AML & Sanctions Compliance for NFT Marketplaces
The global market for non-fungible tokens hit $42bn this year as digital images fast became popular investment assets, rivaling the size of the fine art world.
The global market for non-fungible tokens hit $42bn this year as digital images fast became popular investment assets, rivalling the size of the fine art world. Considering that NFT sales were at $100m in 2020, it seems as though we are on the precipice of a looming digital gold rush in 2022.
That being said, the market is nowhere near stable and still largely unregulated, leaving the door open for unscrupulous market manipulators and financial crime. Investors who want to participate in this lucrative and fast-paced market have to look at methods and strategies to secure their future, including taking the necessary steps for improved governance and customer safety.
What are NFTs?
NFTs or non-fungible tokens grant the buyer ownership of a unique digital asset (e.g., a piece of virtual art, clothing, music, or property). This ownership is recorded on a decentralized ledger known as a blockchain.
Bitcoin, a cousin of NFTs, is fungible. One bitcoin can be exchanged for another or sold for cash. Non-fungible tokens are one-of-a-kind, and each has its own unique code, which means it cannot be compared to another asset.
NFTs are mostly traded via drops or timed online sales by marketplaces backed by blockchain. Like with any form of art, it’s hard to place a value on an NFT. In recent years, we’ve seen buyers invest $6.6 million in a video by Beeple, nearly $400,000 for a video by Grimes, and over $90-million for a piece called The Merge.
Growth in the NFT Space
Despite not yet acting like or even remotely resembling a more conventional market, the NFT industry is booming. This is perhaps best explained by the number of celebrities and mainstream businesses that have added NFTs to their projects and personal portfolios.
The Weeknd raised over $2 million, turning his unreleased songs into NFTs, while Coca-Cola earned $575 000 selling customized items that could be worn in Decentraland, a virtual metaverse. Other notable brands and celebrities that have released NFTs include Gucci, Nike, Adidas, the Matrix film series, and talk show host Jimmy Fallon.
The market isn’t hampered by its volatility. The Global NFT Market is expected to grow at a CAGR of 185% from 2021 to 2026, with personal use representing the largest sector. No doubt, new players and regulations will emerge in the next five years, which is why new entrants to the industry have to start addressing inherent risks and pitfalls from the start.
AML Risks for NFT Marketplaces
NFT technology has raised alarm bells from anti-money laundering advocacy groups and Interpol. The majority of NFTs are purchased using cryptocurrencies on online marketplaces. Cryptocurrencies can in specific cases be held and purchased without divulging one’s identity, making them an attractive resource for criminals (particularly ransomware hackers that demand payment in crypto).
Money launderers can exploit the trade and sale of NFTs by forging NFTs, as with a recent Banksy print sold online. Criminals can also hack into the NFT marketplace’s user accounts and sell stolen tokens before laundering the proceeds. In some instances, NFTs are used as the transfer mechanism between criminal parties, such as hiding information about security vulnerabilities within an NFT sold to hackers.
A “Know Your Customer” system and ongoing monitoring by platforms and compliant cryptocurrency exchanges will be the best defense against money laundering and fraud in the NFT industry.
Addressing Risks
In 2021, the US Congress passed AMLA, the Anti-Money Laundering Act of 2020, to regulate the activity of financial institutions. While the Act doesn’t acknowledge NFTs directly, the Act expands its definition of financial institutions to include businesses involved in the exchange of “value that substitutes for currency or funds”, which could relate to cryptocurrency and, by association, the purchasing of NFTs.
Some businesses that operate on the blockchain (including NFT marketplaces) are concerned that they may be classified under the existing American Securities Act of 1933.
This Act contains a set of obligations that anyone selling an investment tool to US citizens must abide by, including preventing money laundering and guaranteeing investor rights. There are also similar regulations in Europe (MiFID/MiFIR) that can come into play.
While legislative and compliance requirements are in their infancy for NFTs, it’s in the best interest of trading platforms to implement greater controls sooner rather than later.
Know Your Customer
A recent paper by British defense and security think tank RUSI addressing NFTs and money laundering concerns emphasized the need for implementing a KYC monitoring system to lower the risk of fraud while trading NFTs. KYC or Know Your Customer is a mandatory process used to identify and verify a customer’s identity both when they first open an account and then periodically over time. It’s already a standard process in the banking world, and financial institutions that fail to comply can face hefty fines and sanctions. If NFT providers/markets were to fall under the definition of asset providers or financial institutes, they would certainly have to comply with KYC standards in the future.
KYC processes require that financial institutes create a customer identity, recognize the nature of their actions, and evaluate the money laundering risks connected with a customer to monitor their ongoing activities.
Solid KYC process and AML compliance programs are the first steps any NFT firm should take to prove to their clients and authorities that they are serious about preventing money laundering and financial crime. They should also take steps to screen buyers and sellers and prove to clients that tokens sold on their platform are genuine and that transactions can securely take place.
PEP Screening
Most financial institutions provide PEP screening as part of their due diligence. PEP stands for politically exposed persons. This can prevent crimes related to corruption and bribery within your institution and within the financial sector itself.
A politically exposed person is someone with a prominent public function, making them a potential target for bribery and corruption. This can include Heads of State and Governments, senior politicians, military officials, family members of important politicians and government officials, etc.
Even financial institutions outside the NFT world find very little guidance to help them conduct a sufficient check when dealing with higher-risk customers, which is why partnering with a specialist company is essential.
Sanctions Screening
Like PEP screening, sanctions screening is the verification of names and aliases on sanction lists as part of anti-money laundering programs. This prevents entities or persons belonging to embargoed jurisdictions or sanction lists from transacting using the financial institution in question.
Sanctions for non-compliance carry hefty penalties worldwide, but it can be complex. Sanction lists published by issuing bodies aren’t always aligned, and the definition of sanctions is continually widening, leaving room for interpretation. Prioritizing sanctions risk is critical. Companies must invest in rigorous compliance controls, such as effective sanctions screening processes, to mitigate exposure risk and ensure they meet their obligations under sanctions regimes.
Why Implement KYC/AML Processes
Suppose NFT marketplaces don’t start preparing in advance. In that case, they may not have the time and resources to become compliant when (not if) AML regulations come into effect, which could lead to devastating penalties.
NFT marketplaces will also need the assistance of banks if they want to turn crypto earnings into fiat currency in the future. Banks, who face increasing scrutiny of their own, won’t be willing to partner with companies that do not have clear AML programs in place as they cannot afford to face sanctions for supporting any form of money laundering.
In most cases, the absence of verification procedures alone is enough to lure fraudsters to an NFT platform. Users that have spent thousands (or millions) on fraudulent goods are unlikely to trust the platform again, causing irrevocable harm to a marketplace’s image and reputation. Artists are also less likely to partner with marketplaces that do not protect their work or allow fraudulent copies to be sold, impacting the business’ bottom line.
There are other financial benefits too. Being AML-compliant is seen as a benefit to investors and other businesses. When NFT marketplace Nifty Gateway built up their own compliance program, they landed partnerships with both Christie’s and Sotheby’s, bringing digital art to physical auction houses for the first time.
Kickstart your KYC/AML Program
It can be extremely difficult for new NFT platforms to navigate the constantly evolving industry and keep abreast of compliance requirements.
You can read sanctions.io's Ultimate Sanctions Screening Guide to learn more about sanctions screening.
Sanctions.io is a comprehensive API-first solution that NFT Marketplaces can use to scan their clients and business partners against global Sanctions Lists, Crime lists and PEP lists. If you would like to take the first step towards becoming more compliant, you can start a free 7-Day trial here.
