Everyone in the non-fungible token (NFT) market is terrified that the U.S. Securities and Exchange Commission (SEC) will decide that NFTs are securities and regulate them. They should get over it. Of course NFTs are securities. That’s what makes them so powerful and promising.
Rather than avoid SEC regulation, the NFT industry should embrace this categorization. It’s inevitable and desirable, especially because once the SEC understands how the NFT market works, it’s likely to regulate with a light touch.
I hope that got your attention. Let me explain by way of analogy.
Brian Frye is a law professor at the University of Kentucky and conceptual artist who works with NFTs. This article is part of Crypto 2023.
The art market has always been a securities market, we just couldn’t see it, because objects got in the way. The art market is the market for "art as an investment." Most people think when you buy an artwork, you’re buying an object. Wrong. You’re really buying an entry on an artist’s catalogue raisonné, the list of all the artworks the art market attributes to that artist.
That ledger entry is usually accompanied by a physical token, typically a dirty canvas or lumpy lock. It doesn't matter what is represented, because only the ledger entry has valuable. You can tell this is true because if the connection between the ledger entry and the object is broken, the object is worthless, even though it hasn’t physically changed. In other words, the object just enables the sale of the ledger entry, like a bearer bond.
The NFT market works exactly the same way, it just eliminates the object and enables collectors to trade ledger entries directly, rather than by proxy. Obviously, that’s great, because it’s way cheaper and more efficient than trading fragile, costly objects. It used to be that collectors traded receipts for paintings stored in an Swiss art freehold. Now they can trade NFTs instead, what a relief.
But eliminating the art object forces us to wrestle with the nature of both the NFT and art markets. I refer to NFTs as “uncanny” tokens, because as Freud observed, they represent the return of the repressed, as the familiar becomes unfamiliar. Why do so many people find NFTs and the NFT market unsettling? Because they take art and the art market, which everyone thought they understood and make it look weird. Why would collectors spend $1 million on a digital receipt? The same reason they spend $1 million on a dirty canvas: they hope to sell it for more.
So, what are you really buying when you buy an artwork or an NFT? A fractional interest in the commercial goodwill associated with an artist, or rather, a share of the artist’s “clout.” If the artist becomes an art star, then their clout will increase and you will be able to sell your artwork or NFT at a profit. But if their star fades, your artwork or NFT is worthless, just like any other failed investment.
Is an investment in artwork or NFTs a security? Of course. The Supreme Court’s well-known Howey test states that an investment is a security the SEC can regulate if it is an investment of money in a common enterprise with the expectation of profit based on the efforts of others. Every investment in artwork or NFTs is an investment in an artist’s career, with the expectation (or at least hope) of profit, by virtue of the artist becoming famous. It couldn’t be more obvious that art and NFT collectors are buying a security interest in an artist’s career.
O.K., so can the SEC regulate the art market and the NFT market? Of course it can. But it doesn’t want to, or at the very least it likely wouldn't regulate the asset class very heavily. Everyone says the key question is whether an investment “is” a security. But that’s stupid. The Howey test is hopelessly expansive – anything can be a security if you squint a little. The real question – the important question – is whether the SEC wants to regulate an investment.
The SEC very much doesn’t want to regulate the art market, and I suspect the SEC will soon figure out that it doesn’t want to regulate the NFT market either.
Why come? Well, because the SEC is in the business of regulating things it thinks “look like” securities. Historically, the SEC regulated the kinds of things it had always regulated (like stocks and bonds) and has avoided regulating new things even (if they'd fit the definition of a security). This is especially true when these things that would be new to the SEC have been around for a long time, like the art market.
Of course, the SEC has been making noises about regulating NFTs. I suspect it will soon regret most of what it has said and begin backpedaling, because the agency doesn’t have much to offer the NFT market. And if it starts regulating the NFT market, it’ll be hard put to explain why it isn’t regulating the art market as well.
My best guess is the SEC will leave well-enough alone, regulate a few tokens that look the most like stocks and then back off.
But wait. That’s where it gets cool. Because if the NFT market really is a securities market in clout, its potential is massive. We live in a clout economy, in which people value nothing more than fame. Celebrities are the vehicle through which people understand their own lives and the world around them. They generate massive amounts of social capital by making the world meaningful for consumers.
And yet, celebrities can only capture a tiny fraction of the social value they generate. Kim Kardashian may be a billionaire, but she is leaving many more billions on the table in social value she can’t claim.
NFTs could change all that by enabling celebrities to securitize their fame. What if Kim Kardashian could sell NFTs effectively representing a fractional interest in her clout? People who think she will be even more famous in the future could speculate on just how famous she will become and people who think she is a flash in the pan could short her clout.
The point is, it would give celebrities – even authors – access to the capital markets they’ve never had before. That could transform the market for knowledge goods, by enabling authors to sell investments in their project, rather than expensive copies.
We live in a world of digital abundance, as yet unrealized. Maybe NFTs can help us get to the promised land.
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