Cryptoassets in the metaverse: The risks, opportunities and legal considerations

18 minute read
02 November 2022

In October 2021, Mark Zuckerberg announced the rebranding of Facebook to Meta, which led to the concept of the metaverse. Considered the next evolution of the internet, the metaverse is hard to define but in very basic terms, it can be described as a virtual world that's revolutionising the way in which people can live, work, shop and interact with others from the comfort of their homes.

Through technology that has evolved in the world of gaming and advances in virtual reality, Web3, NFTs (non-fungible tokens), blockchain and cryptoassets, the metaverse is now a genuine prospect attracting unprecedented interest from entrepreneurs, big businesses and the investment community.

In this article, we discuss the role of the blockchain in the metaverse and the key legal considerations when using cryptoassets in this virtual world.



What are 'cryptoassets'?

The metaverse and cryptoassets seem to be concepts that go hand-in-hand – virtual worlds and virtual assets. But, these are very much separate concepts that can happily exist without one another.

In the UK, cryptoassets are recognised as being cryptographically secured digital representations of value or contractual rights that use a form of distributed ledger technology (DLT), otherwise known as 'blockchain', and can be transferred, stored or traded electronically.

So cryptoassets are a store of value which can be transferred or exchanged digitally on DLT. But what does that mean?

DLT is a decentralised database managed by multiple participants across multiple notes. Blockchain is a type of DLT where transactions are recorded with an immutable cryptographic signature called a hash. The transactions are then grouped in blocks and each new block includes a hash of the previous one, chaining them together, hence why DLT is often referred to as blockchain.

Blockchain technology enables everyone involved in a transaction to know with certainty what happened, when it happened, and confirm other parties are seeing the same thing without the need for an intermediary providing assurance, and without a need to reconcile data afterwards.

By definition, the metaverse does not require DLT. However, DLT adds value to the metaverse which cannot be ignored. Below are some of the use cases.

What is the role of DLT in the metaverse?

  • Payments – All cryptoassets rely on some form of DLT and are a means to make payments in the virtual world. Using cryptoassets for payments in the metaverse carry the same benefits as using crypto for payments in the real world. They serve as a pseudo-anonymous and relatively quick method of moving funds globally. There are low barriers to entry, users merely need an internet-connected device to transact with cryptoassets. There is also less reliance on intermediaries, low transaction fees and faster transaction speeds compared to dealing with real currency transfers.

    However, there are two further benefits of using cryptoassets in the metaverse – programmability is by far the most significant feature that it contributes to the metaverse. It can enable, for example, streaming of payments. A user can agree to pay an amount for every minute spent in a virtual gallery, enabling an immersive 'metaverse native' payment method.

    They are also irreversible – crypto payments do not use any third party intermediaries and are irreversible in nature. This makes it ideal to use in a trustless environment.
     
  • Representation of digital ownershipNFTs rely on DLT and make digital ownership possible in the metaverse. A user, for example, can buy land in the metaverse and be assured that it is authentic and cannot be duplicated. Read our guide to NFTs to find out more about these.
     
  • IdentityDLT makes it possible to identify oneself in a secure way. New technologies such as zero-knowledge proof blockchains make it possible to securely share identification information without the fear of it being misused. This makes it possible to verify the validity of a dataset while preserving the privacy of the data itself. For example, assume a scenario where you need to check the age of the individual in the metaverse. The individual would be hesitant to share the passport details in the metaverse with the fear of it being misused. But with zero-knowledge proof, it becomes possible to verify the age without actually sharing the information itself.
     
  • Web3 – By far the most critical application of DLT to the metaverse is that of the Web3 ethos. The Web3 builds internet services on decentralised platforms, putting the web in the hands of its users and community. The ownership of the platform is tokenised and the users' own tokens of the platform based on their contribution to the platform. Tying this back to metaverse, the builders across the metaverse would be much more comfortable in building a decentralised world where they would have a say in the platform and are able to accrue value from its growth.

What are the key considerations when using cryptoassets?

The first consideration should be from a regulatory perspective, as there are serious consequences for businesses who unknowingly undertake regulated activities, or who act as cryptoasset exchanges or wallet providers, without the necessary permissions and licences from the regulator. In the UK, this constitutes a criminal offence which carries a penalty of up to two years' imprisonment and an unlimited fine.

