At the start of 2021, NFTs were only known to a niche group within the crypto community. By year’s end, the market had swelled to over $40 billion (1) and had become a rakish phenomenon even to non-crypto adopters due to a rapid surge in investor demand.

Large sums of money have historically been hidden and shuffled around under the guise of art. Agglutinating this commodity within a rapidly expanding digital market has inadvertently broadened the pool for money laundering under the guise of NFT trading.

As outlined in the updated guidelines for cryptocurrency providers, FATF considers NFTs or "crypto-collectables", as distinct from cryptocurrency (2).

Despite not being regarded as virtual assets, there is an allusion to NFTs being categorized as other relevant types of financial assets that fall within the parameters of FATF standards.

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How Is This Decision Being Interpreted?

The FATF’s current standing on NFTs has perpetuated an onus upon financial regulators within individual governments to decide how they should be classed and regulated; in accordance with how they behave. While regulators are predictably lagging, a few interesting views have surfaced from law firms who are trying to ‘make it make sense’ by extrapolating citation 17 to concerning and even absurd ends.

Image: Section 50, as noted by citation 17‍

Following this logic the associates at Guido Hidayanto & Partners in Jakarta published a premonition that should be triggering red flags across the industry; NFT Marketplaces and/or creators could be accountable for copyright violations. According to the law firm, strict enforcement of copyright infringement legislation can mean up to two years in prison for parties found guilty of using images under Indonesian copyright in their NFT (3).

Unsurprisingly, India continues to be problematic due to a lack of clarity surrounding the perceived use cases for NFTs, and a callback to legislation put in place before the invention of the PC. One law firm published a dizzying opinion in the Asia Business Law Journal (4).

“Most NFT-related transactions take place through smart contracts, which may stipulate the terms of a licence, provide automatic royalties in case of resale transactions, set limits to the use of copyrights, and track subsequent purchases of an NFT. A smart contract is governed by the Contract Act, 1872, and the Information Technology Act, 2000.”

Perhaps the most pragmatic and direct approach was from the Korean government’s FSC, who confirmed after careful consideration of the FATF’s position, they will abstain from any form of NFT regulation (for now). This statement is not without criticism, as industry experts warn of exploitations for money laundering (5).

But buyer beware, regulators are not shy to take retroactive enforcement when it comes to money laundering. The current statute of limitations for the federal crime of money laundering is five years in Korea, Japan, and also in the US (6). Blockchain data provider Chainalysis notes that intelligence pools for crypto-related crime will only increase as blockchain analytics groups continue to retroactively identify illicit transactions (7).

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Industry Veterans on the Inside Looking out

This isn’t the first time regulators have come around sounding the alarm in the crypto community, and veterans of this 10 year old industry have proven exceptionally resilient. Lawyers are in the business of communicating the intent of regulations, but VASPs have the benefit of experience to enhance their predictions of how things will play out.

Josh Sandhu Co-founder of Europe’s first NFT Advisory, Quantus Gallery, is hesitant to make specific allegations as to the speed at which NFT regulations will be put in place at this time.

“Anti-money laundering checks aren't required for NFTs just yet, at least ones classed as ‘investments’, but at some point, they will be - as a Hybrid gallery we comply with Art AML checks as we're also selling traditional in conjunction with digital and I fully expect regulations to come in soon, but it needs to be applied in a way that doesn’t destroy this market.”

In a bid to tighten the control of NFT trading, the Securities and Exchange Commission (SEC) plans to make it a legal requirement for NFT marketplace operators to apply for a business licence (8). Under the act, each NFT will be examined individually to determine whether it falls under any specific type of "digital asset". While NFTs are not defined in the Digital Asset Business Act (9), their function as a coin that represents a holder's ownership or access rights to some unique asset resembles that of security tokens and utility tokens, which could make them subject to the SEC's supervision. Conversely, SEC member Hester Peirce already predicts an increasing fractionalization of NFTs in 2022, since they are already deemed as "valuable assets" (10).

One region has taken a leap ahead by issuing commemorative stamps as NFT’s, the future-focused UAE. Regulators are taking a back seat to technology adoption in all forms in the hopes of attracting top global tech talent and investment, and to further their stated objective to ‘build the best and most dynamic economy’.

The most predictable actions of governments is finding ways to collect tax or revenue. So long as NFTs maintain the spotlight for minting new millionaires, rest assured regulation and taxation will not be far behind.

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How Can AML Best Practices Be Proactively Implemented?

