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-collectibles," distinct from cryptocurrency (2).
Despite not being regarded as virtual assets, NFTs are alluded to being categorized as other relevant types of financial assets that fall within the parameters of FATF standards.
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 their behavior. While regulators are predictably lagging, a few interesting views have surfaced from law firms that are trying to ‘make it make sense’ by extrapolating citation 17 to concerning and even absurd ends.
Following this logic, the associates at Guido Hidayanto & Partners in Jakarta published a premonition that should trigger red flags across the industry: NFT Marketplaces and 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 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 came from the Korean government’s FSC, which confirmed, after careful consideration of the FATF’s position, that they will abstain from any form of NFT regulation (for now). This statement is not without criticism, as industry experts warn of exploitation for money laundering (5).
But buyer beware: Regulators are not shy about 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 the US (6). Blockchain data provider Chainalysis notes that intelligence pools for crypto-related crime will only increase as blockchain analytics groups continue to identify illicit transactions (7) retroactively.
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 about the speed at which NFT regulations will be implemented 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.”
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 license (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 predicts an increasing fractionalization of NFTs in 2022 since they are already deemed "valuable assets" (10).
One region has taken a leap ahead by issuing commemorative stamps as NFTs: 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 furthering their stated objective to ‘build the best and most dynamic economy’.
Governments' most predictable actions are finding ways to collect taxes or revenue. So long as NFTs maintain the spotlight on minting new millionaires, rest assured that regulation and taxation will not be far behind.
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 an 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.
NFT marketplaces turn a blind eye to the nature of manipulation when it’s been intentionally embedded into its very design. 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 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 the risk of money laundering (15). NFT marketplaces could implement a stolen art registry and take a cue from the Art Loss Register, which lists stolen art and prevents its resale in legitimate auction houses.