Examining the Legal Validity of Non-Fungible Tokens in India.

Non-Fungible Tokens (“NFTs”) are the newest craze in the market today. They’re effectively a certificate of ownership for crypto assets, and they use the same blockchain technology as cryptocurrencies. Additionally, trading in NFTs is now only available through cryptocurrencies. However, the similarities between cryptocurrencies and NFTs end there.

Cryptocurrencies are interchangeable or “fungible,” However each NFT is one-of-a-kind and so cannot be traded like a cryptocurrency; thus the name “non-fungible.” NFTs can also indicate tangible assets, allowing for physical asset exchange on a digital marketplace. NFTs may represent a wide variety of objects, including artwork, GIFs, trading cards, and even virtual real estate. Despite the fact that the essential feature of digital production is a limitless supply, NFT allows for the ownership of a specific digital creation. The underlying idea is to limit the endless supply of digital creations, hence increasing the value of those creations. While several replicas of that artwork may exist on the internet, the NFT owner owns the original, and an extravagant amount of money is paid for these digital “bragging rights.” WazirX, Zebpay, and other crypto-trading platforms have already started their own virtual NFT marketplaces in India. With NFTs hitting the Indian market and sales surging at an all-time high, it's critical to examine them from a legal perspective.

The Mysterious World of Cryptocurrency

The legal ambiguity concerning the legal standing of cryptocurrencies in India is the most significant impediment to NFT trading, because, as previously noted, NFTs are only tradeable in cryptocurrencies. Furthermore, to date, all Indian platforms that have begun trading in NFTs are cryptocurrency exchanges. Despite the fact that cryptocurrencies are not illegal in India, the “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019” pushes for a full prohibition. Those who trade in cryptocurrency face a fine or perhaps jail under the law.

In Internet and Mobile Association of India v. Reserve Bank of India, the SC held that the April 2018 RBI circular prohibiting all regulated organizations from trading in cryptocurrencies was irrational and hence violated Article 19(1)(g) of the Indian Constitution. Furthermore, the government's position on cryptocurrencies changed dramatically in early 2021, with the finance minister indicating that the government was not planning a full ban on cryptocurrency and that it would allow individuals to experiment with it. The Reserve Bank of India also issued a circular instructing banks not to rely on the 2018 circular, which was overturned by the SC. As a result of this disagreement, there is no clear understanding of the legal status of cryptocurrencies in India, which makes trading in NFTs riskier.

Is it possible to classify NFTs as securities?

As previously stated, there is currently no law in India prohibiting the trading of NFTs. The legality of NFTs in India is unclear, and the idea that trading in NFTs is prohibited under the “Securities Contract (Regulation) Act, 1956” (“SCRA”) adds to the confusion. In India, there is no specific legal structure for NFTs. As a result, there is classification among academics over how to classify NFTs. Some argue that NFTs are contracts, while others argue that they are derivatives. If the latter is correct, trading in NFTs in India would be prohibited.

The definition of “derivative” under S. 2(ac) of the SCRA states that it also includes a contract whose value is derived from the prices or index of prices of underlying securities. If NFTs are considered derivatives, they are not permitted to be traded on virtual platforms under S.18A of the SCRA, which states that derivative contracts are legal only if they are traded on a recognized stock exchange. In this case, the platform where NFTs are traded will have to apply to the Central Government for recognition as a stock exchange. NFTs are non-fungible, as previously stated, and it is this non-fungibility that distinguishes them from other securities. As a result, if a specific NFT pertains simply to an existing asset and is offered as a guarantee of the asset's validity, 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 stake in the NFT) on the other hand, which have arisen as a result of exorbitantly priced NFTs that most people cannot purchase, may be classified as a security. Furthermore, if guarantees of a return on investment are made, NFTs will appear to be a speculative investment rather than a digital collection, and hence might be classified as a security in India.

NFTs in the United States:

NFTs in the United States, like in India, are unregulated, and the legal situation is a mess. On April 12, 2021, a petition was filed with the “Securities and Exchange Commission” (“SEC”) urging the agency to develop a framework for the regulation of NFTs. Aside than that, there is no official document on NFTs. Dealing in NFTs, however, can amount to breaching the law, according to SEC authorities, because NFTs can sometimes take the form of a “investment contract.”

At this point, it's worth noting the much-discussed ‘Holeyest,’ which was established by the SC of the United States in SEC v. W. J. Howey Co. 'Investment contract' is included in the concept of 'security' under US law, among other things. An investment contract, according to the United States Supreme Court, occurs when money is invested in a shared venture when returns are expected via the efforts of others. The term 'activities of others,' refers to third-party efforts to realize an asset's investment potential, is the most disputed. It is case-by-case if the earnings are the product of others' labor. For example, formed from a GIF or a painting is not a security since the GIF/painting is in its final stages and so its worth is not based on “other people's labor.” In contrast, if a real estate developer has financed a project by issuing NFTs (representing a floor or unit), these NFTs would be considered securities under the Howey test since the purchasers of the NFTs anticipate a return based on the developer's efforts.

