Xiao Sa: What does the “Initiative on Preventing NFT-Related Financial Risks” mean?

On April 13, 2022, the Internet Finance Association of China, the China Banking Association, and the China Securities Association issued the "Initiative on Preventing NFT-Related Financial Risks" (hereinafter referred to as the Initiative) . At one time, large companies, practitioners, and buyers called and left messages to inquire. Regarding the issues of general concern, Sister Sa shared her views as follows:

NFT=or≠Digital Collection

The word NFT was used in this initiative. Once it was issued, some practitioners left a message: We are not NFT, we are digital collections and digital artworks.

This practice of covering one's ears and stealing the bell will not help solve the problem. The role of NFT in promoting the cultural and creative industry is obvious to all parties in society. The digitization of artworks and artistic creation is both a general trend and a manifestation of cultural confidence. However, in the process of selling NFT, there is a tendency of financialization, especially the opening of the secondary market, which further stimulates consumers' speculation. Please note that the initiative was proposed by a self-regulatory organization in the financial sector rather than a cultural organization, which shows that the problem of financialization of digital collections has been highlighted and has been noticed by regulatory authorities.

The underlying commodities/digital works are decoupled from financial assets, and financial products cannot be issued or traded in disguised form.

To be honest, this week some practitioners asked whether it is possible to combine real estate with NFT to issue financial products, but Sister Sa refused. If interpreted in a broad sense, "not including financial assets such as securities, insurance, credit, precious metals in the underlying commodities of NFT, issuing and trading financial products in disguise." The "etc." here should be "interpreted in a homogeneous manner", with the same nature and similar spillovers as securities, insurance, credit, and precious metals. Sister Sa believes that real estate should be interpreted in, and advises friends with similar ideas not to test the law.

So, what are the legal consequences of linking financial assets to NFTs and selling them? The biggest red lines are Article 174 of the Criminal Law, the crime of establishing a financial institution without authorization, and Article 179, the crime of issuing stocks, companies, and corporate bonds without authorization .

Can the secondary market still be opened?

There is no doubt that opening a secondary market is helpful for NFT price discovery (neutral term). That is, there is no major legal issue in opening a secondary market. The key is that this business is a licensed business, which is not something that can be done by consignment platforms, issuance platforms themselves or SPV companies .

From the practical experience of Sister Sa in handling cases, Document No. 37 and Document No. 38 are still the legal bottom line of the secondary market. Among the various exchanges retained by various provinces, basically no licenses that can completely block the crime of illegal business operation under Article 225 of the Criminal Law have been found. Don't be disappointed. Exchanges can try to list some NFT digital collections within the scope permitted by the documents.

In the long run, if there is market demand, there must be institutional supply. Beijing, Shanghai and Shenzhen all have their own licensed exchanges or sandboxes within a limited scope, which may provide financial consumers with another target choice. It is unknown and it will take time.

Adding anti-money laundering obligations

Domestic NFT issuance and trading platforms are generally highly compliant, and it is rare to find non-international versions accepting Bitcoin, Ethereum, USDT or platform coins. However, some platforms have international versions, and there is a widespread phenomenon of accepting virtual currency. If Chinese people engage in business that is illegal in China but legal overseas, the jurisdiction will eventually fall on China. Please don't be too smart.

In terms of real-name authentication, most platforms are still able to do it, but the general awareness of anti-money laundering is insufficient. In fact, both national and international standards require that "counterparties" be included in the compliance system. We recommend that platforms purchase anti-money laundering services. The most stringent is the anti-money laundering system in the financial industry, which can be used as a reference for implementation .

At the same time, we found that there are a large number of underage buyers on the NFT platform. According to Article 19 of the Civil Code and relevant policies, we redesigned the algorithm based on behavioral habit portraits to predict and handle purchasing behaviors that do not conform to the cognitive level of minors in advance , to prevent young people from becoming addicted to it and causing heavy financial burdens on families.

No financing support is provided for investing in NFTs, excluding payments

Some payment companies are very worried about whether they will be regulated by the initiative. Judging from the existing terms, "no financing support will be provided for NFT investment." The financing here refers to " leverage " rather than payment channels.

However, according to recent practices of aiding and abetting trust crimes and the dismantling of the idea of ​​"technological neutrality", payment channels must have some understanding of their own merchants and cannot use the excuse of not knowing the source of customer funds. Doing a good job of KYC is a basic obligation of payment companies , and they should be more cautious about new businesses, especially those related to virtual assets.

