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Are NFTs Securities? | Investor Junkie

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In 2020, NFT trading volume was a mere $21.7 million. In 2021, it exploded to $40 billion.

Many NFT buyers are just interested in supporting their favorite indie artists. And others may simply be filling their digital art galleries or claiming bragging rights for “owning” famous memes and gifs.

But a significant portion of NFT buyers are bonafide investors who see NFTs as the next gold rush of the digital age. And considering that the secondary NFT market reached $15 billion last year, many of them are getting rich.

When investors start flipping assets for massive gains, it begs the question: Are these assets securities? Should they be regulated? If not, what missteps would put NFT investors square in the SEC’s crosshairs?

Let’s investigate whether NFTs should be considered securities.

The Short Version

  • NFTs aren’t securities because they don’t pass the Howey test.
  • However, there are some cases where NFTs are awfully close to acting like securities.
  • While the SEC doesn’t consider NFTs securities right now, that could change in the future.

What Are NFTs?

NFTs, or non-fungible tokens, are unique data strings that live on a blockchain.

To understand NFTs, we first have to understand where they’re generated and stored: the blockchain.

Blockchains are like giant online ledgers of data. They can be added to and read but never edited. Think of a giant stone wall in the town square where people can chisel on essential data  but never erase their neighbor’s.

The Bitcoin blockchain was generated in early 2009 and still operates today. But it can only be used to store financial data. With Ethereum, users can store all kinds of data on its blockchain. It allows the storage of non-fungibles, i.e. one-of-a-kind strings of code.

The implications of storing unique data to a secure, decentralized blockchain are endless — we can keep medical records there, legal data, and of course, ownership of art. 

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: “Chris owns NETFLIX 2087 by Beeple.”

In summary, NFTs are “certificates of ownership” stored on the Ethereum blockchain that certify that one particular person or group “owns” a digital piece of art.

Find out more >>> What Is an NFT? 

What Are Securities?

A security is a financial asset that can be traded. Stocks, bonds, options, futures, and banknotes are common securities examples.

Notably, all securities are fungible, meaning interchangeable. Your ten shares of AAPL are just as good as my 10 shares of AAPL. Like quarters and dollar bills, nothing functionally differentiates one share of AAPL from the next.

There are four different types of securities: Equity, debt, hybrid, and derivatives. 

Equity securities represent a partial ownership interest in an entity like a business. If that sounds a lot like stock, that’s because it is. Shares of stock are the most commonly cited example of equity security.

Debt securities represent loans with pre-established terms on the size, renewal date, and, of course, the interest rate. The most common example of a debt security is a bond. Like most debt securities, bonds entitle their holders to regular principal payments, plus interest.

Hybrid securities contain elements and characteristics of multiple types of securities. An oft-cited example of a hybrid security is the convertible bond, debt securities that can convert into a predetermined number of shares.

Derivatives are a security whose price derives from the value of an underlying asset. For example, when you purchase oil futures on NYMEX, you’re not buying the oil; you’re buying the right to buy the oil at a specific price later (well, technically, the obligation). Since the oil futures contract was based on today’s oil price, that makes it a classic example of a derivative.

So, Are NFTs Securities?

To find out if NFTs are securities, let’s go down the list.

  1. NFTs don’t meet the criteria for debt securities. They share virtually no DNA with a bond and don’t represent a loan made to or by the artist.
  2. By that logic, NFTs don’t fit the bill for hybrid securities either.
  3. How about derivatives? NFTs are too simple to be derivatives. They may be complex in concept, but they’re pretty straightforward as an asset. They’re just art pieces and don’t represent any other underlying asset.

That leaves us with equity securities. It might seem strange to compare shares of NVIDIA to a digital artwork of a cat in a cowboy hat. But stocks and NFTs share a surprising amount in common:

  • They both represent ownership
  • External market forces drive their values
  • They’re both expected to experience capital appreciation (in some cases), and,
  • Both are perceived as good “investments” by certain players

But at the same time, NFT collectors have been able to stave off regulators by repeating a simple defense: “Hey, man, they’re just art.”

