FTI Consulting Webinar Snapshot – Investing in Cryptocurrency and Non-Fungible Tokens (NFTs)

Context

5 years ago, cryptocurrencies were seen as a niche investment, reserved for technical experts. But since then, there has been a significant shift with the public, institutional investors, and large banks all starting to take large stakes in cryptocurrencies and more recently NFTs. At the start of 2020, the global market was only $4.9bn USD, and it’s projected to hit $5tn by 2030 – which may be a low estimate.

So crypto and NFTs are seen as an exciting, potentially inflation-proof, opportunity, outside the traditional investment system and there is huge ‘fear of missing out’ (FOMO) among aspiring investors. But with such opportunities also come significant pitfalls. Those with nefarious intentions are becoming more interested, as are regulators and Governments, who are now taking a more proactive approach to regulation.

Legal Risk

Today, legal disputes in relation to crypto are often brought in relation to fraudulent behaviour, which is a shift from the initial wave of cases relating to crypto which tended to arise from contractual disputes between traders and cryptoexchanges, or amongst syndicates of investors.

Now, ‘do your own research’ has never been a more appropriate adage for those looking to avoid legal risk when investing. A lack of experience and the desire to not miss out on what is seen as an exciting new trend is often the human cause of the current wave of litigation cases arising from crypto transactions.

Nevertheless, it’s important to remember that cryptocurrencies are still a legally protected asset. Very few crypto projects are truly decentralised, and so if something goes wrong, the perpetrators can generally be sought out and redress achieved.

NFT Investment Risks

The NFT industry has rapidly grown as a distinct form of digital asset in recent years. This market is increasingly popular with mainstream brands, such as Visa, and amateur investors, but also bad actors looking to exploit individuals.  Social engineering attacks are becoming increasingly common, which often involve consumers being directed to replica websites and duped into buying what they think is the real NFT.

The panelists discussed means of safeguarding against these risks, which included carefully evaluating links posted on social media channels and being alert to the risk of fake payment windows popping up on sites when trying to purchase NFTs. Basic research into accounts advertising NFTs is crucial, and systems such as two-factor authentication, or hardware keys should be actively used to mitigate risk. Separate digital wallets for NFTs and blockchain transactions were also identified as a sensible precaution.

Reputational Risks

There is already a reputational deficit for this area of investing, due to misunderstanding and lack of transparency. The misunderstanding is born through a general lack of knowledge of what cryptocurrency is and how it works. For example, a recent survey by FTI Consulting in the US suggested 80% of respondents had confusion over what blockchain meant in practice. And because of the anonymity of cryptocurrency , this translates as a lack of transparency, and an industry running ahead of regulation.

The reputational risks associated with crypto traders and exchanges themselves are broader than the immediate concerns around cybersecurity and fraud. As these are new and fast growing business, as we often find in these areas, there can be issues around the working culture within them, and we have already seen some high profile cases of workplace discrimination. There is also the challenge of energy consumption of the industry for example it is thought that Bitcoin’s carbon footprint is estimated to be the equivalent to New Zealand. If you’re organisation has a strong approach to ESG or even BCorp status, these factors might provide a challenge to your reputation..

So how can investors protect their reputation?

• Go in with your eyes wide open and understand the risks. It is important to stop and do your due diligence first, however bad the fear of missing out might be.
• Prepare to answer questions on your investment. Are you comfortable responding to arguments detractors may make? It is important to understand your own risk tolerance.
• Make sure you understand the processes for investing in these areas. You will need to be able to lean on that process of due diligence in the event of a future issue, e.g. ‘this is the process that was followed and lead to our decision to invest’.
• Act responsibly. As a potential early investor in an industry currently outpacing regulation, you will contribute to the reputation of the crypto or NFT industry moving forward. Acting transparently and responsibly will have an impact on how this area is regulated in future.

A range of other issues were raised in discussion

The direction of future regulation

The panelists agreed that establishing a robust legal basis for the industry is essential to protect consumers, even if the appetite for regulation from firms in emerging technologies has varied in the past. They noted crypto exchanges in the US are seen as partners by both industry and law enforcement. In fact, the public face of blockchain makes it harder for criminals to avoid detection.

Avoiding risks in use of blockchain technology

The most effective way to mitigate risk is to ensure businesses are alive to cyber incidents and have procedures in place with a ‘when not if’ approach to information security change processes. The panelists noted that incorporation of blockchain in financial institutions creates profound transformational opportunities – one example cited from a UK perspective was that putting the DVLA database on a blockchain system could prevent car theft by making it easier to track ownership data.

NFTs and legal protection

The use of blockchain makes it easier to track and validate ownership which is hugely helpful for purchasing NFTs. But there is lots of counterfeiting going on; for example, people being duped into paying huge amounts of money for JPEGs. The dichotomy of crypto is that it is public and transparent, but anonymous. The panelists agreed that storing information on the blockchain was vital to identify fraud. To do this, blockchain analytics to an expert level are essential.

It was also noted that if your cryptoassets (i.e. cryptocurrency or NFTs) are taken by bad actors based overseas, that the world’s various legal systems are well-experienced in dealing with cross-border disputes. Investors can have confidence in the international process to enforce court orders  and they should seek the enforcement of legal rights in the same way as they would with any other commodity.

Cryptocurrency and the environment

The panelists discussed the risk that crypto could eventually be seen as a ‘dirty’ investment due to the energy required to produce it, although there is still a long way to go in the public’s understanding before it becomes headline news. To mitigate risk, it is important that investors are aware of this issue and transparent in how they consider it.

It was also noted that this is a particularly sensitive political ‘hot potato’ in Sweden, Estonia, Kosovo and Georgia, where there are outright bans on mining bitcoin on environmental grounds. Similarly, there have been concerns that certain countries are using blockchain or cryptocurrency to circumvent sanctions.

Prospects for central bank-backed digital currencies

On this issue, the panelists emphasised the importance between the privacy of individuals and the interest of the state, noting that Governments don’t need to have insight into every transaction in the economy. They raised that there have been recent suggestions that a US-backed digital currency would be unconstitutional and lack the protection that physical currency provides for consumers. It is also no coincidence that countries which have banned crypto have also launched their own competitor central bank-backed digital currency.

How the crypto market and application of blockchain will evolve

The panelists were optimistic, noting that the possibilities in this area are endless. One example cited was that if the Land Registry could be on the blockchain, then a transaction many people face would be easier and less costly. Similarly, those under-served populations, such as people living day to day without access to their local banking system, are well-served by cryptocurrencies,.

A clear challenge of the application of these technologies will be filtering out actors such as terrorist groups and the panelists noted that even with the budgets and legislation at the hands of states, they were still present in commercial banking. They agreed that if exchanges continue to make money, then robust anti-money laundering or terrorist financing procedures will be needed.

To watch the full recording please click the video below, or the link here: