Applying crypto technology to digital and physical assets creates a new economy of non-fungible tokens -- but are they security tokens?
Ownership of collectibles and all types of assets has taken on new meaning thanks to blockchain technology. The properties of blockchain and cryptography have made it so that assets can be owned in both the physical and digital worlds, with verified ownership and transparent provenance.
Why does this matter? Because it gives us physical world capabilities in the digital world, creating brand new economies and markets. Most of all, it creates brand new opportunities for creators and investors.
NFTs explained: blockchain-based assets with unique value
Crypto assets can be fungible or non-fungible. Fungibility is the ability for an asset to be interchangeable with another of its kind. A group of digital assets that each hold unique value and are based on blockchain technology are called non-fungible tokens, or NFTs.
Consider bitcoin and ethereum, two cryptocurrencies who both have a supply that is interchangeable; one bitcoin or ether is worth the same amount, no matter which bitcoin or ether you’re holding. In comparison, digital collectibles have unique characteristics, giving them different values so that one can not be interchanged for another. This could include digital art, in-game items, and trading cards.
What are the crypto properties of NFTs that make them exciting as a new asset class?
NFTs can also be thought of as digital files that can be owned. Take digital media files for example, like art, music, or text, which can be secured on the blockchain so their attribution is now transparent and automatically referenced. A recent and highly publicized example of this is Jack Dorsey minting his first tweet to the blockchain and selling it as an NFT.
But NFTs can represent physical assets as well bringing these crypto properties to real estate, art, or anything else. As Ethereum.org explains, “[NFTs] can be used to represent ownership of any unique asset, like a deed for an item in the digital or physical realm.”
Based on blockchain technology, NFTs use programmable smart contracts to determine how the asset can be bought and sold, and how the original creator of the asset can continue to be compensated during those transactions. The blockchain provides a built in secondary market for in-demand collectible items.
How are assets tokenized as NFTs?
The act of tokenizing a digital file, collectible, or physical asset involves "minting" ownership of it onto a blockchain, which records the asset’s ownership and subsequent transfer information.
During the process of minting a non-fungible token on-chain, the creator of the token signs it with their cryptographic keys. This cryptography is what authenticates ownership of the asset and supports royalty payments that may be made to the creator as the asset is sold on a secondary market.
The underlying physical ownership of the asset, such as a real estate deed, is held by a trust company as fiduciary for owners as represented by the blockchain.
NFTs make it possible for any asset to be verified on the blockchain with transparent and public provenance and permissionless ownership.
What is the difference between NFTs and tokenized securities?
Often, NFTs can actually be securities. Both NFTs and tokenized securities are assets represented digitally on the blockchain, both can be digital or physical, and both can be traded on secondary markets.
An NFT is a tokenized asset with unique value. Tokenized securities can be fungible assets, like fractionalized shares, but they can also be unique, or non-fungible, when applied to assets like real estate, for example.
What causes an NFT to become a security? Generally, if you sell 100% of an NFT to one person then it’s not a security and is no different from a private sale of a work of art of selling a home. However, blockchain technology intrinsically gives the ability to fractionalize the NFT or sell part of the ownership to a broad range of buyers. Instead of one person owning a Picasso for example, the token representing a work of art can be sold in pieces to thousands of people who are buying it in hope that it appreciates in value and will each own a piece of the asset.
As part of clarifying what a “security” is, the SEC also defines the term “investment contract.” This is any contract whereby a person invests money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party, and can therefore sweep NFTs into the definition of a security.
Where do NFTs and tokenized assets trade?
It depends on whether or not the NFT is a security. If not, NFTs can be sold on many secondary markets or peer to peer to like art, real estate, and other typical real world assets. If the NFT is a security, then those securities should only be trading on registered Alternative Trading Systems (ATSs). Maybe one day, they’ll even trade on NASDAQ or NYSE.
Does selling a fractionalized NFT mean the NFT has to “IPO”?
Thankfully, no. The JOBS Act provides a variety of very useful frameworks for selling securities to both accredited and non-accredited investors. Leveraging regulatory exemptions like Reg CF (4a6) or Reg A, creators of NFTs can fractionalize the asset and sell it to a broad audience online through general solicitation. Will we see crowdfunding portals dedicated to fractionalizing NFTs? Only time will tell...
Prime Trust’s rails support easy and compliant use of NFTs
Prime Trust founder and CEO of Prime Core Technologies Scott Purcell recently summed it up well saying, “I love NFT's, they are poised to help revolutionize fractional asset ownership, royalties, and many other things. But people involved need to pause for a moment and get the regulatory side of the house in order.”
Prime Trust, along with FundAmerica, our Regulation Crowdfunding portal, broker-dealer partners, and our ATS partners (for secondary trading) support the NFT space compliantly. Our custody, payment, settlement, and compliance rails will help NFT issuers and buyers and sellers avoid very serious and unnecessary legal and regulatory issues. Our financial infrastructure is here and ready.
Learn more about Prime Trust’s all-in-one financial infrastructure for NFTs and tokenized assets.