Financial Crime Risks and Regulatory Uncertainty Facing the NFT Market

By Alma Angotti, Gene Bolton

It is impossible to read news headlines, let alone financial news, without coming across mention of Non-Fungible Tokens (NFTs). NFTs are one of the hottest commodities in the already hot market of Decentralized Finance. During 2021, the NFT market saw trading volumes of more than $13 billion, and trading volume for 2022 seems set to eclipse that number, with more than $6 billion in January alone. From celebrities, to institutional investors, to the general public, interest in the NFT market has ballooned along with valuations.

This interest in NFTs is not limited to the private sector. Both the federal government and international working groups have also expressed interest in NFTs. In December 2021, the Financial Actions Task Force (FATF) issued an updated cryptocurrency guidance that discussed NFTs,  while in early February 2022, the Department of the Treasury issued a study on money laundering risks in the art market that also discussed potential criminal applications of NFTs.


Risks in the NFT Market

In keeping with FATF’s recommendations, the recent Treasury report stated that NFTs that are “unique” and “collectible” are generally not considered virtual assets. However, NFTs that are used for “payment or investment purposes” could be considered virtual assets, thereby qualifying any NFT marketplace that deals in these assets as a virtual asset service provider (VASP). The Treasury report cites these FATF VASP guidelines and states that handling these “payment or investment” NFTs could open a NFT marketplace to the associated FinCEN anti-money laundering/know your customer (AML/KYC) regulations, likely as a money services business. Importantly, US federal agencies have not offered guidance on what qualifies an NFT as “collectible” versus for “payment or investment purposes,” so remaining compliant could prove difficult for NFT marketplaces, particularly those without robust AML/KYC programs.

In addition to the regulatory risks, NFTs are susceptible to many of the same financial crime risks as more traditional digital assets, such as Bitcoin and Ether, including:

Wash Trading

Wash trading is when the same individual is on both sides of a transaction, the purpose of which is to mislead the public about the underlying asset’s liquidity and value. Wash trading, while illegal in more traditional equity and commodity markets, has not faced the same regulatory scrutiny in the NFT market. While not necessarily a crime, a recent report from blockchain analytics firm Chainalysis indicates that wash trading is occurring in NFT markets, allowing perpetrators who engaged in this type of activity to make large amounts of money. 

Rug pulls

While not exclusive to NFTs, “rug pulls,” which are fraudulent projects where the organizers have no intention of providing a product or service after a user provides funds, are prevalent in this space. Both NFT marketplace operators and potential NFT buyers need to be aware of rug pull typologies to avoid them.

Money laundering

Like more traditional digital assets, NFTs face a heightened money laundering risk due to the ease of conducting transactions and the pseudonymous nature of blockchains. Indeed, the recent Treasury report specifically cites NFT marketplaces as vulnerable to money laundering, both from bad actors buying and selling NFTs to criminals creating their own NFTs and self-dealing to launder the funds. This last possibility is particularly concerning, as NFTs can be set up to provide a transaction fee to the NFT’s creator each time it is sold. This could allow bad actors to continue to profit from their illicit, self-dealing funds long after they are originally laundered, by selling NFTs to unsuspecting third parties.

Sanctions risk

Office of Foreign Asset Control (OFAC) sanctions apply to all US persons regardless of other AML/KYC requirements. While NFT marketplaces or institutional investors interested in holding NFTs may not be regulated as VASPs, they still must prevent transactions with sanctioned entities. Even inadvertent transactions with sanctioned entities can open a counterparty to regulatory enforcement. While sanctioned entities do not appear to be heavily active in the NFT market1, it is possible that as the market continues to expand, sanctioned entities will attempt to use NFTs to circumvent US sanctions.


How Can Guidehouse Help?

Guidehouse has the expertise, knowledge, and experience to assist various clients across the NFT market, ranging from NFT marketplaces, institutional investors interested in financing NFT marketplaces, or institutional investors interested in trading and holding NFTs directly.

Guidehouse can help NFT marketplaces with:

  • Developing robust AML, KYC, and sanctions compliance programs.
  • Evaluating existing compliance programs to ensure they meet regulatory expectations and industry best practices.

Guidehouse can help institutional investors with:

  • Developing compliance programs as a condition of investment.
  • Evaluating compliance programs at potential investment targets and making recommendations on how to meet regulatory standards and industry best practices.
  • Developing compliance programs to ensure that acquisitions have not been held by sanctioned parties or other bad actors.

As US regulators issue new regulations and guidance, our team has the expertise to help your organization through the regulatory and compliance environment and address the mounting complexities as NFTs and other digital assets continue their growth and adoption by the financial system and the public at large.

Special thanks to Nick Bohmann for contributing to this article.

1 According to Chainalysis’ report, all activity by sanctioned entities is related to the peer-to-peer exchange Chatex, which was designated by OFAC in November 2021.

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