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NFTs and Illicit Financing: Smoke versus Fire
An initial look at the illicit financing risks of NFTs
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In recent weeks and months, I’ve been getting a lot of questions about the illicit financing risks of NFTs. I’ve given some initial thought to this problem, and I see these risks along several lines. But to start with, let’s explore what NFTs are in as simple terms as possible.
Non-fungible tokens (NFTs), which first emerged in late 2017, are digital tokens (like cryptocurrencies) built using blockchain technology. The tokens function as “virtual deeds” that convey ownership of a digital asset. The most common NFTs are digital art that are sold on platforms, most often using cryptocurrencies like Bitcoin or Ethereum. Owning an NFT is like owning a painting or photograph; in this case the owner can profit from the NFT by selling rights to use the image, and the artist can also profit when the NFT is re-sold. Each NFT is stamped with a long, constant string of alphaneumerics that is also recorded on the blockchain, creating a permanent record of who owns what. NFTs provide an unchangeable record of ownership and blockchain technology can be used to allow an owner of an NFT to trace previous transactions.
Illicit Financing Risks
Many NFTs are being sold for hundreds of thousands, and in some cases, millions, of dollars. As with any high-value good, there are risks that these NFTs could be used to move value between illicit actors for money laundering, sanctions evasion, terrorist financing, or other illicit financing activities. For instance, to move millions of dollars between actors, ownership could be transferred (either through a sale or perhaps a gift). This could be useful for individuals seeking to settle accounts (like imbalances generated through trade-based money laundering), or as payment for services rendered, including from sanctioned entities. Of course, the value of NFTs is highly subjective, so there are risks in terms of adopting this method of moving value – there is no guarantee that the recipient or beneficiary of the NFT will be able to sell it for the value that it has been assigned in the transaction.
Another possible use for NFTs in the illicit financing space includes a “wash trade”, a form of “self-laundering” of funds. In this case, a criminal creates an NFT, sells it to himself for a lot of money, and uses cryptocurrency to pay for it. At the end of the transaction, the money looks like a legitimate payment for the “art” created.
While these are two possible methods of using NFTs in the illicit financing space, these examples are far from exhaustive. Ultimately, criminals, terrorists, and other illicit actors will exploit any high value good they can in their pursuit of moving money surreptitiously if it’s expedient for them to do so. There are also other ways that NFTs could be used for criminal activity, outlined in this RUSI report.
However, NFTs have a built-in transparency mechanism (through the blockchain) that makes them more difficult to use for value-transfer than other high-value goods like precious metals, stones, and art. The transparency of the blockchain means that transactions are recorded and are auditable. As with most illicit financing mechanisms, there are workarounds to this transparency used by illicit actors, but the default transparent nature of the blockchain might make it less likely to be used for this type of illicit financing, as opposed to other high-value goods.
Finally, most NFTs are purchased using cryptocurrencies, which layers levels of potential obfuscation. If illicit actors are able to anonymously acquire cryptocurrencies, and anonymously (or pseudonymously) purchase NFTs, then these transactions become harder to trace. This is particularly true for platforms like Binance that have a history of poor “know your customer” policies and practices. However, as more states regulate the use and sale of cryptocurrency and require the implementation of “know your customer” principles, these transactions become more traceable when authorities are able to acquire the right legal authorities to unmask the sender and receiver.
As we consider the “use case” for illicit financing using NFTs, it’s important to think through all the mechanisms involved to pinpoint where actual vulnerabilities lie, and where they can best be mitigated. At the moment, most of those vulnerabilities appear to lie in the purchase of cryptocurrencies — if this can be done anonymously, then that facilitates the sale of the NFT in a pseudo-anonymous way. Tightening crypto regulations and know your customer requirements for cryptocurrency exchanges might be one of the most effective ways of mitigating the illicit financing risks of NFTs.
In the short term, I expect to see some “proof of concept” use of NFTs for illicit financing from different illicit actors, potentially for sanctions evasion, money laundering, laundering proceeds of corruption, and perhaps even terrorist financing. At the same time, there are likely some barriers to entry in the market and vulnerabilities for illicit actors that might prevent this from becoming a widespread illicit financing mechanism.
This is a quick look at NFTs and their potential use for illicit financing. I intend to refine this analysis over the coming weeks and months, so bookmark this post if this topic is of interest to you so you can track the updates. And of course let me know if you have other areas you want me to explore!