Xiao Za: In-depth Interpretation of the Initiative on Preventing Financial Risks Related to NFTs Released by Three Associations Including the Internet Finance Association

Author: Xiao Za lawyer

NFT=or≠Digital Collectibles

The term NFT is used in this initiative, and once it was issued, some practitioners commented: We are not NFTs; we are digital collectibles and digital artworks.

This self-deceiving approach is unhelpful for resolving the issue. The role of NFTs in promoting the cultural and creative industry is evident to all parties in society. The digitization of artworks and artistic creation is not only a trend but also a manifestation of cultural confidence.

However, during the selling process of NFTs, there has been a tendency towards financialization, especially with the opening of the secondary market, which further stimulates consumers' speculative mentality. Please note that this initiative is proposed by a self-regulatory organization in the financial sector rather than a cultural organization, indicating that the issue of financialization of digital collectibles has become prominent and has drawn the attention of regulatory authorities.

Decoupling underlying goods/digital works from financial assets, no disguised issuance or trading of financial products

To be honest, this week some practitioners asked whether it is possible to combine real estate with NFTs to issue financial products, which was rejected by Sister Za. If we interpret broadly, "not including securities, insurance, credit, precious metals, and other financial assets in the underlying goods of NFTs, nor disguising the issuance and trading of financial products" should be understood in the same way. Sister Za believes that real estate should be included in this interpretation and advises friends with similar thoughts not to test the law.

So, what are the legal consequences of linking financial assets with NFTs and selling them? To clarify, the biggest red line is Article 174 of the Criminal Law regarding the unauthorized establishment of financial institutions and Article 179 regarding the unauthorized issuance of stocks, corporate, and enterprise bonds.

Can the secondary market still be opened?

Undoubtedly, opening a secondary market is helpful for price discovery (a neutral term) of NFTs. That is, establishing a secondary market itself does not pose significant legal issues; the key is that this business belongs to licensed operations and cannot be conducted by consignment platforms, issuance platforms, or SPV companies alone.

From Sister Za's practical experience in handling cases, Document No. 37 and Document No. 38 still represent the legal bottom line for the secondary market. Among the various exchanges retained in different provinces, there is basically no license that can completely block the illegal business operation as per Article 225 of the Criminal Law. Do not be disheartened; exchanges can attempt to list some NFT digital collectibles within the scope allowed by the documents.

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

Increase anti-money laundering obligations

Overall, domestic NFT issuance and trading platforms have high compliance levels, and there are few instances of non-international versions accepting Bitcoin, Ethereum, USDT, or platform tokens. However, some platforms have international versions, and there is a common occurrence of accepting virtual currencies. Chinese individuals engaging in activities that are illegal in China but legal overseas will ultimately fall under domestic jurisdiction; do not be overly clever and end up being misled.

In terms of real-name authentication, most platforms can achieve this, but there is generally insufficient awareness of anti-money laundering. In fact, both national and international standards require that "counterparties" be included in the compliance system. We recommend that platforms procure anti-money laundering services, with the strictest being the anti-money laundering systems in the financial industry, which can be referenced for implementation.

At the same time, we have found that there are a large number of minor buyers on NFT platforms. According to Article 19 of the Civil Code and relevant policies, based on behavioral habits, algorithms should be redesigned to predict and handle purchasing behaviors that do not meet the cognitive level of minors in advance, preventing adolescents from becoming addicted and causing heavy financial burdens on families.

No financing support for investing in NFTs, excluding payments

Some payment companies are worried about whether they will be regulated by the initiative. From the existing terms, "no financing support for investing in NFTs" refers to "leveraging" rather than payment channels.

However, based on recent practices regarding the crime of assisting in illegal activities and the dismantling of the "technology neutrality" idea, payment channels must understand their merchants and cannot argue ignorance of the source of customer funds. Conducting KYC is a basic obligation for payment companies, and they should be more cautious regarding new businesses, especially those related to virtual assets.

Is issuing multiple NFTs for a single work a disguised ICO?

The most noteworthy aspect of this initiative is the explicit statement that "not to weaken the non-homogeneous characteristics of NFTs through methods such as splitting ownership or mass creation, thereby disguising token issuance financing (ICO)." This seems to imply that large-scale issuance of NFTs carries high legal risks.

