Why NFT Profile Pics Matter to Investors – and Regulators

It seems nobody – not even the U.S. government – can agree on exactly how to classify the digital assets known as non-fungible tokens (NFTs). Yet the digital art pieces have taken off in popularity and attracted buy-in from creators, collectors, a growing sector of digital asset lawyers and everyday social media users.

One prevailing trend is NFT profile pictures, or PFPs. Collectors throughout 2021 began switching over their social media avatars to display their most prized pieces of their NFT collections. Twitter last month attempted to make PFPs more legitimate by releasing a tool to verify PFP authenticity. Platforms like Reddit and OnlyFans are reportedly next in line.

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Collectors like displaying their NFT profile pictures because the avatars convey confidence in blockchain as an emerging technology. They are also a signal of belonging and status. In addition, NFTs often come with “utility,” meaning a record of ownership can unlock access to online and in-person membership communities. With all the hype, demand for these exclusive assets has made prices skyrocket.

The tokens produced by NFT artists are something of a cultural timestamp. Designed collaboratively by artists and developers, PFPs depict a mix of randomly generated characters. The artwork uses a templated base, and then an algorithm assigns a unique mix of attributes for each minted NFT. Some characteristics end up being more rare – such as the pale blue alien CryptoPunk that just sold for $23 million – which gives certain NFTs more value than others.

The top collections board on OpenSea, a popular NFT marketplace, shows a seven-day trading volume of 6,185 ETH for the CryptoPunks collection, one of the first (and inadvertent) PFP collections to drop before the trend took off. Below that on OpenSea’s board are newer collections that contain up to 10,000 randomly generated avatars with mixed traits.

Floor prices for popular PFP projects on OpenSea vary widely. The Coolman’s Universe collection of 10,000 cartoon “Speshies,” for instance, is No. 45 on OpenSea’s top collections list and has a floor price of roughly 1.4 ETH with a seven-day trading volume of about 887 ETH as of time of writing. Meanwhile, the World of Women collection, with its 937 ETH seven-day trading volume, ranks at No. 43 and has a floor of about 8.74 ETH.

Owning one of these or other PFPs entitles the collector to certain privileges. On its website, for instance, World of Women lists the benefits of NFT ownership. Those include holders-only raffles and discounts, an invitation to an annual gala, and curated presales, among other perks. And on the social justice of things, the sold-out Women Rise project outlines a road map to support gender equality and girls education, including donating 2.5% of profits to the Malala Fund. PFPs therefore signal inclusion into the type of well-curated and values-aligned future collectors want to be part of, along with the promise of community.

But when profit also enters the equation, regulators and lawyers have questions.

According to the Howey test, a monetary investment in a common enterprise with the expectation of profit derived from the effort of others is the definition of a security. Buying into an NFT collection to support a good cause or join an art community is one thing, but it’s also no secret the most rare and coveted PFPs are now worth millions.

But while the U.S. Securities and Exchange Commission (SEC) has issued general guidance on digital assets, the agency hasn’t focused specifically on NFTs, which differ from stocks or even cryptocurrencies like bitcoin.

“[SEC guidance] really wasn’t designed with NFTs in mind,” explained James G. Gatto, a licensing and regulatory issues lawyer and partner at the law firm Sheppard Mullin, during an online NFT conference in February.

In most cases, an NFT isn’t going to be a security, Gatto said, but his firm has encountered a few examples in which NFTs did have the traits of a security, meaning securities law should come into play. The main instance so far has been in the case of fractionalization, or taking a high-value piece of art and creating multiple NFTs that share the revenue.

This model is similar to the one used by alternative investment platform Masterworks, which says in its disclaimer that it is “testing the waters under Regulation A under the Securities Act of 1933.” Masterworks files its artwork with the SEC as a security, even though the platform itself isn’t registered or licensed as a brokerage. While PFPs won’t automatically fall into the fractionalization category, this particular nuance could have implications for some NFT marketplaces like Fractional that offer shared ownership of expensive digital art pieces.

As with every purchase, investors should have a clear investment thesis backing their reasoning for buying NFTs. The recent Pudgy Penguins scandal makes this point clear. The Pudgy Penguin project’s founders never delivered on their promises, and the cringeworthy failure made headlines when Pudgy Penguin NFT holders coded a smart contract to maintain the liquidity of their tokens while denying the original owners access to any more trading profits. The situation was described as a “blatantly fraudulent illegal securities offering and embezzlement” in a LinkedIn post written by Carlos Mercado, a data scientist and founder of crypto outfit CharlieDAO.

For every failed NFT project, however, is a similar thriving community with transparent leadership and an engaged collector base – and sometimes it’s hard to know which is which. “Blatant” often becomes clear only in hindsight.

NFT enthusiasts would then tell investors to consider the “why” behind their purchases and not view PFPs as a get-rich scheme. Doing so not only protects investors from making impulsive NFT purchases, but could also be a buffer when teasing out exactly what is a security and what’s not. NFT collectors won’t necessarily have to defend their NFT purchases from the SEC one day, but everyone should always have a sound thesis backing his buys.

“There are collectibles, utility tokens and clear securities in the NFT space. It is important to understand the differences when buying them,” Mercado wrote in a follow-up LinkedIn post after I spoke to him about his Pudgy Penguins commentary. Mercado is not a lawyer – just a data scientist and Web 3 enthusiast – but he has experience buying a variety of digital assets. He also speaks with digital asset lawyers regularly while building out his DAO, or decentralized autonomous organization, of token holders.

“I buy plenty of NFTs just because I want to support those artists,” he told CoinDesk. “Then I buy other entities that are like, ‘We’re going to build this game. It’s going to look so cool. Here are previews of our new 3D renderings.’ There’s a clear promise of development [in these examples], and expertise from the people who want your money. That’s where you get into security territory – if they’re promising you something.”

Investors should always be able to articulate what they hope to gain from their NFT purchases, even if it is just to support an artist. With PFPs specifically, it will be harder to make the case that the purchase was just for the love of art, since the artwork is randomly generated and the images facilitate online social engagement and unlock utility of some kind.

But if profit is the secondary motivation for your purchase – behind community membership and well-curated benefits – that argument is easier to convey when you have a track record of aligning your dollars with your values, hobbies and social life.