Non-fungible tokens (NFTs) have been met with considerable interest in the last few years. After a period of tremendous growth, however, the NFT market experienced a sharp drop in demand and prices in mid-2022. Despite this downturn, there can be no doubt that NFTs continue to be highly relevant. Their technical characteristics make them eligible for many different forms of application.

NFTs are supposedto combine the special characteristics for which crypto tokens are known on the market, like good transferability and low risk of falsification, with the means of individually assigning the specific token to an address on the blockchain.

Since NFTs are also used in the financial sector, BaFin is examining the potential of this phenomenon and particularly also the risks associated with it. From the supervisors’ perspective, it is important to find out what relevance NFTs have for the financial market and what the consequences will be for offerors, service providers and customers.

NFTs: unique cryptographic tokens?

NFTs are cryptographic tokens that are based on distributed ledger technology (DLT) – especially blockchains, which are a special form of DLTs. NFTs, as their name implies, are not fungible with each other due to their technical characteristics: they are non-interchangeable.

This design makes it possible to uniquely assign individually identifiable tokens to a particular address on the blockchain. With fungible tokens, on the other hand, it is not an individual token that is assigned to each address but only the respective share of all existing tokens of that kind. The best-known standard for fungible tokens is the ERC-20 standard on the Ethereum blockchain.

Both NFTs and fungible tokens can also be created on the basis of other blockchains – such as Solana, EOS or Tezos – as well as on the basis of other standards.

The criterion of uniqueness for NFTs merely conveys information about their technical characteristics – such as the individual identifier of a token (also called a token ID) – but not necessarily about the contents to which the token pertains or the rights associated with it. For example, a smart contract can be used to create many NFTs, each of which has its own individual identifier but also all of which are assigned the same rights or contents.

Numerous fields of application

There are many different possible applications for NFTs. Probably the most prominent categories of NFTs are “collectibles” and digital art. Collectibles are collector’s items in digital form; some can also provide bonus functions enabling holders to interact with the tokens. For artists, NFTs can make it possible, for example, to participate in any future proceeds generated when the collectibles are resold. NFTs are also put to use in the context of gaming and the metaverse, such as in the form of tokenised game objects or real estate in digital worlds.

Supervisory practice as in the case of fungible tokens

When conducting supervisory assessments of NFTs, BaFin takes the same approach that it takes for fungible tokens. Market participants can find more information in the interpretive letters¹ BaFin has published on this subject.

Not yet classified as securities for supervisory purposes

In cases where NFTs are to be categorised as securities under the EU Prospectus Regulation or as capital investments under the German Capital Investment Act (Vermögensanlagengesetz – VermAnlG), issuers are generally required to draw up a prospectus.

NFTs are to be classified as securities if they embody rights comparable to securities and are transferable and negotiable on the financial market.

Rights comparable to securities include membership rights or contractual claims on assets, as in the case of shares and debt instruments.

The criterion of transferability can be deemed met in the case of the prevalent standards. The requirement of negotiability requires a minimum level of standardisation. This requirement is considered fulfilled in the case of NFTs if the tokens do not convey rights that differ from each other. A differing token ID does not per se constitute a significant distinguishing criterion.

To date, BaFin is not aware of any NFTs that would have to be classified as securities for supervisory purposes. One reason is that the tokens have so far lacked embodied rights comparable to securities. Another reason is that NFTs are usually given individual rights and contents, and this rules out standardisation and thus negotiability in terms of the supervisory definition of securities. At the same time, there is some possibility that NFTs may be classified as securities in future. This could be the case, for instance, if 1,000 NFTs were to embody the same repayment and interest claims.

Possibility of classification as capital investment

As an alternative to classification as a security, an NFT may be designated as a capital investment under the VermAnlG (section 1 (2) of the VermAnlG). It is entirely possible, for example, that an NFT serving as proof of ownership for a work of art is to be classified under the category “other investments” (section 1 (2) no. 7 first alternative of the VermAnlG) if it embodies the issuer’s obligation to sell the work of art at a profit and grants the token holder a claim to repayment and interest. Nevertheless, there is no obligation to draw up a prospectus or a capital investment information sheet if fewer than 20 units, in this case NFTs, are offered in the context of the issue (section 2 (1) no. 3 (a) of the VermAnlG).

Authorisation requirements: decided on a case-by-case basis

As with other tokens, the question of whether NFTs are to be classified as financial instruments within the meaning of section 1 (11) sentence 1 no. 10 of the German Banking Act (Kreditwesengesetz – KWG) or section 2 (5) of the German Investment Firm Act (Wertpapierinstitutsgesetz – WpIG) must generally be decided in light of the circumstances of the individual case. It is important to know which rights an issuer associates with the tokens and how the tokens can be used once they have been issued.

The use of NFTs that is currently to be observed, however, especially in cases where they are used to tokenise digital works of art, does not necessarily point to designation as a financial instrument in the form of a capital investment or a debt security. These NFTs generally lack further financial rights; where individual tokens have individual contents, the necessary level of standardisation is missing. Without this interchangeability, there can also be no classification as a unit of account. In the case of fragmented NFTs, where fungible tokens each represent an equivalent share of an NFT, this interchangeability requirement would generally be met, however.

