8.1 Non-fungible Tokens

Non-Fungible Tokens (NFTs) are difficult to define legally. As discussed in Chap. 3, NFTs are a digital form of ownership certificate. The digital ownership can be of various items such as collector goods, arts and land. Whilst NFTs have practical value they are also associated with MLFT.Footnote 1 The use of NFTs in the Metaverse is likely to be widespread as Metaverse itself offers its own NFT trading and generating system.Footnote 2 The NFTs can be used to own land in the Metaverse or exclusive ownership of art used to decorate virtual realities. The following paragraphs will therefore discuss how to regulate NFTs. In particular whether these should be regulated as a virtual currency or according to their physical counterparts.

The NFT is not quickly associated with currency as it represents ownership of an asset. It is therefore questionable if NFTs meet the criteria of a virtual currency. In particular that of a digital representation of value that is accepted as a means of exchange. It is easy to argue that a NFT has value, but that does not make it an accepted means of exchange. A car has value, yet it is unlikely a consumer will use it as means of exchange when buying groceries. The concept of value within the functional properties of a currency is that it is fungible. Jevons argued in 1875 that fungible currency was economically more beneficial than payment systems through barter.Footnote 3 This concept of fungibility is still considered valid today.Footnote 4 If this definition of value is used, NFTs would not be considered a virtual currency. By definition a NFT cannot be divided, thus not classifying as currency. It is likely that value should be determined according to the functional definition of money. Meaning that a token would have to be fungible in order to classify as a virtual currency. The main basis for this argument is the definition given by the Financial Action Task Force (FATF). The FATF uses the same definition for virtual assets and virtual currencies. It defines both assets and currencies as “[…] functions as (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value […]”.Footnote 5 The use of a single definition for both assets and currency, suggests a broad definition for value. The inclusion of medium of exchange, unit of account and/or store of value, however, directs towards a more functional approach to value. Instinctively it is difficult to define NFTs as money. NFTs represent commodities rather than a currency. Fairfield therefore suggests classifying NFTs in a similar fashion as the physical counterpart they represent.Footnote 6 Certainly from a legal certainty point of view this type of classification has merit. Particularly when the NFT is used to guarantee ownership and the parties disagree on the execution of the contract. This type of classification would provide tools to answer questions on jurisdiction and what legal principles should apply. Such a classification, however, creates uncertainty with regard to the wallets that store the NFTs and a potential loophole with regard to AMLD5. The NFTs themselves can prove ownership and thereby can replace legal fictions such as the posser is expected to be owner. This type of certificate of authenticity is clearly not a currency similar to fungible coins. There is thus ample reason not to classify them as virtual currency. So why bother?

The NFTs, however, represent value stored in the digital wallet. The value is technically related to the object it represents. However, it can be easily generated and used as a messaging system. The digital wallet used to store an NFT is the same as those used to store other virtual currencies. If not supervised the result would be a two-fold loophole. Firstly a provider focusing on NFT storage would therefore be able to avoid supervisory oversight by stating its business is storing NFT, rather than virtual currencies. This situation is highly unwanted. Secondly as Fairfield describes the NFT can represent the deeds to i.e. land.Footnote 7 He therefore argues that NFTs should be considered personal property and the law of sales should apply.Footnote 8 Physical real estate transactions are considered part of the types of transactions that involve MLFT.Footnote 9 A physical land transaction would, therefore, normally be transacted through a notary or solicitor. These professions are covered under the AMLD5.Footnote 10 The law of a real estate transaction will generally be determined by the country where it is physically located. The question is under what, if any, jurisdiction would a plot in the Metaverse be located? Could virtual reality providers determine how sales are conducted? Furthermore the value of virtual real estate varies greatly.

One of the Metaverse realities currently in existence is Decentraland. Plots of Decentraland currently trade at $6000 per plot.Footnote 11 This market is furthermore rapidly rising.Footnote 12 The idea that virtual assets are less valuable than physical assets no longer applies to all cases. However, in other virtual realities plots of lands may be worth a fraction of the plots in Decentraland. To require a solicitor to assist in the purchase of a virtual plot of land worth €10,- seems excessive. Similarly in the United States NFTs are (likely) supervised through the National Defense Authorization Act.Footnote 13 It however is not clear whether an NFT should be considered as the sale of an “antiquity” or a cryptocurrency. Leading some to fear for an aggressive enforcement theories.Footnote 14 The opposite is, however, also possible namely that of no enforcement. To avoid regulatory oversight it would be the most straightforward to classify an NFT as a virtual currency. The wallets would then monitor NFTs entering and leaving the wallet as if it were cryptocurrency. Though intuitively it would be odd to consider NFTs currency, it is not economically odd to consider commodities as currency.

