Non-fungible tokens (NFTs) are unique digital assets that utilize blockchain technology to record ownership and evidence authenticity of a unique good or asset. Using NFTs to record ownership and authenticity enables the owner of such a good or asset to transfer ownership to a buyer, while maintaining a record of the transfer on the blockchain. Unlike fungible tokens such as Bitcoin, NFTs are unique and therefore cannot be traded for another identical token. Currently, the most common NFTs authenticate digital art, collectibles such as digital trading cards, and content (primarily video clips), which appear visually in gif, jpeg, or other common media formats.

An NFT is not a content file: it does not contain digital art or a video clip, which itself has intrinsic value. Rather, the NFT is a unique cryptographic key contained within a digital token that verifies the corresponding content file as genuine and establishes a record of ownership as it is transferred on a blockchain, which allows it to be transferred without risk of fraud. For example, a deed to property could be embodied and stored on a blockchain as an NFT, which could then be transferred from the seller of the property to a buyer as a means of recording the sale transaction and resulting new ownership.

Generally, with respect to NFTs that authenticate digital art and collectibles, NFT marketplaces provide a platform for artists and content creators to sell their work through the sale of an NFT directly to individual purchasers who are users of the NFT marketplace. These marketplaces operate on a blockchain, such as the Ethereum blockchain, on which many NFTs are programmed. Commonly, an artist or content creator shares the revenue from the sale with the NFT marketplace on which it is sold.

NFT marketplace users fund an on-marketplace wallet with cryptocurrency (for example, ETH) from an off-marketplace digital asset wallet. (Note that some NFT marketplaces provide users the ability to buy and sell NFTs in fiat currency as well.) From their on-marketplace wallet, users can exchange funds for NFTs. Once a user buys an NFT on an NFT marketplace, they can transfer their NFT from their on-marketplace wallet to an off-marketplace digital asset wallet, which allows the user to interact with other blockchain applications, including other NFT marketplaces, and to send NFTs and cryptocurrency peer-to-peer across the blockchain.

Many NFT marketplaces facilitate a secondary market for the buying and selling of NFTs once the NFT is initially released and purchased. An NFT may be sold by its initial purchaser to another buyer in the NFT marketplace on which the NFT was first purchased (from the NFT seller’s on-marketplace wallet to a buyer’s on-marketplace wallet), or directly to a buyer across the blockchain, once the user moves the NFT off the NFT marketplace (from the seller’s off-marketplace digital asset wallet to a buyer’s off-marketplace digital asset wallet).

The buying and selling of NFTs is rapidly entering the mainstream without the safeguards that accompany regulated financial instruments. This is because NFTs do not fit squarely within the parameters of traditional financial instruments. Rather, NFTs implicate a range of existing regulatory and legal frameworks. Depending on facts and circumstances, an NFT marketplace could be subject to anti-money laundering/Bank Secrecy Act (AML/BSA) obligations and securities laws obligations. NFT marketplaces, creators, and market participants also need to consider how intellectual property, tax, and data privacy laws may apply to their businesses. One regulatory regime that has received little attention to date in the NFT space is consumer protection. Because NFTs are often sold to retail buyers, NFT marketplaces and market participants should be aware that consumer protection regulations may apply to such sales.

The regulators chiefly responsible for consumer protection, including the Consumer Financial Protection Bureau (CFPB), the Federal Trade Commission (FTC), and state regulators, have barely begun to examine NFTs. As a result, NFTs could be a hotbed of misinformation and false advertising. Most importantly, mainstream buyers of NFTs often have little understanding of what they are purchasing and resellers may represent inaccurately (or fail to understand how to represent accurately) what they are selling. In addition, buyers purchasing through an NFT marketplace are subject to limitations of liability and buyer beware provisions located in each marketplace’s terms of use or community standards. NFT marketplaces use these terms of use to disclaim liability for potential counterfeits, fraud, or user malfeasance occurring in its marketplace.

Federal regulators led by the FTC, under 15 U.S.C. § 45, have the power to utilize laws governing unfair or deceptive acts or practices (UDAP) against misinformation flowing through the NFT advertising, sales, and reselling process. Certain elements undergird FTC deception cases:

FTC allegations in its September 25, 2019 lawsuit against Match.com illustrate the FTC's use of UDAP to protect a reasonable consumer from user misrepresentations occurring on an online platform. In that case, the FTC alleged, among other claims, that Match.com generated certain user-triggered email advertising based on activity created from known fraudulent accounts. Those emails led the consumer to subscribe to the Match.com service only to find that the fraudulent user initiating the activity was already deleted from Match.com. Consumers were left with a paid subscription as a result of a misleading and false advertisement that was alleged to be both permitted and generated by Match.com.

Although Match.com did not involve NFTs, the FTC’s use of UDAP to punish the marketplace for underlying user malfeasance could be applied to NFT marketplaces. For example, a "reasonable" NFT consumer may be misled by the omission of material information (for example, relating to the ownership of intellectual property) or deceiving (or fluctuating) valuation received during a marketplace user’s NFT marketing and sales process.

This would not be the FTC's first foray into commercial activity relating to digital assets. In 2018, the FTC halted operations of Bitcoin Funding Team, which, the FTC alleged, falsely promised that participants could earn large returns by enrolling in moneymaking schemes flowing through cryptocurrencies. NFT marketplaces must also beware, as the FTC has brought numerous actions against companies for allegedly facilitating fraud – for example, Moneygram (FTC settlement in 2009), for failing to take steps to crack down on fraudulent money transfers.

Similar to their federal counterparts, state UDAP statutes modeled after the federal statute in each of the 50 states and the District of Columbia are designed to protect each state's consumers from unscrupulous business practices and could be used by state attorneys general to protect their citizens from deceptive NFT activity. In addition, state banking authorities regulating money services businesses (MSBs) emphasize consumer protection issues, and their jurisdiction already encompasses payment systems. That jurisdiction would reach to the sale, redemption, storage, and trading of digital currencies underlying an NFT sale.

For federal or state statutes permitting civil relief, UDAP claims are most impactful and industry shifting when asserted on a putative class basis. However, even if NFT consumers were defrauded by an NFT marketplace in droves, an NFT's non-fungibility (the bedrock of an NFT) could force each buyer to form an individualized assertion, which may not satisfy the commonality requirement of Fed. R. Civ. P. 23(b)(3) required for class certification (although courts have shown willingness to adopt the "fraud on the market" theory to meet this commonality requirement).

From permitting federally chartered banks and thrifts to provide custody services for crypto assets (holding unique cryptographic keys associated with cryptocurrency) (see Legal Update, OCC Clarifies Authority of Banks to Provide Cryptocurrency Custody Services), to protecting the “fairness” of digital asset markets (see the Eliminate Barriers to Innovation Act of 2021), both legislators and regulators are seeking to place guardrails around digital assets, and in turn, NFT transactions.

For now, all participants in the NFT ecosystem should consider a wide range of applicable laws and regulations in order to avoid uncertain commercial relationships and scrutiny from regulators. This is especially true from a consumer protection perspective given most NFT buyers are retail customers and do not require accreditation as a sophisticated investor to participate in the marketplace. While market participants are responsible for ascertaining and complying with their legal obligations, regulators also need to examine and understand the mechanics of both NFTs and NFT marketplaces. Despite skepticism about NFTs and their underlying purpose, like cryptocurrencies and blockchain technology, the ability of NFT technology to disrupt a range of industries should not be underestimated.

More on NFTs to come from Practical Law and the authors of this article.