Anna Mosna, postdoctoral researcher at the Leuven Institute of Criminology (LINC), KU Leuven and Giulio Soana, Ph.D. candidate at Luiss University and KU Leuven
Photo credit: Mario Taddei, via Wikimedia Commons
What if we told you that you can buy a digital image of an ape wearing a crown and heart-shaped glasses for two and a half million? Well, you may find this a bit pricey. This does, however, not seem to be a common feeling as images of funny looking apes have sold, over and over, at stellar prices. This specific project is called Bored Ape Yacht Club (BAYC) and features 9999 images of apes, each one slightly different from all the others. The combined value of the collection is reportedly a dizzying 2.9 billion dollars. This is just one of the many non-fungible token (NFT) ventures that have been flourishing in the last few years.
Trade in NFTs represents a new market that features virtual goods at skyrocketing prices and apparently little regulation and oversight. With sums of this magnitude at stake, it is inevitable to think about the repercussions of this new market for illicit financial flows control. And indeed, NFTs receive increasing attention in the financial integrity arena. In its ‘2022 Crypto Crime Report’, Chainalysis, one of the most renowned crypto analytics companies globally, identified a growing relevance of NFTs to pursue money laundering and wash trading. This risk was confirmed by the latest virtual assets (VA) report published by the Financial Action Task Force (FATF) in June 2022. There, NFTs have been recognised as one of the key market developments to keep under close watch.
What are NFTs?
Before delving into the intricacies of the anti-money laundering regulation, a brief introduction on what NFTs are, is in order. Non-fungible tokens are one of the latest implementations of blockchain. They exploit blockchains’ immutability and decentralization to create unique, unalterable, and programmable tokens that can be freely traded among the participants of the network. On the one hand, blockchain’s publicity and immutability safeguards the authenticity and uniqueness of the token while allowing anyone to verify it by, simply, accessing the ledger. On the other hand, blockchain’s decentralization means that there is no single entity that can unilaterally modify or control the status of the token once it is created. The token can both be a digital representation of a physical or digital asset–as a work of art, a song, or a ticket to a concert–or solely exist as a digital token. In this latter case, the value is determined exclusively by the characteristics intrinsic to the token, its rarity, in case of a token series like BAYC, being an important factor.
While NFTs may be used in multiple ways–spanning from the amelioration of the supply chain to the metaverse–there is one type that presents a particularly high risk in terms of financial integrity as it is completely decoupled from any pre-existing digital or physical value: digital art, also referred to as collectible tokens, digital collectibles or crypto-collectibles. These are, furthermore, the prime and largest implementation of this technology.
Sharing characteristics with both virtual currencies and works of art, collectible NFTs are difficult to frame into a specific category, difficult to regulate and, thanks to their dynamism, prone to misuse for criminal purposes–including money laundering. It is therefore interesting to examine where–if anywhere at all–NFTs can be positioned among the sectors currently covered by the anti-money laundering (AML) framework applicable in the European Union (EU).
The progressive extension of anti-money laundering rules – what about NFTs?
Over the years, anti-money laundering rules have been continuously expanded to address a growing array of laundering tactics. Control and regulation instruments have come to cover alongside service providers and intermediaries in traditional fields, such as the banking sector, also other entities offering financial services, such as the insurance sector, or operating outside the spectrum of financial businesses, such as the real estate sector. Increasing awareness of the potential misuse for the purposes of money laundering and terrorism financing of virtual currencies, due to the anonymity they ensure, and of art transactions, nurtured by the speculative nature of prices at which they are carried out, has triggered a similar extension.
Among others, these risks have been highlighted, in the FATF Updated 2021 Guidance for a risk-based approach to virtual assets and virtual asset service providers and, regarding the art market, already in the FATF 2006 Study on trade-based money laundering. Likewise, consciousness of these concerns is reflected in the most recent EU legal instruments in matters of anti-money laundering. The rules enshrined in Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorism financing as amended by Directive (EU) 2018/843 (Fifth AML Directive) now apply also to entities engaged in exchange services between virtual currencies and fiat currencies or trading in works of art.
