Piracy, Plunder, and Non-Fungible Tokens

Problems on the OpenSea

Bloomberg’s Matt Robinson reported on March 2 that the U.S. Securities and Exchange Commission is scrutinizing creators of NFTs, and the crypto exchanges where they trade, “to determine if some of the assets run afoul of the agency’s rules,” citing the usual “people familiar with the matter”.

It’s another shot across the bow for proponents of cryptoassets.

NFTs, or non-fungible tokens, are digital assets that are unique and not interchangeable — like a snowflake — rather than fungible — like a grain of corn in a silo. NFTs are more like diamonds, real estate, or even professional sports trading cards because they have unique characteristics that drive their overall value. Digital asset cousins bitcoin and Ethereum, and fiat currency such as the U.S. dollar, are fungible since one unit of bitcoin or one U.S. dollar is as good or equal to another.

Bloomberg says the focus of the SEC’s probe is whether non-fungible tokens, in particular those that represent fractional ownership of art, real estate or sports memorabilia, for example, are securities and should therefore be regulated as securities. The SEC’s enforcement attorneys have sent subpoenas to all kinds of creators and exchanges demanding information about their token offerings.

According to data from Chainalysis, NFT activity ballooned in 2021, to about $44 billion worth of crypto sent to smart contracts on the Ethereum blockchain during 2021, up from $106 million in 2020.

I warned there would be a reckoning on Feb. 9 in an OpEd in the FT:

Trickier accounting challenges might be coming. Take the hot market for NFTs, or non-fungible token art, for example. How should companies record NFTs in their accounts? David Larsen, an alternative asset specialist at Kroll, told me there is still very little secondary market for NFTs. So how will companies put a Bored Ape NFT on the balance sheet?

How does one even value, buy, and even display digital art in NFT form? 

The answer in many cases is OpenSea, an exchange introduced by the same group of investors that sponsored Coinbase, Robinhood, and the various DeFi exchanges such as Compound.  

OpenSea is one of a handful of platforms that enables market participants to sell a digital asset known as a non-fungible token, or NFT. These type of assets have gone in and out, and now back in in a big way, since CryptoKitties back in 2017. The recent increase in popularity, and value, coincides with the dramatic escalation in the number of active users and revenue per user in the last two years.

One group not mentioned in the Bloomberg story are the iconic, publicly-traded brands such as WWE, Gucci, AMC, and Playboy that drove mainstream awareness of NFTs when they introduced their own on OpenSea. AMC is even issuing an NFT for fans that see the theatrical release of The Batman.

OpenSea is backed by the several of the same old familiar names we’ve written about before.

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According to data from NFTGO.IO, at midday on March 3, 0.057% of all NFT holders, consisting of “🐋 1,098 whales hold NFTs worth $3.95B,” control “23.17% of the global market cap of $17.04B”.

The largest exchange and a significant share of NFT market cap is dominated by a relatively small cadre of “investors”.

FOMO Market Manipulation

Michael Milken and Jordan Belfort did business in the wrong decade.

OpenSea says it is a peer-to-peer market platform, but this modest positioning contradicts reality as large brands onboard to sell NFTs driven by “investor” speculation. Hype drives FOMO, or fear of missing out, which in turn drives speculative bubbles and the same old insider abuses. OpenSea acknowledged a recent case of insider trading by its own executives. The Tonight Show’s Jimmy Fallon was criticized for alleged market manipulation for hyping his Bored Ape NFT on his show where guest, Paris Hilton, also touted her purchase.

“This is my ape,” the late-night comedian told his audience during an interview with Paris Hilton, flashing a picture of a sailor cap-wearing cartoon monkey. “It reminded me of me.”

Companies that use celebrities and sports figures to hype their NFTs can get quick returns that may be worth the risk of the SEC coming after them and their celebrity touters.

None right now better illustrates this strategy than venerable athletic brand Adidas, which in December 2021 released its first NFT to the public. The Adidas NFT reportedly grabbed around $22M and is still going strong. NFT influencer GMoney has a collaboration deal with Adidas and also owns part of the collection. According to Ledger Insights Adidas collaborates with “cool crypto brands and influencers through deals with Bored Ape Yacht Club, The Sandbox game, Coinbase and others.”  Adidas is not traded on a U.S. stock exchange but it’s easy to see how this trend could spread to U.S.-listed competitors such as Nike or Under Armour.   

