Does a Security NFT make sense?

In Belobaba, as the first crypto investment fund with a regulated security token, we understand how challenging is the process to make it real. But in the other hand, we know how important is to offer this STO to the investors, it really makes the difference!

These securities are fungible tokens, but can NFTs be securities? Not yet… Most people would not expect NFTs to be deemed a security. Leading securities enforcement agencies have yet to inspect NFTs as securities. But maybe it can change in the future due to the evolution of the NFT projects.

Examples like the TQ Olympo project to tokenize Team Queso, a leading eSports club in mobile gaming, through a security NFT was not possible due a lack of regulation. This innovative idea had to be replaced by an STO and an NFT as a vehicle to engage the community.

In 2020, NFT trading volume was a mere $21.7 million. In 2021, it exploded to $40 billion and the secondary market reached $15 billion.

Many NFT buyers are just interested in supporting their favorite indie artists or just claiming bragging rights for “owning” famous memes and gifs. But a significant portion of NFT investors see NFTs as the next gold rush of the digital age.

When investors start flipping assets for massive gains, it begs the question: Are these assets securities? Should they be regulated?

Introduction: STOs and NFTs

STOs stands for “security token offerings.” They involve an offering of digitalized securities such as stocks, bonds, or other token and coin projects. STOs offer ownership interests and will typically also involve voting rights or the rights of the investors to receive dividends. Further, the value of the “security” will generally rise and fall based on the value of the issuer. An STO is registered or exempted by a regulatory and supervisory body of the securities markets, like SEC in the US or GFSC in Gibraltar, and is compliant with securities laws.

Non-fungible tokens (“NFTs”) are pieces of a digital asset that are stored on the blockchain. NFTs are unique and non-fungible—meaning they cannot be exchanged for one another. Each NFT is one-of-a-kind. This scarcity creates value. The ownership of each piece is located on the blockchain, which represents a permanent and genuine record of ownership. When you buy an NFT on OpenSea, you’re not buying a .JPG or even the copyright to use a specific piece of art. You’re just buying a string of data on the blockchain that says: Toni owns “Everydays: The First 5000 Days” by Beeple. Just dreaming…

It might seem strange to compare STO with NFT, but share a surprising amount in common:

·        They both represent ownership

·        They’re both expected to experience capital appreciation (in some cases)

·        Both are perceived as good “investments” by certain players

So, Are NFTs Securities?

To determine whether a new coin or token is an “investment contract” or “security,” the SEC and courts use a test called the Howey Test. The Howey Test comes from a Supreme Court opinion from 1946: SEC v. W. J. Howey Company, 328 U.S. 293 (1946). The test has four prongs, each of which must be satisfied for the new coin or token to be considered, and therefore, regulated as a “security”. In short, the four prongs are as follows:

1.      An investment of money;

2.      In a common enterprise;

3.      With the expectation of profits;

4.      Derived solely from the efforts of third parties.

If one or more elements are not satisfied, the coin or token is not security. NFTs fail to meet condition number three and four of the Howey test.

The creators of NFTs generally don’t call their products “investments.” They mint them, tweet about them to generate buzz, and sell them as products.

After that point, some of their NFTs might rise in value due to limited supply and high demand. But as far as the creator is concerned, they’re simply selling products, not investments. There’s no written expectation between buyer and seller that the price of the NFT is going to soar.

That’s a critical distinction because outright labeling your digital asset “a good investment” is a surefire way to invite regulatory scrutiny and get classified as a security.

The Securities and Exchange Commission (“SEC”) has not yet issued any formal guidance on whether NFTs are securities, although some sources report that the SEC is beginning an investigation into the issue.[1] Based on the definition of “security,” most NFTs, as the public currently uses them, are unlikely to be considered securities

But Here’s Why That Could Change

As I covered in a previous article “The evolution of NFTS”, the NFT2.0 are forcing the projects to offer better benefits to the holders. There is no longer a place for a PFP project without added value to the investor. So, you could find some projects like the “Laid Back Llamas” offering different kinds of benefits to the NFT owners, like airdrops or royalties if the Llama is casted in LBL Tv series.

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But there are other NFT projects that are close to offering a security NFT as it is sold with the expectation that it would generate a token. Although the profit is a “utility token”, if it has a monetary value the NFT is close to passing the Howey Test. An example could be CyberKongz NFT, where the owners of the Genesis NFTs will receive daily the project “utility token” called $BANANA just for holding it in their wallet.  

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Another case is Mutant Cats, which rewards with $FISH tokens when the holders stake the NFTs.

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Takeaways

The most popular use of NFTs at the moment—exchanging digital currency for a digital asset—is unlikely to constitute a securities-related exchange. NFTs don’t pass the Howey test mainly because there is no expectation of profit or is not totally related to the performance of a company. However, there are some cases where NFTs are awfully close to acting like securities thanks to the new evolving plans of the NFTs projects and, of course, with the regulation.

In Belobaba we are continuously searching for innovative projects to invest and collaborate, to bring to our investors the chance to be part of this revolution. 

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