However, the focus of this clause is on "disguised token issuance financing." In other words, the policy resists behaviors that disguise token issuance financing, and the statement about "weakening the non-homogeneous characteristics of NFTs through methods such as splitting ownership or mass creation" is merely an example of a typical model of token issuance financing (ICO).

In other words, a typical behavior of using NFTs for token issuance financing (ICO) is to weaken the non-homogeneous characteristics of NFTs through methods such as splitting ownership or mass creation, but it cannot be said that any behavior conforming to this model is an act of token issuance financing.

So how should we understand token issuance financing (ICO)? The "Announcement on Preventing Risks of Token Issuance Financing" jointly issued by the People's Bank of China and seven other departments clearly states that token issuance financing is essentially an illegal public financing behavior. In financing activities, the object of financing will certainly imply "investing and waiting for returns at some future point." Therefore, this clause in the initiative should be understood in a "penetrating" substantive manner, rather than going around in circles regarding ownership, property rights, or claims.

In fact, this is consistent with the regulatory authorities' past attitude towards ICOs, which warned against the risks of Bitcoin speculation during the Bitcoin boom and the risks related to virtual currencies during the prevalence of virtual currencies. Today, with the concepts of the metaverse and NFTs becoming popular, related illegal actors are again using the forms of the metaverse and NFTs to disguise ICOs. This is certainly resisted by regulatory authorities.

Therefore, the reason this initiative mentions methods such as splitting ownership or mass creation is precisely because these methods can, to some extent, weaken the non-homogeneous attributes of NFTs, making them susceptible to exploitation by illegal actors for ICOs. Thus, as long as relevant enterprises operate NFT platforms legally and compliantly without engaging in disguised ICO behaviors, there will be no such legal risks.

However, it should be noted that the interpretation of "disguised" often lies with regulatory authorities. Even if enterprises believe their actions do not constitute an ICO, there is still a possibility of being misjudged. Therefore, it is best for enterprises to take relevant measures to enhance the non-homogeneous characteristics of NFTs to prevent related legal risks.

At the same time, it is not advisable to mechanically interpret "disguised" as allowing any behavior, treating normal sales and promotional activities as disguised token issuance. The understanding of "disguised" should return to the purpose of the initiative, which is to block financial risks rather than suppress the digital transformation of the cultural industry.

In Conclusion

The "Initiative on Preventing Financial Risks Related to NFTs" is of great significance in preventing the financialization of digital collectibles and realizing the cultural value of the digital collectibles industry itself. To understand the essence of the "Initiative," one must recognize that we are preventing the financialization of digital collectibles, not the digital collectibles themselves. The financialization phenomenon of NFTs is particularly prevalent in foreign markets, where foreign digital collectibles are often issued on public chains and can be freely transferred and resold.

This makes the financialization of foreign digital collectibles unimpeded, and the cultural and artistic value of digital collectibles themselves is submerged in the tide of financialization. Disruptive behaviors such as "wash trading" that disturb trading order are also common, and these irregularities inherently harbor the potential for systemic financial risks. Before the announcement of the "Initiative," mainstream domestic digital collectibles platforms had issued industry self-regulatory documents to ensure real-name verification throughout the entire process and comprehensive chain review of content.

However, there are still a few platforms that are eager to act, attempting to use the guise of "promoting cultural IP" to engage in the financialization of digital collectibles. This approach is akin to drinking poison to quench thirst, cutting off the path for industry development. The announcement of the "Initiative" is a powerful tool to block the financialization of the digital collectibles market and support the healthy development of the industry. The six behavioral norms in the "Initiative" essentially eliminate the possibility of financialization of domestic digital collectibles. This is significant good news for realizing the cultural and artistic value of digital collectibles themselves.

At the same time, existing platforms dedicated to realizing the cultural and artistic value of digital collectibles need not be overly anxious. As long as relevant enterprises operate digital collectibles platforms legally and compliantly, without engaging in or disguising ICO behaviors, there will be no related legal risks. The digital collectibles industry itself has enormous development prospects, but it cannot be denied that the characteristics of digital collectibles pose risks of financialization. The release of the "Initiative" is a timely remedy that helps the domestic digital collectibles market to embark on a healthy and positive path in the cultural industry.