Non-fungible tokens (NFTs) have exploded into the mainstream as an innovative – and very lucrative – a new way for artists and other creators to monetize their productions.
From an industry that was worth just US$13.7 million in the first half of 2020, the industry is now worth US$2.5 billion – an impressive leap by any standard.
For the art and broader creative industries, this new, blockchain-based approach to verifying authenticity and ownership presents a revolutionary new way to reward creators of both digital and physical media.
NFTs are also strengthening intellectual property protection through decentralization, democratizing the art industry by providing greater access to art markets, and stimulating new digital creativity.
However, like most industries and technologies, NFTs also have a dark side: in their case, a vulnerability to fraud and exploitation through money laundering.
The problem is that while many crypto-based platforms and companies have been brought into the regulatory fold over the last several years, most global regulatory regimes and authorities have yet to develop clear guidelines and approaches for regulating NFTs.
NFTs: What are they?
Put simply, NFTs are a certificate of ownership that is stored on a blockchain. They are described as non-fungible as they are unique and cannot be replicated – even if the object or digital item they convey ownership of can.
The Opportunities
By using blockchain technology to verify ownership of a piece of art, artists and other creators now have access to a powerful means of being rewarded for what they create. While it’s easy to copy and distribute a piece of digital media, having a certificate of ownership that is verified and sold by the true creator of the art adds a new layer of credibility to artistic ownership.
In less than a year, this new technological development has revolutionized the art industry, allowing digital creators to gain access to a market that they had so far had few opportunities to benefit from.
However, the lack of adequate KYC on NFT platforms can pose problems to this system.
As well as opening up NFTs to exploitation for money laundering, the lack of robust identity verification also adds a vulnerability that fraudsters can claim to own a piece of art – and sell it – to the detriment of the original creator and the credibility of the space as a whole.
The Risks
So, how can NFTs be used for money laundering? A common and simple example of what money laundering using an NFT can look like is as follows:
You buy a piece of art from yourself (using a different account) for US$1 million. You then sell that art for much less money to someone else (or another account you have control over).
The result: you have the same or a similar amount of money as you did in the first place. However, your financial records will indicate that you have made a significant loss, absolving yourself from paying tax on those funds.
Alternatively, if you have acquired that money illegally, you can use a similar process to ‘wash’ the cash to appear like you have legally acquired it through a profitable NFT trade.
A case to demonstrate how NFTs can be vulnerable to fraud was presented in a recent article published by Wired, that told the sad story of how thieves sold NFTs of an artist who had died, exploiting her legacy and artwork for criminal gain.
These vulnerabilities are made possible through a lack of adequate KYC and AML measures on NFT platforms.
Compliance Void
When it comes to regulations, authorities are still very much playing catch-up with NFTs. Global regulatory bodies such as the Financial Action Task Force (FATF) still haven’t explicitly identified NFTs and the platforms they are traded on as an asset and space that needs to be regulated.
That means that NFTs and the platforms used to buy and sell them are in somewhat of a legal grey zone. However, that doesn’t mean that NFTs are not affected by regulations. Depending on the jurisdiction, NFTs can be classified as:
- Virtual Assets (VAs)
- Artworks
- Investments
Added to that, the reason why global regulatory watchdogs have yet to properly define NFTs is because they tend to take their time in developing adequate and effective regulatory responses to what is a complex technological, political and economic global environment.
For this reason, many of the major NFT platforms still lack any KYC whatsoever. Opensea and Rarible, which have been used for some of the largest and most high-profile NFT trades, requires absolutely.
Greater regulation is imminent
Regulation of art is nothing new. The traditional art space has long been considered a hotbed of money laundering activity, due to the anonymity with which many deals are made, the large sums of money involved, and the volatile nature of artworks’ prices.
At the same time, traditional art is also vulnerable to other similar problems facing NFTs – counterfeiting and fraud. Some digital artists have already found that their creations have been sold as NFTs without their knowledge or approval that have been blamed on the lack of adequate Customer Due Diligence (CDD) on NFT platforms.
And the division between the traditional art market and NFTs is also becoming increasingly blurred, with famed art houses such as Sotheby’s and Christie’s recently launching their own high-profile NFT markets.
Earlier this year, the FATF released new draft guidance and sought input from industry stakeholders on how to best address the compliance challenges of the present and near future. In that guidance, the watchdog has alluded to NFTs, but has yet to release precise rules on how it expects its signatory members to regulate the space.
What that means is that while NFTs and their platforms are still very much a ‘Wild West’, they probably won’t be for long. The vulnerability of the digital art space to exploitation by criminals and fraudsters is simply too pronounced for global regulators to allow it to develop in an unregulated way.
For these reasons, NFT platforms and creators will most likely soon face similar regulatory oversight as the crypto space began to experience a few years ago. CDD – which is still all-too lacking on NFT platforms – will need to become more robust and standardized as part of the industry’s maturing process.
And, for the reasons outlined above – that’s probably not a bad thing.
By implementing effective and efficient KYC as part of a robust AML regime, NFT platforms can:
- Prepare for future regulations
- Earn trust from their users and build credibility
- Secure their defenses against money laundering and other illicit financial practices
- Make it easier to cash out proceeds by fostering greater acceptance and linkages with the traditional banking system.
How NFT platforms can use KYC-Chain
KYC-Chain’s integrated KYC solution can be customized for NFT platforms to address the entire spectrum of risks they face from fraud, exploitation by criminals, and impending regulatory scrutiny:
As a Tier 1 process, platforms can use KYC-Chain to check that users are who they say they are in order to secure their defenses against fraudulent sales and strengthen intellectual property rights and transparency.
For platforms that want to ensure compliance and mitigate money laundering risks, platforms can use KYC-Chain to institute a Tier 2 process that involves conducting mandatory KYC checks on customers when they engage in transactions, including buying, selling NFTs and withdrawing funds from a platform.
This level of KYC can help shield NFT platforms from money laundering and terrorist financing risks, and allow them to be well-positioned for when global financial regulations inevitably expand in a way that affects them.
Being able to demonstrate a robust KYC and AML approach can also allow platforms to gain better access to the global financial system, making buying/selling NFTs and withdrawal of funds through the platform easier and more transparent.
Some NFT platforms have already opted to conduct some basic KYC processes for general users of their platform, building trust and credibility among their user base, while securing their place in the fast-developing regulatory environment.
Does your NFT project or platform need an effective, efficient and dynamic KYC solution? Get in touch and we’ll be happy to discuss how we can make KYC-Chain work for you.
