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Money Laundering Via Non-Fungible Tokens

Editor’s note: This blog was first published at the Oxford Business Law Blog site.

If you would like to hear more about this topic, please consider visiting our lecture “Non-Fungible Tokens (NFTs) in the art market: A new medium for money laundering?” at the CEPOL conference on the 9th of June, 14:30-14:50 CEST. 

When we think of art, what often comes to our mind is a Picasso, a Dali or a Modigliani painting. Times are changing, technological evolution is happening, and this could not leave the art market unaffected. A new form of art called Non-Fungible Tokens (NFTs) came a la mode during spring 2021. A work of art by the artist Beeple was sold for 69 million dollars by Christies on 11 March 2021—a record amount of money for an NFT. NFTs can be any type of digital asset. The most common types are objects in virtual worlds, artworks and digitalised characters from sports, music or other artistic activities. NFTs are blockchain-based tokens which securely map ownership rights to digital assets. As paintings that belong to someone are exposed in museums and art galleries for the public, NFTs are analogous to that as they provide a means of representing possession or ownership of digital assets such as games, art and music.

The ownership of NFTs is usually registered on an Ethereum network. There are several examples of NFTs which became suddenly famous and valuable. Such an example is CryptoPunks which were trading for 50 to 100 dollars until April 2020, but suddenly their price went between 20,000 to 100,000 dollars in March 2021. There is a specific distinction between NFTs and other types of blockchain tokens such as Bitcoin. Bitcoin and other cryptocurrencies are fungible; there is no distinctive element between two Bitcoins as they have the same characteristics, and they convey the same rights to their owners.  Hence, they are called “fungible” tokens. NFTs, as their name suggests, are a special form of blockchain-based tokens as they represent a unique value which cannot be fully replaced by a different token. Each NFT is unique and different from other NFTs, thus non-fungible.

This blog contribution focuses on the money laundering (ML) concerns raised by NFTs as they can be used as an obfuscation method to conceal proceeds of crime and illegal income. The key aim is to present the problematic aspects of NFTs in relation to ML, analyse the EU legal framework on anti-money laundering (AML) and to what extent it covers NFTs and provide some thoughts on what can be done to address the gaps therein.

NFTs and money laundering

The record sales of NFTs demonstrate a volatile market where exorbitant amount of money is involved. Concerns have been raised around the globe whether this amount of money spent on NFTs is used in order to facilitate illicit financial transactions and/or circumvent the increasingly robust anti-money laundering (AML) legislation both at the EU and international levels. It is intriguing, after all, that collectors want to spend vast amounts of money for just a digital image when they can buy traditional art with the same amount of money. From a more critical perspective, the rise of NFTs coincides with the traditional art market being subjected to strict AML rules in the EU. Putting the traditional art market on the radar of AML rules and law enforcement agencies (LEAs) may have driven criminals to search for alternative methods of laundering their criminal proceeds. NFTs, blockchain technology, anonymity and the lack of a legal framework create an ideal space for such criminal activities.

Under the EU’s AML Directive (EU) 2018/843 (known as the Fifth AML Directive), all market participants, meaning someone who is involved in the purchase or sale of a work of art for more than 10,000 euros, has obligatory duties in relation to countering ML. Such a person shall carry out Client Due Diligence (CDD) to verify the identity of the purchaser and to verify the source of the funds used for the purchase prior to any transactions involved. If there is any suspicious activity, these should be reported to the relevant authorities (often to the Financial Intelligence Unit of that jurisdiction). These new requirements put the art market in the same position as banks and other financial institutions with the aim to better control a market that was, for a long time, excluded from AML rules and reporting obligations.

The EU’s fifth AML Directive does not provide an explicit definition of ‘works of art’, and it does not define or mention NFTs. Thus, it is not certain whether NFTs would be considered as works of art under the Directive and be subject to AML and counter-terrorist financing rules such as Know Your Customer (KYC) practices. Because of the common features between traditional art markets and NFTs such as price volatility and anonymity of buyers, it may be the case that certain regulators will decide to consider NFTs as works of art and subject the trading of NFTs to their respective AML regulations. The EU’s Fifth AML Directive does not provide clear details on the reporting requirements on NFTs despite its regulatory extension to virtual currency exchanges and custodian wallets. One possible explanation is that, back in 2018 when the directive was created, NFTs were not widely known and used and thus stayed out of regulatory scope of the EU’s AML legal regime.

Nevertheless, the European Commission proposed on September 2020 a Regulation which may include rules that would apply to NFTs. The Markets in Crypto-assets Regulation (MiCAR) provides a definition for crypto-assets, the first EU legal instrument to do so. MiCAR thus defines crypto-assets as ‘digital representation of value and rights which may be transferred electronically, using distributed ledger technology or similar technology’. The purpose of the MiCAR is to put in place control and monitoring measures for crypto-assets which are not regulated under the existing EU financial legal framework. The proposal is expected to be adopted in the next couple of years and to be implemented by Member States no later than 2024.

The MiCAR proposal aims to provide rules on the public offering of crypto-assets, the admission of crypto-assets on a trading platform, the licencing of crypto-asset service providers and the implementation of market abuse rules for crypto-assets businesses. There are three main categories of token in the proposed MiCAR. These are asset-referenced token, e-money tokens and other crypto-assets with different requirements for each in relation to licencing and issues. NFTs may fall under the last category: ‘other crypto-assets’. In this last category, issuers do not have any specific licensing obligations but are required to be a legal entity (even when being established outside the EU) and to comply with certain business and governance conduct requirements (Article 13 of the MiCAR).

While the other crypto-assets will be subject to specific rules about the admission to trading on a trading platform, the authorisation of related service providers and market abuse rules, the proposal exempts issuers of crypto-assets which are unique and non-fungible from the requirement to publish a white paper for public offerings. Consequently, NFTs will be exempted from the obligation to publish such a white paper. The expectation from the MiCAR is to include NFTs and thus subject their issuers and traders to AML and counter-terrorist financing rules. In the recitals of the MiCAR, special reference is made to ‘virtual assets’ as defined by the Financial Action Task Force (FATF). In its latest draft guidance on March 2021, FATF replaced a previous reference to ‘assets that are fungible’ with ‘assets that are convertible and interchangeable’. This definition from FATF may involve NFTs, but this is not clear yet.

Preliminary conclusions

The aforementioned analysis highlights a legal uncertainty about NFTs and ML. This regulatory gap of NFTs may increase the risk of high-value NFT transactions which will be used as a means of circumventing the AML rules at the EU level. NFTs can be easily traded as there is no physical representation or transport, and NFTs allow a high level of anonymity in their transactions. Moreover, they are connected to crypto-currencies which are increasingly being used in serious and organised crime schemes, and the uptake of this payment medium as part of investment fraud is accelerating.

It may be a question of time until NFTs are put under the AML rules, but the alarm should be sounded now in order to mitigate the risks that NFTs pose to society.

Author: Coventry University (CU)