The first criterion for money is that of a medium of exchange. It has to be accepted as a form of payment. This criterion flows forth from the concept of “double coincidence of wants”.Footnote 15 A problem that occurs in barter transactions. If I want apples and have pears I would need to find someone who would want pears and has apples. If the opposing party only has nectarines then the transaction would not occur. Money can solve this issue through universal acceptation. NFTs represent objects, therefore if two parties conduct a transaction whereby an NFT is traded against a service it would be considered barter. However this need not be the case. The EBA considers that the term value can also refer to a form of commodity.Footnote 16 Economic research has furthermore argued that goods can be considered a medium of exchange. Currencies can take the form of commodities through intrinsic properties and extrinsic beliefs.Footnote 17 A particularly popular example of commodity currency are cigarettes. Cigarettes served as commodity in Germany after the war.Footnote 18 Whilst there are various examples of commodity currencies they are not always present in complex economies. Commodity currencies rise due to the lack of money and trade higher in value than its utility value. When (fiat) money is introduced commodity currency is crowded out.Footnote 19 The Metaverse is likely to have various options of non-commodity currency provided on the blockchain. Though it could be argued that cryptocurrencies should not be considered viable currencies due to the, often extreme, price fluctuations. Whilst the initial cryptocurrencies fluctuated in value, newer currencies such as stable coins are pegged to a fiat currency and their value is relatively stable. It is therefore unlikely that there is a great need for a commodity value. Secondly due to the complex economy of the Metaverse it is difficult to use NFTs as a unit of account.

The criterion of unit of account is to demonstrate the value difference between goods and services.Footnote 20 It allows a potential customer to distinguish the price attached to different objects. The difficulty with NFTs is that their value depends upon the considered value of the object it represents. NFT1 does not necessarily have the same value as NFT2. NFTs can furthermore fluctuate heavily in value. Thus making it difficult to store value, which is the third criterion for currency. The same price fluctuations, however, are true for bitcoin. Bitcoin can therefore also be considered not to fulfill the store of value criterion.Footnote 21 Nevertheless bitcoin and other cryptocurrencies are perceived as currency.Footnote 22 Despite the difficulty in its store of value bitcoin, however, can be exchanged against other cryptocurrencies and fiat currencies. NFTs, however, have to be sold rather than exchanged. Whilst from a regulatory point of view it would be straightforward to consider NFTs as virtual currency, it seems unlikely they will qualify as such. The qualification of NFTs according to their physical counterpart seems equally risky. Not only because it risk lack of jurisdiction but also because it may stifle the Metaverse economy. Considering the ease of monitoring NFTs through the wallets it is recommendable to change the legal definition of a wallet provider. Rather than the term ‘virtual currency’ the FATF’s term ‘virtual asset’ seems preferable whereby virtual asset should be interpreted as a commodity or currency. The wallet can then supervise the currency and NFTs within.

8.2 Stateless Firms

Anonymity is a particularly interesting risk with regard to the Metaverse and virtual reality in general. The previous chapters have discussed due diligence and customer verification duties in the three stages of MLFT. Specific to the Metaverse, however, will be the possibility of anonymous companies. The physical counterparts of anonymous companies are shell corporations. Shell corporations have a significant role in the process of MLFT. These corporations hide their true owner. Thus providing a disconnect between the owner and the illegal transfers.Footnote 23 The EU response to the anonymity of the shell corporations is through the UBO registry. The UBO registry contains the information on who controls and owns the corporation or trust. The AMLD4 set the ownership indication at above 25% of shares owned directly or indirectly by the same legal person(s).Footnote 24 There has been some discussion as to whether setting exact ownership limits is the right direction,Footnote 25 and whether privacy is safeguarded. It is too early to tell whether the UBO is effective,Footnote 26 nevertheless the registry seems to decrease the possibility for shell corporations within the EU to hide their owners. The duty to register is based upon the nationality of the legal person. The obvious risk are those companies not located within the EU. The EU, however, does not have any jurisdiction to regulate the companies outside its own territory. The transactions to companies with less regulatory obligations are part of the subjective MLFT risk criteria. The system whilst not flawless improves the regulation of these companies. The regulatory obligations within the EU are furthermore based upon FATF recommendations.Footnote 27 Thus the best approach for the EU (and FATF) is to promote international compliance with these regulatory recommendations. The Metaverse brings similar risks of being able to transact with countries in various jurisdictions. These will have to register with the UBO registry within their own jurisdiction. Companies providing digital services are not exempt from registration, depending on where they are incorporated these firms will have to register with their respective UBO. The Metaverse, however, transforms the concept of a shell corporation into a completely new risk; namely that of stateless firms.

