Reading time: ~ 2 m
The Financial Action Task Force on Money Laundering has outlined its views on cryptocurrency, including views on NFT and decentralized finance.
Financial Action Task Force on Money Laundering (FATF) released the highly anticipated Guide to Virtual Assets, which outlines the standards that could change the crypto industry in the United States and around the world. The guide aims to address one of the most important challenges for the cryptoindustry: convincing regulators, legislators and the public that it is not conducive to money laundering.
The guidance is especially concerned with those parts of the crypto industry that have recently caused significant regulatory uncertainty, including decentralized finance (DeFi), stablecoins, and intangible tokens (NFT). The guidance is largely in line with the new US regulatory approach to DeFi and stablecoins. On a positive note for the industry, the FATF appears to be less aggressive towards NFTs and perhaps calls for speculation that NFTs are not virtual assets. However, the guidelines open up the opportunity for members to regulate NFTs if they are used for “investment purposes”. We expect this indication to add fuel to the fire of the NFT rally, which continues for most of 2021.
Expanding the definition of virtual asset service providers
The FATF is an intergovernmental organization tasked with developing policies to combat money laundering and terrorist financing. While the FATF cannot create binding laws or policies, its leadership has significant influence over anti-terrorist financing and money laundering (AML) laws among its members. The US Treasury is one of the government agencies that generally follows and complies with the rules based on the FATF guidelines.
The long-awaited FATF leadership is taking an “extended approach” to expand the definition of virtual asset service providers (VASP). This new definition includes the exchange between virtual assets and fiat currencies; exchanges between several forms of virtual assets; transfer of digital assets; storage and administration of virtual assets; participation and provision of financial services related to the offer and sale of a virtual asset.
Once an organization is labeled as a VASP, it must comply with the applicable requirements of the jurisdiction in which it does business, which typically includes the implementation of anti-money laundering (AML) and anti-terrorism programs. And also, be licensed or registered with the local government and are subject to supervision or monitoring by that government.
Separately, FATF provides a broad definition of virtual assets:
“A digital representation of value that can be digitally traded or transferred, and used for payment or investment purposes.” But excludes “digital representations of fiat currencies, securities and other financial assets that are already covered in other provisions of the FATF Recommendations.”
Taken together, the definition of VA and VASP, the FATF appears to extend AML, anti-terrorism, registration and monitoring requirements to most players in the crypto industry.
Impact on DeFi
The FATF guidelines for DeFi protocols are not so clear. The FATF starts with a statement:
“The DeFi application (ie software) is not a VASP according to the FATF standards as the standards do not apply to the underlying software or technologies …”
The leadership does not stop there. Instead, the FATF explains that the creators of the DeFi protocol, owners, operators, or others who maintain control or sufficient influence over the DeFi protocol “may fall under the FATF definition of a VASP if they provide or actively promote VASP services.” It is further explained in the guide that DeFi project owners / operators who qualify as VASPs are distinguished by their “attitude towards the activities undertaken”. These owners / operators can exercise sufficient control or influence over the assets or project protocol. This influence can also exist by maintaining “ongoing business relationships between them and users,” even if it is “exercised through a smart contract or, in some cases, voting protocols.”
In line with this, the FATF recommends that regulators not only accept claims of “decentralization”, but instead conduct their own scrutiny. The FATF goes so far as to suggest that if there is no managing entity on the DeFi platform, the jurisdiction can order the VASP to be created as a legally binding entity. In this regard, the FATF has done little to change the regulatory status of most DeFi players.
Impact on stablecoins
The new guidance confirms the organization’s previous position that stablecoins – cryptocurrencies whose value is tied to a store of value such as the US dollar – fall under FATF standards like VASP.
The guide addresses the risk of “mass adoption” and examines the specific design features that affect AML risk. Specifically, the guide points to “central stablecoin governing bodies” that “will generally be subject to FATF standards” as a VASP. Based on its approach to DeFi in general, the FATF argues that claims of decentralized governance are not enough to avoid regulatory oversight. For example, even when the governing body of stablecoins is decentralized, the FATF encourages its members to “identify committed organizations to mitigate the associated risk, regardless of institutional structure and name.”
Management encourages VASP to identify and understand the AML risk of stablecoins prior to launching them on an ongoing basis, and to manage and mitigate the risks prior to the introduction of stablecoin products. Finally, the FATF invites stablecoin providers to seek a license in the jurisdiction in which they primarily conduct their business.
Impact on NFT
Along with DeFi and stablecoins, NFTs have skyrocketed in popularity and now form the backbone of the modern crypto ecosystem. In contrast to an expansive approach to other aspects of the cryptoindustry, the FATF reports that NFTs “are generally not considered virtual assets under the FATF definition.” This may suggest that NFTs are not VAs and their issuers are not VASPs.
However, as with its approach to DeFi, the FATF emphasizes that regulators must “consider the nature of the NFT and its function in practice, and not the terms or marketing terms used”. Specifically, the FATF states that NFTs that are “used for payments or investment purposes” can be virtual assets.
While management does not define “investment objectives,” the FATF likely intends to reach out to those who buy NFTs with the intention of selling them later for a profit. While many buyers buy NFTs because of their connection to an artist or work, most of the industry buys them because of their ability to add value. Thus, while the FATF’s approach to NFTs does not appear to be as broad as its guidance for DeFi or stablecoins, FATF countries can rely on the formulation of “investment targets” to introduce stricter regulation.
What the FATF guidance means for the cryptoindustry
Management is closely monitoring the aggressive stance of US regulators towards DeFi, stablecoins and other major parts of the crypto ecosystem. As a result, both centralized and decentralized projects will come under increasing pressure to comply with the same AML requirements as traditional financial institutions.
Going forward, DeFi projects, as we are already seeing, will delve deeper into DeFi and experiment with new governance structures such as Decentralized Autonomous Organizations (DAOs) that are approaching “true decentralization.” Even this approach is risky, as the broad definition of VASP given by the FATF creates problems for key smart contract signers or private key holders. This is especially important for DAOs because signers can be classified as VASPs.
Given the FATF’s broad interpretation of who “controls or influences projects,” crypto entrepreneurs face a tough battle, not only in the United States, but around the world.