Get ready for the feds to start prosecuting NFT traders

Studies show that most attempts to launder trade in non-fungible tokens (NFT) are unprofitable. But that doesn’t stop them from trying, making it a glaring regulatory and enforcement issue for the industry.

In laundering, manipulators buy and sell an asset among themselves to create the impression that the asset is more in demand and therefore worth more than it otherwise would be. With NFTs, wash trading is pretty straightforward: Imagine an investor has $1 million in Ether (ETH). The investor creates an NFT and proceeds to sell it to themselves for all the ETH they own. The transaction is then on the blockchain for 1 million dollars in ETH. The price of NFT is set through a wash trade for the benefit of the individual who minted the NFT.

It might be tempting to think that this is a “victimless” crime since it’s unlikely that any money actually changed hands if it was a wash trade, but that’s untrue. By rewarding allegedly fake high-volume traders with real money, NFT investors risk losing millions to scammers, and legitimate traders can be tricked into overpaying for their investments.

Related: GameFi developers could face big fines and hard time

These fraudulent transactions also drive Gresham’s Law (bad money drives out good money) in crypto, driving out legitimate investors and traders as the exchange’s reputation is tarnished.

When it comes to NFTs, however, the rules are not so clear. Such tokens may not be securities, so the same laws and regulations governing securities trading may not apply to them.

The background on laundry trade laws

Wash trading has been banned in the United States since the passage of the Commodity Exchange Act in 1936 in response to its popularity as a manipulation tool. Since then, however, the Securities and Exchange Commission and the Commodities Futures Trading Commission have scrutinized the markets and taken a number of enforcement actions against “wash traders”, thereby adding some degree of certainty to the securities and futures markets.

According to the SEC, “Wash trading is an abusive practice that misleads the market about the genuine supply and demand for a stock.” Meanwhile, the US Internal Revenue Service prohibits taxpayers from deducting losses resulting from wash sales, so it is entirely possible that NFTs for wash sales could lead to an enforcement action. It depends on how NFTs are classified by regulators.

Traders should carefully examine the sales history before buying NFTs

Accepting the idea that cryptocurrencies tend to be volatile, along with the slow pace of enforcement actions against new assets such as NFTs, it seems natural that many sellers would try to inflate the asset’s value to attract new buyers and Make Money. NFT buyers should think twice and do their due diligence before making a significant investment in an NFT.

It may appear that they are getting a valuable asset due to the number or size of transactions that the investment has been involved in, but the truth may be that the asset was only bought and sold between two wallets owned by the same person making the asset appear more in demand than it actually is.

The SEC is likely already preparing its first NFT traders

Even with laws and enforcement measures, we still see laundering in the mainstream securities and commodities markets, so you can be sure that it exists in newer and developing markets. Hopefully the SEC is already working on enforcement in the NFT market. Investigations are generally non-public, so some traders may already be under scrutiny. It’s a safe bet that in the long term, federal regulators will catch up with this new asset class, and wash trading among NFTs will also be limited.

Related: Smart NFT traders take advantage of crypto’s unregulated landscape by laundering trades on LooksRare

The SEC should move to protect investors, first by deciding that NFTs will be treated as securities, and then monitoring exchanges for signs of manipulation as they do for other asset classes.

Brendan Cochrane, Esq., CAMS is the blockchain and cryptocurrency partner at YK Law LLP. He is also the principal and founder of CryptoCompli, a startup focused on the compliance needs of cryptocurrency businesses.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.