ACFCS Special Contributor Report: It Starts with Art – NFTs, money laundering and terrorist financing

The Skinny:

  • The United States Department of the Treasury’s recent publication of its “Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art” did more than just turn attention to the art market. It introduced the ‘emerging digital art market,’ and for the first time, opened up serious attention at the government level on NFTs (Non-Fungible Tokens) from a money laundering and terrorist financing perspective. 
  • The Treasury defines NFTs as “digital units on an underlying blockchain that can represent ownership of a digital work of art.” The study also has broad implications for the NFT sector, including art creators, sellers and marketplaces, because, depending on how these entities buy and sell NFTs, they could be acting as a quasi-crypto exchange, thus tripping global recommendations and regional fincrime compliance rules, according to the U.S. Treasury.  
  • The financial crime risks – and anti-money laundering (AML) controls – related to NFTs, fraud, the art world and crypto value blockchains have also risen in recent months for financial institutions after recent historic changes in the United States to transform the compliance regime of the country from pleasing federal regulators to serving law enforcement.

By Dev Odedra
Independent AML expert, director, Minerva Stratagem Consulting
February 9, 2022

With editing and minor content contributions by ACFCS VP of Content, Brian Monroe

The United States Department of the Treasury’s recent publication[1] of its “Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art”[2] did more than just turn attention to the art market. 

As well as traditional art, it introduced the ‘emerging digital art market,’ and for the first time, opened up serious attention at the government level on NFTs (Non-Fungible Tokens) from a money laundering and terrorist financing perspective. 

The Treasury defines NFTs as “digital units on an underlying blockchain that can represent ownership of a digital work of art.”

The study also has broad implications for the NFT sector, including art creators, sellers and marketplaces, because, depending on how these entities buy and sell NFTs, they could be acting as a quasi-crypto exchange, thus tripping global recommendations and regional fincrime compliance rules, according to the U.S. Treasury.  

Whilst the aim of this study where NFTs are concerned was on art, the increasing application of NFTs should be something regulators and the compliance community should be thinking about more broadly from a money laundering, terrorist financing and sanctions context.

The financial crime risks – and anti-money laundering (AML) controls – related to NFTs, fraud, the art world and crypto value blockchains have also risen in recent months for financial institutions after recent historic changes in the United States to transform the compliance regime of the country from pleasing federal regulators to serving law enforcement.

So what AML rules apply to NFTs? Are they akin to crypto coins? Art? Securities?  

What changes you ask? Big ones.

Congress in January 2021 passed the U.S. Anti-Money Laundering Act (AMLA), what many at the time called the “biggest anti-money laundering reform in a generation,” a powerful package of updates crafted to break open beneficial ownership blind spots, bolster public-private information sharing, foster innovation and refocus the lens on effectiveness.

As part of the update, the legislation stated that U.S. fincrime compliance rules would eventually capture “dealers in antiquities” and that the U.S. Treasury would engage in an “assessment” of AML rules applying to “dealers in arts.”

To read the full AMLA, click here. To read the conference AMLA, click here.

Virtual asset service providers (VASPs), including crypto currency exchanges, in the U.S. and many other countries are already subject to AML rules.

But NFTs seem to straddle the line between the crypto world, the art world, the securities sector and the realm of traditional banking and finance – not neatly fitting into one of them so that banks, regulators and jurisdictions know how to classify them and quantify them for fraud and money laundering risks, rules and restraints.

Moreover, the risks for banks and currency exchanges touching the rip-roaring NFT space have risen from a regulatory scrutiny perspective with the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN) releasing last year its formal list of countrywide AML priorities.

FinCEN’s stated AML priorities are:

·       corruption;

·       cybercrime, including relevant cybersecurity and virtual currency considerations;

·       foreign and domestic terrorist financing;

·       fraud;

·       transnational criminal organization activity;

·       drug trafficking organization activity;

·       human trafficking and human smuggling; and

·       proliferation financing

Even while formal notices of proposed rulemaking are not expected to be released for several months, the FinCEN priorities put a stake in the ground – several actually – telling the domestic and international financial sectors here is what you need to focus on, or else.

So banks engaging the NFT space – whether doing transactions for formal marketplaces, moving money for bubbly social media influencers and celebrity spokespersons and funding an up-and-coming startup riding the hype wave – have a lot to consider.

