On April 28, the Joint Chiefs of Global Tax Enforcement (the J5), a global joint operational taxation group consisting of Australia, Canada, Netherlands, United Kingdom, and the United States, issued an intelligence bulletin (Bulletin), enumerating its perceived dangers of non-fungible tokens (NFTs).

NFTs, ERC-20, and Fungibility

Cryptocurrencies and NFTs are similar in the sense that the fundamental composition of both tokens is simply encrypted data that lives on the blockchain. However, these tokens do differ in an important way: fungibility. A large swath of today’s cryptocurrencies is traded and held on the Ethereum blockchain. For a cryptocurrency to operate on the Ethereum blockchain, it should comply with the ERC-20 standard, which is the smart contract protocol for Ethereum-based fungible tokens. Due to compliance with the ERC-20 standard, developers can seamlessly deploy new tokens (in the form of smart contracts) that are automatically interoperable with pre-existing Ethereum-based decentralized applications and software wallets like MetaMask. ERC-20 tokens are mutually interchangeable.

For example, Tether (USDT), the largest stablecoin by market capitalization, is an ERC-20 token. There are approximately 74 billion USDT tokens in circulation, and as stablecoins, each of these tokens (supposedly) possesses the same value of $1, as the issuer claims that for every unit of its stablecoin in circulation, there is a matching U.S. dollar in a bank account somewhere (algorithmic stablecoins are different — rather than being backed 1:1 by dollars, there are two tokens, the stablecoin itself and a sister token that is issued (created) or burned (destroyed) as needed to maintain the stablecoin’s price). Stated differently, each of the USDT tokens in circulation is intended to have identical data properties.

Conversely, NFTs are non-fungible. NFTs deployed on the Ethereum blockchain should comply with ERC-721, which is the smart contract protocol for Ethereum-based non-fungible tokens. All ERC-721 tokens have globally unique data properties, which makes these tokens immune from replication on the blockchain. Due to their lack of fungibility, NFTs can potentially serve as depictions of inherently unique data structures that constitute ownership identifiers of real-world, tangible assets like artwork, real estate, and products within a supply chain.

J5’s Perceived Dangers of NFTs

The Bulletin is compartmentalized into two sections: (1) strong indicators of fraud and (2) moderate indicators of fraud. The most striking indicators discussed within the Bulletin were phishing scams and lack of verification.

Phishing Scams

Phishing, a practice in which a cyber attacker purports to be a legitimate company to induce an individual to perform an action that materially benefits the cyber attacker, is a common tactic among NFT scammers. In the NFT space, phishing may manifest in URL impersonation of legitimate NFT marketplaces. For example, OpenSea.io is the URL of the world’s most prominent NFT marketplace. A scammer may deploy an exact replica of the OpenSea website and slightly modify the URL to deceive OpenSea patrons and obtain access to a consumer’s NFT wallet — or worse — convince a consumer to cough up his or her private keys.

Lack of Verification

Generally, each NFT marketplace will employ a standard for verifying NFT collections sold on its platform. For example, for a NFT collection to be designated as a verified collection on NFT marketplace LooksRare.org, a NFT collection must generate, inter alia, at least 250 ETH in trading volume on LooksRare.org or 500 ETH in trading volume across the NFT marketplace ecosystem. Today, 250 ETH is equivalent to approximately $500,000 USD. Trading volume is a reliable parameter for verifying the veracity of NFT collections because it indirectly substantiates market sentiment of a particular NFT collection and its developers.

Our Take

Although the Bulletin is not comprehensive, it does bring to the forefront a few problematic issues that stand to undermine an otherwise beneficially disruptive technology. But while the risks associated with consumer usage of NFTs will continue to persist due to regulatory nascency, the tech will likely remain a fixture in the global economy for years to come as tokenization of tangible assets becomes more prevalent.