Article written by Dave Loxton (Partner) and Elani Vogel (Candidate Attorney), checked and released by Dave Loxton
29 September 2021
If you have seen the headline of Twitter CEO, Jack Dorsey, who auctioned his first ever tweet as a nonfungible token (“NFT”) for a dazzling $2.9 million in March this year, then you may be wondering what the hype is behind this seemingly perplexing technology. Reuters reported in July 2021 that the market for NFTs had surged to new highs in the second quarter, with $2.5 billion in sales so far this year, up from just $13.7 million in the first half of 2020. In this article, we provide a brief overview of what an NFT is, how it is bought and sold and how fraudsters are attempting to exploit vulnerabilities in the NFT landscape.
- What is an NFT?
An NFT is a unique, one-of-a-kind digital asset that represents real-world objects like art, music and videos, which acts like a digital certificate of authenticity.
NFTs exist as a string of numbers and letters stored on a blockchain ledger in the form of smart contracts (blockchain protocols that directly control the transfer of digital currencies or assets between parties under certain terms and conditions) and are bought and sold online, frequently with cryptocurrency (“crypto”). This information is encrypted (ensuring authenticity and scarcity) and can contain:
i. who owns the digital asset;
ii. who sold it;
iii. when it was sold; and
iv. customised terms, for example, that automatic royalties shall accrue to the creator upon each resale of the asset.
To understand how NFTs work, one needs to understand the concept of fungibility (the ability of an asset to be exchanged for another asset). NFTs are different from crypto in that it is nonfungible (unique tokens which hold data instead of value (akin to a unique signature), and which cannot be exchanged for one another), whereas crypto is fungible (an asset capable of being traded or exchanged for one another and being equal in value – for example, my R10 note is equal in value to your R10 note). The value of a fungible is not linked to its uniqueness, whereas each NFT token is unique.
- Buying and selling NFTs
Any object can become an NFT, as long as it has been “minted” (put on the blockchain as a token). Similar to the way that metal coins are minted and added into circulation, NFTs are also tokens that get “minted” once they are created. Whether you are, for example, an artist who wants to sell your art as an NFT or an investor/purchaser, you would need to acquire a digital wallet. Depending on the accepted payment methods of a specific NFT store (explained below) you will likely need to purchase some crypto via a crypto exchange.
There are several NFT marketplaces with varying levels of due diligence requirements. NFTs are generally sold in an auction style in these marketplaces.
- NFTs and fraud
NFTs are premised on the understanding that the people minting it are who they say they are i.e. that a seller really owns what he/she is trying to sell as an NFT.
One can draw a parallel between NFTs and crypto – the lack of a regulatory framework makes it vulnerable to fraud.
Organizations facilitating crypto transactions are currently operating in a regulatory void. In 2018, the Crypto Assets Regulatory Working Group (CARWG) was formed to review the South African government’s position on crypto assets and in April 2020 they published a position paper to present the South African policy position on crypto assets. This position paper presents 30 regulatory recommendations, one of them being that certain services rendered in respect of crypto assets must be included in the definition of ‘financial services’ under the Financial Sector Regulation Act 9 of 2017, and must also be included in the licensing activities under the Conduct of Financial Institutions Bill, 2018.
Accordingly, there are crypto regulations in the pipeline, however, none has been promulgated. Similarly, NFTs remain unregulated, and hence vulnerable to exploitation for the wrong means.
We will likely see a spike in NFT fraud as its popularity (in an unregulated environment) grows. The following are examples of how fraudsters are already taking their piece of the NFT pie:
i. replica stores, which copy or impersonate the designs and domain names of existing, legitimate NFT stores/marketplaces;
ii. fake NFT stores, which sell NFTs that do not exist; and
iii. counterfeit NFTs or artist impersonation.
In future, we can expect cases of money laundering through NFTs. Kirby Plessas (US Open Source Intelligence Expert) explains in the Association of Fraud Examiners’ (ACFE) Fraud Talk podcast that, for example, a semi-famous artist may be captivated by the idea of her name appearing in news reports (knowing that same will result in a spike in the price of her art). Fraudsters may approach her and promise that they can make her name appear in a headline if she mints her art as an NFT and sell it as such. In return, the fraudsters may demand a cut of the selling price of her NFT. They would then get their buyer to purchase the artist’s NFT at an exorbitant price. In this way, fraudsters can easily launder money through their purchase of the NFT.
At present, the main problem with NFTs seems to be verification of a seller and lack of proper due diligence measures by NFT marketplaces. The implementation of Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) controls by NFT marketplaces, together with consumers’ awareness of red flags when selling or purchasing NFTs, can mitigate the risk of NFT fraud to a great extent.
Schindlers Attorneys has numerous legal specialists should you require any assistance with NFT fraud investigation. Should you require any such assistance, please do not hesitate to contact us.
[Please note our articles are meant for information purposes and do not constitute legal advice.]
In this article, we provide a brief overview of what an NFT is, how it is bought and sold and how fraudsters are attempting to exploit vulnerabilities in the NFT landscape.