At issue: institutions could unintentionally fail in these priority areas tied to crypto, fraud, corruption and even organized criminal activity if they have a compliance stumble in some formal relationship with the NFT world – chiefly because a bank would have such a difficult time risk-ranking entities hidden behind virtual worlds that value anonymity. 

The art world has a rich history of being a magnet for dirty money. NFTs will make it worse

From a financial crime perspective, the art world has long been a destination for dirty money, moved in secret for the wealthy, elite, corrupt and criminal.

Adding NFTs to this murky mix has ample potential to make things worse – without the need to ever even move a bulky sculpture or delicate, decades-old painting, said Ross Delston, an independent U.S.- based attorney and expert witness specializing in AML/CFT compliance.

“While there is no shortage of avenues to launder money in this world, the art market is one of the better ways to do so,” he said. “It’s unregulated in the US and internationally, prices and sales are opaque at best, with anonymous buyers a common occurrence, and large dollars can be laundered without any questions raised.”

Viewed as a subset of the art market, the NFT market is “even less transparent since it is new and mysterious, pricing is volatile, and what is considered rare and valuable is largely unpredictable,” Delston said.

Moreover, banks face a cavalcade of obstacles trying to risk rank what NFTs are actually valuable and what artists are legitimate, known and bankable talents.

Though, in some cases, the NFT is a hilariously obvious cash or attention grab.

“There is no lack of new entrants since anyone can come up with something saleable without even being an artist, including celebrities like a former U.S. president’s wife who created a NFT for her hat,” Delston said.

This is very different from the traditional art market which has “barriers to entry for both sellers and buyers based on the artist, the gallery, and, at the high end, with established auction houses, galleries and dealers,” he said.  

“So NFTs are well situated to be one of the prime avenues for not only money laundering but also corruption,” Delston said. “Do you want to funnel some serious money to your favorite political figure? Go online to buy their NFT anonymously and for big bucks!”

How big are those bucks?

Consider this: even in its relative infancy, the overall value of the NFT world has already breached the billion-dollar barrier – with individual pieces commanding tens of millions of dollars.

As with other forms of finance and business, the study acknowledges that innovation in technology in the digital art market brings with it money laundering risks. 

It notes that NFTs, such as pieces of high-value digital art, can be minted, held, transferred and destroyed through smart contracts. One of the benefits for those in investigations and compliance is that NFTs can be publicly verifiable and auditable.

The study recognizes how high profile NFT pieces – like Beeples ‘Everydays: The First 5000 Days’ that sold for more than $69 million – can soar, evincing that the digital art market can reach similar levels in terms of valuations to physical works of art. 

Treasury analysts also pointed out in the study that, according to US authorities, during Q1 of 2021, around $1.5 billion in NFT art was traded, having grown by 2,627% from Q4 of 2020.

While such growth in an unstable and still-evolving NFT space is stratospheric, as a point of context, it is still only a fraction of the total US art market in 2020, which was said to be more than $20 billion.

Rather than eschew virtual upstart, highbrow art houses getting in on NFT action

The growth in demand for NFT art has also been recognized by well-established traditional auction houses. 

It was Christie’s who made its first NFT sale[1] with Beeples ‘Everydays: The First 5000 Days’, followed by Sotheby’s first NFT sale announced in early 2021[2]

In tandem, it’s not just highbrow auction houses and art dealers that are involved in NFT art sales.

Online marketplaces such as OpenSea and SuperRare as well allow owners and artists of digital art a platform to sell their pieces. 

Of note in this respect, the study states “Depending on the nature and characteristics of the NFTs offered, these platforms may be considered virtual asset service providers (VASP) by FATF and may come under FinCENs regulations.”

That blanket statement, however, comes with a very confusing caveat.

Typically, “digital assets that are unique, rather than interchangeable, and that are used in practice as collectibles rather than as payment or investment instruments, depending on their characteristics, are generally not considered to be virtual assets under the FATF definition.”

Conversely, NFTs or other digital assets, that “are used for payment or investment purposes in practice may fall under the virtual asset definition, and service providers of these NFTs could meet the FATF definition of a VASP.”

If that happens, depending on the jurisdictions, they would trip requirements for the full suite of AML rules, including full compliance programs and impending requirements to capture and share data and details on customers with other virtual value and brick-and-mortar bank players – a still-coagulating miasma called the “Travel Rule.”

This should give pause for both developers of platforms and traditional financial institutions looking to bank such clients.

Why?

