The red-hot market for nonfungible tokens, or NFTs, continues to draw regulatory scrutiny. A Department of the Treasury report issued on February 4, 2022, is the latest to focus on potential regulatory issues associated with this digital asset class.
The report, entitled “Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art” is a wide-ranging study of potential money-laundering vulnerabilities in the global art trade. In one section, it focuses on the emerging market for digital art and the role that auction houses, art dealers and the growing number of digital trading platforms play in the primary market and secondary markets for NFTs.
The report notes that depending on the nature and characteristics of the NFTs offered, platforms may be deemed virtual asset service providers (VASP) under FinCEN’s regulations. Under these regulations, a VASP is any business that conducts one or more of the following activities or operations for or on behalf of another natural or legal person: (1) exchange between virtual assets and fiat currencies; (2) exchange between one or more forms of virtual assets; (3) transfer of virtual assets; (4) safekeeping or administration of virtual assets or instruments enabling control over virtual assets; and (5) participation in and provision of financial services related to an issuer’s offer or sale of a virtual asset.
Treasury observes that digital assets that are unique, rather than interchangeable, and that are used in practice as collectibles rather than as payment or investment instruments are generally not considered to be virtual assets under its regulations. The report opines, however, that NFTs or other digital assets used for payment or investment purposes in practice may fall under FinCEN regulations, and some NFT platforms and service providers may qualify as VASPs, depending on the characteristics of the NFTs that they offer. The report points out that platforms or other persons doing business transferring virtual assets during the buying or selling of NFTs may have obligations under FinCEN’s rules for money service businesses if they are doing business in the United States.
The report also warns that NFTs can be used to conduct “self-laundering,” where criminals may purchase an NFT with illicit funds and proceed to transact with themselves to create records of sales on the blockchain. In this way, Treasury hypothesizes that the NFT could then be sold to an unwitting individual who would compensate the criminal with clean funds not tied to a prior crime. Treasury expresses concern that the ability to transfer some NFTs via the internet without concern for geographic distance and across borders nearly instantaneously makes digital art susceptible to exploitation by those seeking to launder illicit proceeds of crime, because the movement of value can be accomplished without incurring potential financial, regulatory, or investigative costs of physical shipment.
Furthermore, the report expresses concern that the smart contract underlying an NFT may facilitate conditions for money laundering. The report cites the example of an NFT’s smart contract that provides for the payment of a royalty to an artist each time their work is sold. Treasury notes that such smart contracts could create an incentive to shape a marketplace where the work is traded repeatedly in a short period. Although this structure can ensure that artists are compensated for their work past the first sale, Treasury posits the activity can also pose risks because the incentive to transact could be higher than the incentive to verify the identity of the buyer of the work, or even can create a situation where it is not possible to conduct due diligence if transactions are conducted in rapid succession. Moreover, Treasury cautions that traditional industry participants, such as art auction houses or galleries, may not have the technical understanding of distributed ledger technology required to practice effective customer identification and verification in this space.