A product manager at OpenSea, a $13 billion online marketplace for non-fungible-tokens (“NFTs”), was indicted in the first-ever “insider-trading” action brought against a person using blockchain-based assets to allegedly enrich himself. According to the indictment, Nathaniel Chastain used his advance knowledge of OpenSea’s planned NFT postings to strategically purchase those NFTs before they were listed by OpenSea to then sell them off at “two to five times” his purchase price. This allegedly happened forty-five times.
As evidenced by these criminal charges, NFTs are an area of interest to the Department of Justice (“DOJ”). These completely digital assets are created and maintained, in theory, on a blockchain, and are viewed as collectibles akin to assets like paintings, vinyl album pressings, collector cards, and the like. NFT sales comprised an estimated market of $40 billion last year and though demand may have softened in recent months, the market for NFTs remains strong. DOJ thus joins regulators of blockchain technologies such as the Securities and Exchange Commission (“SEC”) and the Commodities and Futures Trading Commission (“CFTC”) in looking critically at criminal conduct exploiting novel technological infrastructures.
That the charge of wire fraud can be used to reach NFTs is not the first expansion of the grasp of federal prosecutors using that statute. But as a matter of classifying the charges against Mr. Chastain as “insider trading,” the facts are less clear: the charges were not brought under traditional insider trading laws, such as the Insider Trading Sanctions Act of 1984, but instead were brought under wire fraud and money laundering statutes. For insider trading to occur in the traditional sense, there must be securities involved; and NFTs are—at least for now, though the SEC may ultimately conclude otherwise—not generally considered to be securities. In any case, it is the alleged misuse of the proprietary property of OpenSea that gives legs to the DOJ’s classification, not the nature of the assets involved.
And the winds of change continue to blow for blockchain-based markets. Aside from the looming September deadline for the first of the required reports under President Biden’s March executive order that seeks to coordinate the federal government’s response to crypto assets, a bipartisan bill to help classify crypto assets by an analysis of the purpose of the assets as well as their level of decentralization was released earlier this week. The authors of the bill—Sen. Lummis (R-WY) and Sen. Gillibrand (D-NY)—are both from states with proactive crypto regulation, and there is some confidence that despite looming elections, the bill will shape the discussion of a legislative approach to crypto asset regulation moving forward.
Whether or not NFTs are merely “digital tulip bulbs” akin to the speculative fever that gripped Holland in the 17th century or a store of more lasting value remains to be seen. Aside from behavior like that alleged of Mr. Chastain, another serious concern for NFT markets is the tenuous existence of the digital asset. As a matter of infrastructure, the “location” of the representation of the digital asset is disconcertingly often not tied to an immutable blockchain, but instead to a VPS. This is because access to the Ethereum blockchain where many NFTs are located is governed by an API call from often-non-custodial wallets used by many investors to an aggregated platform that sells access to nodes on the Ethereum blockchain network. This essentially means that an owner of a so-called “off-chain” NFT really only owns a non-cryptographically secure image held by a non-blockchain aggregator, and can unilaterally change without owning the token itself, because the image itself is not stored on-chain.
Nevertheless, on-chain storage is an option—albeit an expensive one—for NFTs, though adoption at scale of this alternative has not yet occurred. And broadly speaking, it is likely that development of federated architectures leveraging established protocols and fast-developing platforms that pursue the dual goals of distributed trust and the power of scale will continue. It is also likely, as the criminal charges against Mr. Chastain show, that prosecutors will continue to reach criminal conduct, even when it is committed in new ways and with new technologies.
Article written with assistance from Cranfill Sumner LLP clerk Christian Smith-Bishop.
Originally Published At The JD Supra Platform