Mark Kenkre and Ben Rees discuss the unregulated NFT marketplace

Mark Kenkre, Partner and Head of the Investment Fraud and Mis-Selling Team and Ben Rees, Technical Director, discuss the unregulated NFT marketplace, in Fraud Intelligence.

Mark and Ben’s article was published in Fraud Intelligence, 01 June 2022, and can be found here.

In their increasingly diverse forms, crypto assets continue to make big headlines across the world. After a series of precipitous falls over the past few weeks, the cryptocurrency market has shrunk by more than 50 per cent compared to its peak last November. As a result, more than $1.5 trillion in aggregate value has been wiped from the cryptocurrency market following the downturn.

The widespread decline comes in the wake of last year’s surge in almost everything crypto – record investment and participation levels, soaring values and the launch of several thousand new cryptocurrencies. Amid this frenzy with crypto-evangelists encouraging tens of millions to invest worldwide, non-fungible tokens (NFTs) emerged as another crypto asset class that caught investor interest last year.

Based on equivalent technology, NFTs are unique cryptographic tokens which are mostly held on the Ethereum (ETH) blockchain, making the NFT itself unalterable and verifiable without any need for a centralised authority to supervise, monitor and regulate activity. NFTs are typically bought via a marketplace, such as OpenSea, either in an auction or at a fixed price. Sales are usually made via ETH, linking the buyer’s crypto-wallet to an associated smart contract.

Widely portrayed as an exciting, fast-growing area of the crypto world, NFTs have become especially popular with retail investors and celebrities alike. The NFT market saw global sales of $40bn in 2021, partially assisted by the decision of Meta (Facebook) to allow users to mint and sell them.

Versatile in their application, NFTs can be used to represent real-world items, ranging from artwork and real estate to musical compositions. In that way, they can theoretically provide additional income to musicians and artists and potentially democratise ownership by providing an easier route into the ecosystem compared to traditional auction houses. For example, Sir Paul McCartney recently endorsed an NFT linked to his 1968 handwritten notes for ‘Hey Jude’.

There has also been an increase in deal-making involving NFT infrastructure. For example, Yuga Labs which owns the NFT business Bored Ape Yacht Club (BAYC), has reportedly been valued at between $4bn and $5bn. Among its celebrity fans, BAYC has attracted Gwyneth Paltrow and Snoop Dogg, who both own Bored Ape NFTs that have sold for roughly $300,000 each.  

Such NFTs confer no ownership to anything but the digital file, while the objects they represent are invariably owned by someone else. And, in common with the sentiment affecting everything crypto, that market has also headed south in recent weeks with fewer buyers and shrinking NFT valuations.  In March 2021, an NFT of the first tweet posted by Twitter co-founder Jack Dorsey was sold to a Malaysian investor for $2.9 million. When the owner recently put it up for resale, the highest bid was less than $14,000.

But some NFT valuations have also reached stratospheric levels. To put this in context, the most valuable painting ever sold at auction was Leonardo da Vinci’s painting “Salvator Mundi”, which fetched $450.3m in 2017 at Christies in New York. But even this masterpiece was eclipsed last October by “CryptoPunk 9998” – an NFT sold by Larva Labs for a remarkable 124,457 ETH ($532m).

The purchaser of CryptoPunk 9998 therefore put a value on the NFT that was $83.7m more than the most expensive painting ever created. If this had been entirely genuine, CryptoPunk 9998 would have become the most valuable art sale ever recorded. It was immediately offered for re-sale at a staggering 250,000 ETH, or more than $1 billion. When the story of the NFT sale first broke, it was not immediately evident that the seller and the buyer of CryptoPunk 9998 were in fact the same person, who had simply sold the image to themselves.

So how did this bizarre sale take place? As the Bloomberg headline explained at the time – An NFT Just Sold for $532 Million, But Didn’t Really Sell at All.

Instead of a conventional sale, the NFT was essentially created, sold by and bought by the same individual with documentation which “proves” that the NFT is worth $532m. In theory, this would then allow the purchaser to obtain loans worth hundreds of millions of dollars using the NFT as collateral. In this smoke and mirrors exercise, enormous apparent value is created from nowhere.

Although such digital alchemy might on the face of it appear like a great idea, it is in fact illegal. The practice is known as “wash trading”, a form of market manipulation which has long been illegal in regulated financial markets. For example, it first became illegal in the United States under the Commodity Exchange Act (CEA) 1936. Subsequent US legislation has extended the regulatory teeth against wash trading in relation to assorted categories of financial instruments.

But – and it is a big but – the practice is not illegal in the US or in other leading jurisdictions for NFTs, so there has not yet been any enforcement action regarding them. That is because, in common with other crypto assets, they remain a largely unregulated asset class.

Nor is the CryptoPunk 9998 incident a one-off, but rather it has become the business model of choice for many in the NFT world. According to a recent report by the blockchain data firm Chainalysis, the NFT marketplace is full of people who buy their own NFTs in order to drive up prices.

The scale of the problem was recently highlighted by industry data aggregator, Cryptoslam, and cited by Bloomberg: roughly $18bn of the trading volume (around 95% of total activity) on the LooksRare NFT trading platform can be attributed to wash trading.

In its essence, the trading of crypto assets, entirely free from regulation, is frequently cited by libertarian commentators as being a utopian ideal, but the risks that this creates for unwary and unsophisticated investors is extremely high. The unregulated NFT marketplace is a golden opportunity for scammers.

In the US and across Europe, a host of well-known sports stars have flocked to crypto assets and NFTs, either as a means of further monetising their brand or as a form of investment, but often without a full understanding of the risks that these asset classes can bring.

Once the NFT market rebounds, as it surely will, the unrealistic and potentially fraudulent valuations that have been generated will undoubtedly create another round of investor hype in relation to these assets. At the same time, some sellers will continue to make very significant short-term profits from buying and selling NFTs.

But, to borrow two well-worn sporting clichés, at the end of the day this is a zero-sum game.

Compared to the small number of people who make profits, there are a large number of unwary investors who will inevitably suffer big losses. Set alongside various market estimates which suggest that a remarkable 50% of NFT investors lose access to their assets (due to phishing attacks, for example), this means that NFTs remain an incredibly high-risk investment / asset class.

Regulators, such as the UK’s Advertising Standards Agency, are targeting potential misinformation relating to NFTs, but until there is comprehensive regulation implemented across the crypto sector with full enforcement applied, it remains something of a Wild West market for investors.

Sports stars and other celebrities who are seduced by the dazzling potential of NFTs must ensure that they have a full understanding of exactly what they are involved in and the potential risks to their capital, their reputation, or both.