Before extending these operations bank accounts and the ability to transact globally through direct and correspondent relationships, they would be wise to get a thorough understanding of the nature, function and characteristics of these platforms from a financial crime perspective.

If you want to do something right, do it yourself (laundering that is)

Banks should also be cognizant that while regulators the world over have not ensconced NFTs or related marketplaces in AML rules, getting any as a customer would require an institution to engage in enhanced due diligence to understand what, if any, fraud, countercrime or customer monitoring controls are in place – at the marketplace, or NFT supply chain level.

Fincrime professionals engaging in these risk-ranking initiatives should also prepare themselves for the most high-risk answer of all to such inquiries: nothing at all.

Whilst the ‘Emerging Digital Art Market’ section only accounts for about 2.5 pages of the 40-page study, it does manage to squeeze in a money laundering typology when it comes to NFTs in art in the form of “self-laundering.”

The scheme is described as an activity whereby criminals purchase NFTs using illicit funds and then go on to sell these NFTs to themselves, in order to create a record of sales on a blockchain. 

This record then helps to sell the NFTs to unwitting third parties who would have paid for their cryptocurrency with legitimate funds – allowing “clean” funds to be exchanged for funds from an ultimately illicit origin.

Whereas the typology given in the study shows a combination of purchases of NFTs using illicit funds with Wash Trades (where the ultimate buyer and seller of the NFT are the same user/person), a recent investigation[1] by Chainalysis into NFTs broke down their findings by money laundering and wash trading involving NFTs. 

Chainalysis found that transactions to NFT marketplaces from illicit addresses saw a significant increase in Q3 2021 – with more than $1 million worth of cryptocurrency being sent over. 

As part of their investigation into wash trades, they identified 262 users who had sold NFTs more than 25 times to wallet addresses the seller had financed themselves – suggesting there was significant wash trade activity and some money laundering activity using NFTs.

Although traditional art such as paintings or sculptures may be fairly easy to transport and store, with digital art, this is made even easier.

In short, a criminal removes the need to physically move or store the ‘asset,’ facilitating the ability to transfer it across borders and locations much more easily as well as store and exchange it without much regulatory oversight, which may make it an attractive asset to use for money laundering.

The section on NFT art concludes by highlighting that the characteristics and structure of the digital art market creates its own set of vulnerabilities, including:

·       NFT platforms vary in structure, ownership and operation – the platforms operates differently, therefore would have different standards and due diligences processes.

·       Physical art galleries may tend to increase awareness of artists they represent and may want to protect the gallery’s reputation, whereas sellers of digital art may not have similar incentives.

·       Digital art using NFT’s can use ‘Smart Contracts’, a set of rules that can be used to instruct the NFT how to behave – e.g. generate revenues in the form of royalties for the initial creator every time a piece of NFT art is sold and then resold.  Such incentives could lead to potential situations where the incentive to transact is higher than the incentive to do due diligence on buyers, especially if multiple transactions occur over a short period of time.

Going beyond NFTs as laundering portals, also a risk as vehicles to skirt sanctions

The Emerging Digital Art Market’ section of the study doesn’t stray far from the focus of money laundering.

But fincrime compliance professionals would be wise to read between the lines and survey the landscape of another area of risk in the NFT space that was not included in the study: sanctions busting by blacklisted regimes, companies and individuals. 

Sanctions risks within the traditional art market can cross over into the digital art world, as was the case with Nazem Said Ahmad[1], who was added to the OFAC SDN (Office of Foreign Assets and Control – Specially Designated National and Block Persons) list in 2019 and said to have used money laundering and tax evasion schemes to help fund Hizballah.

How much was the art collection he had amassed worth?

Easily, millions of dollars, including pieces by Andy Warhol and Pablo Picasso, some of which had been displayed in his gallery and Beirut penthouse[2].

So what are some ways digital art involving NFTs could present sanctions risks? 

OFAC has already answered this.

The U.S. agency responsible for crafting sanctions policies and designating jurisdictions and entities for a wide array of draconian designations – including ties to terror groups, money laundering and drug trafficking networks – recently sanctioned virtual currency exchange, Chatex[3], which included for the first time crypto wallet addresses holding NFTs[4].  

According to Elliptic, the NFTs included amongst them a number of other virtual assets, such as plots of digital land and NFT gaming collectibles, including digital art collections[5]

Whilst considerations by government are being made on NFTs when it comes to money laundering, sanctions risks are also something that should be part of the conversation.