Is it a disguised ICO if one work issues many NFs?

The most noteworthy thing about this initiative is that it clearly stipulates that " do not weaken the non-homogeneous characteristics of NFTs by means of splitting ownership or batch creation, and do not conduct disguised token issuance and financing (ICO) ". This seems to mean that there are high legal risks in the large-scale issuance of NFTs. But in fact, the focus of this initiative is on "disguised token issuance and financing". In other words, the policy resists the behavior of conducting disguised token issuance and financing, and the statement "weakening the non-homogeneous characteristics of NFTs by means of splitting ownership or batch creation" is just an example of the typical model of token issuance and financing (ICO). In other words, the typical behavior of using NFTs for token issuance and financing (ICO) is to weaken the non-homogeneous characteristics of NFTs by means of splitting ownership or batch creation, but it cannot be said that any behavior that meets this model is the behavior of token issuance and financing .

How do we understand ICO (initial coin offering)? The Notice on Preventing Risks of Token Issuance and Financing jointly issued by the People's Bank of China and seven other departments clearly pointed out that token issuance and financing is essentially an illegal public financing behavior. In the financing behavior, the financing object must have the intention of "investing and waiting for returns at a certain point in the future" when providing funds. Therefore, this clause in the initiative should be understood in a "penetrating" manner, and should not be confused about ownership, property rights or debt rights .

In fact, this is consistent with the previous attitude of the regulatory authorities towards ICO, that is, when Bitcoin was popular, it warned against the risk of Bitcoin speculation, and when virtual currency was popular, it warned against the financial risks related to virtual currency. Today, the concepts of Metaverse and NFT are popular again, so related illegal personnel use Metaverse and NFT to carry out ICO in disguise. This is of course resisted by the regulatory authorities.

Therefore, the reason why this initiative mentions methods such as splitting ownership or batch creation is that such methods will weaken the non-homogeneous properties of NFT to a certain extent, which can be used by criminals for ICO. Therefore, as long as the relevant companies operate the NFT platform legally and in compliance with regulations and do not conduct disguised ICOs, there will be no such legal risks . However, it should be noted that the right of interpretation of disguised forms often lies with the regulatory authorities. Even if the company believes that its behavior does not constitute an ICO, it may be misjudged . Therefore, it is best for companies to take relevant measures to enhance the non-homogeneous characteristics of NFTs to prevent related legal risks from arising.

At the same time, we cannot mechanically understand that "disguised" means any behavior is acceptable, and it is not advisable to regard normal sales and promotional activities as disguised currency issuance. To understand "disguised", we have to go back to the purpose of the initiative itself, which is to block financial risks rather than inhibit the digital development of the cultural industry .

Final Thoughts

The "Initiative on Financial Risks Related to NFTs" is of great significance for preventing the financialization of digital collections and giving full play to the cultural value of the digital collection industry itself. To understand the essence of the "Initiative", we must understand that what we are guarding against is the financialization of digital collections, not the digital collections themselves . The financialization of NFTs is particularly prosperous in foreign markets. Foreign digital collections are mostly issued on public chains and can be transferred and resold at will. This makes the financialization of foreign digital collections without any obstacles, and the cultural and artistic value of digital collections themselves is also submerged in the tide of financialization. "Counter-knocking" and other behaviors that disrupt the trading order are also common. These chaos themselves contain the possibility of systemic financial risks. Before the announcement of the "Initiative", domestic mainstream digital collection platforms all issued industry self-discipline books to ensure that the digital collection platform is fully named throughout the entire process and the content is fully reviewed.

However, some platforms are still ready to "financialize" digital collections in the name of "promoting cultural IP". This practice is tantamount to drinking poison to quench thirst and cut off the development path of the industry . The publication of the "Initiative" is a powerful tool to prevent the financialization of the digital collection market and promote the healthy development of the industry. The six behavioral norms in the "Initiative" basically cut off the possibility of financialization of domestic digital collections. This is a major good news for the development of the cultural and artistic value of digital collections themselves .

At the same time, there is no need for existing platforms dedicated to leveraging the cultural and artistic value of digital collections to be overly nervous . As long as the relevant companies operate the digital collection platforms legally and in compliance with regulations and do not conduct or covertly conduct ICO activities, there will be no relevant legal risks. The digital collection industry itself has huge development prospects, but it is undeniable that the characteristics of digital collections make them at risk of being financialized. The release of the "Initiative" is a good medicine for "timely correction", which will help the domestic digital collection market embark on a healthy and positive cultural industry path.