Non-fungible token (work of art) anti-money laundering regulation and compliance

In February 2022, the US Department of the Treasury published a study of the Facilitation of Money Laundering and Terror Finance through the Trade in Works of Art (the “Study”).  The Study notes that the emerging online art market may present new risks, specifically through the structure and incentives of certain activity in this sector of the market.  The certain activity being the sale and purchase of non-fungible tokens (“NFTs”).  Indeed, Gherson’s criminal litigation, investigations and regulatory team have recently written a blog on NFT regulation in the UK.

The Study goes on to examine how the emerging digital art space constitutes a separate marketplace and represents something quite new. Specifically, the technological innovations in the digital art space can present potential anti-money laundering (“AML”) challenges.

What are the potential benefits for AML compliance?

However, before turning to these challenges and how they can be addressed, first a look at the benefits.  An NFT is a claim to ownership (in the form of non-interchangeable data stored on a blockchain) of a unique (often digital) item.  This claim of ownership, which can be bought and sold, uses blockchain technology to establish the individual ownership of the underlying item, which can be, for example, an (often digital) image, a digital video or music file.  The use of blockchain technology potentially enables both public verification and auditability and, therefore, there is the potential for greater transparency of all transactions and participants.  This is obviously hugely beneficial for AML purposes.  Indeed, the benefits of this technology in enabling transparency in investigations are starting to be appreciated “Crypto investigations can move quickly, says former FinCEN head”.

What are the potential risks for AML compliance?

Of course, the challenges of a new technology can bring new risks. Therefore, in order to properly implement effective compliance, it is necessary to consider what particular risks can arise and how they can be addressed.

The Study specifically outlines the following risks:

What are the risks arising from the characteristics?

1. NFTs can be used to conduct self-laundering (where an individual transacts with themselves to launder illicit funds and then sells to a third party).
2. The technology enables the possibility to have direct peer-to-peer (i.e. direct person-to-person) transactions which might reduce the possibility to record and monitor parties and transactions.
3. Digital art assets are easier to transfer discreetly as there is no need to transport any physical item.
4. In addition, there are no accompanying costs (and regulatory requirements) of physical shipment, therefore, discreet transfer and storage is easier.

What are the risks arising from the structure?

1. NFT platforms range in structure, ownership and operation (no single platforms operate in the same way), therefore, a firm understanding of the relevant structure is necessary.
2. Platforms have different incentives to galleries and may not operate as transparently.
3. The involvement of smart contracts can create an incentive for repeated sales which are harder to track and monitor – as such, the incentive to transact can be higher than the incentive to conduct proper customer due diligence (“CDD”). In worst-case scenarios it might not be possible to conduct CDD.
4. Finally, traditional industry participants might not have the understanding of distributed ledger technology required to implement the effective compliance measures.

How can these issues be addressed to ensure effective compliance?

In order to properly address an issue, it is primarily necessary to thoroughly understand it. Ensuring that these issues are properly addressed and all relevant compliance requirements are met, therefore, requires combining a deep understand of blockchain and distributed ledger technology, and a firm understanding of the applicable regulatory environment.

Indeed, Gherson’s criminal litigation, investigations and regulatory team recently helped MusicArt to comply with relevant anti-money laundering (AML) law and regulations as it launches into the NFT marketplace.

Specifically, the firm advised on all aspects of legal and regulatory compliance. To ensure MusicArt complied with all required provisions, the team also advised on the applicable UK AML regulations. In addition, it successfully applied for registration with HMRC for AML supervision.

To secure the compliance of requirements of the UK AML regulations, the team ensured the successful registration, drafted bespoke policies and procedures which considered the novel features of NFT technology, including to ensure customer due diligence, and advised on all aspects of the regulations.

Do you need assistance complying with the applicable regulations and/or the registration process?

To operate in the UK, relevant cryptoasset businesses need to have applied to register with the FCA and they need to adhere to a number of compliance rules. Given that breaches of the AML regulations can attract potential civil or criminal liability and penalties, it is important that firms seeking regulatory approval are aware of all the requirements and have in place robust policies to ensure compliance. Further, businesses that have an exposure to NFTs will also need expert bespoke advice on which regulations are applicable.

How Gherson can assist

For those who would like advice on this issue, including those who have had issues with the registration process, our specialist regulatory and compliance team can guide individuals and companies through the process.  If you have any questions arising from this blog, please do not hesitate to contact us for advice, send us an , or alternatively, follow us on Twitter, Facebook, or LinkedIn to stay-up-to-date.

 

The information in this blog is for general information purposes only and does not purport to be comprehensive or to provide legal advice. Whilst every effort is made to ensure the information and law is current as of the date of publication it should be stressed that, due to the passage of time, this does not necessarily reflect the present legal position. Gherson accepts no responsibility for loss which may arise from accessing or reliance on information contained in this blog. For formal advice on the current law please don’t hesitate to contact Gherson. Legal advice is only provided pursuant to a written agreement, identified as such, and signed by the client and by or on behalf of Gherson.

©Gherson 2022