As obliged entities, virtual currency service providers and art market actors must carry out customer due diligence (CDD) that includes know-your client procedures (KYC). As a result, customers and beneficial owners must be identified and their identity verified. CDD also requires a continuous assessment of the business relationship considering its purpose and intended nature. If these compliance measures cannot be carried out, virtual currency service providers and art professionals must refuse to carry out the transaction. They further have an obligation to submit suspicious transaction reports to their national Financial Intelligence Unit (FIU) and to keep documents acquired in compliance with their due diligence duties along with supporting evidence and transaction records for at least five years after the end of the business relationship or after the end of the occasional transaction. These due diligence duties and record keeping obligations are intended to ensure more transparency and better traceability of transactions and to thereby more effectively prevent and, possibly, enforce laundering activities occurring in the trade with virtual currencies and in the art market.
The considerations that led to the inclusion of these two sectors within the scope of application of AML rules suggest that there is a comparable need to do the same with the trade in NFTs. NFTs are similar in nature to virtual assets and, at times, to works of art. These tokens even combine and magnify the respective risk factor of each of these two categories. Like virtual assets, NFTs are immaterial and can be exchanged globally and instantaneously in a pseudonymous fashion. Like works of art and collectibles, NFTs have a variable and subjective price that can be artificially inflated.
Against this background, the question about the extent to which existing AML rules are already applicable to the trade in NFTs imposes itself. The answer, which is likely to differ according to the use made of the NFTs considered, will depend on the possibility to actually subsume NFTs under the concept of goods whose trade is already regulated. In short: virtual assets, virtual currencies or works of art.
Non-fungible tokens as virtual assets and virtual currencies
The link between NFTs and virtual assets is an obvious one. With virtual assets, NFTs share the technology they both predominantly employ, the blockchain. Most NFT projects are even rooted in an infrastructure–Ethereum–that issues a coin–the Ether–that is classified as a VA. It is, then, natural to wonder if these tokens are themselves virtual assets and, thus, if they fall within the scope of the same financial integrity regulation as VAs.
Virtual assets have been, since 2014, object of a progressively stringent regulation. Through ad-hoc guidelines, the FATF has extended to numerous players in the VA world–such as exchangers, wallet providers–registration and compliance duties. According to the FATF glossary, virtual assets are ‘a digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes’. Notwithstanding the distinct similarity to such assets, according to the FATF, NFTs are, in principle, not considered to be virtual assets. As provided by the above-mentioned 2021 Guidance, ‘[d]igital assets that are unique, rather than interchangeable, and that are in practice used as collectibles rather than as payment or investment instruments […] depending on their characteristics, are generally not considered to be VAs under the FATF definition’.
This exclusion does however not imply that NFTs are entirely exempt from the application of anti-money laundering rules. As the FATF Guidance clarifies, this definition of ‘virtual assets’ must be interpreted broadly and functionally–meaning: through the analysis of the concrete function of the analysed asset. First, the FATF specifies that the exclusion only covers tokens that are used as collectibles. If NFTs are used in practice as means of payment or investment, they would still fall within the definition of VA and, one could add, also within that of ‘virtual currencies’ as coined by the Fifth AML Directive. The Directive defines virtual currencies as ‘a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically’.
Second, the exclusion of NFTs from the scope of the VA regulation does not preclude collectible NFTs from falling, depending on their concrete use, within a different category of regulated asset. This would, for instance, be the case where NFTs are digital representations of other financial assets that are already covered by FATF standards. Also in this case, the AML regime governed by the Fifth AML Directive may apply.
Non-fungible tokens as works of art?
What if NFTs are not used as means of payment or investment, but indeed only used as collectibles? Parallels between NFTs and works of art are, unlike those between NFTs and VAs, not structural but content-related. Collectible NFTs encapsule (digital) art. Can they therefore be defined as ‘works of art’ within the meaning of the Fifth AML Directive?
The Fifth AML Directive does not provide for a definition of the concept of ‘works of art’. Even without considering digital contents, this raises the question as to whether only those who trade in so-called ‘fine art’ are subject to the EU AML regime or whether these rules apply also to those who trade, more generally, in cultural objects including, hence, antiquities. As was foreseeable, national implementation laws reflecting different sensitivities towards the need to protect cultural heritage have based their provisions upon different understandings of what ought to be considered a work of art.
