NFTs and 'Insider Trading': How to Stay in Compliance

Source: AdobeStock / Chad McDermott

 

Snežana Gebauer is Partner and Chris Walsh is Manager at global advisory firm StoneTurn.
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Without a doubt, 2021 was the year when the crypto market made its greatest strides, reaching an estimated USD 3 trillion. It was also the year when non-fungible tokens (NFTs) gained massive popularity.  After Mike "Beeple" Winkelmann sold an NFT at Christie's Auction for USD 69 million, artists, investors, brands, celebrities and many others helped spike interest in NFTs. NFT sales reached USD 17.7 billion in 2021, and they are considered disruptors of many industries.

The latest crypto meltdown also impacted NFT sales, and the prices of popular NFTs have plummeted over recent weeks. Some argue that NFTs will endure this crypto crash because they are a unique digital asset class.  

What makes NFTs different than other digital assets? They are tokens that rely on the blockchain, and whose underlying assets can be digital or physical. The blockchain guarantees their provenance, transfer, and record-keeping of ownership. In addition to digital artwork, which is what made NFTs mainstream, NFTs can be used to own music, video clips, gifts, tweets and more. 

NFTs can also function like membership cards or tickets, providing access to events, exclusive merchandise and special discounts, as well as serving as digital keys to online spaces where holders can engage with each other. NFT holders can leverage value over and above simple ownership, and creators have a vector to build a highly engaged community around their brands. As asset class in their own right, NFTs are likely to have a significant impact on the world of art, photography, music and other creative fields.

Given the enormous profit potential coming from trading these assets, NFTs have received the attention of regulators, opening a debate about whether NFTs are securities and whether financial regulations designed for tradable financial assets should apply to NFTs. 

And so regulatory enforcement begins.

On June 1st, 2022, prosecutors in New York’s Southern District charged and arrested Nathaniel Chastain, a former product manager at the online marketplace OpenSea. OpenSea claims to be the world's first and largest Web3 marketplace for NFTs and crypto collectibles.

According to the indictment, Chastain was tasked with selecting NFTs to be featured on OpenSea’s homepage. OpenSea kept those homepage selections confidential until they went live, since a main page listing often translated to a jump in price for both the featured NFT, as well as NFTs made by the same creator. Chastain would secretly buy an NFT just before OpenSea featured the piece on the front page of its website. Once those NFTs hit the main page, he would allegedly sell them “at profits of two- to five-times his initial purchase price.” Chastain now faces one count of wire fraud and one count of money laundering, in connection with a scheme to commit insider trading in NFTs. 

Does this case indicate that NFTs should be treated as securities? Or is insider trading an illegal practice that should be prosecuted regardless of the asset? These recent charges seem to suggest that it no longer matters whether insider trading occurs on the stock market or the blockchain.

If NFTs are treated as securities, how will securities laws impact NFTs? Whether a particular NFT is deemed to be a security or not will depend heavily on the purpose it was created for and how it is marketed to buyers. If an NFT is marketed and sold as a static asset, such as a photograph with a certificate of authenticity, it’s less likely to be deemed a security. However, if the NFT is sold with the assumption or intention of returning profit, then it could very well be categorized as a security. 

While this debate about the treatment of NFTs as securities evolves, it is important for creators of NFTs to operate under the assumption that securities laws apply to them. 

Exchange platforms that host NFTs for sale and distribution should proceed with caution: if they are facilitating the trade of NFTs that are deemed to be a security, then the NFT exchange platform could be deemed to be operating an unregistered securities exchange, a conduct that would be sanctioned by the Securities and Exchange Commission (SEC).

To mitigate risks, companies that issue NFTs or facilitate the trading of NFTs should implement NFT trading policies, or proactively assess their existing policies and practices in a similar manner that public companies mitigate insider trading risks. The NFT trading policies should remind employees that non-public information about the launch or promotion of an NFT is confidential information and has to be treated as such. 

Companies could consider prohibiting some or all employees from purchasing NFTs, at least for a period after the initial launch. They also could consider extending the prohibition to family members and relevant third parties. In addition to implementing a policy, companies must regularly train and communicate with employees to ensure active awareness and compliance.

To stay ahead of looming regulation and regulatory activity, NFT creators, investors or trading platforms should take a conservative position and look to public companies for best practices. While it can feel daunting to get started, implementing cohesive policies are a critical step to take in order to mitigate risks relating to insider trading.

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Learn more: 
- Regulatory Scrutiny Increasing as Crypto Becomes Financial Stability Risk – Report
Top NFT Collections Rise in Price After Latest US Fed Hike

- Ex-OpenSea Head Arrested for NFT Insider Trading
- NFT Insider Trading On OpenSea Highlights Benefits of Decentralization

- 'NFTs May Be New, but This Criminal Scheme Isn't': Ex-OpenSea Head Arrested for NFT Insider Trading
- The Right Side of Crypto Regulation: Institutions Need to Avoid Thucydides’ Trap

- Crypto Exchanges Hotbit and Bitfinex Face Regulatory Headwinds
- Former Coinbase Manager Pleads Not Guilty To Wire Fraud Charges