Whether a business is conducting a regulated activity, even through the metaverse, will largely depend on the nature of the cryptoasset and the activity which the business is carrying on in respect of it.

In the UK, the Financial Conduct Authority (FCA) published Final Guidance on Cryptoassets in July 2019 to help firms understand whether, and the extent to which, their cryptoasset activities fall under FCA regulation and the types of tokens that would be regulated. The FCA clarified that security tokens and E-money tokens are regulated.

Security tokens

Security tokens include specific characteristics that bring them within the definition of a 'specified investment' such as a share, a unit in a collective investment scheme or a debt instrument, and therefore falling within the regulatory perimeter. It is a tokenised, digital version of traditional securities which grant holders some, or all, of the rights conferred on shareholders or debt-holders.

Firms carrying on a regulated activity involving a security token by way of business in the UK, will require authorisation by the FCA. Activities that may be caught include:

  • dealing in investments as principal or as agent;
  • arranging deals in investments;
  • advising on investments, safeguarding and administering investments; and
  • issuing e-money and money remittance.

Market participants should also be aware of the FCA's financial promotions regime; it is an offence to communicate an invitation or inducement to engage in investment activity unless that person is an authorised person or the content is approved by an authorised person. An offer of security tokens to the public may also be caught by the UK Prospectus Regime.

E-money tokens

E-money tokens are those tokens that meet the definition of electronic money in the UK E-Money Regulations. When issuing these tokens, firms must ensure that they have the correct permissions and comply with relevant rules. E-money is defined as:

  1. Electronically stored monetary value that represents a claim on the issuer;
  2. Issued on receipt of funds for the purpose of making payment transactions;
  3. Accepted by a person other than the issuer; and
  4. Not excluded from the definition of e-money in the E Money Regulations.

Due to the fact that they are not used as a store of value, are not centrally issued on the receipt of funds and do not represent a claim against an issuer, cryptocurrencies like Bitcoin and Ether are unlikely to constitute E-Money.

All other tokens, if they are not security tokens or e-money tokens, are unregulated. These include exchange tokens and utility tokens (including basic NFTs).

Exchange tokens are not issued or backed by any central authority and are designed to be used as a means of exchange. These tokens can enable the buying as well as selling of goods and services without the need for traditional intermediaries, such as central or commercial banks. Due to the fact that they tend to be decentralised, with no central issuer obliged to honour contractual rights, the FCA's view is that they do not typically grant the holder any of the rights associated with specified investments.

Utility tokens

Utility tokens typically provide holders with access to a current or prospective product or service but do not grant holders rights that are the same as those granted by specified investments. They may have similarities with rewards-based crowdfunding where participants contribute funds to a project in exchange for a reward; for example, access to products or services at a discount. The FCA's view is that, much like exchange tokens, utility tokens can usually be traded on the secondary markets and can be used for speculative investment purposes. However, this doesn't mean that these tokens will constitute specified investments.

NFTs

It should be noted that NFTs have emerged in recent years, to a huge fanfare from artists, celebrities and influencers. "Non-Fungible" essentially means that the token is unique and, unlike cryptocurrencies such as Bitcoin or Ethereum, are not mutually interchangeable. NFTs typically represent a claim to ownership of a unique asset, often digital in nature, such as digital art, videos or music files but there is no reason why they cannot also lay a claim to real estate! Whether an NFT is a regulated token would very much depend on its individual characteristics. Read our guide to learn more about NFTs and the rewards and the risks.

Stablecoins

And then there are stablecoins, which are tokens whose value the issuers have attempted to stabilise, for example by pegging them to fiat currencies or a reserve of low-volatility assets. While they have a common purpose, they vary greatly in their structure and arrangements, making them inappropriate for any single classification. They could therefore fall into any category or security, e-money or unregulated tokens, depending on their individual characteristics and design.

Even if a cryptoasset is unregulated, there is a secondary, but equally important, consideration as to whether registration with the FCA is required for anti-money laundering (AML) purposes. Generally speaking, cryptoasset exchanges and cryptoasset wallet providers must be registered with the FCA before carrying out those activities in the UK.

Advertising considerations for brands

Advertising is another key area to consider. The popularity of cryptoassets continues to grow with major brands experimenting in the space, often for PR purposes. What are the regulatory implications for brands and firms promoting cryptoassets, either as their core business or simply to create a marketing buzz?

