AML Regulations and the Metaverse
The term Metaverse entered the world's collective consciousness in October 2021 when Facebook rebranded as Meta and founder Mark Zuckerberg introduced a virtual replica and announced that human beings might soon migrate to a virtual world governed entirely by its users. According to Gartner, by 2025, 25% of people will spend at least an hour in the metaverse a day, working and transacting in a virtual space. Investors, legislators and employees are still coming to terms with what the metaverse is, what it may mean, and how current regulations will govern the vast number of transactions occurring in virtual environments every day.
What Is the Metaverse?
The metaverse is a network of 3D virtual worlds focused on social interaction. While it's often associated with virtual reality headsets, the term doesn't refer to a specific type of technology but rather how individuals interact with technology. Its primary characteristics include a persistent virtual world that continues to exist even when one isn't participating and augmented reality that combines both the digital and the physical world. The metaverse also applies to the digital economy, where users can create, buy and sell items. The 3D virtual world game Decentraland is a good example: users may buy virtual plots of land using cryptocurrency, create art and fashion items sold as NFTs in galleries and virtual stores, and interact with one another. Huge sums of money are trading hands via the platform. One of the most expensive pieces of virtual property sold in the game fetched $3.5 million.
What Is an NFT?
NFTs or non-fungible tokens are individual digital cyber currency tokens containing unique data to verify and validate their ownership. Much like artworks, the value of an NFT is determined by the market and demand for the token. Each NFT is unique and tied to a digital asset, such as a digital file, music file, video or image. Blockchains store NFT data in their system for their users to trade. Transactions are recorded on blockchain ledgers. Originators can store the NFT anywhere, while the blockchain stores the proof of ownership over the NFT. NFTs can be sold and bought like any other cryptocurrency, but unlike crypto coins, they are non-fungible. Cryptocurrencies can be exchanged for one another because they are the same (fungible); NFT tokens are unique. The non-fungible token market reached sales of $17.6 billion in 2021.
NFT Regulation Challenges
While the NFT asset class is booming, its growth may have outpaced global regulatory and legal frameworks. It is highly likely that - as a highly valuable, cross-border and fully digital asset - NFTs will continue to be the target of cybercriminals. Account takeovers, key vulnerability, and phishing attempts have already plagued the industry. The anonymity of the blockchain world and centralized NFT marketplaces make NFTs particularly attractive to nefarious parties. The lack of identity verification means that fraudsters can claim to own a token and sell it to the detriment of the creator and the market.
NFTs are not specifically regulated, but legal obligations may be imposed by states or international bodies, depending on local law. This can include KYC (Know Your Client) checks, record-keeping and verification of what is sold and other AML compliance requirements, particularly related to the upcoming Markets in Crypto-Assets Regulation (MiCAR) that will be applicable in Europe. The status of NFTs is not officially decided, but it is believed that NFTs may be considered securities per Financial Conduct Authority guidance and thus subject to increased governance. The Financial Action Task Force (FATF) has stated that NFTs should be regulated as virtual assets if they meet the definition thereof (as per FATF Guidance on NFTs). If the definition is satisfied, companies dealing in or with NFTs are obliged to meet compliance and monitoring obligations.
Can The Metaverse Be Used For Money Laundering?
The inclusivity and lack of intermediaries and AML checks in the metaverse is a double-edged sword. While it presents an inclusive and democratized way of acquiring and providing finance, the metaverse may well be the new frontier for money launderers. Criminals can turn cash acquired through illegal activities into non-traceable, easily obscured currencies which can be sold repeatedly to purchase and sell items in the metaverse, knowing that the growing ledger of transactions will be impossible to trace. Cryptocurrencies can also be used to layer illegally gained funds via online entities before integrating the funds back into the financial world and using them to fund illegal activities.
Legitimate digital currency issuers are already willingly complying with regulators and adopting advanced techniques for transaction monitoring and identity verification. While regulations aren't in place as of yet, it's clear that companies operating in the virtual world expect that to change - and soon.
Conclusion
The rise of a new virtual asset class, growing demand and value, and the lack of regulation mean that there are significant risks and challenges posed for companies involved in the metaverse. Managing these risks sooner rather than later should be high on the agenda for every digital business. Adopting a risk-based approach that prevents unwanted transactions, minimizes risks and reduces the potential for illicit activity through best practices and advanced software will be the key to preparing for the stricter regulatory environment that is sure to follow.
