Dion Seymour comments on NFT regulation in TheWealthNet
Crypto Tax & Accounting Technical Director, Dion Seymour, comments on NFT regulation in TheWealthNet.
Dion’s comments were published in TheWealthNet, 21 April 2023.
“Currently there are few regulations in place for cryptoassets, an umbrella term that includes NFTs.
“Since the 10 January 2020 UK cryptoasset service providers (CASPs) have been required to register with the Financial Conduct Authority (FCA) for the purpose of money laundering regulations (MLR). The main regulation for the cryptoasset sector to adhere to is the Fifth Money Laundering Directive (MLD5), which is a very narrow set of rules relating to anti-money laundering. MLD5 which was drafted prior to the growth year of NFTs in 2021 does not explicitly mention NFTs.
“The MLRs define a cryptoasset as a “cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically.” Activities that do not fall within scope of MLD5 regulations are outside the regulatory perimeter of the FCA and, therefore, not under any obligations.
“As noted in the definition the regulations do not specifically mention NFTs. This does means that there is uncertainty as to whether they are in scope of MLD5, however, it does not mean that they are not regulated.
“Whilst many may think of an NFT only as an image, influenced by popular NFTs such as Bored Ape Yacht Club (BAYC) which is a collection of various images of bored looking apes. The reality is that the term ‘NFT’ is a broad, umbrella term. NFTs can cover a range of uses, for example, proof of purchase/authenticity or documentation.
“The NFTs in the use cases mentioned above (collectibles and non-collectibles) could fall into the exchange and/or utility token categories and so will be unregulated. However, in theory, an NFT could have characteristics similar to those of traditional securities. Where an NFT does call into this category it could be regulated as a security. Although, on a practical level, it is very unlikely that an NFT has the necessary characteristics to be e-money.
“Therefore, it is the substance of the NFT that needs to be considered rather than the use if the term. An NFT could fit met the definition or not, depending on its characteristics, and it appears the determining factor is whether an NFT is a “representation of value or contractual rights”. For example, a ticket could represent the contractual right to attend an said event, however, digital artwork (such as a BAYC) might not necessarily represent any value or contractual rights.
“MLD5 does not provide an explicit definition of ‘works of art’, which is taken from domestic legislation, nor does it define or mention NFTs. For artwork, the definition is taken from VAT legislation which is primarily focused on physical art rather than digital art. [Note that in the UK the regulator for artwork is HMRC]. However, platforms that trade or issue NFTs “by way of business” may be considered to be cryptoasset service providers (CASPs) and thus be within MLD5. [Note that in the UK the regulator for CASP is the FCA].
“A draft guidance from the Financial Action Taskforce (FATF) replaced a previous reference to ‘assets that are fungible’ with ‘assets that are convertible and interchangeable’. This definition from FATF may involve NFTs, but this is not clear yet. In February 2023 FATF released a report into “Money Laundering and Terrorist Financing in the Art and Antiquities Market” that states “Art can also include digital art or collectable items, such as those secured through or represented as NFTs”. As there has been no guidance from either the FCA or HMRC on this specific matter, it is not certain if NFTs should be considered as works of art under the Directive and, therefore, be subject to the counter-terrorist financing rules such as Know Your Customer (KYC) practices.
“The 2023 FATF report identifies the vulnerabilities presented by NFTs such as the ease of transfer of ownership, subjective valuation and wash trading. However, it did not attempt to provide any quantum on the risk.
“The art sector has long had concerns regarding how artwork can be used to facilitate money laundering. The risks presented by NFTs are not new, however it is new technology that can achieve similar outcomes. Wash trading is a good example of how the NFT marketplace can be used for money laundering. Wash trading occurs when a buyer and seller are either the same person or are colluding, and this is banned in conventional markets. However, due to the unregulated nature of the crypto sector, it can still occur, particularly with NFTs, due to their subjective valuations. Not all NFT trading platforms are regulated (or need to be regulated) which can provide a greater degree of anonymity.
“In this simple example for money laundering:
- “Firstly, the money launderer buys a cheap NFT on a platform, for example on Opensea using “clean money”.
- “The NFT is offered at a higher price on Opensea, and the money launderer buys this NFT from himself, or with a colluding party, with the amount of black money to be laundered.
- “The consequence of the sale is that it increases the value of the NFT so that it is now artificially higher. If the money launderer succeeds in selling the NFT to an unconnected third party the “money” will flow into the legal economy as “clean money”.
“Late last year, the Department for Digital, Culture, Media & Sport (DCMS) launched an inquiry into NFTs and the blockchain where they note that “NFT regulation in the UK is largely non-existent.” It is telling that the inquiry states that it would consider whether NFT investors are at risk and may (emphasis added) also look at wider benefits and if more regulation is needed.
“Separately, HM Treasury opened a consultation in February 2023 to seek views on the future financial services regulatory regime. The stated aim for any regulation was the same risk, same regulatory outcome. The proposed framework for NFTs follows the same approach: the fact that the token is an NFT will not alone determine the regulatory treatment. For example, the consultation confirmed that non-fungible tokens (NFTs) will not be in scope of the cryptoassets financial promotions regime “since NFTs can represent a wide array of different assets which might constitute non-financial services products.”
“Taking a measured and considered approach is to be welcomed. However, at a time when other jurisdictions are quietly stealing the lead, such as the EU, faster progress will need to be made for the UK to be considered a global cryptoasset hub.”