Are NFTs ‘financial products’ in Australia? A cryptic definition explained

What is an NFT?

NFT stands for non-fungible tokens. An NFT is a type of digital asset that is unique. NFTs are characterised by the following value-driven properties: transferability, uniqueness, permanence, programmability, permissionless and digital ownership. Like traditional digital assets, NFTs are generated (minted) on a blockchain using cryptography. The blockchain immutably records the transaction history of the NFT: from issuance to all subsequent exchanges. No two NFTs are exactly alike, akin to diamonds or original tangible artworks. NFTs thus cannot be readily traded or exchanged in equivalence due to their namesake non-fungible properties. By contrast, fungible items, like common stock, bitcoin or a dollar coin, are identical and interchangeable. Often compared to digital passports, NFTs are the first instance of verifiable digital uniqueness and scarcity.

State of Play - NFTs

NFTs exploded into the mainstream in 2021, with a strong focus on artistic and community value. While NFTs have moved on from the apex of their hype and now come with lower price tags, their reach and use cases have expanded. NFTs have entered the sectors of music, sport and gaming, digital identity, social media, real-world assets, and other Web3 applications. Some companies incorporate NFT offerings into their business models. Nike generated $185M in NFT sales,²  Starbucks sold out 2000 NFTs within minutes, ³ Ticketmaster debuted token-gated ticketing,⁴ and Reddit’s NFTs reached 16M holders.⁵  NFTs are now used to represent ownership of other assets (tangible and intangible), such as physical artwork, real estate, sound recording and vehicles.

We have seen time and time again that linking digital tokens to finance has a magnetic pull. Decentralised Finance (DeFi) is testament to that. The financialisation of NFTs, albeit still in its infancy, is another notable technological primitive that will continue to evolve. Examples of financial NFT applications to date include:

• NFTs as loan collateral, enabling NFT owners to access funds while retaining their assets. NFT lending projects (such as NFTfi and ParaSpace) permit users to borrow liquidity or engage in Buy Now, Pay Later (BNPL) transactions by depositing NFTs or tokens as collateral.
• NFTs as on-chain carbon credits, verifying and storing information for carbon emission offsets. The carbon removal credit is first minted as an NFT on a platform such as MintCarbon. Once issued or used in real world, the carbon credit NFT is retired (burned), preventing its trade on a secondary market. In a time of increased scrutiny of ESG, carbon credits on the blockchain may have the potential to inject some much-needed transparency and credibility into the current voluntary carbon market.
• NFT exchange-traded funds (ETFs) such as Kucoin NFT ETFs, providing investors indirect exposure to the NFT space.
• Fractional NFTs for proportionally shared ownership, whereby the NFT itself is stored in one place and other separate tokens are issued to represent shared ownership of that NFT. Fractional NFTs let smaller investors own smaller, more affordable portions of blue chip NFT collections such as Axie Infinity’s rarest NFTs.

The potential for financial NFTs being transformative has been spoken about for a while now. The applications discussed above lay the groundwork for future NFT-based financial tools.

Legal Treatment

In Australia, the financial services laws already apply to digital assets that are financial products, meaning the Australian Financial Services Licence (</p>) framework applies to any business providing financial services in relation to those digital assets. Although Australian law does not currently recognise NFTs as a specific legal asset or financial product, there have been some proposals put forward. A recent proposal to regulate crypto asset providers is the Digital Assets (Market Regulation) Bill 2023 (Cth) (Bill). However, the Senate Committee reviewing the Bill has recommended that further consultation be undertaken instead of passing the Bill.

On 16 October 2023 the Australian Federal Treasury released its public consultation paper regarding the proposed regulatory regime for digital asset platforms (such as crypto exchanges, brokers, market makers) and a new type of financial product called a ‘digital asset facility’ for certain asset holding arrangements. The consultation paper acknowledged that many digital assets will not be financial products, including some digital assets used in non-financial industries such as video gaming, media and entertainment, health care, fitness and lifestyle, and gambling. Significantly, the consultation paper proposed a ‘financialised functions’ regime to cover specific activities that do not involve financial products but still need to meet additional minimum standards. One such ‘financialised function’ would be where a digital asset platform intermediates the sale of entitlements to fund the development of ‘non-financial’ products and services. The consultation paper proposed that a digital asset platform with a funding tokenization function must, amongst other things, ensure fair distribution of facility tokens to backers in the form of NFTs or fungible tokens.