Along with the concerns mentioned above, there are a slew of other legal and regulatory issues that arise with the introduction of NFTs. Intellectual property rights, the right to privacy, and money laundering are among the most pressing regulatory issues. The writers will discuss how NFTs may be used to launder money in the following section of this blog.

NFTs: A Cutting-Edge Money Laundering Tool?

Laundering money involves three primary steps:

(i) Placement,

(ii) Stacking, and

(iii) Integration.

The most important and difficult component of money laundering, perhaps, is ensuring that the source of the money becomes untraceable; i.e., layering the money. Criminals have always preferred to hide their ill-gotten money by buying legal items whose worth is difficult to verify, such as art. “Beauty rests in the eyes of the beholder,” as Plato famously observed, and this is precisely why criminals prefer to conceal their ill-gotten money by buying art, simply because the value of art is basically subjective. Furthermore, art transactions give criminals with much-needed anonymity and privacy. There are also few regulations, which means that most art dealers are not required to register transactions or authenticate their clientele. With the introduction of NFTs, the problem of money laundering through art is only going to become worse.

To begin with, NFTs can offer perfect anonymity. The blockchain technology that NFT uses is a public ledger that records every transaction involving a cryptocurrency. Blockchain is a vital technology for the production of NFTs. It uses cryptography to connect blocks to form a growing list of records. A cryptographic hash, or a string of letters that uniquely identifies a piece of data, links each block to the one before it. A Merkle tree is a data structure that maintains a sequence of blocks' transaction records. This makes it possible to quickly access prior records. There is a form of ledger that is kept. While it is theoretically feasible to walk backwards via this ledger, identifying wallets through which the cryptocurrency traveled, and then linking those wallets to persons using IP tracing, cryptocurrency tumblers can make this effort exceedingly difficult. To make the original source of the cryptocurrency untraceable, a 'tumbler' simply mixes identifiable or traceable cryptocurrency with non-traceable ones. The defendant in the recent case of USA v. Harmon was accused of conspiring to launder monetary instruments by using a bitcoin tumbler known as “Helix.” This tumbler's service had been touted expressly as a tool to conceal transactions from authorities. Furthermore, persons who acquire NFTs use pseudonyms and their profiles lack any information that may be used to identify them. For example, Vignesh Sundaresan, who paid $69 million for the most expensive NFT, purchased it secretly and only subsequently revealed his name.

Second, because there are no set parameters or criteria for pricing NFTs, it might be subjective. Even while art, other than crypto art, can be evaluated subjectively, there are a few parameters that can be used to calculate a price range, such as the age of the artwork, its quality, uniqueness, and so on. An animated flying cat with a pop-tart body, on the other hand, was recently auctioned for over $600,000. Because there are no parameters for determining the worth of this flying cat and other similar NFTs, money launderers may acquire them at inflated rates, making it incredibly easy to launder significant quantities of money.

Conclusion: What's next ?

Aside from the issues mentioned above, there is also the question of ownership rights in NFTs. When thinking about the intellectual property implications of NFTs, it's important to distinguish between ownership of the NFT and ownership of the intellectual property that supports it. The rights granted by an NFT seller are decided by the rights transferred through a license or assignment, which might vary from one NFT to the next. As a result, what is necessary is a solid legislative stance on this issue, as well as a clear statutory framework.

NFTs are the most recent type of crypto asset. NFTs can also act as securities in specific scenarios, as mentioned above, and can be traded on peer-to-peer decentralized exchanges. India could also learn from countries with a well-balanced legal and regulatory environment, such as Singapore, Canada, Japan, and Switzerland. For effective trading of NFTs in India, cryptocurrency legalization is required. NFT trading is dangerous until and until a definite judgement is made on the validity of cryptocurrencies in India. Second, the government will have to clarify whether NFT is considered a derivative or not.

The fact that the Financial Action Task Force (the world's anti-money laundering watchdog) has taken note of NFTs and published draft recommendations is a strong signal that they may be exploited for nefarious reasons if left uncontrolled. If NFTs are deemed legal in India, amendments to the “Prevention of Money Laundering Act, 2002”, as well as the “Antiquities and Art Treasures Act, 1972,” would be necessary. Taking more advice from the European Union's “Fifth Anti-Money Laundering Directive” may also be beneficial. In reality, the most ideal alternative appears to be a separate legislation to prevent money laundering through the art market, with NFTs included in the definition of art.