The United States Department of the Treasury published a report on February 6 under the heading “Study of the facilitation of terrorist finance through the trade of works of art.” Only a small portion of the document’s 40 pages is dedicated to the emerging digital market, which the department uses to understand the market for NFTs. Even a short mention of NFTs in this context could have significant implications for the tone and content of the regulatory debate regarding the asset class.
What was the report?
The report’s overall tone is not alarming for NFT space. It casually mentions growing interest from both legacy institutional players and private investors in the digital art market. However, there are some key points that highlight potential regulatory concerns regarding this rapidly growing sector of digital asset industry. According to Treasury estimates, $1.5 billion was traded in the first three months in 2021.
NFTs do not have a financial classification. Nonfungible tokens can be classified as collectibles due to their unique nature. However, certain situations could allow them to be considered “virtual assets” according to the Financial Action Task Force’s (FATF) definition. Financial Crimes Enforcement Network regulations would apply to platforms that facilitate NFT trading. This would mean that it would first be required to report under the Anti-Money Laundering/Combating the Financing of Terrorism reporting requirements.
The question of classification may not be key to NFTs’ regulatory future. However, the FATF could stand firm in its October 2021 position that nonfungible tokens were not to be considered “virtual assets” but “would be covered under the FATF Standards as that type.” According to the FATF guidance, “Countries should […] review the application of FATF standards to NFTs case-by-case.”
Tatiana Revoredo is a founder member of the Oxford Blockchain Foundation. She noted that the FATF doesn’t recommend regulation of peer to peer (P2P), transfers. The U.S. Treasury report seems to go a little further, potentially laying the foundation for regulation that goes beyond what the international task force has recommended.
The Treasury’s report also focuses on the potential for money laundering in the asset class. According to the authors, NFTs are a major advantage for money laundering because they do not require the physical shipping of digital art objects. This means that there is no financial, regulatory or investigative cost to physical shipping. However, the connection between NFTs and money-laundering vulnerability of an object is not convincing. Cointelegraph was informed by Ryan Fayhee (partner at Hughes Hubbard).
This risk isn’t just for NFTs; there are also AML risks associated with the sale of luxury goods like a bottle of expensive wine or a diamond.
The report also briefly addresses NTFs vulnerability to hyperspeculation. Contrary to traditional art markets that have relatively long commercial cycles, digital art has a much faster pace of trade. For example, painting must be correctly and repeatedly identified, appraised, auctioned, etc. Digital art has different properties than traditional art, which have relatively slow commercial cycles. The painting should be properly and repeatedly identified, evaluated, auctioned, e.t.c.
What are the actual risks?
Chainalysis, a blockchain analytics firm, estimates that $1 million worth of crypto was sent to NFT markets from known illicit addresses (those linked with scam activity). This figure is up from $1.4 million in Q4. These numbers also show an increase in stolen funds and money sent from sanctions-risky addresses to NFT marketplaces. For example, Chatex, a Latvia-based platform, made headlines last year due to its allegations that it was facilitating nefarious transaction.
Chainanalysis points out that it is only a small fraction of the $8.6 million worth of cryptocurrency-based money laundering the analysts tracked in 2021. NFTs attract shaft funds in a way that is far better than the traditional art market. It is unlikely that it will always be this way. Joseph Weinberg (an adviser to the Organization for Economic Co-operation and Development, OECD, and Financial Stability Board) wrote:
It is natural that NFTs development, which has been going at a rapid pace, would expand to include technology that solves regulatory problems. This has been true for crypto as a whole and all industries that have grown from small to large.
Thibault Verbiest from Metalaw’s fintech and cryptofinance division spoke to Cointelegraph. He agreed that regulatory clearance was necessary as the sector is growing. Even Know Your Customer (KYC), procedures shouldn’t be viewed as too difficult.
NFTs would have the main advantage of offering a more efficient way to transfer assets […], although privacy and censorship resistance might be reduced. This is likely the middle path and a good compromise, as the NFT industry grows and professionals and technology is democratized.
Nick Donarski is the founder and chief technology officer of HFT company Ore System. He agrees that clear communication will only benefit the sector and lessen the impact on misinformation and fake news.
Blockchain technology and NFTs are just digital photos. That’s it. They are a hash and data blob, as unattractive as it sounds. They are what define the controls that must be in place. These same growing pains were experienced by the internet 20 years ago.
Future of digital art
Cointelegraph spoke with no experts on the subject who were persuaded by the Treasury’s “NFT as money laundering tool” narrative. Fayhee believes NFTs are less likely to be used to launder money than other art forms, because they can provide a permanent chain that allows for ownership inspection. This is not possible in traditional art markets where it is more difficult to inspect ownership history and access it.
It is important to keep in mind that NFT was not even a market two years ago. There is still a lot of consolidation and maturation ahead. Donarski stated that the digital space will be just like the gallery, shows, and media.
Vergiest hopes that the digital art market will establish its own reputation. However, this doesn’t mean that the industry can’t do more to address regulatory concerns. It is vital that the industry creates the necessary tools and mechanisms to support the new market, such as art authentications and royalties payment mechanisms. The public must also be informed about these developments. Vergiest pointed out:
It is important to educate the public and regulators about blockchain risks, financial risk and legal risks in order for the NFT market to accelerate its natural growth process towards becoming a democratized and digitalized version of traditional art markets.
Revoredo noted that the issue at hand involves a technology still in development, and it is difficult to imagine legislation that could adequately address all possible scenarios. This situation makes it crucial to be proactive in shaping regulatory narratives and social value for the emerging industry.