The Dark Side of NFT

When trying to explain or even define an NFT, it is usually very tempting and easy to fall into one of two traps.

On the one hand, it is possible to glorify the concept and describe it as a “new future” where any artist or creator is able to sell the tokenized version of their art without actually losing the ownership rights. On the other hand, there is a severe skepticism trap, when defining NFT turns into shaming any individual or company engaging with it, calling it a “passing fad”, and being extremely suspicious towards any cryptocurrency-related transaction.

In reality, NFTs fall somewhere in the middle of the spectrum between extreme loyalism and extreme skepticism. The majority of skeptics usually come from a place of confusion and hardship to understand a novel concept. At the same time, new followers of the NFTs see only rising values of the tokens, the possibility to profit, and new opportunities for the artists. And of course, there is also the environmental aspect running like red line access to the novel concept.

Much has been said about the benefits of NFTs and their progressive nature. We decided to dig deeper and, after defining the concept in the clearest way possible, look into its darker side. Tag along for the ride.

What are NFTs and where did they come from?

An NFT or Non-Fungible Token is a name for any unique digital asset. The part “non-fungible” in NFTs stands for “irreplaceable”. It’s just that the term “Irreplaceable Tokens” does not sound as catchy, as the term “IT” has been claimed already. The most commonly known examples of NFTs are art pieces and unique in-game items. At the same time, bitcoins are not NFTs, as they are interchangeable. 

The history behind NFTs goes back to 2012-2013 with the appearance of Colored Coins. These little rascals were representing small denominations of bitcoin used to represent various types of assets, including property and company shares. The main weakness of Colored Coins was the need to have a consensus in the network regarding their value. Even if a single person was no longer believing that 100 Colored Coins were worth 100 acres of property, the entire network was no longer functional.

 

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Next, there was Counterparty founded in 2014 that allowed asset creation on the Bitcoin blockchain with its own decentralized exchange and crypto token XCP. It even had its own game and meme trading. Furthermore, Spells of Genesis game pioneered the issuance of in-game-items via Counterparty in 2015 with its own token BitCrystals. Other trading games and rare Pepe memes started appearing on Counterparty in 2016. 

 

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Memes began appearing on Etherium in 2017 with the rise of its prominence, along with the new NFT project Cryptopunks that combined ERC721 and ERC20. Its founders allowed claiming Cryptopunk tokens for free to anyone with an Ethereum wallet, resulting in the appearance of the secondary market involving the trading of these tokens.

At this point, it is important to clarify the meaning of the ERC or “Ethereum Request for Comment”. This concept supports interactions between tokens in the network and their correct functioning. The most common standard was ERC20 because of its ability to ensure interactions with other applications and tokens. However, the creation of unique tokens required a new standard, which became the ERC721. Essentially, it is a technical standard for NFTs on the Ethereum blockchain that allows tracking ownership and movements of tokens within each block of the chain.

While the preceding tokens were flying under the radar, including because of their technical deficiency, the new game CrytoKitties that had its own NFTs using the ERC721 standard, hit the mainstream in 2017-2018. 


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Twitter

 

The launch of CrytoKitties coincided with the cryptocurrency bull market, contributing to the transaction values reaching $100,000 per token. In the following 2018 and 2019, the NFT ecosystem started expanding with SuperRare and OpenSea marketplaces gaining popularity and users. 

This brings us to the modern-day when NFTs went mainstream and many artists, musicians, influencers, vloggers, and even CEOs and owners of Space exploration companies are actively issuing, purchasing, or interacting with NFTs. For instance, an artist Beeple sold a collage of his digital art collection token for $69 million, as the CEO and founder of Twitter, Jack Dorsey sold an NFT of his first tweet for $2.9 million.

There is always a dark side

As we overwhelmed you with the information about standards, memes, and sky-high token sale prices, there is a key piece of information missing. Specifically, we need to answer the question: “Who is buying these tokens and what are their sources of funds?” The bad news is that with the majority of the mentioned transactions, the primary sources focus on an artist or a source of the NFT, rather than an individual or a business entity that made a purchase and their reasoning.

Another Bubble

Concerning the Beeple NFT and its purchase, CNBC was able to contact the person that bought it and to have an interview with him. Vignesh Sundaresan, known under his pseudonym Metakovan online, purchased the NFT with his friend. Vignesh Sundaresan is the Singapore-based founder of Bit Access, which is a Bitcoin ATM provider, as well as the founder of the Meta Purse NFT project. In his interview, he mentioned that he has been in the cryptocurrency industry since 2013 and saw an opportunity to become a part of the revolution in art as it was changing its medium. At the same time, Vignesh Sundaresan avoided stating his net worth or the capital he needed to acquire the Ethereum used for the purchase. 



 

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The transactions with the NFTs raise concerns about the sources of funds used, the ability to verify these sources, and further use of capital. For instance, it may be possible to use anonymity for making purchases of NFTs and selling them for a loss to get tax write-offs. In this situation, verifying the price of transactions in terms of their correspondence with the market may become an issue. 