Another way to think of it is that criminal groups, and blacklisted regimes – like Iran and North Korea – and designated terror groups, like Hizbollah, Isis, al-Queda and others, are always looking for the path of least resistance to find entre into the international financial system.

Trying to leave an email without a trail? Enter the draft, if you get my drift

These groups are savvy, knowing that there are typically fewer controls to purchase an NFT, or other digital asset, on an exchange like OpenSea, than trying to move funds through a licensed virtual currency exchange or bank.

Moreover, once the digital asset is sold – potentially even by co-conspirators – the funds could potentially look legitimate to other crypto exchanges, making it easier to move the funds internationally to support terror cells anywhere in the world.

Overall, the burgeoning, rollicking and rolling virtual realm of NFTs offer opportunities for innovation, but may also present a bevy of risks beyond direct fears of laundering, including fraud, scams and evading OFAC and global sanctions regimes. 

This gets even more challenging knowing all of the tricks bad guys have in place to communicate and throw investigators off of their digital scent — including communicating through standard email channels — without ever needing to actually be sent. 

A step back shows that terrorist networks can use the email function of Gmail, Yahoo and others to type up an email message and leave them as a ‘draft’ without sending them. 

That way, the message can be picked up by other members of the network anywhere in the world to open and read[1], and then easily delete the never sent message, resulting in relatively minimal traces of digital, trackable communications. 

How secure, or easily crackable messages will be for law enforcement tied to NFT marketplaces, is an unknown investigators may encounter sooner rather than later. 

Although not the only NFT marketplace to offer such a feature, OpenSea allows ‘Unlockable Content’[2] to be included when creating NFTs, which could contain anything from a message to a password to unlock features as part of the NFT experience. 

Could this unlockable content feature also be used as an obscure way of communicating between nefarious actors, such as criminals and terrorists? 

This is a particular risk for financial crime as OpenSea does not conduct due diligence on its users, nor does for example MetaMask – one of the unhosted cryptocurrency wallets that connects to Opensea, in order to buy and sell NFTs. 

Although a reply has not been received as of yet, the following were questions I had put to OpenSea towards the end of 2021:

·       Can Opensea view the content contained in the Unlockable Content?

·       Is the content of the Unlockable Content monitored by OpenSea?

·       Is the content of the Unlockable Content encrypted?

NFT art is just the start. What’s next? Gaming, real estate in real, virtual worlds?

Art as a starting point on the focus on NFTs and financial crime should serve to open up further considerations on risks posed by other applications of NFTs. 

In a relatively short space of time since 2019, NFTs have come a long way when an NFT ‘1-1-1’ Formula 1 car from the blockchain game ‘F1 Delta Time’ was sold for a record $110,000[1] at the time. 

Nintendo recently suggested it was interested in NFTs[2], though many industry watchers are still trying to figure out how they may add to the gaming experience – without the venerable, merry Mario-maker losing sight of its core score: fun, memorable and even emotional gaming experiences.

A massive gaming market where Nintendo is just one vendor, may also present financial crime risks through the use of NFTs if they are to be adopted en masse amongst the gaming community. 

Beyond gaming, NFTs have also reached the mortgage sector.

In November 2021, the decentralized mortgage lender Bacon Protocol[3] was said to have minted its first seven mortgages as NFTs[4], giving investors and borrowers new options to access the residential mortgage market – at the same time giving those in compliance something to think about from a financial crime risk perspective.

Historically, real estate has been an arena rife for money laundering schemes.

Drug trafficking syndicates and kleptocrats engaging in grand corruption have long used buying pricey real estate in the United States, Canada and the United Kingdom to park and safeguard their illicit assets – all too often hidden behind shadowy gatekeepers and shell companies with impenetrable ownership structures.

Art may have opened up the discussion on NFTs and money laundering, but as they find their way into more and more sectors, both lawmakers and compliance staff may want to start thinking about what risks NFTs could pose beyond the digital art market from a financial crime perspective.

This would be a vital way to help ensure a safer environment is created for users and a more hostile one is created for criminals.

About the author

Dev Odedra is an independent anti-money laundering and financial crime expert. 

He has more than a decade of experience in managing financial crime risk in the retail, corporate and investment banking sectors. 

His expertise covers investigations, advisory and controls implementation and improvement. 

Dev is also a prolific author and gathers and analyzes many of the biggest financial crime compliance news stories on social media to help the community keep abreast of key criminal, regulatory and program trends. 

Want to chat with Dev? Feel free to connect with him here