Are KYC, AML and other regulations coming to the NFT market?

Incoming regulations could be coming for the $2.5B NFT market

By Vanessa Malone

Non-fungible tokens (NFTs) make up a $2.5 billion market and growing, up from $13.7 million in the first half of 2020.¹

Many of the leading NFT platforms, including OpenSea, Axie Infinity, CryptoPunks and Rarible have seen record volume in the last few weeks. OpenSea’s transaction volume earlier this month saw $95 million in 2 days which exceeded its entire volume registered in 2020.

The surging NFT market isn’t just attracting eager buyers and sellers. Regulators are highlighting gray areas and racing to form guidance on the NFT market.

As with most technological innovations, many NFT platforms have moved faster than regulation which could be opening the door to KYC, AML, and securities law violation risks.

KYC/ AML

The NFT market currently falls in a KYC/AML gray area, with no compliance regulations specifically required for the industry. However, NFTs are mostly associated with art and collectibles which could have implications in the near future.

Art is already widely considered an avenue for money laundering. Art sellers have never been required to report large art transactions or suspicious activity to regulators. Art buyers have also been able to remain anonymous. Pair this with the anonymity Ether, Bitcoin, and other cryptocurrencies offer, and you can see how NFTs could act as a honeypot for bad actors.

On January 1, 2021, Congress passed the Anti-Money Laundering Act of 2020 as part of the National Defense Authorization Act, with the biggest changes to the Bank Secrecy Act (BSA) in two decades. This includes a new law requiring antiquities dealers to comply with the requirements of the Bank Secrecy Act. Art dealers will now have to adopt AML programs designed to combat money laundering and fraud.

The AML Act also extends the scope of the BSA to crypto exchanges, maintaining that virtual currency businesses are money services businesses, and therefore, subject to BSA requirements.

If NFTs get filed into either of the above categories, it could mean NFT platforms would need to make big changes to comply with KYC and AML regulations.

This could prove challenging. It is very uncommon for NFT platforms to require an identity verification process to participate. Most NFTs operate as a free-for-all.

OpenSea, the largest NFT marketplace doesn’t require KYC. Neither do many of the other NFT platforms. This means buyers and sellers don’t know who they’re transacting with which creates obvious risk.

The buyer of the $600,000 Nyan Cat flying Pop-tart meme was anonymous, appearing only as “oxy7eb2…3f6b” on Foundation’s site.²

What if the buyer was a bad actor? What if this NFT is sold in a year to someone who is?

Another feature becoming more attractive for NFT creators is a built-in royalty stream where the smart contract siphons off a percentage of every future sale of an NFT and passes it (as ETH) to the creator. This creates an endless AML issue for every creator whose work is sold on Ethereum.

While NFT platforms are currently not responsible for this legally, there is a branding and business advantage to protecting ones buyers and sellers from nefarious activity.

Also for prominent athletes, musicians, artists, and entertainers jumping in to offer their own digital collectibles, credibility and authentication are critical to protect their reputations.

Securities law:

Most NFTs up until this point have been classified as art and collectibles authenticated by a blockchain, not securities. However, certain types of NFTs raise more securities law red flags.

One particular area of concern comes with fractionalized NFTs. Because some NFTs are being sold for millions, the demand for fractionalized NFTs has surfaced.

Take CryptoPunks for example, which have been known to sell NFTs for millions. A collection of 50 CryptoPunk NFTs have been fractionalized into millions of tokens where each fraction represents partial ownership of the larger collection.

This may seem like a great way to increase liquidity potential and accessibility for everyday buyers but they risk running into more regulatory scrutiny. During a Security Token Summit in March, 2021, SEC Commissioner Hester Pierce, also known as “Crypto Mom,” said investors should be careful not to create unregistered securities when buying and selling fractional shares in an NFT.

Especially as NFTs continue to get creative, creators need to think about whether or not the NFT is being created to earn a return on investment.

Concluding thoughts:

The NFT market has only begun making waves. It is important for participants to pay attention to the changing landscape and the platforms that are addressing the regulatory implications head on.

About Upstream:

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About Horizon:

Horizon is a fintech company that builds and powers global securities exchanges with an integrated suite of software for compliant issuance, management, and secondary trading of securities. Our in-house solutions combine Wall Street and Silicon Valley to power the next generation of securities offerings and trading in the U.S. and globally. Learn more at https://www.horizonfintex.com/.

Sources:

1 Reuters

2 NY Times

Horizon licenses and operates global securities exchanges.