If nothing else, Facebook’s recent announcement that it plans to change its name to “Meta” is a sign that the metaverse is coming and that our legal system must be prepared for it. As the metaverse, the concept of a virtual version of the physical world, gains increased popularity, individuals will engage in more transactions involving non-fungible tokens, or NFTs, to purchase the virtual items that will inhabit metaverse worlds. Accordingly, the United States will need more robust regulatory frameworks to deal with NFT transactions, especially in the gaming industry, where NFT use will likely rise significantly.
In most other areas of digital media and entertainment, NFTs are often associated with niche items, such as high-priced autographs and limited-edition collectibles. However, in the video gaming sector, existing consumer spending habits on rewards such as loot boxes, cosmetic items, and gameplay advantages provide fertile ground for explosive growth in NFT use. This article will explore the outlook for NFTs in gaming, why gaming NFT creators should consider the potential impact of financial regulations on their tokens, and how current U.S. financial regulations could apply to this ownership model.
A. Current State of Virtual Currencies and Items in Gaming
Gaming has long been the gateway for consumers to explore immersive digital experiences, thus explaining why virtual currencies and collectible items have such strong roots in this sector. Further, given the popularity of virtual currencies and collectibles in gaming, it is no surprise that cryptocurrencies and NFTs have similarly experienced success in this space.
NFTs, or non-fungible tokens, are unique digital assets that consumers may purchase with fiat currency or cryptocurrency. NFTs can be “minted” for and linked to almost any digital asset (e.g., video game items, music, social media posts), and even many physical assets. While NFTs are blockchain-based just like cryptocurrencies, the key difference between the two is that a NFT is not mutually interchangeable with any other NFT (i.e. they are non-fungible). So why are they so special? As digital experiences continue to move to the metaverse, NFTs will serve as a primary means for consumers to connect with companies, celebrities, and, eventually, each other.
In the simplest explanation, metaverse is the concept of a digital twin of the physical world, featuring fully interconnected spaces, digital ownership, virtual possessions, and extensive virtual economies. Mainstream media has already given significant coverage to metaverse activities that have appeared in popular games, such as concerts in Fortnite and weddings in Animal Crossing. However, more futuristic examples of how NFTs and metaverse could transform our daily lives exist in the Philippines with Axie Infinity and Decentraland, a blockchain-based virtual world.
In Axie Infinity, players breed, raise, battle, and trade digital animals called Axies. The game was launched in 2018, but it took off in popularity during the COVID-19 pandemic as many families used it to supplement their income or make several times their usual salary. To date, the game has generated $2.05 billion in sales. Meanwhile, plots of virtual land in Decentraland, a 3D virtual world where consumers may use the Etheruem blockchain to purchase virtual plots of lands as NFTs, are already selling for prices similar to those offered in the physical world. For example, in June 2021, a plot of land in the blockchain-based virtual world sold for $900,000.
The growth in popularity of Axie Infinity has already caught the eye of the Philippine Bureau of Internal Revenue, which has announced that Axie Infinity players must register to pay taxes. As financial regulation of NFTs looms, it will be imperative for U.S. gaming companies to consider how federal courts and the government will recognize the status of NFTs.
B. Financial Regulation and NFTs
As NFT transaction volume grows, there will undoubtedly be greater scrutiny over these transactions by financial regulators. While the current legal and regulatory environment does not easily accommodate virtual assets, there are a two primary ways NFTs may be regulated.
1. Securities Regulation
One of the most hotly discussed legal issues concerning NFTs involves whether these tokens should be recognized as securities. Under SEC v. W.J. Howey Co., a transaction is deemed an investment contract under the Securities Act where all of the following four factors are satisfied: (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others.
Intuitively, NFTs, in the form of virtual collectible items, don’t seem like traditional tradable securities as they are unique, non-fungible items. Indeed, they do not appear to demonstrate the type of “horizontal commonality” that federal courts have held to be necessary to satisfy the “common enterprise” aspect of the Howey test. “Horizontal commonality” is generally understood to involve the pooling of money or assets from multiple investors where the investors share in the profits and risk.
However, the Securities Exchange Commission has stated that it “does not require vertical or horizontal commonality per se, nor does it view a ‘common enterprise’ as a distinct element of the term ‘investment contract.’” Therefore, the fungibility aspect of the token alone may not preclude it from inclusion under securities regulation.