Member States with considerable wealth of antiquities and a long-standing tradition of strict cultural heritage protection laws, such as Greece or Italy, have adopted a broad notion of works of art and extended national anti-money laundering rules to those trading in fine art and to those trading in antiquities. States that are mainly market countries for cultural objects, such as Germany and the United Kingdom–where the Fifth AML Directive was implemented before Brexit–have opted for a narrower concept of ‘works of art’. Aligning their definition to the one provided in their respective laws on value added tax, they apply their AML regime to those who trade in paintings, drawings, engravings, sculptures and other objects that can be entirely executed by hand. The trade in antiquities is included insofar as the antiquities traded qualify as paintings, drawings, engravings, sculptures. This understanding excludes antique furniture, coins and stamps collections from the concept in question.
A workable definition of ‘works of art’ based on the lowest common denominator that has informed national implementations comprises objects that are individually conceived and executed by a person by hand or, one could reasonably add, with the help of different techniques and technologies, as long as the creative process remains human-initiated. Revolving around the two focal points of human creativity and uniqueness this definition excludes objects that are the result of automated reproduction of a potentially unlimited series of identical items. The question now is whether, applying this criterion to digital art, it would allow to identify collectible NFTs, such as those containing an image of an algorithm-generated Bored Ape, as a work of art as envisaged by the Fifth AML Directive.
The societal perception of NFTs such as the Board Apes is already that of iconic images, of art. This is confirmed by the fact that collectible NFTs are sold in digital galleries and at digital auctions–as was the case with the NFT ‘Everyday: The First 5000 Days’ by Mike Winkelmann, known as Beeple, that was sold for 69.3 million dollars with fees at Christie’s in early 2021–and, most importantly, by the fact that many artists that have been creative outside the Web3.0–Marina Abramović being an eminent example–consider this kind of NFTs as a new, attractive form of artistic outlet.
From a legal standpoint, the concept of ‘work of art’ included in the Fifth AML Directive seems equally to allow for such an inclusion: NFTs are by definition unique and those who are relevant as collectibles–let’s think about the Bored Ape collection, about Beeple’s ‘Everyday: The First 5000 Days’ or about Marina Abramović’s ‘Hero 25FPS’–are the result of human ingenuity and creativity. That being said, as the concrete application of the AML regime designed by the Directive in question depends on national legal instruments implementing its provisions and given that many national laws, like the relevant German framework, identify works of art through lists of categories of objects, it is likely that legislative adjustments may be necessary at that level before the current AML rules are capable to govern the trade in collectible NFTs as well.
The general exclusion of collectible NFTs from the purview of the VA regulation does not equal an automatic exclusion of the trade in NFTs from the scope of application of AML rules. Depending on the concrete use that is made of NFTs, they may still be considered virtual currencies or fall within the scope of a different category of regulated assets. This is particularly meaningful in regions, like the EU, where a more stringent regulation than the one envisaged by the FATF has been adopted: it suffices to think of the application of the travel rule to unhosted wallets.
Furthermore, the EU AML regime extends also to the trade in works of art–a category, as has been argued above, under which collectible NFTs could be subsumed. Collectible NFTs appear, indeed, to fulfil the basic requirements of ‘works of art’ as identified by laws implementing the Fifth AML Directive. An extension of the AML regime is therefore possible and, perhaps, not entirely inappropriate in light of the very nature of collectible NFTs: as digital art, they are susceptible to highly subjective, at times arbitrary price-setting. This feature is exacerbated when NFTs exist only as digital tokens. In that case, they do not have any relation to a pre-existing digital nor to a physical artistic expression that could act as a possible parameter for such pricing.
Wherever prices can be modified at will and single transactions exceed several millions of dollars–or euros, or pounds–there is an inherent and, arguably, quite sensitive risk of money laundering. Introducing regulation and control appears therefore to be a sensible consideration. As a matter of fact, the policy discourse surrounding NFTs of the last year shows how both the private and the public sector are eager to discuss such measures for the trade in NFTs. This also shines through the Proposal for a Regulation on markets in crypto-assets (MiCA) that is currently undergoing the ordinary legislative procedure. While it does not seem that NFTs will be included in the definition of ‘utility token’ nor, in principle, in the scope of application of MiCA–in line with their positioning regarding FATF standards–Recital 8b that has been newly added to the Proposal for the Regulation refers to the need to reflect on a separate legislative proposal of an EU-wide regulatory regime for NFTs.