Treasury Department Focuses on Emerging Digital Art Market and NFTs

Earlier this month, the Treasury Department dropped its long-awaited report on the art market, bearing the somewhat uncolorful title, “Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art.” The report, which was commissioned (ok, mandated) by the Anti-Money Laundering Act of 2020, examined money laundering and terrorist financing risks in the high-value art market, including the market for digital assets.

Keeping up with the latest splash in the world of contemporary art, the report spilled considerable ink on the hot topic of non-fungible tokens (commonly referred to as NFTs), focusing on the possibility that transactions involving NFTs could be susceptible to money laundering. As Treasury remarked, players in the art world can transfer NFTs “via the internet without concern for geographic distance and across borders nearly instantaneously” and “without incurring potential financial, regulatory, or investigative costs of physical shipment.” As a result, the Department suggested that NFT transactions could fall under the jurisdiction of the Financial Crimes Enforcement Network (FinCEN). Although jurisdictional issues over NFTs are far from settled, some common-sense regulation may well benefit this growing industry.

As the report explains, “NFTs are digital units, or tokens, on an underlying blockchain that represent ownership of images, videos, audio files, and other forms of media or ownership of physical or digital property.” In a sense, NFTs are a convenient and verifiable way of establishing and then keeping track of ownership and provenance, with some (important) twists. The digital asset is a bearer instrument that codifies its ownership on the blockchain and is minted, held, or transferred, via smart contracts and digital wallets. Smart contracts, which facilitate the exchange on a blockchain network, but are different from a typical legal contract, can govern the ownership and transferability of NFTs. Specifically, the smart contract is a self-executing program that is recorded in the blockchain and governs what can and cannot be done with an NFT. The terms of a smart contract can be used to generate revenue each time an NFT is transferred, which can then promote the development of a marketplace for trading.

Because NFTs are blockchain based, they are “publicly verifiable, auditable, and digitally unique due to being derived cryptographically.” But, unlike other digital assets, like bitcoin, NFTs are provably unique and do not fluctuate according to an exchange rate. Instead, prices are determined by the buyer and seller, like a piece of art.

According to the report, depending on the nature and characteristics of the NFT offered, the platforms that exchange NFTs can be considered virtual asset service providers (VASPs) by the Financial Action Task Force (FATF), a global intergovernmental money laundering and terrorist financing watchdog, and also may fall under FinCEN regulations. Per the FATF, NFTs generally do not fall under the definition of “virtual assets” because most NFTs currently are unique collectables, rather than interchangeable investment instruments. But, NFTs that instead are used for payments or investing may, in fact, fall under the FATF definition. As a result, parties doing business in the United States transferring virtual assets during the buying and selling of NFTs may have anti-money laundering (AML) obligations under FinCEN rules for money services businesses.

So how could all of this be used to launder money? The report paints a dark picture. It notes that a bad actor could purchase an NFT with illicit funds and transact with his or herself to create records of sales on the blockchain in a process called self-laundering. To obtain clean funds, the bad actor can sell the NFT to another individual who has no connection to any illegal operation. Further, to escape any reporting on a public ledger, bad actors could engage in peer-to-peer transactions of NFT-secured digital art. In addition, smart contracts present money laundering risks because transactions can occur without identifiable information regarding who the buyer is, and because transactions can occur rapidly without due diligence.

In response to the money laundering risks, the report lays out a number of recommendations. As a non-regulatory avenue, the Treasury Department suggests “(1) encouraging the creation and enhancement of private sector information-sharing programs to foster transparency among art market participants and (2) updating guidance and training for law enforcement, customs enforcement, and asset recovery agencies.” If the Treasury Department decides to use its regulatory authority, the report proposes “(1) using FinCEN recordkeeping authorities to support information collection and enhanced due diligence and (2) bringing certain art market participants under the AML/CFT legal framework and obligating them to create and maintain AML/CFT programs.”

The Biden Administration has prioritized tackling corruption, both at home and abroad, and any anti-corruption regime requires targeting and dismantling money laundering schemes. The report illustrates that both the administration and Congress are focused on preventing the flow of illicit funds through the exchange of artwork and digital assets like NFTs. Given the growing relevance of digital assets in the financial industry, it is important for clients who engage in these kinds of transactions to understand their Bank Secrecy Act/AML obligations and consider the nature of the business dealings in NFTs and the details surrounding a particular platform or business partner.

We continue to monitor developments relating to the Anti-Money Laundering Act, including with respect to digital assets and NFTs, right here on Enforcement Edge. If you have questions, reach out to any of the authors or your trusted Arnold & Porter contact.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This blog post is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.