Market Abuse: Money Laundering, Wash Trading

As it stands, money laundering has the potential to be the most prevalent form of manipulation within the NFT market, simply due to how easy it is for holders to inflate their value through wash trading. NFT platform LooksRare is a prominent use case, resorting to the audacious tactic of airdropping its LOOKS token to 185,000 wallets of eligible OpenSea users in attempt to convert trade loyalty; also known as a “Vampire Attack” (11). It also regularly shills out stashes of its token to encourage trade in specific collections, such as Doodles and Bored Ape Yacht Club.

It’s evident NFT marketplaces turn a blind eye to the nature of manipulation when it’s been intentionally embedded into its very design. There’s only so far inauthentic transactions can propel platforms bidding for public dominance before their NFT trading honey trap is revealed. According to Catherine Zhu and Louis Lehot of Foley & Lardner LLP, it’s the responsibility of each participating business to consider the legal ramifications of still-developing law, policy and regulation applicable to each link in the chain of NFT commerce (12). Their outlined unified code of conduct is proposed to ensure NFT marketplaces are legally compliant long before opening their trading floor.

Europe is getting the ball rolling by including crypto asset regulation within their governing frameworks. The MiCA proposal, passed by the European Union on September 24 2020, will regulate the implementation of market abuse rules for crypto asset businesses, (among other digital asset related risks) within the next four years (13). Thus extending the AMLD5 Directive, which the European Parliament and of the Council implemented back in 2018, by including virtual currency exchanges and custodian wallets (14). NFTs are predicted to fall under the "catch-all" category of other crypto assets, under Title II of the MiCa Proposal (13).

According to a recent comment by CFCS at RUSI, KYC policies and ongoing monitoring, similar to those used in the traditional art market and in compliant cryptocurrency exchanges, are necessary to mitigate risk of money laundering (15). NFT marketplaces could take a cue from the Art Loss Register, which lists stolen art and prevents its resale in legitimate auction houses, by implementing a stolen art registry.

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Sanctions and Terrorist Financing

If anything can be learned from El Salvador’s Chivo Wallet’s wave of 884 identity theft cases, it’s that without KYC checks, anyone could feasibly open an account and start minting, buying, or selling NFT’s on a marketplace (16). Back in November, the Treasury Department's Office of Foreign Assets Control (OFAC) seized Telegram bot-based P2P cryptocurrency exchange Chatex for related ransomware attacks (17) and added it to its Specially Designated Nationals and Blocked Persons (SDN) list (18).

OFAC’s more targeted advisory released in October clearly outlines what they expect of all digital asset companies in terms of compliance best practices. It considers the existence of a robust compliance program as a mitigating factor when assessing penalties and enforcement actions, namely KYC and Transaction Monitoring (19). Additionally, FinCEN is actively issuing a request for information (RFI) on ways to modernize risk-based AML/CFT laws and regulations, issued pursuant to the Bank Secrecy Act (BSA), so that they effectively and efficiently protect U.S. national security (20). Acting Director of FinCEN, Himamauli Das, issued the following statement:

“We recognize that the illicit finance threat landscape continues to evolve and that technology and innovation now play an important role in the efficient application of resources to combat illicit finance. I urge all relevant stakeholders to review the RFI and comment on ways that FinCEN can modernize AML/CFT regulations and guidance and better promote a risk-based approach to AML/CFT compliance.”

The current regulatory landscape was not designed for the rapidly evolving digital asset environment. The jury is still out on how soon we are likely to see regulators go to the mat in the NFT arena. It's clear that by applying a baseline standard of compliance practice that corresponds with existing policies and regulations can be a bold way for NFT marketplaces to uphold their responsibility to users whilst strengthening trust in their platform, and in the very assets they depend on.

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References:

1. “How NFTs became a $40bn market in 2021 | Financial Times.” 31 Dec. 2021, https://www.ft.com/content/e95f5ac2-0476-41f4-abd4-8a99faa7737d. Accessed 13 Jan. 2022.

2. “Updated Guidance for a Risk-Based Approach for Virtual Assets and Virtual Asset Service Providers | FATF.” Oct. 2021, https://www.fatf-gafi.org/media/fatf/documents/recommendations/Updated-Guidance-VA-VASP.pdf. Accessed 13 Jan. 2022.

3. "NFT regulations in Indonesia | Asia Business Law Journal." 1 Dec. 2021, https://law.asia/nft-regulations-indonesia/. Accessed 18 Jan. 2022.

