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What are NFTs and why should they be regulated?

We explain what NFTs are, what makes them so attractive to criminals, and how a robust AML approach can help financial institutions mitigate NFT risks.

Napier AI
April 19, 2022

Non-Fungible Tokens (NFTs) have undeniably exploded in popularity and in the headlines recently, but are they just another bubble due to burst? Or are they the future of art and high-value assets?

NFTs aren’t new: much like cryptocurrencies they had a quiet first few years of existence before going mainstream. The first ever NFT, Quantum, was minted in 2014 and was sold in June of 2021 by Sotheby’s, one of the world’s largest fine art brokers.

Reuters reported that in 2021 NFT sales hit $25 billion, but that this massive growth showed signs of slowing down towards the end of the year.

This trend for digital art especially seems to have dominated headlines in the first few months of 2022, with many influential figures and celebrities hopping on the NFT train and propelling their existence into the public awareness - including the particularly vocal Paris Hilton. One trend has seen NFTs of iconic internet moments being sold to the highest bidder, notably the first tweet of Twitter founder Jack Dorsey from 2006 (sold for $2.9m worth of Ether) or the 'Doge' meme (sold for $4m worth of Ether).

And trading isn’t just limited to tech-savvy individuals and celebrities, even large, world-famous institutions like Christie’s and the British Museum have gotten in on this craze.

What is an NFT?

A non-fungible token, or ‘NFT’ is a cryptographic asset that is one-of-a-kind and, unlike cryptocurrencies and other fungible tokens, cannot be traded or exchanged at equivalency – so they cannot be used as currency or in commercial transactions.  

NFTs are stored on a blockchain with unique codes that identify them and, while image-based artworks are the most well-known form, an NFT can be any form of art, from a video to a song or a voice clip. It’s not what the asset is that’s important, as much as its non-fungibility and uniqueness as an asset.

Are NFTs being used to commit crime?

In the financial crime and compliance world, we’re bitterly aware that any emerging technology or trend can be adopted by opportunistic criminals and be used for sinister purposes unless effectively regulated and monitored.

Another parallel with cryptocurrency can be seen in the media coverage of criminal cases that involve NFTs. With the popularity of these tokens, there are plenty of high-profile criminal cases making the headlines that see them feature in predominantly theft and fraud cases.  

One method that criminals have adopted is to sell ‘stolen’ NFTs of artwork, without the knowledge of the artist who created the original, ‘real’ piece. For example, a fake Banksy was put up for sale on Open Sea but proved later to be a scam.

How NFTs are used for money laundering  

NFTs have the potential to be used in much the same ways as any other type of high-value asset to launder money. Typically, an asset is purchased with illegally gained proceeds, then held or sold on to ‘clean’ the dirty money by obscuring the original source of the funds.

After fraud and theft, two of the other biggest financial crime risks that have presented so far with their rise in popularity have been money laundering through NFT purchases and wash trading, which is where the value of an NFT is inflated and one party acts as both buyer and seller in a transaction.

“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. The NFT could then be sold to an unwitting individual who would compensate the criminal with clean funds not tied to a prior crime.” - The US Treasury  

NFTs are similarly, if not more, difficult to value than more “traditional” forms of art and their value can fluctuate. Art, as a high-value asset, is incredibly vulnerable to being used for money laundering, as its value is largely subjective, and there is often a great deal of confidentiality around ownership and even the location of the artwork which makes art an attractive asset to acquire with dirty money and inconspicuously. The issue of subjectivity is arguably heightened with NFTs, for example, Quantum was predicted to sell for up to $7 million US dollars, and bidding started at $100 but, in the end, it sold for just $1.47 million.

How are NFTs regulated?

Most jurisdictions don’t currently have regulations or legislation that apply to NFTs.  

However, existing regulations around digital assets and tokens can apply in some instances, depending on the token’s characteristics, what the token is being used for, and the scope of jurisdictions and regulatory frameworks where the NFT in question is minted or marketed, and where key players in a transaction are based.

For example, in the UK, exchanging an NFT for cash or other cryptoassets triggers a registration requirement under conditions of the Money Laundering Regulations 2017.

Crucially, financial institutions who plan to or already do facilitate any kind of transactions involving cryptoassets need to ensure they continually comply l with evolving regulatory requirements.  

How can we stop criminals using NFTs for money laundering?

The vulnerability of NFTs as a means of money laundering comes at the point of buying and selling them as these transactions are not currently regulated. Even though the certificates of ownership for these digital assets are stored on the blockchain, there are no Know Your Customer (KYC) and Anti-Money Laundering (AML) checks in place to verify the source of funds before the transaction is completed, giving criminals ample opportunity to place illegal funds into the system.  

Additionally, NFTs are often bought and sold using cryptocurrencies, which themselves are increasingly exploited by criminals.

As with any emerging technology, the longer NFTs are around, the more that law enforcement and regulators will get to grip with the various risks they pose and be able to define specific typologies, which are passed onto financial institutions to inform risk policies and AML system rules. But if digital assets like NFTs remain unregulated, there is a high chance that they will only become more attractive to money launderers as they offer an easy means to transfer high amounts of money across borders rapidly.

How can financial institutions keep up with threats like those posed by NFTs?

The most effective way to safeguard your compliance processes is to ensure you have a robust anti-financial crime approach built on the latest that RegTech has to offer. As criminals continue to use the latest technologies to evade detection, AML processes must similarly embrace digitalisation.

Having an AML solution that is able to keep pace with evolving regulatory changes and allows you to quickly introduce new screening configurations, monitoring rules, and regulatory checks is critical to keeping up with the highly digitalised and constantly evolving financial crime landscape we face in the 21st century.

Napier’s anti-financial crime platform is designed to be flexible, adaptable, and user-friendly so that you can respond to emerging threats, new typologies, and the evolving regulatory landscape with ease. Our solutions are powered by artificial intelligence (AI), which helps to detect and safeguard against emerging financial crime typologies as well as known ones.

Discover next-generation financial crime compliance technology

Book a demo of our AI-enhanced solutions or get in touch to find out how Napier can rapidly strengthen your AML defences and compliance capabilities and prepare your organisation to face emerging financial crime threats and new technologies.

Photo by Viktor Forgacs on Unsplash

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