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NFTs: Has the time come for regulation?

NFTs regulation

By Wolfgang Berner, CTO & Co-Founder, HAWK:AI

As the NFT market gains momentum, market participants need to be aware of, and prepared for, stronger regulation and potential enforcement actions within the field of Anti-Financial Crime (AFC).

Does existing NFT regulation exist? Yes and No.

Based on the latest Financial Action Task Force (FATF) guidelines, NFTs defined as collectibles may not be directly affected by AML regulation. The FATF stresses, however, that not the name but the usage of NFTs is important. As long as NFTs are potentially used for payment, storing of value, or investment purposes, they should be covered by AML regulation.

As current usage highly suggests such purposes, market participants should review their current AML prevention programs to avoid heavy enforcement actions. One example was of enforcement was against BitMex, where FinCen recently imposed US$ 100 million in fines onto the crypto exchange.

With this in mind, there are two answers to the posed question. 

The first is: NFTs have no dedicated regulatory framework, yet. Bearing the risks of money laundering and fraud in mind, this should be rectified soonest (and is currently in progress).

The second is: NFTs may already be covered by existing AML regulations, based on their usage. While we need to wait for regulatory and judicial clarity in Europe, market participants and financial institutions should pre-empt formal regulation with internal AML and fraud programs. 

Expanding on the application of existing regulation to NFTs, the US Department of Justice’s Office of Foreign Assets Control (OFAC) already enforces the evasion of Sanctions laws by market participants holding and trading sanctioned NFTs. Recently, OFAC sanctioned the Latvia-based “cryptobank” Chatex and connected addresses (of which 42 belong to NFTs) for engaging with the Russian darknet marketplace Hydra. The consequences of US Sanctions breaches like these are substantial and life-threatening for any organization.

Market participants should ensure they don’t engage in any activity connected with sanctioned parties and related blockchain addresses. Entities outside the US should be aware that Sanctions regulations not only apply for US entities but worldwide, as long as an entity has a so-called US nexus.

Key factors to consider when designing AFC regulation for NFTs

In our view, regulation and its enforcement, especially for Anti-Financial Crime topics, is driven by three factors within the NFT space. 

First: The exponential increase in revenues brought the topic on the agenda, not only for business but also for regulators. Further expected growth in numbers makes the issue for regulation ever more important.

Second: NFTs, in their different forms, bear certain inherent risks (such as the subjective value of the object the NFT represents, and hence the transfer of value it allows) when it comes to Money Laundering / Terrorist Financing, Financial Sanctions evasion, or Fraud and Scams. With expected increasing market size, those risks will increase significantly.

Third: NFT-adjacent fields of regulation, such as the Crypto ecosystem as well as the Arts and Antiquities sector, face increasing regulation which will, sooner or later, spill over to the highly connected NFT ecosystem.

To conclude, regulation of any area that could potentially benefit financial crime is important, but financial institutions should not wait for regulation to force their hand. Using existing AML/Fraud regulation as a baseline, financial institutions should consider how existing programs, and planned updates, can handle NFTs. After all, they are another one of the many innovations that change consumer behavior in the global financial system.

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