NFL star Rob Gronkowski (Gronk) endorses a lot of brands including Tide, Dunkin Donuts, USAA, and Draft Kings which recently issued an NFT with his image. Draft Kings, which is traded in the U.S., is leveraging a relationship with Tom Brady’s non-fungible token (NFT) platform Autograph, which facilitates the endorsement deal with Gronk, Brady, and Tiger Woods.

There is plenty of token inventory for those interested in the Gronk collection. He’s also on OpenSea pushing a plethora of NFTs. OpenSea has real time interactive data to explore the Gronk collection sales volume over the last 90 days. The average price is 1.725 ETH, which translates into roughly $4,500. The clear uptick in December 2021 below occurred around the time Brady, Gronk, and the Tampa Bay Buccaneers clinched a playoffs spot as defending Super Bowl Champions.

The Plunder

What happens when a brand issues NFTs but only a small number of “investors” hold the majority of the tokens? This scenario occurs at an increasing number of companies in the NFT space.

Playboy is a prime example of a company with extensive intellectual property ripe for the NFT strategy. In October 2021, Playboy issued their very first NFT collection known as Rabbitars. Sales are still on-going and there are roughly 5.3K owners. A look at the top 13 Rabbitar owners below based on unique crypto wallet address shows that ownership is very concentrated. The number of tokens might seems small but the total value of those held is big. For example, the value of the Shocka.eth’s value is around 18.32 ETH, around $50.2K.

There are also a growing number of cases of market manipulation such as “rug pulls”. Reuters describes a “rug pull” as a take-the-money-and-run scheme where the developers of a new coin offer the coin for sale, in exchange for more established coins, such as Ethereum, for example. It’s not much different than a “pump and dump” in the microcap equities environment. As soon as the value can be pumped up with hype and “investor” FOMO, creators cash out taking the Eth or bitcoin used to pay for the new coin and draining its liquidity. The new coin or token is now worthless. It happened with an NFT named after the hit Netflix program Squid Games. Short-term hype increased popularity and escalated the value of the cryptoasset, and then creators took “investor” money.

And then there are the scams of “wash trading” and “spoofing” where NFT prices can be manipulated because buyers and sellers are anonymous. In “wash trading” one person buys and sells the same NFT to create an appearance of market demand. In spoofing, fake trades are entered and then canceled to temporarily increase the price allowing a market manipulator to sell at a higher price. These schemes can have individual and corporate tax and financial disclosure implications.

This is not a hypothetical concern. Bloomberg reported on Feb. 16:

The source of funds for the winning bid in Melania Trump’s first NFT auction appears to be the creators of the project themselves.

A series of blockchain transactions show that the cryptocurrency used to purchase Trump’s non-fungible token came from a wallet that belongs to the entity that originally listed the project for sale. The former first lady began an auction in January for a collection of NFTs on the Solana blockchain, with art from her first official state visit in 2018.

A week later OpenSea customers were targeted in a scam that netted millions. ZDNet reported:

Last week, NFT marketplace OpenSea announced the rollout of contract migrations and an upgrade to make sure inactive, old NFT listings on Ethereum expire safely and to allow OpenSea to “offer new safety features in the future.”

The contract migration timeline was set from February 18 to February 25. NFT holders are required to make the change, and OpenSea published a guide to assist them. After the deadline, any listings that were not migrated would expire, although they could be re-listed after this window without further fees. 

However, an attacker saw an opportunity to cash in. Check Point Research has suggested that phishing emails were sent to users, linking them to fraudulent websites.

“Some hackers took advantage of the upgrade process and decided to scam NFT users by using the same email from OpenSea and resending it to the OpenSea victims,” the researchers said.

Protecting yourself on the OpenSea

In the golden era of pirates, merchant ships were often left to protect themselves. The same is true for crypto assets, and the latest digital asset incarnation , NFTs. The landscape changes on almost a daily basis, regulators can’t keep up, media is straining to find journalists with the interest and aptitude to explain it, and everyone charged with protecting investors is too slow to react to a market that requires constant vigilance.

One way to avoid OpenSea may be to get on the waitlist for access to Coinbase’s proposed NFT exchange. The U.S. listed crypto exchange that, for now, does not facilitate trade in anything that is considered a regulated security says it wants to help you trade your Crypto Punks. But, but…

Fortunately for Coinbase it has two SEC registered broker-dealers teed up to take your calls if regulation is imposed. Their FOCUS reports, including audited financial statements, should be filed any day now.

Even Coinbase is finding it’s not that easy for anyone to outrun the bear.

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© Francine McKenna, The Digging Company LLC, 2022

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