The nationality of an economic entity is generally determined through its foundation within a jurisdiction. The entity generates legal personality by its establishment as (limited)company. It needs this legal personality to purchase goods, open a bank account and use other services. If no legal personality is generated the economic activities can be run on a personal title. The nationality of the company is then equal to the nationality of the person. The legal personality of the company is the primary criterion to determine the applicable legislative framework. The Metaverse creates an opportunity for companies to exist without nationality. Virtual reality providers could demand that any economic entity is registered as such with a national supervisor. There are however ways to circumvent such requirements. The economic entity can either find a provider that does not require registration as a (legal) person or by creating its own virtual reality. The easy solution would be to consider such entities sole traders. Sole traders, however, are physically present somewhere and can generally be linked to their business. Generally speaking sole traders will have acquired a bank account which links them to the business. Within the Metaverse it will be extremely difficult to establish the person behind the laptop. Furthermore as previously discussed through the use of virtual currencies it will be easy to set-up an anonymous wallet and enter the economic framework. Without incorporation into a jurisdiction and being able to link the person to the entity the result is a virtual stateless company.

The difficulty with stateless companies is that they can provide full anonymity to its beneficiaries as there is no government entity responsible for their supervision. The lack of supervision and jurisdiction increases the risk of MLFT. The phenomenon of stateless firms is not entirely new. Irish incorporated entities could declare their profits as part of a headquarter located in an tax-free jurisdiction. Thereby avoiding paying tax in both Ireland and abroad. This concept was referred to as that of stateless firms.Footnote 28 Whilst these firms were considered stateless they were only stateless with regard to taxation. The firms still existed and contained legal personality. In order to reduce tax avoidance, countries have generated approaches to determine where a company is located despite its incorporation. These approaches may help determine where the virtual companies are located.

The first approach is whereby location is determined through incorporation into its jurisdiction. This was discussed in the previous paragraph will not be a likely solution for the Metaverse. The second approach is based upon where the company generates its products. To reduce the amount of stateless firms in Ireland the government approach is through a ‘place of incorporation’ test.Footnote 29 This approach considered where the activities and in particular management and control of the company is located.Footnote 30 This approach in the physical world led to serious tax avoidance.Footnote 31 It may, however, form a good approach to establish nationality of online firms. If a company is stateless, its nationality can be determined according to where it conducts its activities. If the virtual reality has a jurisdiction (clause) attached to it, the same jurisdiction would apply to the company. The problem with this approach, however, is that not all virtual realities will be attached to a jurisdiction and persons (or management) may not always be traceable. With regard to the production of physical goods, this is assuming there are physical goods rather than virtual, it might be difficult to trace (though not impossible). The question is whether efforts will be made to trace the production location and by whom. Governments are unlikely to spend resources on tracing a company without clear indication that their economic entity is harmful to their economy. The Commission may spent such resources when the company has ties to the EU. As the Commission may in the future claim residual tax leftovers.Footnote 32 But momentarily this legislation for tax is still within a draft version. Secondly the company’s activities may be fully virtual, i.e. the production of virtual shoes for Avatars. Its economic activities may therefore not perse be linked to physical jurisdiction. To award companies nationalities through a top-down approach may therefore not always be possible. It is therefore this researchers recommendation to establish a bottom-up approach through wallet regulation.

The virtual economic entity may not need to have a legal personality to purchase real estate or limit risk. It will need some form of currency. The due diligence of a wallet would therefore include establishing the identity of their customer. Whereby the wallet would have to establish the UBO of the economic entity. Economic entities without legal personality should be refused service. Currently, however, the due diligence of a company is limited to reasonable measures.Footnote 33 If customer verification could not take place, transactions are only considered suspicious if there are other indications of MLFT.Footnote 34 This level of due diligence is not necessarily suited to prevent stateless entities from gaining access to wallets. The customer due diligence should at least include the verification of the companies existence. If the legal existence of a company cannot be verified, the company should be excluded access. The alternative would be to wait to see if transactions could be considered suspicious. However, if the entity’s nationality cannot be determined investigation will become increasingly difficult and costly. Raising the same question as to whether the investigation will be carried out. Wallets should therefore only provide services or sell their software to clients with a verified legal personality.