[Aiyushi Mehrotra is a 4th Year B.A., LLB. student at Gujarat National Law University, Gandhinagar]
Non-fungible tokens (“NFTs”) are digital blockchain tokens that identify ownership or particulars of unique items, whether they be digital or real in form. They are traded and programmed in the same way as cryptocurrencies like Bitcoin or Ethereum, but that is where the similarities end. Cryptocurrencies like physical money are “fungible,” meaning they may be traded or exchanged for one another. For example the value of four notes worth Rs 500 each is the same as that of a Rs. 2000 note, thereby making it replaceable. This is primarily where NFTs differ. Each NFT contains a digital signature that prevents it from being exchanged for or compared to one another (hence, non-fungible). With recent examples of NFTs of Polygon (investment in Asia’s largest NFT, Colexion), WazirX and NFTically penetrating the Indian market and their sales growing at record pace, it is important to analyse them from a legal standpoint.
There is no official law or legislation put in place by the Indian Government that forbids or restricts an Indian resident from buying or selling NFTs as of now. The ambiguity surrounding the legal legality of cryptocurrencies in India appears to be the main roadblock in NFT trading. The Supreme Court of India in Internet and Mobile Association of India v. Reserve Bank of India, while striking down the Reserve Bank of India (“RBI”)circular no RBI/2017-18/154 dated 6 April 2018 directing all regulated entities to refrain from dealing in cryptocurrencies, opined that the impugned circular was unreasonable and hence violative of Article 19(1)(g) of the Constitution of India. The year 2021 witnessed a drastic change in the approach of the Government towards cryptocurrencies and, with the introduction of the long-awaited Cryptocurrency Bill, a ray of hope is now alive in every crypto enthusiast. The regulatory status of NFTs might potentially change after the draft Cryptocurrency Bill of 2019, titled “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill” is finalised by the Parliament.
Interaction between NFT and Securities Law
Recognized securities, such as stocks and commodities, are only permitted to be traded on regulated and recognised exchanges in India, and all trading is governed by the Securities Contract (Regulation) Act, 1956. However, under Indian law, NFTs are not yet categorised or recognised as “securities”, and no governmental organisation or authority regulates or recognises the trading platforms on which NFTs are traded. Some opine that NFTs fall under the ambit of mere contracts, whereas others consider NFTs to be a derivative based on their characteristics. If the latter is true, it would provide a legal backing to a ban on trading in NFTs in India.
The Securities Contract (Regulations) Act, 1956 prevents undesirable transactions in securities by regulating the business. Section 2(ac) of the Act, which defines a “derivative”, provides that the instrument also includes a contract which derives its value from prices or index of prices of underlying securities. If NFTs are held to be viewed in the capacity of derivatives, then they cannot be traded on virtual platforms by virtue of section 18A of SCRA which provides that contracts in derivatives shall be legal only if they are traded on recognised stock exchange, which would be either BSE or NSE, unless there is further recognition of a stock exchange with the Central Government for this purpose.
NFTs are non-fungible, as previously stated, and it is this non-replaceable nature that distinguishes them from other securities. As a result, if a particular NFT relates simply to an existing asset and is offered as a guarantee of the asset’s authenticity, classifying it as a security (derivative) would be incorrect. Rather, it should be guided by contract rules in general. Fractional NFTs (which provide a partial ownership interest in the NFT), on the other hand, which have arisen as a result of exorbitantly priced NFTs that most market players cannot purchase, may be classified as a security. Furthermore, if promises of a return on investment are made, NFTs will appear to be a speculative investment rather than a digital collection, and hence could be classified as a security in India.
The easy trading of NFTs in India requires the legalisation of cryptocurrencies. Trading NFTs is risky unless and until a definitive decision on the legality of cryptocurrencies in India is reached. A proposal for a central bank digital currency (CBDC) backed by the country’s banking regulator could be included in the Cryptocurrency Regulation bill set to be introduced soon. The Bill, which is expected to be introduced in Parliament during the winter session, aims to ensure that the RBI maintains control over the country’s monetary economics while also limiting speculative betting on cryptocurrencies, as unregulated cryptocurrencies have the potential to destabilise the macro-economy and create large speculative bubbles.
Interaction of NFT and Collective Investment Scheme (CIS)
Any scheme or arrangement made or offered by any company under which the contributions or payments made by investors are pooled together with the objective of receiving income, profits, produce or property and is managed on behalf of the investors is called a collective investment scheme (“CIS”). Going by this definition, do NFTs also amount to CIS ?
CIS are more frequently known as ‘investment funds’, ‘mutual funds’ or simply ‘funds’ where money is pooled together with that of other investors, and spread over the whole range of assets within the fund. The qualities of an NFT and the rights granted to a token buyer will determine if it is a type of financial instrument such as a security. The non-fungibility of the token will have no impact on the NFT’s regulatory standing.
If all the NFT does is bestow the ability to keep the asset and purchase and sell it, it is unlikely to be perceived as a security and is more likely to be viewed as a utility or exchange token. If the NFT shares features with a security, such as a share or a unit in a collective investment plan, it may be classified as a “security token.” The issuing of NFTs that qualify as units of a collective investment undertaking could result in the need for a collective investment undertaking licence. Because the essential attribute of e-money is its intrinsic fungibility, the bulk of NFTs are unlikely to be categorised as e-money tokens. According to SEBI guidelines, an existing CIS that failed to file an application for registration, was not interested in obtaining provisional registration, was not granted provisional registration, or after being granted provisional registration fails to comply with the provisions of the Regulations must be wound up. The ambiguity around the nature of NFTs is intriguing.
Apart from the challenges of licencing or creating a legal framework that would control the NFT, and its implications on current laws of the land such as money laundering, intellectual property infringement, and taxation, the influence of NFTs on the environment shows to be a greater concern. The blockchain technology used to create or mine digital currencies necessitates a massive amount of computational power, and more computing power equals higher energy usage. This backbone, or reality, of highly complex technology, which in theory relies on the public ledger concept, is based on computers running calculations 24 hours a day, seven days a week. These computers do not have memory, and their main purpose is to perform micro-calculations. Most NFTs are stored on a blockchain called Ethereum. One Ethereum uses about 178.89 Kilowatts per hour which is still more than 1,00,000 Visa transactions. As of April 2021, Ethereum used 33 Terawatt hours of electricity which is the same amount of power as the entire country of Serbia and as of December 2021 has clocked 94.1 TWh per year. One solution to this can be the use of clean energy or to build out another “layer” on top of the existing blockchain.
All of the new markets that have sprung up around the world, particularly in the west, are mature markets with higher per capita income and a different attitude toward money and savings. The situation is changing, however, with the arrival of the next generation of investors and savers who aspire to be asset-light. Because of this lack of standardisation, NFTs are unable to allow transactions at all levels of the market and are unlikely to emerge into a new unregulated currency system. The middle ground appears to be a strict regulation of NFTs rather than a complete prohibition.
– Aiyushi Mehrotra