NFTs and compliance: Why we need to be having this conversation

“Good people do not need laws to tell them to act responsibly, while bad people will find a way around the laws.” — Plato

The above quote has withstood the test of time. Across industries, markets, communities and ideas, people ultimately will find a way to either do good or at worse, wrong. Nonfungible tokens (NFTs) and crypto are certainly no exception to the rule. The industry is exploding — overflowing even — with endless drops, jaw-dropping floor prices and adoption across ever-expanding corners of culture.

NFTs are moving forward at breakneck speed, and the money is there. According to data from market tracker DappRadar, NFT sales skyrocketed to $10.7 billion in the third quarter of 2021, up more than 8x from the previous quarter. That's a lot of Apes and Penguins.

Creators, brands, institutions — everyone is diving headfirst into this world right now. It's time to take a look around. At the end of the last year, we saw an alarming headline for the NFT space: The U.S. government made it illegal to buy a handful of NFTs after putting 57 cryptocurrency addresses and one exchange on the Treasury Department Office of Foreign Assets Control (OFAC) sanctions list. According to OFAC, the addresses identified were facilitating ransomware and money laundering. Reports for blockchain data company Elliptic reported that the total amount of crypto in the sanctioned wallet addresses surpassed $300 million.

Darknet markets and nefarious transactions

The Treasury Department named a Latvia-based exchange Chatex as responsible for facilitating these nefarious transactions, which they said related to "illicit or high-risk activities such as darknet markets, high-risk exchanges and ransomware." Elliptic noted this wasn't the first, but the second, time the U.S government has sanctioned an exchange — and the eighth total time crypto addresses have been sanctioned. While this was one of the first times the government specifically (and officially) flagged a malicious crypto address, these events have undoubtedly occurred many times in the past. Before NFTs, the art industry was a deep haven for money laundering. This issue has persisted for ages as the traditional art world has remained predominantly unregulated and resisted compliance requirements like Know Your Customer (KYC) and Anti-Money Laundering (AML).

Related: From NFTs to CBDCs, crypto must tackle compliance before regulators do

NFTs, and crypto, for that matter, have had a historically uphill battle to be viewed by the world as legitimate industries and not just dark networks for illegal activity. Beyond my work founding Shyft Network, where we help cryptocurrency firms comply with AML, the Travel Rule and build compliance into blockchain data, I wrote some of the first crypto regulations working to keep the sector safe. We've come a long way since 2010. And I mean, a long way.

What we saw earlier in the month with Chatex is likely a situation along the lines of dirty wallets taking their crypto, going to a marketplace like OpenSea, and buying and exchanging NFTs to use the process as a mixer to wash their money. This event is similar to when hackers steal Ether (ETH) and send it to a smart contract, which anonymizes the output to hide its source.

Battle-coded compliance

Just like we don't want security flaws in crypto that require government intervention, we don't wish to see security flaws in NFTs. We want to move forward. To do that, we need compliance infrastructure not only in crypto but also in the NFT industry — and the technology itself. We need battle-coded regulatory actions and compliance protocols, like KYC rules for any first-time customer transaction in the NFT space, to be coded into transactions.

It makes sense that development in NFTs, which has already been moving forward at a rapid speed, would grow to include technology that creates solutions for regulation. The same has happened for crypto at large and most industries that grow from something small to something massive, especially when institutional investors come into the mix. Whether it's investors, brands, or consumers, the list of "rug pulls" and downright illegal activity that has taken place is growing.

Related: FATF guidance on virtual assets: NFTs win, DeFi loses, rest remains unchanged

As NFT use cases grow and evolve outside of just collectibles (see: real estate, publishing, ticketing), they also present a unique opportunity for compliance technology. It might not be as sexy a conversation as you hear across other elements of NFTs, but it's still essential. Compliant NFTs can provide a strong tool for authenticating users, acting as credentials and even enabling people to create a credit history. This next generation of NFT technology can provide auditable guarantees on the reputation of users while at the same time allowing users' personally identifiable information to be protected on-chain.

Where next for NFTs?

So what's the next step? Currently, NFT's are being looked at by regulators based on the substance rather than the form of compliance. I would like to see KYC and AML requirements that are flexible enough to adapt to the many forms NFTs can take, be that artwork, digital tickets or a smart contract that doubles as a deed for a home. This implementation protects against someone buying a house from someone whose sources of funds can't be verified or who's suspected of carrying out illegal activities. The same level of care and protection should go for dropping your hard-earned ETH on a Pudgy Penguin (guilty).

We must create complaint NFT technology utilizing an on-chain KYC rules engine that can be customized so that a KYC policy from one marketplace or exchange can be made available across many at once, or pre-defined rules can be created around particular NFT platforms that users can choose to opt-in. The infrastructure we’ve built allows for the verification of digital identities with externally-linked NFT metadata to allow for investigations (when required) to happen seamlessly. In doing so, compliant NFTs will help provide a layer of certainty to buyers, marketplaces, investors and institutions who participate in transactions and power this incredible industry. Those who facilitate sales will know for sure if the asset (whatever it may be) wasn’t stolen or bought with dirty money. Total peace of mind.

NFTs have already smashed records and surprised even the most vocal critics who have questioned their legitimacy and sustainability in the last year. Now, to truly set up this industry for not just a "boom," but the next generation of mass adoption, we need to have secure systems in place to take us to the moon (safely).