Fraudsters, money launderers and more ungodly operates on the entire NFT market. Andrew Pimlott outlines the problem and what the authorities are doing about it.
Non-fungible tokens (NFTs) may have captured the public’s imagination, but they are an increasingly risky purchase. Not only have NFT values plummeted in recent months, in common with the entire crypto-asset market, but there is an increasing likelihood of buyers being scammed. NFTs are also used by money launderers, tax evaders, sanctions violators and other criminals.
A high-profile scam first came to light last month when US prosecutors in the Eastern District of New York charged Aurelien Michel, a 24-year-old French national living in the United Arab Emirates (UAE), with defrauding buyers of Mutant Ape Planet NFTs of more than $2.9 million in cryptocurrency.
The scheme involved selling NFTs to buyers who were promised a series of benefits designed to increase demand for, and the value of, their newly acquired NFTs. But once they had bought them, they were “rug-pulled” – a cryptocurrency scam where the seller pulls out before the project is complete, leaving the buyer with worthless assets and the seller walking away with all the money.
NFTs are seen by some as an exciting new way to own digital assets such as art that will rise in value. Others see NFTs as a global confidence trick akin to the Emperor’s New Clothes because the assets do not exist in the real world, they can fall spectacularly in value and the risk of fraud is high.
Law enforcement agencies and regulators warn the public about the dangers and how to avoid them. At the same time, they investigate and prosecute offenders where they can and tighten up laws and regulations around NFT.
NFTs explained
A non-fungible token is a digital unit of data stored on a blockchain that represents either a digital asset or a physical asset. The digital asset can be something like a digital artwork, video or music. The physical asset can be something like a painting, house, or other real object.
“Non-fungible” means “non-fungible” because an NFT is unique and not fungible with other NFTs. This is in contrast to a cryptocurrency like Ether, which is the same as other Ether and therefore interchangeable with any other Ether.
One of the most famous NFTs is the Bored Ape Yacht Club (no relation to Mutant Ape Planet), a collection of 10,000 NFTs of cartoon-like primates, which the platform describes as “unique digital collectibles that live on the Ethereum blockchain.” A Bored Ape NFT is not just “a demonstrably rare piece of art.” says the website, but it comes with a Yacht Club membership card and the buyer’s avatar to move around the club.
Another place to buy NFTs is Decentraland, a browser-based virtual reality world on the Ethereum blockchain that opened to the public in 2020. Buyers enter Decentraland as avatars, walk around, chat with others, and buy NFT land, real estate, art and goods from stores that use the cryptocurrency MANA.
NFT fraud is low but on the rise
The nature and extent of NFT fraud is described in the report NFTs and financial crime: money laundering, market manipulation, fraud and sanctions risks in non-fungible tokens, published by Elliptic, a London-based provider of crypto-asset risk management services to businesses worldwide. It says NFT crimes represent “a small but notable” portion of overall non-NFT related trading activity.
The main findings include:
• Over $100 million worth of NFTs were publicly reported stolen through fraud between July 2021 and July 2022, netting the perpetrators $300,000 per fraud on average. In July 2022, over 4,600 NFTs were stolen – the highest month ever – indicating that fraud has not abated despite the crypto bear market.
•Over $8 million of illicit funds have been laundered through NFT-based platforms since 2017, representing 0.02% of trading activity originating from known sources.
• Tornado Cash, a US-sanctioned mixer (a platform that mixes coins to hide their origin) was the source of $137.6 million of cryptoassets processed by NFT marketplaces and the laundering tool of choice for 52% of NFT fraud proceeds before being sanctioned by OFAC in August 2022. The prolific use of “threat actors” engaging in NFTs underscores the need for effective sanctions screening of NFT platforms.
A report from the US Treasury Department last year – Study of the facilitation of money laundering and terrorist financing through trade in works of art – focused on traditional art, but noted that “technological innovations in the digital art space also present potential challenges for money laundering,” a reference to NFTs.
Apart from the Mutant Ape Planet case in January, there have been other prosecutions in the US. Rikesh Thapa, co-founder and former CTO of NFT creation platform Blockparty, was charged in December with running a scheme to defraud the company of more than $1 million worth of US dollars, cryptocurrency and utility tokens.