Amazingly, this defense works. Although NFTs straddle the line between product and security, the SEC disqualifies them as securities (for now) because they fail the Howey Test.

Do NFTs Pass The Howey Test?

According to the SEC, for an asset to qualify as a security, the sale of that asset must pass the Howey test.

The Howey test finds its origins in the 1946 Supreme Court case SEC v. W.J. Howey Co. Back in the ’40s, the Howey Company was selling tracts of citrus groves to Florida residents, getting access back via lease, and selling fruit grown on the property for profit — which it then shared with the landowners.

Clearly, this leaseback arrangement involved an investing contract. But Howey failed to register the transactions with the SEC. The SEC established the Howey test to help future businesses avoid this mistake.

According to the Howey test, a transaction qualifies as an “investment contract” (and thus the asset exchanged is qualified as a security) if it includes three factors:

  1. An investment of money
  2. A common enterprise (i.e. shared goals between investors and those selling the asset)
  3. Reasonable expectation of profits derived from the efforts of others

The SEC has used the Howey test to classify certain ICOs (initial coin offerings a.k.a. IPOs for cryptos) as investment contracts, thus qualifying the underlying crypto as regulatable security.

Why NFTs Aren’t Securities

NFTs manage to scoot by because they fail to meet condition number three of the Howey test.

You see, unlike the founders of certain scam cryptos that I won’t mention, 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.

In summary, NFTs may share a lot in common with stocks, but they’re not securities because they’re not sold with the expectation of profits. Capital gains aren’t part of an NFTs initial value proposition to buyers.

Instead, NFTs are marketed purely as art and collectibles. They can’t be classified as securities simply because their value increases.

Should NFT Investors be Worried About Regulation?

For now, NFTs investors shouldn’t be worried…but they should be wary. NFTs are already walking a fine line, as the SEC has regulated other digital assets. Here are just a few of the places where NFTs could misstep and slip into the crevasse of regulation:

Secondary Sales/Profit Redistribution

When Zoë Roth auctioned off her Disaster Girl NFT for $473,000, she included a contract term stating that each time it sold again, she’d get a share of that sale, too.

Such stipulations are becoming more common among artists looking to generate passive income from their NFT sales — and they’re also attracting SEC attention, implying a common enterprise and expected profits down the road.

The Secondary Market

NFTs are able to skirt regulatory scrutiny because creators do not market them as investments.

But what about the investors who buy them? What happens when they market them as suitable investments to attract other investors and artificially inflate values?

Secondary NFT sales reached $15 billion in 2021, begging the question: How long until a specific subpopulation of buyers, the investors, become too loud for regulators to ignore?

Corporate Marketing

Folks sometimes forget that Bitcoin started just like NFTs: a cool, new technology that was never intended to become an investment.

And yet, once values rose, marketplaces emerged to facilitate trade–and many of these marketplaces didn’t hesitate to market their wares as “investments.”

Bitcoin has managed to avoid becoming a security because it has no central leadership or authority.

But NFTs have clear paper trails leading back to their creators. So, if you one day mint an NFT on a website that markets your creation as an investment, the SEC might come for you both!

Partial Ownership AKA Fractionalization

Historically speaking, when you’re able to purchase a fractional share of an asset, that’s a clear sign to the SEC that it’s an investment vehicle.

After all, the “it’s just art and I like it” defense falls apart pretty quickly when you buy 1/826th of a painting.

Case in point, the company Masterworks, which sells partial ownership in physical art, must register their transactions with the SEC.

With NFT prices skyrocketing, how long before creators and investors do a “stock split” to attract more buyers?

The Bottom Line

The SEC may not regulate NFTs as securities today. But if the investing community isn’t careful, I sense that may eventually change.

If and when the SEC starts regulating NFTs, I predict they’ll regulate all of them. They won’t cherry pick like they do with cryptos, since that would take too much work.

Do you think that the SEC should classify NFTs as securities and start taxing them? Let me know in the comments. I’m curious to hear your thoughts!



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