Are NFTs the Next ICO Fraud?

Source: CryptoPunks / Larva Labs

Just when you thought you were safe and the US enforcement agencies had cleaned up the ICO (Initial Coin Offering) space, you are not. Next up is the NFT craze, and it is no different than what happened previously with ICOs. Only this time, the fraud is hiding behind art and collectibles.

Want to Buy Virtual Artwork for $1.98M?

Source: CryptoPunks / Larva Labs

You can buy this CryptoPunk 6649 for $1.98M. You will not be the only owner. Sorry. Instead, you will share this asset with 87 of your friends. This puts this virtual artwork made in ten minutes by a decent artist at $174M. Not bad for a piece of artwork no one will ever be able to hang on their wall.

What’s going on? The NFT marketplace has exploded. People are buying unique virtual artwork on the blockchain and then trading it. Sound familiar? This is what the ICO marketplace was four years ago.

A bunch of founders wanted to create a new cryptocurrency or blockchain, wrote a white paper in a few days, posted it on a website, did some shroud marketing, talked to lots of people in funky cities around the world and Voila!

Once the ICO launched, they raised $15M in 59 seconds.

The reason why investors jumped into these ICOs is simple. The promoters convinced one or more trading platforms to list this new crypto and allow the investors to trade and make a 5X return just days after their investment.

Everything was working so well for everyone until the SEC decided to look into it. Sadly, they determined these crypto sales were the sale of securities, and none of the companies behind those sales had registered those securities with the SEC. The SEC sued quite a number of them. Hundreds of millions of dollars of restitution later and many convictions and bans from ever running a public company, the ICO market crashed to nothing. Things got really quiet.

Enter the NFT (Not a Fraud Technology)

NFTs are taking a similar approach to ICOs, and perhaps an even more creative one. A bunch of business people find cool artists to create virtual artwork, piece it up in many tokens, and then auction off the tokens to investors. Then those investors turn around and sell it on marketplaces.

These operators are creating unique artwork divided into, say, 100 tokens and convincing investors that if they buy them they will be able to resell them for more money because no more NFTs like this one will be issued, ever. Depending on the scarcity of the tokens, people can buy them for $10 or $1M. What an interesting way to create FOMO (fear of missing out) and operate a secondary marketplace.

So where can you buy one of these “cryptopunks” for $1.98M? Cryptopunks was created by Larva Labs, which claims to be an experimental projects company. On their website, as of August 16th, they claim that there were 12,002 sales in the last 12 months, and the total value of those sales today is $1.04 Billion dollars.

Yes you read that right. Over a billion dollars of value behind these pixelated images. Crazy?  Maybe not because people are willing to buy them. However, the problem is that these friendly and sometimes scary images are sold to investors who are buying securities.

Of course, the pixelated image itself is not a security by any means. It is just artwork. But selling artwork in pieces of ownership is a security. Look at Masterworks. They will sell fractional ownership of a painting to many investors, and each painting’s offering is registered with the SEC. I wrote an article previously about NFTs and showed how these are securities because they trip the Howey test (a famous standard to determine whether something is a security or not).

The core of the issue is that there are marketplaces to sell, and investors expect profits.

It’s All About the Marketplace

Similar to other historical crypto marketplaces, a key appeal for NFTs is that there is liquidity. People can trade these assets amongst each other. OpenSea is the marketplace for Cyberpunks.

Source: OpenSea

If you look at the trading history for Cyberpunk 6649, you will be amazed.

Source: OpenSea

As you can see, investor “KeyboardMonkeyVault” bought it for 450 Ether and sold it 2 days later for 810. The profit was 360 Ether. At $3,159 a piece, that’s a total of $1,137,240. In two days. Wow!

All of this is good until the SEC and the 50 State Administrators realize these NFTs are securities and that they need to protect investors from fraud. Clearly, no one really knows who KeyboardMonkeyVault is because OpenSea and Larva Labs are not regulated entities. They are not broker-dealers. They are not Alternative Trading Marketplaces. They are not registered with the SEC and supervised by FINRA.

So what are the consequences if the SEC looks into this? Remember what happened to the ICO craze? Not so good for those business people and operators.

While we wish them well, I am not sure things will go their way. Selling securities without the proper licenses is a violation of laws in the United States. Furthermore, they could be prosecuted for fraud and all sorts of other violations.

The good news is that SEC Chairman Gary Gensler has publicly announced that they are going to look into this and said, “I believe we have a crypto market now where many tokens may be unregistered securities, without disclosures or market oversight.” Don’t say people weren’t warned when this NFT business comes back to reality.

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