Experts Say Lummis-Gillibrand Proposal May End Crypto Gaming

Experts say the landscape for crypto gaming is bleak under Senate legislation sponsored by Sens. Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY).

The proposal, the Responsible Financial Innovation Act, would regulate cryptocurrencies as either commodities or securities, depending on their classification. The Howey Test, promulgated by the Supreme Court in 1934, defines an asset as a security if it involves (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) derived from the efforts of others.

The legislation would define cryptocurrencies almost universally as securities. Regulation of non-fungible tokens (NFTs) would be split. Those that do nothing — for instance, pictures archived on a blockchain — would be commodities. Those that serve a purpose — for example, those that act as playable characters in a game — would generally be securities, creating a range of regulatory implications.

“If you create an NFT for some project, and then say anyone who puts money into that will get a percentage of profit or revenue — once you start with a distribution of revenue, it’s not a regular NFT anymore,” blockchain expert and Rutgers Business School Fintech Professor Dr. Merav Ozair told GoblinCrypto in an interview. “It’s about whether you’re treating it as an investment, and whether there’s a distribution of profit to the holder.”

Additionally, Ozair noted, projects that sell NFTs to raise revenue could face repercussions related to unregistered token sales. “Once they’re using it to generate capital, they fall under the definition of a security,” Ozair said.

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Violations by DeFi Kingdoms, Cosmic Universe, and Other GameFi Projects

DeFi Kingdoms (DFK), the top game on the Harmony blockchain, could serve as an example of a prime offender under the law’s provisions. The project, launched in August 2021, sold more than 2,000 characters — known colloquially as “heroes” — as NFTs to users within a matter of months. Valued at $500 or more at the time, those characters briefly peaked at prices in excess of $80,000.

The characters generated revenue by allowing their owners to “summon” (or breed) new characters, which they could sell to new users. On the bright side, Ozair said, that revenue-generating mechanism wouldn’t automatically result in classification as a security.

“A security is not just generating revenue,” Ozair said. “A commodity also generates revenue. It’s about whether you’re treating it as an investment, and whether there’s a distribution of profit to the holder. So there’s a difference between passive holding and distribution to the holder.”

Cosmic Universe, another game on the Harmony blockchain, is an example of a project that incentivizes users through passive distribution. The project, like DFK, sold 10,000 NFT characters — or “wizards” — to its users. While users wait for the game to become playable — something that’s scheduled to happen before 2023 — they have the ability to “stake” their wizards to earn interest in the form of the game’s native token, MAGIC.

That game also sold NFTs to its users in the form of in-game land, which users are tentatively expected to have the option of staking in the future. DFK similarly offers land, though its future function has not been announced.

OK to Use Loopholes?

For developers facing increasingly tight economic conditions this year, Ozair said there are no loopholes. The Securities and Exchange Commission is unlikely, for instance, to smile upon projects that refrained from selling their NFTs directly, but instead used them to incentivize users to buy their cryptocurrencies. DFK, serving as another example, “airdropped” — or raffled — an additional round of 500 hero-breeding characters this year to users who held the game’s native token, JEWEL.

“If you’re giving users a perk, then what you’re giving them with the offering would fall under the definition of a security,” Ozair said. “If you’re holding a token as an investment, then it’s an investment. But if I’m promising anything from it, then it’s a security.”

NFTs Could be Commodities if Developers Don’t Profit

The dynamic presents a conundrum for a broad swath of the $7 billion GameFi industry. Selling NFTs to raise funding was common among GameFi projects during last year’s frothy market conditions, and they have found few alternatives for raising capital under this year’s brutal market conditions.

Analysts point out that there is some room for developers to operate — if they don’t profit from selling their NFTs or tokens.

“Since NFT projects vary in how they operate and what sorts of promises they make to customers, it’s impossible to lump all NFTs into one regulatory basket,” the nonprofit Lincoln Network’s Luke Hogg told GoblinCrypto. “SEC Commissioner Hester Peirce has indicated that some NFT projects (specifically fractionalized NFTs) might fall under SEC jurisdiction, but most NFT projects are more likely to be commodities under the Commodity Futures Trading Commission’s (CFTC) jurisdiction.”

Killian Laverty, a policy analyst with the Washington, D.C.-based FreedomWorks, a conservative nonprofit that supports the Lummis-Gillibrand proposal, said the issue was “really about decentralization.”

“It’s about the rights of the consumer, but also how the platform operates,” Laverty said in an interview with GoblinCrypto. “Bitcoin, for instance, is a store of value. It’s not debt. It’s not equity. There are no managerial efforts. When there is no manager, that is when it becomes a commodity.”

Potential Consequences

Congress is unlikely to take the legislation up before 2023. It’s improbable regulators will take widespread enforcement action before that time. If the law does pass, Ozair said, “I am sure the regulators will have a lot of work to do — lawsuits, investigations, and all of that.”

In addition to facing fines, the SEC may require projects that facilitate the trading of NFTs deemed securities to register as brokers, track users who own their products, and file disclosures like other trading platforms. If they’re unable or unwilling to comply, the SEC may technically prohibit Americans from using their platforms — or playing their games.

Some companies have been proactive in anticipating action. FTX Exchange, in launching an NFT marketplace last year, made a point to exclude NFTs that actively rewarded owners. FTX US President Brett Harrison told Decrypt at the time that “about 10 projects” made changes to fit the exchange’s criteria, saying they were unaware of the regulatory landscape.

“In almost every case, the creators of the project were unaware of the potential regulatory risks, and learning about them was the main reason for their decision to move to a different model,” Harrison said.

Ozair advised that companies should either work to become compliant — quickly — unless they have plans to influence the legislation before its passage.

“Eventually someone is going to knock on their door,” Ozair said. “Look at what happens to a lot of those who try to do something like that. Like, ‘Try it and see,’ maybe they’ll come after us and maybe they don’t.’ Eventually, they come. They get fined millions of dollars and they get closed down. No one wants to be in that situation, so why not think ahead?”