On February 4, 2022, the U.S. Department of the Treasury (Treasury) published a study of money laundering and terror financing risks associated with the art trade (Study), as required by the Anti-Money Laundering Act of 2020. Although the Study’s overall conclusion is that “the art market should not be an immediate focus for the imposition of comprehensive [anti-money laundering (AML)/countering terrorist financing (CFT)] requirements,” the Study highlights the explosive growth of the market for nonfungible tokens (NFTs) as an area of potential concern. NFT marketplaces and other intermediaries in NFT transactions should pay careful attention to Treasury’s evolving interest in this space and to the ways in which otherwise legitimate platforms can be abused for money laundering and terrorist financing purposes.
Generally speaking, NFTs — as defined by Treasury — are digital tokens on a blockchain that represent ownership of images, videos, audio files, and other forms of media or ownership of physical or digital property. The tokens represent and verify the ownership of a unique digital asset, such as a piece of digital art. Because the NFTs are on a blockchain, they are publicly verifiable, auditable, and digitally unique. But unlike virtual assets on a blockchain with fluctuating exchange rates, such as bitcoin or ether, the value of each NFT in theory depends on the individual exchange between a buyer and seller and the subjective valuation the parties place on the NFT.
Treasury acknowledges that the uniqueness of each NFT generally renders NFTs outside of the definition of a “virtual asset” as defined by Financial Action Task Force (FATF) and suggests, but does not state outright, that the same result should follow under Financial Crimes Enforcement Network (FinCEN) regulations.1 However, the Study warns that an NFT or other digital asset may, depending on the facts and circumstances, qualify as a “virtual asset” under the FATF definition if it is “used for payment or investment purposes in practice.” This, in turn, would render service providers of such NFTs, including NFT platforms, as regulated virtual asset service providers under the FATF regime.
Similarly, providing a marketplace for NFTs could trigger “money services business” treatment under FinCEN regulations if the NFTs, while nominally unique, take on characteristics that give them “value that substitutes for currency.” NFTs may also be investment assets that take on the characteristics of a security or are offered pursuant to a securities transaction that is subject to the U.S. federal securities laws. The issuers of NFTs that are securities will need to consider registration with the U.S. Securities and Exchange Commission or rely on an applicable exemption from registration. In addition, the marketplaces that support trading in NFTs that are securities will need to consider whether their activity requires registration as a national securities exchange or broker-dealer. Moreover, the Study notes that when platforms facilitate transactions in NFTs using other virtual assets, the handling of those related assets can itself trigger the application of FinCEN rules.
The Study specifically identifies three potential ways that criminals may seek to exploit NFTs: (1) self-laundering, where criminals purchase an NFT and transact with themselves to create a record of sales, which would then provide a third party with sufficient assurance as to its valuation and demand to purchase the NFT; (2) abusing the capability of some NFTs to be transferred directly via peer-to-peer transactions without an intermediary and without concern for geographic distance and across borders, permitting the movement of value without incurring potential financial, regulatory, or investigative costs of physical shipment; and (3) the perversion of incentives among industry participants, such as an incentive to encourage rapid, repeat transactions in a short period (to the detriment of due diligence efforts) based on the ability for smart contracts to generate revenue per transaction. Some of these vectors may be most susceptible to abuse via high-frequency trading of lower-value NFTs that begin to blur the unique qualities of the underlying assets or disguise the identity of participating buyers, while other risks may be exposed by high-value transfers that attempt to wash illegitimate funding in much the same way that high-value physical artwork has occasionally been abused.
Ultimately the Study does not recommend any immediate action in this still-immature field, which is good news for legitimate market participants. However, such participants would be well served to consider AML risks as part of their overall legal risk assessment as well as intellectual property considerations, the potential for inadvertent creation of a security when using fractional interests in NFTs to represent interests in economic returns, the risks of market manipulation, and potential for claims of unfair, deceptive, or abusive acts and practices, particularly where the risks of NFT transactions are not adequately identified for buyers and sellers.
1 The use of FATF definitions in the study in connection with a discussion of U.S. AML/CFT obligations also reaffirms the close coordination between FATF and FinCEN when it comes to virtual assets.
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