Money laundering and terrorism financing risk connected to the NFT market

by | Jun 27, 2022 | Uncategorized | 0 comments

Most people may not be familiar with the technology underlying the non-fungible token (NFT) despite the technology appearing in 2014 for the first time. Nonetheless, things are changing, since NFTs are increasingly becoming a popular way to trade digital works of art. According to DappRadar (a digital analysis firm) approximately $2.4 billion of NFT were traded in the third quarter of 2021, representing a slight increase with respect to the $2.3 billion sold during the frenzy that was seen in the first quarter of the same year. The main auction houses and galleries are now selling pieces of art as NFT; one of these, the Beeple’s 69 million dollar NFT (BEEPLE-COLLECT.COM – beeple NFTs, collectibles, weird crap.) still holds the record high price, while dozen of online trading platforms are emerging and are looking for artists and NFT collectors.

What are NFTs?

NFTs derive from the innovations related to the cryptocurrency world, to better understand the concept we should start from the elements that form the acronym: non-fungible token. A token is generally any type of crypto asset, while the characteristic of being non-fungible implies that there is an underlying contract, specifically a smart contract, confirming that the digital file linked to the NFT solely belongs to a specific and identified wallet on the blockchain.

The smart contract is usually placed on Ethereum, a blockchain that was born to allow the formation of contracts that are fulfilled once a predetermined action occurs; the characteristic of being decentralized implies that the same contract is reproduced in every node and, hence, it is impossible to fraudulently modify it.

Those NFTs that represent a digital work of art generally do not memorize the associated graphic file on the blockchain, owing to the large size of the same file. Again, the token aims at granting the artwork’s authenticity, functioning like an expert’s assessment, and working like an ownership certificate, with the web link connected to the specific work of art.

For the aforementioned characteristics, NFTs are much appreciated by collectors: they provide ownership evidence, even though at the moment there needs to be a certain level of technical competence about blockchain, hash and the technologies that actually archive the digital asset, to also grant its accessibility.

There are also projects that are made to address a fan base and popular sports; such as the NBA Top Shot | Officially Licensed Digital Collectibles that allows purchasing NFTs that capture meaningful and spectacular basketball moments, and it is no accident that the website’s graphic recalls the old-fashioned cards and figures. Even some singers have found in the NFTs a tool to increase the links and connections with their audience; Mahmood was one of the first in Italy: MAHMOOD NFT | Ghettolimpo Limited Edition | Digital Art Rights

The crimes connected to the NFT market

Just like artworks can be falsified, it is possible to do the same with NFTs. A notorious case of identity fraud refers to Mike Winkelmann, the artist commonly known as Beeple. After the drop of “Everydays”, the Beeple’s NFT was targeted by a digital artist known as Monsieur Personne, claiming that he created copies of the famous NFT by Beeple and that he successfully led several NFT trading platforms to think that the originated from Beeple, rather than himself. Some websites put for sale such imitations before the fraud came to the surface and the bids for the fake NFTs were effectively blocked.

An art robbery is possible even in the NFT world. Criminals can hack the users’ accounts on the NFT markets and transfer the NFTs to their own accounts. After being transferred, the hacker can rapidly sell the stolen token on different markets and try to launder the money originating from the transaction. Since the transactions are carried on the blockchain, the hacker would need some systems to hide his tracks, like mixers, for example.

Laundering-related risks

In the FATF crypto-assets Guidance (UPDATED GUIDANCE: A RISK-BASED APPROACH TO VIRTUAL ASSETS AND VIRTUAL ASSET SERVICE PROVIDERS) the NFT definition seems to substantially reduce the money laundering risks:

“Digital assets that are unique, rather than interchangeable, and that are in practice used as collectibles rather than as payment or investment instruments, can be referred to as a non-fungible tokens (NFT) or crypto-collectibles. Such assets, depending on their characteristics, are generally not considered to be VAs under the FATF definition.”

The FATF adopts a practical approach to the phenomenon. However, according to the article: “it is important to consider the nature of the NFT and its function in practice and not what terminology or marketing terms are used. This is because the FATF Standards may cover them, regardless of the terminology. Some NFTs that on their face do not appear to constitute VAs may fall under the VA definition if they are to be used for payment or investment purposes in practice […] Given that the VA space is rapidly evolving, the functional approach is particularly relevant in the context of NFTs and other similar digital assets. Countries should therefore consider the application of the FATF Standards to NFTs on a case-by-case basis” (Paragraph 53).[ADCMS1]

In our opinion, the main discrimination is linked to the possibility of reselling the NFTs on multiple markets, or solely on the market where it was initially originated. In the latter scenario, the main drawback is the asset being poorly liquid, if the market is small: such a market would not be an effective solution to move value and it is likely that it would not attract criminals.