In cases where an NFT contains documentation of the rights of utilisation or of ownership but also further financial rights, such as commitments to distribute profits, it is possible that the NFT is to be classified as a capital investment (see also the information provided above).

The decision of whether NFTs are to be considered crypto assets must be taken on a case-by-case basis. Crypto assets are digital representations of value that are accepted by third parties as a means of payment or used for investment purposes. Particularly due to the lack of interchangeability, it hardly seems realistic to use non-fragmented NFTs, with their individual contents, as a means of exchange or payment. It is a different story with the second alternative – the use for investment purposes, which cannot automatically be ruled out in the case of NFTs. The mere fact that users speculate with an NFT, i.e. they can make a profit by buying and then reselling, is not enough for supervisory authorities to objectively assume that the NFT category concerned is supposed to serve investment purposes. The results of the examination will therefore depend on the rights associated with the tokens and also the advertising claims used by the issuer or third parties in charge of marketing. If the claims emphasise that the NFTs offered are particularly suited for investment, for example, these NFTs may be deemed crypto assets.

If an NFT is designated as a financial instrument in an individual case, the secondary market trading to occur after the issue would be relevant for any possible authorisation requirements. Depending on the implementation, this could mean banking business or investment services, such as principal broking services or investment/contract broking, investment advice and/or the operation of a multilateral trading facility. Activities relating to NFTs that are to be classified as financial instruments require authorisation just as much as activities that concern traditional financial instruments.

For the NFTs currently known, authorisation requirements under the German Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz – ZAG) generally do not apply. If there is a lack of standardisation, such NFTs cannot be used to carry out payment transactions; consequently, the tokens do not constitute e-money within the meaning of section 1 (2) sentence 2 of the ZAG.

It is also possible that the authorisation requirements under the German Investment Code (Kapitalanlagegesetzbuch – KAGB) apply. If, however, the acquisition of an NFT does not involve the raising of capital from investors because it is to be used by one single interested party for the sole purpose of acquiring or buying a work of art, collector’s item or virtual object, or because it is to transfer other rights in such object, there is clearly no bundling of investors’ funds involved, which would be necessary for an investment fund. Consequently, the NFT would be not be deemed an investment fund within the meaning of the KAGB.

Money laundering risks inherent in NFTs

NFTs may be misused for money laundering purposes. Since technically they build on the same systems as other crypto assets, the risks generally identified for the crypto market are also relevant to NFTs. This includes for example anonymous or pseudonymous transactions, the lack of supervised brokers/institutions as intermediaries, the use of foreign unsupervised trading platforms, unsupervised means of payment and payment channels (such as mixers and tumblers) and decentralised exchange protocols.

Overall, it is difficult to make any general assessments of the money laundering risks in connection with NFTs. Due to their many different designs and possibilities for use, NFTs can differ greatly from each other in terms of their characteristics. In real life, however, NFTs are currently being traded primarily in the form of art and collector’s items. These sometimes involve high prices, which also makes such NFTs interesting from a money laundering perspective. In addition, the prices may also be further driven up by “wash trades”, where fictitious sales artificially cause price increases.

NFTs may fall under BaFin’s anti-money laundering supervision

Nevertheless, NFTs are only relevant for BaFin’s anti-money laundering supervision if they are the subject matter of financial services under the KWG. This is the case if, as described above, they are deemed financial instruments within the meaning of the KWG. The provider of such financial services is then to be designated as a financial services institution. It is only in such cases that the obligation under the German Money Laundering Act (Geldwäschegesetz – GwG) (section 2 (1) no. 2 of the GwG) applies and BaFin is the competent supervisory authority (section 50 no. 1 (b) of the GwG). Art NFTs and collector’s items, which are particularly relevant at present, are thus generally not subject to BaFin’s anti-money laundering supervision under current legislation.

Where NFTs do give rise to a requirement under the GwG, they are also subject to the entire canon of obligations under the GwG. One aspect that must be emphasised in this connection is the obligation to fulfil the general due diligence requirements not only when establishing a business relationship but also when transactions are carried out outside of existing business relationships if the respective NFTs are to be classified as crypto assets and exceed an equivalent value of EUR 1,000 (section 10 (3) no. 2 (c) of the GwG). Furthermore, obliged entities that carry out transfers of crypto assets are subject to specific enhanced due diligence requirements under the Crypto Asset Transfer Regulation. Obliged entities that carry out transfers of crypto assets to or from other obliged entities must comply with Articles 4 and 6 and/or Articles 7, 8 and 9 of the Funds Transfers Regulation (Regulation (EU) 2015/847) accordingly. Obliged entities that carry out transfers to or from unhosted wallets must implement other appropriate measures for managing risks and, for example, use blockchain analysis tools.

All in all, NFTs currently require a very nuanced approach when it comes to supervisory classification. Technology provides many various forms of application for these tokens. Their potential for use in many areas of the financial sector is tremendous. At the same time, they entail a number of potential risks, such as in the area of money laundering. From BaFin’s perspective, therefore, it will be crucial – both now and in future – to weigh up the opportunities that NFTs bring to the financial system with the risks they pose for the stability and integrity of the financial system.

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