A more interesting inquiry might involve assessing whether the reasonable expectation of profits associated with an NFT is based on the “efforts of [others],” as outlined in Howey. In evaluating this element of the Howey test, the SEC considers whether a purchaser reasonably expects to rely on the efforts of active participants and whether those efforts are “undeniably significant” and “affect the failure or success of the enterprise.” Under this lens, how an NFT is offered and sold is critical to consider.
For example, if one mints (i.e., creates a NFT for) a piece of graphic art that sits and passively accumulates value, the failure or success of purchasing such a NFT would likely not be highly reliant on the activities of others. As the SEC has noted, price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test. Similarly, if a consumer purchases a digital pet, like those in Axie Infinity, that actively accumulates value through winning a series of battles, the success or failure of this digital pet would also not be highly reliant on the activities of others. However, this analysis becomes more complex when considering the recent increased interest in “fractional NFTs,” or “f-NFTs”, where an investor shares a partial interest in an NFT with others. Since these fractional interests are more accessible to a larger number of smaller investors, they may be more likely to drive market trading and, as such, be recognized as securities.
2. Federal Anti-Money Laundering Statutes
Under the Bank Secrecy Act, the Financial Crimes Enforcement Network, or “FinCEN,” is the U.S. Department of Treasury bureau that has the authority to regulate financial systems to fight money laundering. Although it has yet to comment directly on NFTs, FinCEN has released guidance suggesting that the movement of monetary value through virtual currencies could trigger money transmission regulations.
A critical factor determining whether the transfer of an NFT is a money transmission service will be whether FinCEN recognizes the NFT as “value that substitutes for currency.” If the NFT’s value may be substituted for currency then the transfer of such a NFT would likely trigger money transmission regulations. If players can purchase NFTs using a virtual currency that can cash out for fiat currency, then this transfer may be subject to FinCEN regulation. Alternatively, based on FinCEN’s recent guidance, even if NFTs are purchased with virtual currency that users cannot cash out for fiat currency, money transmission regulation may be triggered. Indeed, depending on how the gaming platform facilitates the transfer of in-game currency, regulatory risks may exist when users purchase third-party goods or make virtual marketplace transactions.
Earlier this year, Congress took a significant step towards making money transmission regulations more inclusive of NFT use cases when it passed the Anti-Money Laundering Act of 2020. Under the Act, art and antiquities dealers are now subject to the same anti-money laundering regulations that previously applied to financial institutions under the Bank Secrecy Act. This development will undoubtedly have a significant impact on the potential liability that gaming platforms can face as “dealers” of NFTs.
The United States is still a long way away from having laws that adequately regulate the creation, selling, and purchase of NFTs. However, NFT usage continues to increase rapidly. Nearly half of all U.S. adults are interested in participating in the NFT market, and gamers are 2.6x more likely to participate in the NFT market. As regulators move quickly to keep up with the pace of this market, firms will need to stay alert to ensure that they maintain regulatory compliance.
Rohun Reddy is a third-year JD-MBA student at Northwestern Pritzker School of Law and Kellogg School of Management.
What’s The Issue?
It seems logical that the creator of a work would own the rights to that work. This general idea imports easily into some industries but creates problems in the music industry. The reality is that the main rights holder of a creative musical work is often not the musicians but collective management organizations (CMOs). After pouring countless hours, days, months, and years into perfecting a single music work or album, the musician often ends up not having total control over his or her work. The music industry is driven by smoke and mirrors where the distributors and records labels often do not disclose who owns the rights to which musical work. George Howard, co-founder of a digital music distributor called TuneCore and professor at Berklee College of Music, describes the music industry as one that lacks transparency. He explains that the music industry is built on asymmetry where the “under-educated, underrepresented, or under-experienced” musicians are deprived of their rights because they are often kept in the dark about their rights as creators.
As a result of the industry having only a few power players, profit is meek for musicians. Back in the day, musicians and their labels were able to get a somewhat steady source of income through physical album sales. However, with the prominence of online streaming, their main source of income has changed. The source of this issue seems to stem from how creators’ rights are tracked and managed.
