Establishing NFT compliance: AML and KYC considerations

Tags: Crypto
NFT compliance

One of the hottest crypto sectors in 2021 has been the rapid expansion of Non-Fungible Tokens (NFTs). The value of tokens sold in the 3rd quarter of 2021 was $10.7 billion, an expansion of 823% from the previous quarter. While the growth opportunities are fantastic, money laundering, market manipulation and other financial crimes threaten developing a trustworthy long-term market. Industry players need to carefully consider the risks and develop strategies and processes that keep consumers safe.

A quick introduction to NFTs

Non-Fungible means unique, so an NFT is a unique token. The power of an NFT derives from the fact that it is mathematically provable as unique and its ownership verifiable on a public blockchain.

For example, a digital graphic is converted into an NFT and then sold online. If the new owner wants to resell the graphic, they can prove they own that NFT, and upon sale, the next owner can do the same. The verifiable record makes selling digital assets much easier, as illegal copies are quickly proven fake.

If buying an NFT, the specific details of the smart (automated) contract require careful consideration; what are you buying? In most cases, you are not purchasing the rights to reproduction, redistribution, or the underlying original asset. Instead, you are often purchasing a specific copy of the asset, with very prescriptive rights to that version of how you use it and even on how you sell it.

Using smart contracts is another game-changing aspect of NFTs; built-in rules on its use can predetermine how it’s sold, used and otherwise interacts with the world. Contracts that auto-execute, only limited by the creativity of programmers and designers, enable multiple NFT use-cases that promise to change digital interactions, as well as in the real world. NFTs aren’t just fancy digital collectibles but are a way to bring foundational business concepts such as ownership and contracts into the rapidly developing web 3.0 metaverse.

KYC and AML used to protect NFT market

The art world has long been a place to hide illicit funds. After all, who’s to say what the actual value of a work of art is? Combine that with the speed of digital transactions and the anonymity of some NFT marketplaces and the appeal to money launderers is obvious; by quickly and easily converting tainted funds into NFTs, they can hide their assets or cover the money trail with multiple NFT transactions.

To date, as the industry is so new, there haven’t been significant initiatives to investigate money laundering in the sector. But regulators and lawmakers will not simply stand by and allow criminals to bypass Anti-Money Laundering (AML) laws. Yaya Fanusie, who spent seven years as an economic analyst and counterterrorism analyst for the CIA and now comments extensively about crypto regulatory issues, states:

“Just as physical art dealers and marketplaces have to institute some procedures to verify their customers as well as to conduct more due diligence on the provenance of the items they trade, there will likely be a need to require NFT dealers and marketplaces to follow similar AML guidelines.”

While Know Your Customer (KYC) requirements don’t specifically mention NFTs, bypassing the rules introduces the risk of potential regulatory scrutiny, fines and sanctions. Depending on the jurisdiction and how more established crypto tokens are regulated, NFT providers and marketplaces might be deemed another Virtual Asset Service Provider. Or perhaps, they’ll be covered under Money Service Business laws. Eventually, as NFTs grow in economic importance, maybe there’ll be requirements specific to the industry.

Any industry player that wants to see the industry grow can heed the advice from Chainalysis, a cryptocurrency investigation and transaction monitoring service:

“Growing consumer access to cryptocurrency requires a careful examination of the funds being used to purchase NFTs and the use of a comprehensive compliance monitoring solution that can help detect and prevent NFT money laundering and market manipulation.”

For now, there are three practical KYC steps to take to ensure a solid reputation in the sector:

  • Establish customer identity
  • Understand the nature of the customer’s activities (primary goal is to satisfy that the source of the customer’s funds is legitimate)
  • Assess money laundering risks associated with that customer for purposes of monitoring the customer’s activities

Taking these steps and having an effective overall AML compliance program demonstrates to regulators and customers that an NFT business is serious about its obligations to prevent criminals from using its services for illegal purposes.

Developing a safe marketplace

Beyond AML/KYC considerations, successful marketplaces need to establish trust and safety for all participants. While the NFTs themselves are provable, the average consumer is not a crypto expert and will put their faith in the various NFT marketplaces that the tokens are legitimate and that transactions are safe.

It’s also in the marketplace’s interest to vet all buyers and sellers to protect their bottom line from fraudulent transactions.

Fortunately, the process to establish customer identity for KYC purposes is the first step to prevent fraud and create a safe marketplace. Depending on the jurisdiction and risk considerations, adaptable identity verification procedures can add in levels of identity checks to best match the need for security, compliance and seamless onboarding.

NFT industry players would be well advised to implement innovative identity verification solutions now to protect their customers, their business and the massive opportunities of the industry.


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