Many NFTs will not involve a financial or investment function, and thus the facts will always matter when it comes to determining Australia’s regulatory treatment. For now, the legal status of NFTs depends on what they represent and the rights attached — not how they are named or marketed. However, to the extent an NFT project is considered to fall into the category of financial products or securities under Chapters 7 and 6D of the Corporations Act 2001 (Cth) (Corporations Act) significant regulatory consequences follow. Obligations may arise under the Corporations Act, Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) and the Australian Consumer Law and Regulations, as well as anti-money laundering (AML) and know your client (KYC) obligations.

In Australia, anyone who carries on a financial services business must either hold an AFSL or have the benefit of an exemption. This depends on whether the NFT:

• Will be considered a ‘financial product’ or a ‘security’ within the meaning of the Corporations Act; and
• Whether the provider is carrying on a financial services business in the jurisdiction.

ASIC's Guidance

ASIC’s approach has evolved over recent time. ASIC’s Information Sheet 225 “Crypto-assets” states that it is the responsibility of the entities involved to ensure they consider all rights and features of the proposed cryptocurrency, as well as the way in which it will be offered. Those entities include, without limitation, digital asset issuers, intermediaries, exchanges and trading platforms, crypto asset payment and merchant service providers, and wallet providers and custody service providers. Entities should be prepared to justify a conclusion that their NFT and the means of offering it does not involve a regulated financial product or seek appropriate authorisation if it is a regulated financial product.

Noting that an NFT is simply a form of cryptocurrency, the starting point for this inquiry is whether crypto assets have the potential to be considered a financial product. But the litmus test is whether the activity driving the NFT meets the definition of a financial product, security or an interest in a managed investment scheme. Each of these definitions is discussed below.

Definition of financial product

Australian law adopts a functional approach to the assessment of whether something is a financial product. Under s 763A of the Corporations Act, a financial product is a facility through which a person does one or more of the following:

• makes a financial investment;
• manages financial risk; or
• makes non-cash payment.

As can be seen, the definition is very broad.

Definition of security

Under s 761A of the Corporations Act, a security is a share or debenture in a body, or a legal or equitable right in a share or debenture of the body. An option to acquire a share by way of issue will also be considered as a security.

Definition of managed investment scheme

A managed investment scheme (MIS) is a form of collective investment vehicle. It is defined under s 9 of the Corporations Act and has three elements:

• people contribute money or assets (including crypto assets) to obtain an interest in the scheme;
• any of the contributions are pooled or used in a common enterprise to produce financial benefits or interests in property, for purposes that include producing a financial benefit for contributors; and
• the contributors do not have day-to-day control over the operation of the scheme but, at times, may have voting rights or similar rights.

Definition of financial services

A person carrying on a financial services business in the jurisdiction must hold an AFSL unless an exemption applies.

Generally, a person provides a financial service if they:

• deal (including issuing and arranging for dealing to occur) in financial products;
• providing financial product advice in relation to financial products; and
• operate a registered MIS.

As shown above, the current regulatory regime is technology-neutral and applies a substantive test to whether or not a crypto asset is regulated as a financial product and therefore subject to the AFSL regime.

Accordingly, if NFTs have rights and circumstances that are akin to financial products, then they will trigger the relevant regulatory obligations. For example, NFTs that form part of a collective investment product or represent carbon credits will likely constitute a financial product and are thus subject to AFSL regulation. In a similar vein, NFT lending activities may fall within the scope of the credit activities and services caught under the National Credit Consumer Protection Act 2009 (Cth), and the relevant entities may need to hold an Australian credit licence or be otherwise exempt from this requirement.

If the NFT is indeed a financial product, other issues such as disclosure obligations arise. For example, marketing and promotion of a financial product may constitute financial product advice and so would generally need to be supported by an authorisation if it involves a retail audience, unless an exemption applies. The Corporations Act treats all persons or entities as a retail investor unless they are a wholesale client.⁶  Financial product issuers are also responsible for ensuring that a product disclosure statement or prospectus prepared for the product meets the requirements set out in Part 7.9 of Corporations Act and related Corporations Regulations.

Conclusion

The emergence of NFTs with a financial or investment function is a significant innovation for the ecosystem. While NFTs are not always financial products, the question is one of substance over form. It is therefore necessary to consider on a case-by-case basis whether the NFT is regulated or otherwise. Regulatory compliance is necessary to promote market confidence, user acquisition and scalability without hindering innovation. We look forward to sharing more insights as Australia’s regulatory regime develops in respect of NFTs and other crypto assets.