New Treasury Study On Money Laundering Offers Good News For NFTs But Challenges The Market As It Matures

The U.S. Department of the Treasury (“Treasury”) recently released a study examining the potential of the art market to facilitate terrorism and money laundering. Of particular interest to the crypto industry, the study examines the emerging market for digital art, particularly non-fungible tokens (“NFT”). NFT marketplaces, sellers, and purchasers are naturally asking how this new guidance may affect them.

On a positive note, most of this guidance does not differ substantially from the Financial Action Task Force (“FATF”)’s light-touch approach toward NFTs that it adopted in its own report examining digital assets late last year. The study indicated that NFTs do present money laundering risks but are not yet at a level that mandates the imposition of regulations and instead the Treasury will focus its efforts on other areas.

Despite the good news, the NFT industry should heed the study’s guidance, and follow the lead of the traditional art market by instituting due diligence safeguards to ease governmental concerns of money laundering. In this article, we examine the impact of the new Treasury study on the NFT industry and what marketplaces, purchasers, and sellers should expect as the market matures.

THE NEW TREASURY GUIDANCE FOLLOWS THE FATF’S LIGHT-TOUCH REGULATORY APPROACH TO SOME NFTS

Regulators have long been concerned about the potential of the art world to facilitate money laundering. Many institutions have observed that the art world is particularly vulnerable to these concerns because of the use of shell companies, the anonymity that buyers and sellers often seek, the challenge of determining fair market value for pieces, and the ease with which high value art can be transported.

Drawing on these concerns, the FATF released guidance related to NFTs in its recent digital assets report. The FATF is an intergovernmental organization whose mandate is to develop policies to combat money laundering and terrorist financing. While the FATF cannot create binding laws or policies, its guidance exerts significant influence on counter-terrorist financing and anti-money laundering (“AML”) laws among its members. The U.S. Department of the Treasury is one of the government agencies that generally follows and implements regulations based on FATF’s guidance. This connection is especially clear when reading the Treasury study as it adopts much of the analysis and terminology from the earlier FATF report.

The FATF’s guidance took an “expansive approach” in broadening the definition of “virtual asset service providers” (“VASP”), including exchanges between virtual assets (“VA”)[1] and fiat currencies; exchanges between multiple forms of VAs; the transfer of VAs; the safekeeping and administration of VAs; and participating in and providing financial services relating to the offer and sale of a VA. Once an entity is labeled as a VASP, it must comply with the applicable requirements of the jurisdiction in which it does business, which generally includes the implementation and maintenance of AML and counter-terrorism programs, registration or licensing requirements, and be subject to supervision or monitoring by that government.

In its report, the FATF argued that NFTs are “generally not considered to be [VAs] under the FATF definition,” which arguably creates a presumption that NFTs are not VAs and their marketplaces are not VASPs. Similarly, the Treasury observes that NFTs are used in practice as collectibles rather than for payment or investments, and as such are generally not considered to be VAs nor their trading platforms VASPs. In particular, the FATF drew attention to “the nature of the NFT and its function in practice” with a focus on determining whether the NFTs “are used for payment or investment purposes” in determining whether they are VAs and the platforms that offer them are VASPs. In the same way, the Treasury focused on whether NFTs and the platforms on which they are traded are used for payment or investment purposes.[1]

While the Treasury followed the FATF’s guidance on NFTs, it went further by offering several key recommendations that NFT sellers, purchasers, and marketplaces should consider moving forward.

[1]The FATF defines a virtual asset as “A digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes.”

WHAT PARTICIPANTS IN THE NFT INDUSTRY NEED TO KNOW

For NFT marketplaces, the Treasury study provides several recommendations that they can take to address money laundering concerns. For example, the study notes that NFT marketplaces can establish a standardized process to share information with each other on buyers and sellers. This process should help to “facilitate information-sharing requests among private sector entities and potentially allow law enforcement access to such information during investigations.” Similarly, the study suggests that marketplaces use a single database with third-party identity services to verify the identity of buyers and sellers, which would help to provide information to law enforcement agencies and financial intermediaries. At the same time, the study acknowledged that such systems would need to protect the privacy of their buyers and sellers. As a result, NFT marketplaces can address many potential regulatory concerns through standardizing verification processes, cataloguing user information, and instituting appropriate privacy safeguards. As marketplaces create these systems, they should be ready to take advice from regulators who may reach out to them “to make them aware of the reporting tools available to them,” consider “mak[ing] voluntary SAR filings,” and potentially share relevant information with law enforcement agencies.

Given these recommendations, NFT sellers and purchasers should be prepared to submit more information to marketplaces as they seek to bolster their identity verification and information sharing systems. In particular, sellers and purchasers who reside in certain geographic markets that FinCEN has identified as areas of focus or who transact at high-value thresholds will likely be subject to more rigorous scrutiny when creating an account or looking to transact.

Importantly, these “recommendations” are a way for the Treasury to signal to the NFT industry that, as the market matures, it must embrace the responsibility of regulating itself. Self-regulation has a long and storied history in American markets and the NFT industry should not forfeit the golden opportunity that U.S. regulators have given it.

CONCLUSION

While the announcement of a “new study” on digital assets from the Treasury may scare NFT sellers, purchasers, and marketplaces, they should feel emboldened that its recent study strongly parallels the FATF’s light-touch approach. Even better, while the Treasury made several recommendations that would require the implementation of additional processes which may deter some participants, it acknowledged that adding new regulatory requirements for the art industry, including NFTs, is currently a low priority. Instead, the Treasury concluded that it should focus its efforts on “beneficial ownership, real estate, and potentially investment advisers and nonfinancial gatekeepers before potentially turning its attention to the high-value art market.”

In response, NFT marketplaces should consider adopting the Treasury’s recommendations to pre-empt the recommendations becoming requirements. We are optimistic that, in most cases, NFT marketplaces will follow up on this guidance in the tradition of conventional auction houses who maintain much of the suggested information to assure that their works are authentic and represent real value for purchasers. Likewise, NFT buyers and sellers should be prepared to submit more information to marketplaces as they seek to self-regulate. These changes will only propel the NFT industry’s rise to become a dynamic, fundamental pillar of the art world.

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