On the other hand, there are NFT markets, like OpenSea (https://opensea.io/) where it is possible to generate NFTs and purchase other tokens coming from projects originating worldwide, and realized on different blockchains (other than Ethereum, likePolygon).

OpenSea supports several wallets, one of these being MetaMask, which allows to acquire and sell crypto assets without any customer due diligence . Hence, with this wallet on OpenSea, people can freely trade digital assets that are denominated in a cryptocurrency and, once this is converted on a specific crypto exchange, fiat currency. If the exchange does not correctly perform the anti-money laundering controls, moving values with NFTs can become feasible and substantially simple.

In a study focused on the laundering risks that relate to the art market, the US Department of the Treasury claims that “the emerging digital art market, such as the use of non-fungible tokens (NFTs), may present new risks, depending on the structure and market incentives”. [ADCMS1] [Treasury Releases Study on Illicit Finance in the High-Value Art Market | U.S. Department of the Treasury]

The similarities between the art market and NFTs are numerous, and so are the risks: the value of the goods at stake is substantially difficult to assess since it is intrinsically related to the decisions of the parties, especially if there is not a market sufficiently informed and precedents to rely on.

What evidence has been collected up to now? A study by Chainalysis [NFT Money Laundering and Wash Trading (chainalysis.com)] has traced $44,2 billion worth of cryptocurrency which was sent to ERC-721 and ERC-1155 contracts, the two types of smart contracts on Ethereum associated to the markets and collections of NFTs.

From this analysis some evidences have emerged, namely: market manipulation and examples of laundering use.

There are cases in which the NFT’s owner has sold it and repurchased it to increase its value, using different profiles, a way to artificially increase the value of some collections and, eventually, sold them to third unaware parties. Chainalysis has also identified 262 users that have purchased and sold the same NFT at least 25 times from a profile that was financed by themselves. Even though not everybody has earned money from the transactions, owing to the associated fees (“gas fee”) to grant the smart contract, a group of such user has, overall, earned close to $9 million.

Concerning money laundering, Chainalysis has created a database containing suspect addresses linked to possible unlawful activities, and this was possible through a persistent blockchain forensic activity over the years. By analyzing the number of cryptocurrencies coming from these addresses that have arrived in the NFT markets, they discovered transactions amounting to up to $1.4 million. The overwhelming majority of such activities originated from fraud-associated addresses that were sending funds to NFT markets to make purchases.

Overall, the amounts are still relatively low and characterized by scarce liquidity. Laundering a large money amount through NFT with a value as large as a few million euros can cast some suspects, since the average values are a few hundred euros, at most. For this reason, according to the author, the risks are more closely linked to the financing of terrorism, rather than money laundering.

The threat of terrorism from alt-right

Assume that you want to finance a right-wing extremist group. Assume that you subscribed to a  Telegram channel where you are informed that the supremacist group G88 [a made-up name] has created some NFTs with a nostalgic fashion on OpenSea, selling for 0.5 Ether, which is roughly 500 euros each, at current values. To purchase them, you fund your wallet MetaMask with a prepaid card – a payment method with relatively weak security controls.

Given the limit of 1,000 euros per day, with a set of prepaid cards you can possibly purchase several NFTs and, if the supremacist group has a handful of supporters, it can quickly gather a few thousand euros in cryptocurrencies, mainly Ether. The last step would be to convert Ether in untraceable cryptocurrencies, like Monero, to then purchase weapons on the dark web.

Just like current nazi-fascist groups self-finance their operations through the selling of gadgets, the risk of using NFTs to support terrorist groups seems considerable, especially since neither OpenSea nor MetaMask are equipped with processes to duly check their users. Additionally, there is at least one supremacist NFT that was confiscated from the OpenSean and Rarible marketplace: Alt Right NFT Banned From OpenSea – Trustnodes

This confirms the necessity to quickly adopt a regulatory framework, starting from the identification of the most probable and dangerous risks for society.

First appearance of the article on Risk & Compliance platform: Riciclaggio e finanziamento al terrorismo sul mercato degli NFT (riskcompliance.it)

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