Back to news and insights

The Growing Popularity of NFTs Poses Serious Money Laundering Concerns

June 15, 2022

The value of the Non-Fungible Token (NFT) market skyrocketed in 2021 to $44 billion, up from $106 million in 2020. The adoption of NFTs by high-profile celebrities, including Snoop Dogg, Jimmy Fallon, and Gwyneth Paltrow, has brought awareness of the asset class to a broader audience. However, NFTs present money laundering risks and face regulatory frameworks that have not kept pace with this technology.

What are NFTs?

NFTs are digital bearer instruments that represent ownership of a unique asset. While these can be physical assets, such as property titles, cars and other merchandise, it is in the digital space that these instruments have been most widely used, for example, digital images, videos and tweets.  The tokens are typically recorded on a blockchain ledger to prove ownership and authenticity.  Their “non-fungible” nature distinguishes them from other blockchain tokens, which are fungible or interchangeable (for example, if two people hold one bitcoin each, they hold the same value).

NFTs are commonly bought and sold on specialized marketplaces, like OpenSea, which has around 90% market share by trading volume, and they are managed (i.e., minted, held, transferred, and destroyed) via smart contracts and digital wallets. While the majority of NFT sales are under $200, the sky is the limit. One of the most high-profile NFT sales, Beeple’s ‘Everydays: The First 5000 Days’, was for more than $69 million at a Christie’s auction in 2021. This sale indicated that NFTs representing digital art had reached similar valuation as physical art mediums.

NFTs Pose Unique Money Laundering Risks

Any market where large volumes of money can be moved quickly is vulnerable to money laundering. Money laundering has always been an issue in the fine art world as pieces are relatively easy to move and values are subjective and can be very high.  Criminals can use illicit funds to purchase a piece of physical art and then re-sell it for a higher value, separating it from the origin of funds.  Many in the financial crime space fear NFTs representing digital art are subject to the same vulnerabilities.

According to Chainalysis, a blockchain analytics company, the value sent to NFT marketplaces from illicit cryptocurrency addresses increased in the third quarter of 2021 to over $1 million and again in the fourth quarter of 2021 to just under $1.4 million.  While these amounts are just a fraction of the $8.6 billion worth of cryptocurrency-based money laundering they tracked in all of 2021, with the adoption of NFTs increasing, it is an area to watch closely.

Because NFTs trade on blockchains that also support other cryptocurrencies, it would be possible to use a blockchain mixer to obfuscate transactions conducted prior to purchasing or selling an NFT.  According to Elliptic, a blockchain analytics and compliance company, many large value NFT purchases involve the use of crypto mixing services like Tornado Cash.  There is also the scenario where a criminal takes illicitly sourced cryptoassets, uses a mixer to obfuscate their origin, transfers the new clean cryptocurrency to an NFT marketplace to purchase an NFT, and then re-sells it for increased value, thus creating the appearance that the valid NFT sale is the source of the funds.

In February 2022, the U.S. Treasury released a report, “Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art,” which was mandated by Congress in the Anti-Money Laundering Act (AMLA) of 2020. The Report addresses NFTs and articulates several specific money laundering risks associated with them. The Report points out that NFT platforms range in structure, ownership, and operation, and no two platforms operate in the same way or have the same standards or due diligence protocols.  Traditional industry participants, like art auction houses or galleries, may not have the technical understanding of distributed ledger technology required to practice effective customer identification and verification. Furthermore, while gallery owners have an incentive to protect the reputation of the gallery, sellers of digital art don’t always have similar incentives.

Smart contracts can be used to generate revenue each time a transaction involving the NFT is recorded on a blockchain. While this can ensure that artists are paid royalties for subsequent sales, the Treasury Report considers that this activity can pose money laundering risk because the incentive to transact may be higher than the incentive to verify the identity of the buyer of the work. It can also create a situation where it is more difficult to conduct due diligence if transactions are conducted in rapid succession.

Another risk flagged in the Report is that NFTs can be used to conduct self-laundering, where criminals may purchase an NFT with illicit funds and then sell it to themselves, under a false name, to create records of sales on the blockchain. It is also possible to have direct peer-to-peer transactions of NFT-secured digital art without the involvement of an intermediary, and these transactions may be recorded on a public or a private ledger. As these digital art assets are inherently easier to transfer between transacting parties than traditional art, they are susceptible to exploitation by those seeking to launder the proceeds of crime.

How Can NFT Money Laundering Risks Be Mitigated?

The existing regulatory environment was not designed to accommodate digital assets such as NFTs. At the micro level, blockchain analytic tools have stepped in to fill some of this gap, enabling financial institutions to identify wallets and transactions associated with NFT thefts, block addresses known to be associated with stolen NFTs, and educate compliance staff on red flags.

At the macro level, the lack of regulatory guidance is yet another layer of vulnerability for NFT markets, where criminals may attempt to exploit that lack of consistent oversight.  Some markets may be subject to AML legislation for art dealers or securities brokerages, but there has not been definitive guidance for classifying different kinds of NFTs to determine regulatory implications.

Depending on the nature and characteristics of the NFTs offered, the platform used to trade the asset (such as OpenSea, noted above) may be considered a virtual asset service provider (VASP) by the Financial Action Task Force (FATF) and therefore may come under FinCEN’s regulations in the US. In FATF’s most recent guide for virtual asset service providers, just a single paragraph is dedicated to NFTs.  The guide states that digital assets which are used as collectibles are considered NFTs and are not included in FATF’s virtual asset standards.  Conversely, digital assets that are used as payment or investment instruments would be classified as virtual assets, which would make them subject to the standards, including customer due diligence, applying the travel rule and suspicious transaction reporting.

Similarly, while FinCEN has not specifically provided a regulatory framework for NFTs, the U.S. Treasury Report referenced above uses the same hazy distinction between NFTs as collectibles versus investment.  In practice, the distinction between a collectible and an investment might not be so clear.  The Report concludes by saying that Treasury should address other gaps in AML compliance before turning its attention to the high-value art market.  It does not appear that the money laundering risk related to NFTs is a high priority for FinCEN at this point in time.

In the EU, the draft Markets in Cryptoassets (MiCA) Regulation, proposed in September 2020, could be construed to regulate certain NFT-related market activities. In the UK, NFTs are not currently addressed in the Money Laundering Regulations.  NFTs have not been specifically referred to as cryptoassets by UK regulators, but they may fall within the FCA definition (“a cryptographically secured digital representation of value or contractual rights that uses a form of Distributed Ledger Technology and can be transferred, stored or traded electronically”). If the particular NFT does meet the definition, a business that deals in those NFTs would qualify as a cryptoasset exchange or custodian wallet provider, and must register with the FCA.

As the NFT market continues to increase in size, further legislative and regulatory clarity is required to effectively combat this relatively small, but exponentially growing money laundering risk.

No items found.

FRA Joins ICC FraudNet as Strategic Partner

September 20, 2023

Forensic Techniques to Investigate Emerging Trends

September 20, 2023

Meet FRA Partner Drew Costello – Recognized Among Who’s Who Legal 2023 Thought Leaders

September 20, 2023

Experts Achieve TRM Labs Certifications: Empowering Crypto Expertise and Compliance Skills

September 20, 2023