Growing Concerns Over Potential Abuse in the NFT Market

Industry observers within the cryptocurrency space are noting a significant trend. Data from Google Search indicates that current interest in non-fungible tokens (NFTs) is rapidly approaching levels seen in 2017 during the height of the initial coin offering (ICO) boom.

Echoes of the ICO Era and Regulatory Scrutiny

ICOs largely faded from prominence following increased scrutiny from the SEC, which identified instances of their use for money laundering activities. Now, blockchain transaction specialists are expressing concerns about similar potential for abuse within the NFT ecosystem, despite the inherent traceability of these tokens – and, in some cases, even due to it.

Understanding NFTs: Digital Collectibles

As many are now aware, an NFT represents a unique digital collectible, capable of existing in various forms, such as a PDF document, a social media post, or even a digitized article from a publication like the New York Times.

Immutability and Ownership on the Blockchain

Each item, even with multiple copies, is marked with a unique alphanumeric string, rendering it immutable. This code is also permanently recorded on the blockchain, establishing a definitive record of ownership. While screenshots of digital items can be easily created, the NFT owner retains exclusive rights and the potential to sell the collectible to a buyer.

Record-Breaking Sales and Market Speculation

The most substantial NFT sale to date occurred approximately two weeks ago, with digital artist Mike Winkelmann’s “Everydays: The First 5000 Days” fetching an impressive $69 million. This price positions it as the third-highest auction price ever achieved by a living artist, surpassed only by Jeff Koons and David Hockney. Winkelmann, known as Beeple, previously broke records with a $6.6 million crypto art sale in February, followed by another sale for $6 million earlier this week.

Concerns of a Market Bubble

The current market frenzy has led Beeple to publicly express his belief in a potential “bubble” within the crypto art space, predicting that numerous NFTs will ultimately become worthless.

NFTs as a Potential Avenue for Illicit Activity

The substantial financial activity surrounding NFTs has prompted experts to believe they present a significant opportunity for malicious actors, although no formal accusations have yet been made.

Trade-Based Money Laundering Risks

A key concern revolves around trade-based money laundering, which involves disguising illegal funds through trade transactions to appear legitimate. This practice is already prevalent in the traditional art world, and NFTs, with their currently volatile pricing, present comparable risks.

Challenges in Valuation and Detection

Jesse Spiro, Chief of Government Affairs at Chainalysis, explains that identifying trade-based money laundering in traditional art relies on establishing a fair market value. Discrepancies between this value and the actual sale price – over or under-invoicing – can signal illicit activity.

Averaging Values for Easier Detection

Fortunately, Spiro notes that in cases involving numerous NFT sales, even at varying prices, an average value can be calculated, simplifying the detection of unusual transactions.

Opacity in Pricing and Transaction Execution

However, when establishing a sales history is impossible, determining the legitimacy of a price becomes difficult. Spiro emphasizes that only two willing parties are needed to successfully complete a potentially illicit transaction.

Other Forms of Financial Crime

Beyond money laundering, other criminal activities are possible within the digital asset space, and potentially with NFTs. Asaf Meir, CEO of Solidus Labs, cites wash trades – simultaneous buying and selling of the same asset – and cross trades – trades between accounts within the same organization – as examples of tactics used to manipulate asset prices.

Difficulties for Traditional Surveillance Systems

Both practices are illegal under money laundering regulations and are challenging to detect, particularly for older surveillance systems. Meir explains that crypto markets are heavily retail-focused, with numerous accounts and addresses potentially colluding, sometimes alongside institutional accounts.

Arguments for and Against Illicit Use of NFTs

Not all experts agree that NFTs are actively being used for illegal money transfers. David Pakman, an investor in Dapper Labs, argues that national governments can enforce “know-your-customer” and “anti-money-laundering” laws on marketplaces and exchanges, requiring verified identities for all customers.

Enforcement and Retroactive Investigation

These regulations facilitate the subpoena of marketplaces and exchanges when suspicious transactions are flagged, enabling the verification of user identities. Pakman also points out that even if illicit activity goes undetected initially, it remains subject to retroactive investigation by law enforcement agencies.

Liquidity Concerns and Alternative Methods

Max Galka, CEO of Elementus, suggests that NFTs may not be the most effective vehicle for money laundering due to the relatively low liquidity of secondary markets. He proposes that criminals might prefer decentralized exchanges and liquid, fungible tokens, making fund tracing more difficult.

The Speed of NFT Growth and Compliance Gaps

While theoretically agreeing with these points, Spiro of Chainalysis highlights that the rapid expansion of the NFT market has outpaced the implementation of necessary compliance measures.

Traceability and the Importance of Choke Points

He acknowledges that NFTs operating on the Ethereum blockchain are technically traceable and that entities running these NFTs should prioritize compliance and collaborate with blockchain forensics to monitor fund flows.

Ideal Scenario: Transaction Tracking and Identity Verification

In an ideal scenario, Spiro envisions the ability to track transactions and require personal identifiable information at key conversion points, such as when converting tokens to fiat currency, allowing law enforcement to identify illicit activity.

Current Compliance Challenges and Ongoing Risks

However, the recent security breach on Nifty Gateway demonstrates the current limitations in NFT compliance. Spiro concludes that compliance regarding NFTs remains a “gray area.”

Ultimately, he emphasizes that criminals consistently seek the methods least likely to result in detection, and if NFTs offer such an avenue, they will exploit it.