NFTs – the need for RegTech?
‘There are always two sides to a coin’ – the media hype around the topics of NFT and Metaverse has never been greater and hardly a day goes by without these trends hitting the headlines. Along with the opportunities arising from the technologies, the risks associated with use cases from a financial crime perspective are increasing. Digitization is progressing at a high speed, and probably no one will miss last year’s name change from Facebook to Meta and the associated entry into the metaverse. But even before that it was possible to connect with others in virtual space, like Fortnite or Minecraft. As in real life, it is part of the process that various assets can be traded through the digital world. One possibility is the trading of NFTs, which enable the exchange of digital assets combined with an authentic certificate based on blockchain technology. Even well-known companies have taken advantage of the hype and released their own NFT for trading. But are people and companies aware of the risks, but also the opportunities? From a compliance perspective, there are still some unanswered questions that need to be clarified.
Rapidly growing technologies also cast a shadow from a compliance perspective
According to the 2022 Crypto Crime Report by Chainalysis, two main forms of illicit activity have been observed in the past year: Wash trading to artificially increase the value of NFTs and money laundering through the purchase of NFTs. In principle, these frauds are not new, but the rapid pace of technology application represents a serious threat due to still inadequate regulation.
Wash trading is the practice of buying and selling assets in a way that aims to manipulate or mislead market supply and demand. In this case, the seller is on both sides of a transaction made with the goal of making one’s NFT appear more valuable than it really is. Many NFT trading platforms allow their users to trade by simply connecting their wallet to the platform without any identification process. Therefore, no special effort is required to manage the laundering of NFT trades. In particular, from a compliance perspective there is huge potential for improvement in the identification and verification of market participants to remove initial fraud risks. Customized KYC processes can help detect and reduce transaction risks between multiple addresses and identify the actors behind them. This need is also highlighted by a report from blockchain platform Chainalysis, which states that 262 users have been identified as having sold NFTs more than 25 times to a self-funded address, making a combined profit of nearly $8.9 million from laundering activity.
The future – opportunity lies in risk
The increasing use and adoption of NFTs poses a significant risk to financial crime, which is why stricter KYC/AML protocols are necessary. But what does the current regulatory environment look like regarding NFTs?
The latest guidance from the Financial Action Task Force (FATF) highlighted that NFTs are not directly affected by AML restrictions as they are not viewed as “virtual assets”. However, the FATF emphasizes that pre-existing anti-money laundering regulations should apply to NFTs if the use falls into certain categories, such as use for payment, storage of value or other investment purposes. In addition, NFTs are interconnected with the crypto ecosystem, which is facing increasing regulations. Based on this dependency, regulations will be transferred to the NFT space.
All this uncertainty surrounding NFTs carries risks, but also huge potential for the compliance industry. As mentioned, NFTs are still in their infancy, creating significant KYC and AML risks. In addition, regulators struggle to accommodate rapid technological advances, which creates uncertainty in the market.
As the industry anticipates the implementation of future regulations, it is recommended that players in the crypto and NFT space proactively adopt internal fraud and AML programs. In particular, now is an opportunity to proactively address the fundamental risks of NFTs and establish a sustainable business by preventively adopting risk reduction measures.
This opens up the potential for RegTech use cases and solutions to shine. Agile RegTech solutions enable companies to meet the challenges of a rapidly changing regulatory landscape and stay ahead of technological advances.
Continuous networking and sharing of best practices are key especially in the rapidly advancing areas of technology and regulation.
For further expertise or insights into the NFT ecosystem and Metaverse, feel free to contact RegTech Lab.
This editorial was first published in our Financial Crime and Fraud Report 2022, which showcases the innovation and development of best practices and tools used by financial institutions in their fraud prevention activities to improve the digital engagement process of their customers as they combat financial crime.
About Anna Werner
Anna works as a manager at Deloitte and is one of the initiators of Deloitte’s RegTech Lab. Using RegTech solutions, she addresses compliance pain points by combining regulatory and technology expertise.
About Jan Bartenstein
January is a consultant at Deloitte and deals with innovative processes and approaches. It deals with the topic of strategic trends that occupy our work and how we can release our creative potential.
About Nicolai Kuhn
Nikolai works as a junior staff member at Deloitte in the area of financial crime with a focus on trend scouting and trend checking in the RegTech environment. As part of the RegTech Lab’s trend tracking team, he has experience with innovative solutions for emerging compliance topics.
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