As discussed in Part I of this series, NFT-based lending is pioneering a new avenue of investment and activity on the blockchain that will enable new and innovative use cases. In this Part II, we will discuss the implications for Lenders.

I. Issues for Lenders:

These on-chain loans secured by digital assets present a question for lenders: how do lenders get comfortable extending secured financing to borrowers where the secured asset is digital, like an NFT? In traditional financing, lenders and borrowers negotiate a security agreement, which governs the rights a lender will have in a transaction. Per the Uniform Commercial Code (the “UCC”), which regulates interests in personal property as collateral for debt, a security interest in tangible collateral can be perfected against third parties by possession of the collateral or by filing a financing statement. At the same time, a security interest in many kinds of intangible collateral can be perfected against third parties only by filing a financing statement. Sometimes, best practice calls for possession and filing (when both types of perfection are permitted under the UCC).

Mechanically, when the lender and borrower agree to terms on a peer-to-peer marketplace like Blur (as discussed in Part I of this series), the NFT is placed into a vault – a smart contract with specific storage and security features – with a lien on it; at this point, the principal is transferred to the borrower. As discussed below, the UCC, as currently adopted in most states, does not account for perfection of a security interest in digital assets by any method other than the filing of a financing statement, so a vault & lien combination is insufficient to perfect a security interest in the NFT collateral against third parties; however, the 2022 UCC Amendments provide certain clarity for perfecting a security interest in digital assets against third parties.

In general, the UCC is periodically updated to incorporate emerging technologies and trends. Among other updates, the 2022 UCC Amendments address digital assets and distributed ledger technologies, affording transactors in goods and services updated default rules under the UCC. As such, lenders should be aware of the varying new measures to ensure their loans are adequately secured and perfected against the borrower and any third party, including customers and other creditors of the borrower. Hence, the lender would be first in line to realize on the collateral in a fight with other creditors of the borrower.

Despite the protracted crypto bear market, innovators in non-fungible tokens (“NFTs”) are hard at work. Gone are the days when NFTs were merely profile pictures (“PFPs”) displayed on a pseudonymous social media account or shown for their prestige online or in real life to confused friends and colleagues. As discussed in our two-part series explaining Ordinals and their implications for NFT owners and creators, this year NFTs have expanded beyond the Ethereum blockchain, where NFTs initially grew to prominence as a result of the blockchain’s ability to execute smart contracts, to the original blockchain, Bitcoin.

Beyond Ordinals, gaming-related innovations, new ERC standards, and other innovations, the industry continues to push forward to new frontiers, such as NFT-based lending.

This is Part I of a two-part article on NFT-based lending (Click here for Part II). In this part, we will discuss recent innovations in NFT-based lending, explaining various mechanics and functions. In Part II, we will dive into the legal issues for lenders involving secured transactions under the UCC, Pre- and Post- Article 9 and 12 Amendments.

Last month, the Commodity Futures Trading Commission (CFTC) announced settled charges against three decentralized finance (DeFi) protocols for various registration and related violations under the Commodity Exchange Act (CEA) during the relevant period of investigation.  As a result, each entity paid a civil monetary penalty and agreed to cease violations of the CEA.  According to a statement by Commissioner Kristin N. Johnson, these latest settlements are the first time the CFTC charged a DeFi operator (e.g., Opyn, Inc. and Deridex, Inc.) with failing to register as a swap execution facility (SEF) or designated contract market (DCM). Moreover, these latest enforcements against DeFi entities arrive soon after the CFTC’s successful enforcement and default judgment against Ooki DAO, which the CFTC alleged was operating a decentralized blockchain-based software protocol that functioned in a manner similar to a trading platform and was violating the CEA (prior coverage of the Ooki DAO enforcement can be found here).

Way back (if we’re counting tech years) in 2014, artist Kevin McCoy (“McCoy”) created a digital record of his pulsating, octagon-shaped digital artwork Quantum on the Namecoin blockchain on May 2, 2014, thereby minting “the first NFT.” A lot has happened in the digital asset and NFT space since that

On 7 September 2023, the United Kingdom’s Financial Conduct Authority (“FCA”) set expectations ahead of its new financial promotion rules for cryptoassets (which we wrote about here).

From 8 October 2023, new rules for the marketing of cryptoassets come into force. The new requirements include the need for marketing

In its February 2023 discussion paper (DP23/2) relating to the UK regulatory regime for asset management, the UK’s Financial Conduct Authority (“FCA”) briefly touched on fund tokenisation as an area of technological drive and change in the fund management industry. Please refer here to our update on that discussion paper.

On July 12, 2023,  U.S. Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-N.Y.) proposed a revised version of their previously introduced crypto regulation bill to create better safeguards for the crypto industry generally while adding new, stronger consumer protection provisions and AML provisions.  The Lummis-Gillibrand bill, also known as the Responsible Financial Innovation Act (“RFIA”), identifies the need for enhanced regulation of digital assets.  The proposal addresses this need, in part, by creating clearly defined regulatory roles for the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”), which are two of the leading regulatory bodies currently engaged in regulating the U.S. crypto market, as well as creating a new Customer Protection and Market Integrity Authority self-regulatory organization.  The need for greater clarity in the roles of the CFTC and the SEC and with respect to cryptocurrency regulations generally is certainly timely, given the recent CFTC actions against Blockratize, bZeroX (and its successor Ooki DAO), and others and recent high-profile SEC actions against major crypto exchanges.