Elliot Burr
“What does NFT even stand for, anyway?” Perhaps these words have resonated with you the past few months in conversations with colleagues or friends. While seemingly a throwaway joke, it echoes an unfamiliarity that many people working in financial compliance will see as a large hindrance to their KYC and AML processes.
NFTs, standing for Non-Fungible Tokens, are the part-fad, part-legitimate financial gain tool that has divided many financial heads over the cryptocurrency boom that has ebbed and flowed the past decade. And while we see large banks and institutions starting to see crypto as a more concrete commodity than it has been viewed in the past, these newfound NFTs could pose the next big problem of becoming the gray area that money launderers can exploit for their own advantage.
The Art of Manipulation
NFTs have become a source of much speculation recently alongside such memeable crypto news including the dogecoin surge, and their poor environmental impact. But within certain circles such as the art world or music industry (which has taken a serious hit due to the Covid-19 pandemic), NFTs provide a source of income, sometimes extraordinary amounts.
In part, an NFT allows a buyer to purchase a completely unique digital entity and receive a certification that they are then the rightful owner of it, with this data or information stored on a digital ledger, or blockchain. Many will be familiar with Beeple – the digital artist whose work has thrust the NFT niche into this particularly bizarre zeitgeist – but that popularity has also manifested into serious monetary gain. One of the artist’s works has become the largest selling NFT at auction, around $60 million.
One thing that is credibly sketchy for financial crime investigators is the clear link that NFTs have to the art world – an industry that is notoriously blighted by money laundering activity. Money launderers seek to disguise transactions constantly within sales for commodities such as artworks, which is where the problems lie. Much akin to trade-based money laundering, digital trade transactions can disguise proceeds of criminal activity and make it particularly difficult for AML professionals to identify. With NFTs characteristic of the current times’ unsettled financial markets, they pose a problem perhaps even more tricky than that posed by the art industry. Indeed, they have been named the “best money laundering method in the cryptocurrency world”.
The Crypto Conundrum
Much of this has to do with how NFT platforms, and indeed even the most well-known cryptocurrency providers, can operate with very little, or even no KYC protocols. A large NFT peer-to-peer marketplace such as OpenSea has been identified for not displaying any KYC controls, and attributes its main role as linking together buyers and sellers of digital assets even, with only a single seller address considered a valid background check. This makes the attraction to money launderers a stark reality, experts in flushing illegal proceeds through seemingly legitimate real estate.
As NFTs are paid for using such currencies as Ether or Bitcoin, they are being viewed under the same microscope as cryptocurrencies, particularly the microscopes used by financial regulatory bodies. An advisory in October 2020 by the Office of Foreign Assets Control (OFAC) highlighted sanctions risks posed by the opaque art market, and FinCEN conducted their own crackdown on crypto regulation at the end of last year. According to the regulator, any transaction using cryptocurrencies worth more than $10,000 would require a wallet owner to provide data on their identity.
Further mainstream news on Beeple and NFTs may have spurred even further investigation from these regulatory bodies. In March 2021, the Financial Action Task Force (which works global) issued broader guidance on virtual assets that include NFTs; changing a reference of “asset that are fungible” to “assets that are convertible and interchangeable” to indicate the extent to which different forms of virtual currency warrant strict regulation. NFTs cause debate, but as one example was attributed by FinCEN as a “value that substitutes for currency”, NFTs may indeed in the future come under the same scrutiny as tangible or online transactions.
There is still also the headache of tax evasion also linked to NFTs for financial institutions; the US fails to collect up to $1 trillion in taxes due to the cryptocurrency rage, a difficulty to track. Many sellers and buyers of NFTs are unaware that purchases are subject to capital gains taxes as capital assets rather than currencies.
Improving KYC steps
However, as with much of the furor around cryptocurrencies, a lot of this is all talk, albeit coupled with practical measures in place to make them a more legitimate form of transaction. Last year, FATF labelled the existence of Virtual Asset Services Providers (VASPs) and they became required to pertain to the so-called “travel rule”. This forces any VASP to gain, hold and transmit beneficiary information from one VASP to another on behalf of the client when transacting virtual assets. Under new rules, both the receiving and sending customers’ names, addresses and account details must be transmitted.
This goes some way in helping financial investigators to identify sanction-dodging individuals or companies from the legitimate buyers and sellers in the cryptocurrency world. Illicit transactions in 2019 were found to account for only 1% of all Bitcoin activity that year according to Chainalysis; a figure that should hopefully improve more with greater scrutiny on crypto regulation.
Banks and other financial institutions can at least know that both global and jurisdictional bodies seem to be keeping up with the potential problems that cryptocurrencies face, but must adapt their KYC and AML processes to deal with an ever growing problem that is likened to the same risk as TBML. Nonetheless, with adept processes and techniques to identify fraudulent information (transactions between nefarious bodies) and the fact that much of NFT transfers occur over the traceable blockchain Ethereum, it is just a case of tightening analytics – and data gathering through adverse media and alternative data sources – while the NFT and crypto markets are growing ever more in plain sight.
The problems of gray-area NFTs may be as over hyped as a lot of the crypto-news we may see on social media and other outlets, but more ‘out in the open’ information should be used to the advantage for financial crime investigators to stay ahead of any money launderers that look to NFTs for their activity, while keeping an eye on more advanced transitionary crime that continues to lurk far from plain sight.