4. “A comparison of regulations surrounding NFTs | Asia Business Law Journal.” 1 Dec. 2021, https://law.asia/nft-regulations-comparison/. Accessed 13 Jan. 2022.

5. “Korea's FSC confirms that NFTs will not be regulated | Cointelegraph.” Nov5. 2021, https://cointelegraph.com/news/korea-s-fsc-confirms-that-nfts-will-not-be-regulated. Accessed 14 Jan. 2022.

6. “USA Anti-Money Laundering Laws and Regulations 2021 | ICLG.com.” 25 May. 2021, https://iclg.com/practice-areas/anti-money-laundering-laws-and-regulations/usa#:~:text=1.7%20What%20is%20the%20statute,%C2%A7%203282(a). Accessed 14 Jan. 2022.

7. “Crypto crime was the highest — and lowest — ever in 2021: Chainalysis | The Block.” Jan 6. 2022, https://www.theblockcrypto.com/linked/129409/crypto-crime-highest-lowest-ever-2021-chainalysis. Accessed 16 Jan. 2022.

8. “Regulator tightens control of NFT trading | Bangkok Post.” 7 Jan. 2022, https://www.bangkokpost.com/business/2243303/regulator-tightens-control-of-nft-trading. Accessed Jan 13. 2022.

9. “SUPERVISION & REGULATION | Bermuda Monetary Authority (BMA).” https://www.bma.bm/digital-assets-supervision-regulation. Accessed 16 Jan. 2022.

10. “PYMNTS NFT Series: Can NFTs Be Securities? The SEC Says Yes | PYMNTS.com.” Jan 12. 2022, https://www.pymnts.com/nfts/2022/pymnts-nft-series-can-nfts-be-securities-the-sec-says-yes/. Accessed Jan 14. 2022.

11. “Hot Ethereum NFT Platform LooksRare Is Rife With Wash Trading—And OK With It | Decrypt.” Jan 12. 2022, https://decrypt.co/90317/ethereum-nft-market-looksrare-wash-trading. Accessed Jan 16. 2022.

12. “A Checklist Of Legal Considerations For The NFT Marketplace | Crunchbase.” 9 Nov. 2021, https://news.crunchbase.com/news/a-checklist-legal-nft-marketplace/. Accessed Jan 16. 2022.

13. “Regulatory Approaches to Nonfungible Tokens in the EU and UK | Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates.''15 Jun. 2021, https://www.skadden.com/insights/publications/2021/06/regulatory-approaches-to-nonfungible-tokens. Accessed 14 Jan. 2022.

14. “DIRECTIVE (EU) 2018/843 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 30 May 2018 | EUR-Lex.'' 19 Jun. 2018, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32018L0843. Accessed 18 Jan. 2022.

15. “NFTs: A New Frontier for Money Laundering? | RUSI.” 2 Dec. 2021, https://rusi.org/explore-our-research/publications/commentary/nfts-new-frontier-money-laundering. Accessed 13 Jan. 2022.

16. “El Salvador’s Chivo Wallet Buffeted by Sanction Threat, Identity Theft and Privacy Problems | PYMNTS.com.” 17 Dec. 2021, https://www.pymnts.com/cryptocurrency/2021/el-salvadors-chivo-wallet-buffeted-by-sanction-threat-identity-theft-and-privacy-problems/. Accessed 18 Jan. 2022.

17. “P2P Cryptocurrency Exchange Chatex and Two Russian Nationals Indicted and Sanctioned for Roles in Ransomware Operations | Chainalysis.” 8 Nov. 2021, https://blog.chainalysis.com/reports/ofac-sanction-chatex-revil-sodinokibi-november-2021/. Accessed 18 Jan. 2022.

18. “Cyber-related Designations and Designations Updates | US Department of Treasury.” 8 Nov. 2021, https://home.treasury.gov/policy-issues/financial-sanctions/recent-actions/20211108. Accessed 18 Jan. 2022.

19. “Sanctions Compliance Guidance for the Virtual Currency Industry | Office of Foreign Assets Control.” Oct. 2021, https://home.treasury.gov/system/files/126/virtual_currency_guidance_brochure.pdf. Accessed 18 Jan. 2022.

20. “FinCEN seeks comments on modernisation of US financial crime controls | Finextra.” 16 Dec. 2021, https://www.finextra.com/pressarticle/90814/fincen-seeks-comments-on-modernisation-of-us-financial-crime-controls. Accessed 18 Jan. 2022.