The situation is very similar to the 2001-2002 dotcom bubble when investors were overvaluing Internet-based companies resulting in the bear market. For instance, the technology-dominated index Nasdaq rose from 1,000 to 5,000 points between 1995 and 2000. The bubble burst when it became clear that the majority of the Internet-based companies were unable to deliver projected performance. With the NFTs, it may end with their sudden depreciation in case the majority of the owners decide to sell simultaneously and tank the market.

On the other hand, it is also possible to compare the NFTs to physical art, where prices remain relatively high and depend directly on the perception of the buyers and expert community. The appraisers may provide their valuations that become the basis for the pricing of the art. For instance, it is common to hear stories of art found in possession of common households, as its value exceeds millions. The NFT space does not have a 3rd-party independent valuation, which adds volatility to the market and increases the likelihood of another bubble burst. 

Vulnerabilities in Technology and Legislation

The Financial Action Task Force (FATF) voiced similar concerns in the context of decentralized finance (DeFi) and Virtual Asset Service Providers (VASPs). Specifically, the FATF updated its Guidance on the risk-based approach to virtual assets and VASPs. The updates were classifying the DeFi platforms as VASPs, necessitating their compliance with the rule preventing and comparing financial crime. Thus, these platforms will need to adopt changes preventing money-laundering, financing weapons of mass destruction, and terrorism financing. The main issue with this approach is the inherent anonymity with the DeFi protocols, which makes it near impossible to know their developers and jurisdictions where they operate. 

The arguments against adopting the new FATF Guidance focus primarily on the peer-to-peer nature of the DeFi, implying that its participants are swapping, rather than engaging in transactions. Since these processes do not involve intermediaries, they should not fall under the category of centralized finance. Essentially, the FATF approach implies that the risks and current drawbacks outweigh the benefits of DeFi and NFTs. The good news is that the updates to the Guidance remain in the draft form, as the FATF wanted feedback from the industry. 

Recent findings suggest a substantial vulnerability of the NFTs, as these tokens usually point to a URL on the internet or an IPFS hash. The companies selling NFTs run these IPFS gateways, which ties the availability of the NFTs to the existence of these firms. Specifically, in case they cease existing, the owners of the NFTs might lose them. Case in point, the mentioned Beeple NFT refers directly to tan IPFS hash providing the JSON metadata using a public gateway:


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The IFPS referencing avoids the issue with broken URLs, but still ties each token to the startups that facilitate trading. The Beeple NFT points to the IPFS gateway run by makersplace.com. Thus, in case of possible issues with the company, the owners might lose their NFTs completely. The owners of the NFTs may have to buy out these companies to preserve their NFTs in case of any financial difficulties. In any case, these technical issues are concerning. 

The vulnerabilities in technology related to the NFTs also exist on the end of the users. Usually, these are unsecured accounts without the two-factor authentication (2FA) contributing to hacking. These instances result in the loss of crypto art and unauthorized purchases from credit card accounts

Scams and Money Laundering

There is also concern about the potential fraud in the NFT space related to the originality of the NFTs. Currently, the platforms are lacking mechanisms that would confirm that the artists creating artwork are also making NFTs. The only way artists are able to claim these scams is through direct contact with the marketplaces. For instance, the artist that was working for the Dota game complained that someone was selling her art as NFTs. She had to contact Valve and their legal department and go public on Twitter, to get a reaction. Only after these actions, these NFTs were removed. It is important to note that the source does not state whether the marketplace removed them or the scammer. Such lack of transparency is concerning from the standpoint of market reliability. 

While the majority of experts cite a wide range of risks related to money laundering, NFTs, and DeFi platforms, the majority of these are related to the unhosted wallets that fall outside of the regulatory environment. Nevertheless, these claims remain only in the form of allegations and lack any evidence behind them. Thus, it is possible to expect technical and legal safeguards preventing fraudulent activities in the future and considering these risks for trading strategies, collection, and other operations.

Where are the NFTs headed?

At this point, it is clear that NFTs are a part of the new industry rapidly evolving and gaining prominence. As the new phenomenon continues developing, it is natural to expect volatility, which remains relevant even for top-level cryptocurrencies, such as Bitcoin. The majority of experts are very conservative in their predictions, since the new FATF Guidance, along with the potential environmental and anti-fraud regulations could have significant effects on the NFTs. 

Given the timeline of cryptocurrencies that already comply with the anti-money laundering (AML) requirements, it is natural to expect an identical treatment of the NFTs. Similarly, the long-term strategies of the developed countries entail sustainable development through the minimization of diverse environmental effects. Thus, it is possible to expect tighter regulatory control over blockchains and NFTs. 


AMLBOT - Online scoring of crypto-addresses created by a team of Fintech specialists in line with international AML requirements.

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