In the UK, there are strict codes and rules governing advertising. Where there is a financial promotion, such as an invitation or inducement to engage in investment activity that is communicated in the course of business, this will be subject to the FCA's financial promotions regime. Therefore, any financial promotions in relation to regulated cryptoassets will be subject to stringent advertising rules of the FCA, including its overarching principle that financial promotions must be fair, clear and not misleading.

Promotions of unregulated cryptoassets such as Bitcoin, however, have largely been governed by the Advertising Standards Authority, otherwise known as the ASA. In fact, crypto ads have rocketed to the top of the ASA's priority list, prompting a crackdown on irresponsible advertising.

In November last year, it launched investigations into a number of crypto ads across different media channels, finding that numerous businesses had failed to make clear that cryptocurrency is not regulated. Potential purchasers of cryptocurrency were therefore unaware that they would not be subject to the same protections afforded to products and services regulated by the FCA, for example access to the Financial Ombudsman Service to resolve complaints and the Financial Services Compensation Scheme which protects consumers for losses in the event that a regulated financial firm fails.

The ASA also ruled that multiple crypto adverts took advantage of consumers' inexperience or credulity; for example by failing to ensure that financial information could be readily understood and the risks were sufficiently clear. Some advertisers had been found to trivialise investment. For example, the ASA considered that a promotion offering free Bitcoin, when customers bought a Papa John's pizza, encouraged customers to engage in a highly volatile and risky asset without due consideration and trivialised what was a serious decision. In essence, it was irresponsible to use cryptocurrency to incentivise an inexperienced audience to buy more pizza!

A particular risk for brands promoting crypto outside of their usual business is failing to make it clear that a token or asset is a cryptoasset in the first place! In a ruling against Arsenal Football Club, the ASA ruled that the football club should have made clear that its 'Fan Token' – a utility token in the form of an NFT – was a form of crypotasset.

Essentially, it introduced people to the concept of NFTs and encouraged them to invest, in return for which they could vote on which song to play when 'the Gunners' win.

In December 2021, the ASA censured Arsenal for:

  • irresponsible advertising
  • taking advantage of consumers' lack of knowledge about crypto
  • misleading advertising because the risks of investing in a crypto token were not clear
  • not making clear that the token was a cryptoasset and needed to be paid for by buying cryptocurrency

'Other' considerations

Other considerations when deploying cryptoassets in the metaverse include:

  • Tax – while there are no tax rules specific to cryptoassets, there are general tax principles that apply on the recognition of income or capital profits.
  • 'Ownership' and intellectual property (IP)IP laws globally have a major part to play in proving original ownership of rights. The coding in cryptoassets demonstrates your ownership or other interest and it is important to know what rights you are granting, or being granted. Read our article on metaverse-related trademark considerations for brand owners and guide to the metaverse for brand owners to find out more.
  • Contracts – consumer rights laws protect ordinary individuals from losing money. In the case of cryptoassets, that means that businesses dealing with consumers need to be very transparent, very clear and keep language very simple. The challenge with NFTs, for example, is that even what it stands for – 'non-fungible token' is immediately a barrier. 'Fungible' is not a word that we use in everyday speech, let alone breaking it down into a right over something that is digitised that is not mutually interchangeable.
  • The Courts – before any organisation enters this space, they should understand where they stand legally. Can a company entering into the crypto space rely on the courts to defend them should something go wrong? Is there existing case law on which they can lean when trying to figure out their own legal liabilities? A particular challenge for NFTs from a legal perspective is differentiating between the NFT and the connected underlying asset. In the UK, early case law exists and English Courts are willing, at least based on a preliminary analysis, to treat cryptoassets as property and to protect them as such.
  • Fraud - The anonymous, global nature of cryptoassets creates particular problems so getting resolutions in cases involving fraud can be tricky. While there may be no legal difficulty in establishing that you have a right to recover if you are the victim of fraud, the anonymous nature of cryptoassets and the difficulty of enforcement against those perpetrating the fraud makes actual recovery very tricky.

So there's clearly a lot for businesses to think about when considering venturing into the metaverse and cryptocurrencies in particular. If you have any questions, or would like advice in this highly complex area, please contact Sushil Kuner or David Brennan.


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