In June, Nathaniel Chastain, a former product manager at Ozone Networks, trading as OpenSea, was charged with wire fraud and money laundering in connection with a scheme to commit insider trading in NFTs using confidential information about what NFTs were to appears on. OpenSea’s website for his personal financial gain. The US Attorney’s Office for the Southern District of New York said it was the first-ever digital asset insider trading scheme. “NFTs may be new, but this type of criminal scheme is not,” said US Attorney Damian Williams. “Today’s charges demonstrate the office’s commitment to stopping insider trading — whether it occurs in the stock market or the blockchain.”
In March, Ethan Nguyen and Andre Llacuna were charged with conspiracy to commit wire fraud and conspiracy to commit money laundering in connection with a million-dollar scheme to defraud buyers of NFTs advertised as “Frosties.” When Frosties sold out, instead of passing on the benefits to buyers, the defendants shut down the site and transferred the proceeds to their own cryptocurrency wallets.
In the meantime, civil action is being taken. For example, the New York law firm Scott + Scott filed a class-action lawsuit in a California court in December on behalf of plaintiffs Adam Titcher, Adonis Real and others alleging that Yuga Labs, the creator of the Bored Ape Yacht Club (BAYC) NFT collection, obtained “unsuitable” investors to buy their NFTs. The investors are now seeking compensation for their losses.
The lawsuit alleges that Yuga violated securities regulations “by making false and misleading statements” about the financial benefits of the investments “as well as using celebrity promoters to lure in unsuspecting investors.” Celebrities included in the act include Madonna, Paris Hilton, Justin Bieber, Serena Williams and Gwyneth Paltrow.
An article in The Art Newspaper, quoting from the court papers, said that “the celebrity endorsement and deceptive promotions…were able to artificially inflate the interest and price of the BAYC NFTs…inducing investors to buy these losing investments to drastically inflated prices.”
Most of the publicized NFT fraud cases have been in the US, but a year ago UK tax authorities seized three NFTs as part of an investigation into a suspected £1.4m VAT fraud involving 250 alleged shell companies. HM Revenue and Customs (HMRC) arrested three people and said it was the first UK law enforcement seizure of an NFT.
Tightening of the regulations
It is clear from the above that crime investigators are aware of the threats and are succeeding in bringing some of the offenders to justice. As for financial regulators, they are looking to close regulatory loopholes. A key question is whether NFTs are investments and therefore regulated securities. In the US, the Securities and Exchange Commission (SEC) is investigating this, according to sources such as Elliptic, the Financial Times and legal compliance specialists.
Meanwhile, the US Treasury has Study of the facilitation of money laundering and terrorist financing through trade in works of art the report mentioned earlier, states that NFTs used as payment or investment may fall within the Financial Action Task Force’s (FATF’s) definition of “virtual assets”, meaning firms and individuals who buy and sell them may have to comply with US anti-money laundering of money and terrorist financing liabilities.
FATF, the Paris-based organization that leads global efforts to tackle money laundering and terrorist financing, published its standards for virtual assets and virtual asset service providers in 2019. Countries are incorporating these standards into their anti-money laundering regulations and financing of terrorism. The FATF updated the standards last year, including a section on NFTs, which it says criminals can use “for illicit financial activities, such as money laundering and trade in detergents.”
Whether the FATF’s virtual asset standards apply to NFTs depends on the type of NFT. If the NFTs are truly unique and are used as collectibles rather than as payment or investment instruments, then they “are not generally virtual assets for the purposes of the FATF standards.” However, if the NFTs are used for payments or investments, the standards should be used.
Threat awareness
It is clear that the threat of NFT fraud is being taken seriously by the authorities. The US is leading the way, not only by investigating and prosecuting perpetrators and tightening the rules, but by raising public awareness.
The Manhattan District Attorney’s Office is an example. Its “NFT Scams and Scams” section of its website warns that the “explosion in consumer interest and investment in NFTs” has “also led to increased criminal activity.” It lists the main types of NFT scams and advises buyers on the “basic steps” they should take to protect themselves – such as using two-factor authentication for account access, protecting usernames and passwords, checking that websites selling NFTs are legitimate , and aware of phishing attempts. They may be basic steps, but they need to be repeated constantly because so many people ignore them. A telephone number is provided that people can call if they believe they have been defrauded or suspect someone has committed fraud.
As the NFT market continues to grow, so will the fraud risk. However, if crypto-active service providers, investors and law enforcement agencies remain vigilant, the risk can at least be reduced.
As the NFT market continues to grow, so will the fraud risk. However, if cryptoactive service providers, investors and law enforcement agencies remain vigilant, the risk can at least be reduced.
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