A piece of music has two copyrights, one for the composition and one for the sound recording, and it is often difficult to keep track of both because the ownership of these rights are split amongst several songwriters and performers. The music industry does not have a way to keep track of these copyrights, and this is an issue especially when there are several individuals involved in creating a single musical work. With the development of digital ledger technology and its influence in various industries, it could be time that this development makes its way into the music industry and provide a solution to compensate musicians for their lost profits.
Blockchains: the solution?
Lately, blockchain technology has been at the forefront of conversations. For example, the variation in Bitcoin’s pricing has been a hot topic. Blockchain technology seems like a mouthful, but it is simply a “database maintained by a distributed network of computers.” Blockchains allow information to be recorded, distributed across decentralized ledgers, and stored in a network that is secure against outside tampering.
With the advancement of online music streaming, and entertainment going digital, blockchain seems like the perfect tool to be used in this industry. Since the issue of weakened profits seems to stem from disorganized tracking and monitoring of creators, blockchain technology could be utilized to improve the systems used for licensing and royalty payments. A blockchain ledger would allow a third party to track the process of a creative work and be an accessible way of managing intellectual property rights of these creative works. By tracking and monitoring their works, musicians could potentially gain back their profits, or at least recuperate some of their losses.
In 1998, there were several companies that came together to create a centralized database to organize copyrights for copyright owners so that royalty payments would be made in an orderly fashion. This effort was called the Secure Digital Music Initiative (SDMIT) and its purpose was to “create an open framework for sharing encrypting music by not only respecting copyrights, but also allowing the use of them in unprotected formats.” Unfortunately, this initiative failed to provide a universal standard for encrypting music.
The latest venture was the Global Repertoire Database (GRD) which aimed to “create a singular, compiled, and authoritative ledger of ownership and control of musical works around the world.” This was a very ambitious move and required two rounds of financing which consisted of the initial startup funds and the funds to cover the budgeting for the year. Although there were significant contributions to this mission, some collection societies, such as the American Society of Composers, Authors and Publishers (ASCAP), started to pull out of the fund due to GRD’s failure and debt that it accumulated.
Even though this venture failed to provide a centralized database that could resolve royalty and licensing issues, there is now a growing consensus in the music industry for a global, digital database that properly, and efficiently, manages copyright ownership information. The next venture could utilize blockchain technology because of the advantages for storage, tracking, and security that it offers. In addition, not only could blockchain provide a centralized database so that music content information is accurately organized, it could provide a way to close the gap between creators and consumers and dispose of intermediaries. This would allow for a more seamless experience and transparency for the consumer and allow the creators to have more control over their works. Further, this ledger would allow these creators to upload all of their musical work elements, such as the composition, lyrics, cover art, video performances and licensing information, to a single, uniform database. This information would be available globally in an easily verified peer-to-peer system.
On the other hand, since blockchains are tamper-resistant, the data could not be “changed or deleted without affecting the entire system” even with a central authority. This means that if someone decides to delete a file from the system, such a deletion will disrupt the whole chain. There could also be issues with implementing such a large network of systems, or computers, due to the sheer amount of music that is globally available. Additionally, to identify each registered work, the right holders have to upload digital copies of their works which would require an extensive amount of storage and computational power to save entire songs.
Nevertheless, blockchain could provide the base for implementing a centralized database using a network of systems, or computers, in order to organize royalty payments for these musicians. Proponents contend that, with the help of Congress, this could be made possible. Congress recently introduced Bill HR 3350, Transparency in Music Licensing and Ownership Act. This act, if passed, will require musicians to register their songs in a federal database or else forfeit the ability to enforce their copyright, which would prevent them from collecting their royalties for those works. Although this might seem like an ultimatum, this proposed Act would provide the best way of changing how the music industry stores its information to provide an efficient way to distribute royalties and licensing payments to these artists.
People are split in their opinions about blockchain technology in the music industry. There are some who see this as a more accurate way of managing “consumer content ownership in the digital domain.” Others do not see this as a viable plan due to its lack of scalability to compensate for the vast amount of musical works. Even with the development of the music industry into the digital field, the goal is always to protect the artists’ works. Plan [B]lockchain ledger may not completely solve the royalty problem in the music industry, but it can provide a starting point in creating a more robust metadata database and, in combination with legislative change, the musical works could remain in the hands of their respectable owners.
Jenny Kim is a second-year law student at Northwestern Pritzker School of Law.