follow the right course of action. The upsides include increased tax revenues from capital gains on institutional money and more effective checks against money laundering, both being characteristics of a digital economy.
In the current globalized environment, individual risk management philosophies induce the general flow of global capital to the jurisdictional markets where it is the most protected against risk. Capital prefers the jurisdiction where it is regulated to the point of protection, but not to the point of posing an efficiency impediment to business interests. The United Kingdom is a great example of this, as it has become the jurisdiction of choice for Continental European firms to reincorporate in search of business-friendly regulatory and governance policies.1
Effectively, this frames local regulatory policies within the framework of an international market, governed by the usual rules and principles of markets. The very act of regulation then becomes a transaction – assurety and risk management for investors, who in return invest their capital in that jurisdiction.
In light of this, regulators should craft their regulatory policies to drive innovation, foster capital, and promote growth in their local jurisdictions. Therein lies the value of regulation, whereas overregulating (or plain wrong regulation) becomes its greatest drawback.
Foolish Lethargy: The Problem with Regulation
Regulators tend to overregulate. This actually drives away capital and punishes development. This results in growth and innovation being slowed to a halt if not downright reversed.
Even worse, and more relevant to the subject of NFTs, is the practice of regulating against technologies. Not only is this frivolous but it is also driven by ignorance. Regulation will always stifle technological innovation because it provides unnecessary sanctionable constraints on pioneers.
Furthermore, the rate of regulation is much slower than the rate of innovation. For starters, regulation derives its value from its permanence and stability. Moreso, it exacts a huge toll on political resources where because of how convoluted the regulatory process is compared to the innovative process.
Regulation is meant to provide stability against future risk – the problem is that regulators can’t predict the future of tech so that they can properly address future risks. Regulators simply don’t share the same subject matter expertise as the world’s foremost innovators, nor are they aligned on a common vision for the future. The iPhone was only released in 2007, and blockchain was only implemented in 2008/2009. These are everyday technologies that didn’t exist twenty years ago.
How are regulators supposed to regulate the technologies themselves? The value of regulation is derived from its stability as a function of time, while the value of innovation is derived from its dynamism as a function of time. They work on inverse fundamental value-functions.
Furthermore, technologies tend to be sector and industry-agnostic, meaning they can be used across different sectors and technologies. Regulatory ignorance compounds when they take one of a technology’s many use cases as a benchmark whereas the same technology could be used in different, unforeseen cases.
Unfortunately, ignorance is the nature of the risk posed by frivolous regulation. Regulators are by definition more cautious and less visionary than their pioneering counterparts. Regulators, by virtue (or vice) of not completely understanding the technologies and their use cases, may impose restrictive regulations that stifle innovation rather than promote healthy growth.
NFTs Revolutionize Legal Concepts on Digital and Intellectual Property
Non-Fungible Tokens (NFTs) are uniquely remarkable legal instruments with great potential to revolutionize the very concept of ownership.
NFTs inhabit the blockchain and are governed by smart contracts that self-execute on the underlying [digital] asset. By these virtues, NFTs provide non-interruptible and self-authenticated liquidity of information on the transactable assets in the market. Trading the token means trading the underlying asset. Furthermore, the possession and ownership of the token necessarily occurs in a fashion that is exclusive, public, open, peaceful, and continuous, and their ownership of the asset is further exercisable through the embedded digital instruments. Possession becomes proof of ownership.
NFTs enable the ownership of unique digital assets (and legal rights) in the same way that you would own a unique traditional asset. Furthermore, the governing self-executing smart contract could allow for complex commercial agreements to be repeated with every transaction. Current use cases include a sales royalty for the creators of the underlying asset.
The true ingenuity of NFTs, however, is not in the market for digital assets. Rather it lies in the hybrid market where the digital asset can act as a title deed for a traditional asset.
NFT Regulation Won’t Work – Regulate the Assets Instead
Perception – one word that summarizes all the problems facing the NFT market today.
The truth is, NFTs have become commonly associated with digital art. While that is an interesting (if not gimmicky) use case, NFTs have much more depth. The people currently using NFTs are enthusiasts and the adoption curve is still at the very beginning.
True, deep implementation of the NFT technology has barely scratched the surface. Tokenizing the underlying asset remains the key to full NFT utilization. That means exploring different traditional asset classes to digitally tokenize for trade on the blockchain.
Real Estate, for instance, is a theoretically perfect asset class for trade on the blockchain by representing the title deed as an NFT. This establishes a transparent and fraud-proof real estate market where all securities, rights, and obligations related to real estate are transparently stored on the blockchain and specifically on the NFT itself, with the different transactions one could enact on real estate being represented in the governing smart contract.
This effectively means that we can envision a world where you can buy or sell a house, mortgage it, pay your property tax, and lease it with next to full automation. No need for notaries or public registrars – let the blockchain handle and verify the data, and let the smart contract exercise government oversight over the property.
Of course, there are two requirements for this to happen. First, the government must be the one minting the NFTs, preferably on its own CBDC chain. Second, the government needs to regulate the underlying asset. Not because NFTs should be regulated as a technology, but because real estate is a regulated asset class and it should maintain that property upon tokenization. Tokenization should not change the regulatory properties of the underlying asset.
Regulating NFTs as a technology doesn’t make any sense at all. How can you introduce a single global regulation for the online sale of all asset classes? Because that’s what buying an NFT really is. You’re buying something online, just like you would buy an iPhone from Apple or a book from Amazon. The sale of an NFT is simply the sale of the token representing the underlying asset governed by the smart contract.
Why should the sale of NFT art be regulated when the sale of traditional art isn’t? Different asset classes need different regulatory policies within the NFT space.
Regulators’ Burden: Wise Policymaking
Regulators can live up to their responsibility towards their constituents through wise policy-making. That means the humility to admit their own shortcomings, the pragmatism to compete in the globalized regulatory market, and the foresight to craft regulation that brings value through innovation, not protectionism.
NFTs are promising technologies that are looking to disrupt industries like music, publishing, real estate, and high-value collectibles. Regulators should make use of the technology and be the first to tokenize, not the first to regulate.
Antoine R. Kanaan
Editor in Chief of the Lebanon Law Review.
CEO of HAQQ.