Fraudsters, money launderers, and other miscreants are operating throughout the NFT marketplace. Andrew Pimlott outlines the problem and what the authorities are doing about it.
Non-fungible tokens (NFTs) may have captured the imagination of the public but they are an increasingly risky purchase. Not only have NFT values plummeted in recent months, in common with the entire cryptoasset market, but there is a growing likelihood of buyers being defrauded. NFTs are also being used by money launderers, tax evaders, sanctions violators, and other miscreants.
A high-profile fraud came to light only last month when U.S. prosecutors in the Eastern District of New York charged Aurelien Michel, a 24-year-old French national resident in the United Arab Emirates (UAE), with defrauding purchasers of Mutant Ape Planet NFTs of more than $2.9m in cryptocurrency.
The scheme involved selling NFTs to buyers who were promised numerous 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 fraud by which the seller pulls out before the project is complete, so the buyer is left with worthless assets and the seller disappears 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 fraud risks are high.
Law enforcement agencies and regulators are warning the public of the dangers and how to avoid them. At the same time, they are investigating and prosecuting offenders where they can and tightening up the laws and regulations surrounding NFTs.
NFTs Explained
A non-fungible token is a digital unit of data stored on a blockchain representing either a digital asset or a physical asset. The digital asset can be something like a digital work of art, video, or music. The physical asset can be something like a painting, house, or another real object.
“Non-fungible” means “not-interchangeable” because an NFT is unique and not interchangeable with other NFTs. This is in contrast to a cryptocurrency like ether, which is the same as other ether and therefore interchangeable with all other ether.
One of the best-known NFTs is 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 living in the Ethereum blockchain.” A Bored Ape NFT is not only “a provably-rare piece of art.” says the website, but it comes with a Yacht Club membership card and the buyer’s avatar for moving around the club.
Another venue for buying NFTs is Decentraland, a browser-based virtual reality world on the Ethereum blockchain which opened to the public in 2020. Buyers enter Decentraland as avatars, walk around, chat with others, and buy NFT land, property, art, and items from shops using the MANA cryptocurrency.
NFT Fraud Is Low, but on the Rise
The nature and scale of NFT fraud is laid out in the report NFTs and Financial Crime: Money Laundering, Market Manipulation, Scams & Sanctions Risks in Non-Fungible Tokens, published by Elliptic, a London-based provider of cryptoasset risk management services to businesses worldwide. It says that NFT crimes represent “a small but notable” portion of overall non-NFT-related trading activity.
Its key findings include:
• Over $100m worth of NFTs were publicly reported as stolen through scams between July 2021 and July 2022, netting perpetrators $300,000 per scam on average. July 2022 saw over 4,600 NFTs stolen – the highest month on record – indicating that scams have not abated despite the crypto bear market.
•Over $8m of illicit funds has been laundered through NFT-based platforms since 2017, representing 0.02% of trading activity originating from known sources.
• Tornado Cash, a U.S.-sanctioned mixer (a platform that mixes coins to disguise their origins) was the source of $137.6 million of cryptoassets processed by NFT marketplaces and the laundering tool of choice for 52% of NFT scam proceeds before being sanctioned by OFAC in August 2022. Its prolific use by “threat actors” engaging with NFTs emphasizes the need for effective sanctions screening by NFT platforms.
A U.S. Department of Treasury report last year – Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art – focused on traditional art but noted that “technological innovations in the digital art space also present potential money laundering challenges,” a reference to NFTs.
Aside from the Mutant Ape Planet case in January, there have been other prosecutions in the U.S. Rikesh Thapa, the co-founder and former chief technology officer of the NFT creating platform Blockparty, in December was charged with operating a scheme to defraud the company of more than $1m worth of U.S. 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 by using confidential information about what NFTs were going to be featured on OpenSea’s home page for his personal financial gain. The U.S. Attorney’s Office for the Southern District of New York said it was the first ever digital asset insider trading scheme. “NFTs might be new, but this type of criminal scheme is not,” said U.S. Attorney Damian Williams. “Today’s charges demonstrate the commitment of this Office to stamping out insider trading – whether it occurs on 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 purchasers of NFTs advertised as “Frosties.” When the Frosties sold out, rather than providing the benefits to purchasers, the defendants shut down the website and transferred the proceeds to their own cryptocurrency wallets.
Meanwhile, civil actions are being taken. For example, New York law firm Scott + Scott filed a class action lawsuit in a Californian court in December on behalf of plaintiffs Adam Titcher, Adonis Real, and others alleging that Yuga Labs, creator of the Bored Ape Yacht Club (BAYC) NFT collection, “inappropriately” induced investors to buy its NFTs. The investors are now seeking restitution for their losses.
The lawsuit alleges that Yuga violated securities regulations “by making false and misleading statements” concerning the financial benefits of the investments “as well as using celebrity promotors to lure in unsuspecting investors.” The celebrities included in the action include Madonna, Paris Hilton, Justin Bieber, Serena Williams, and Gwyneth Paltrow.
An article in The Art Newspaper, quoting from the court papers, said “the celebrity endorsement and misleading promotions …were able to artificially increase the interest and price of the BAYC NFTs…causing investors to purchase these losing investments at drastically inflated prices.”
Most of the publicized NFT fraud cases have been in the U.S., but a year ago the UK tax authorities seized three NFTs as part of an investigation into a suspected VAT fraud worth £1.4m involving 250 alleged fake companies. HM Revenue and Customs (HMRC) arrested three people and said it was the first UK law enforcement seizure of an NFT.
Tightening up 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 at closing regulatory loopholes. A key question is whether NFTs are investments and therefore regulated securities. In the U.S., the Securities and Exchange Commission (SEC) is looking into this according to sources such as Elliptic, the Financial Times, and regulatory compliance specialists.
Meanwhile, the U.S. Department of Treasury’s Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art report mentioned earlier, says that NFTs used as payment or investment could fall within the Financial Action Task Force’s (FATF’s) definition of “virtual assets,” meaning that firms and individuals buying and selling them could have to comply with U.S. anti-money laundering and terrorist financing obligations.
FATF, the Paris-based organization that leads global action to tackle money laundering and terrorist financing, published its Standards on Virtual Assets and Virtual Asset Service Providers in 2019. Countries incorporate these standards into their anti-money laundering and counter-terrorist financing regulations. 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 wash trading.”
Whether FATF’s virtual asset standards should be applied to NFTs depends on the type of NFT. If the NFTs are truly unique and used as collectibles rather than as payment or investment instruments, then they “are not virtual assets generally speaking for the purpose of the FATF Standards.” But if the NFTs are used for payments or investments, then the standards should be applied.
Threat Awareness
It is clear that the threat of NFT fraud is being taken seriously by the authorities. The U.S. is leading the way, not only by investigating and prosecuting perpetrators and tightening up the rules, but by increasing public awareness.
The Manhattan District Attorney’s Office is a case in point. Its “NFT Scams and Frauds” section on its website warns that the “explosion in consumers’ interest and investment in NFTs” has “also led to increased criminal activity.” It lists the main types of NFT fraud 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 sites selling NFTs are legitimate, and being aware of phishing attempts. They may be basic steps, but they have to be constantly repeated because so many people ignore them. A phone number is provided for people to call if they believe they have been defrauded or suspect someone of committing fraud.
As the NFT market continues to grow, so too will fraud risk. But if cryptoasset service providers, investors, and law enforcement agencies remain vigilant then the risks can at least be mitigated.
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Andrew Pimlott is Senior Managing Director, Financial Services, Data and Technology, EMEIA, Ankura Consulting.
© Copyright 2023. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.