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

Financial Action Task Force (FATF), released its long-awaited guidance regarding virtual assets. It lays out standards that could revolutionize the crypto industry in America and elsewhere. This guidance addresses the biggest challenge facing the crypto industry: convincing regulators, legislators, and the public that it doesn’t facilitate money laundering.

This guidance addresses the areas of crypto that have brought about regulatory uncertainty recently, including stablecoins (DeFi), nonfungible tokens(NFTs) and decentralized finance (DeFi). This guidance follows the U.S. regulators’ approach to stablecoins and decentralized finance (DeFi). The FATF seems to be less hostile toward NFTs, and may even call for a presumption NFTs are not virtual asset. This is a positive sign for the industry. However, the guidance allows members to regulate NFTs if they’re used for “investment purposes.” This guidance will fuel the NFT rally, which has been ongoing for most of 2021.

Similar: FATF draft guidance targets DeFi compliance

Expanding the definitions of virtual asset service providers

The FATF, an intergovernmental organisation, has the mandate to create policies to fight money laundering and terrorist funding. Although the FATF can’t create any binding laws or policies among its members, its guidance has a significant impact on anti-money laundering and counter-terrorist funding laws. The U.S. Department of the Treasury, one of the government agencies that follows and implements regulations based upon the FATF’s guidance, is also one of them.

FATF’s eagerly awaited guidance adopts an “expansive” approach to broadening definitions of virtual asset service providers. This definition now includes virtual asset exchanges with fiat currencies, exchanges between multiple virtual assets forms; the transfer and administration of digital assets. It also allows for financial services related to the sale and purchase of virtual assets.

After being designated as a VASP entity, it must adhere to the requirements of the jurisdiction where it conducts business. This generally includes implementing Anti-Money Laundering and Counter-Terrorism programs. It also needs to be licensed or registered with the local government, and subject to monitoring or supervision by the government.

Separately, FATF defines virtual assets (VAs), broadly:

“A digital representation or value that can digitally trade, transfer, and be used for payment or investing purposes.” However, it excludes “digital representations or fiat currencies, securities, and other financial assets not already covered in the FATF Recommendations.”

Together, the FATF’s definitions of VAs/VASPs seem to extend AML, counterterrorism, and registration requirements to all players in the crypto sector.

DeFi Impact

The FATF’s guidance on DeFi protocols is not very clear. The FATF begins by saying:

DeFi application” (i.e. the software program) does not qualify as a VASP according to the FATF standards. The Standards are not applicable to underlying technology .

This guidance is not finished. The FATF continues to provide guidance. This influence may also be maintained by having “an ongoing business relationship between them and users”, even if it is “exercised via a smart contract or in certain cases voting protocols.”

According to this language, FATF suggests that regulators don’t accept claims of decentralization but instead conduct their own diligence. The FATF also suggests that jurisdictions could order that a VASP is established as the obliged entity for a DeFi platform that has no entity operating it. The FATF has not done much to improve the regulatory status of DeFi’s major players.

Related: DeFi: What, who, and how can we regulate in a code-governed, borderless world?

Stablecoins: Impact

This guidance confirms that the FATF’s prior position was that stablecoins, cryptocurrencies whose value is tied to a store value like the U.S. dollars, are subject to its standards as VASPs.

This guidance examines the risks of mass adoption and examines design features that impact AML risk. The guidance specifically mentions “central governance bodies for stablecoins”, which “will in general be covered by the FATF Standards” as a VASP. The FATF claims that claims of decentralized governance cannot be ignored regulatory scrutiny, based on its DeFi approach. The FATF encourages its members, regardless of institutional design or names, to identify obliged entities and… mitigate relevant risks, even when stablecoin governance is decentralized.

The guidance requires VASPs to understand and identify stablecoin’s AML risk prior to launch, on an ongoing basis, as well as to manage and mitigate that risk before they implement stablecoin products. The FATF recommends that stablecoin providers seek licensing in the jurisdiction where their primary business is conducted.

Reported: Regulators are looking for stablecoins. But where should they begin?

NFTs: Impact

NFTs are now an important pillar of the crypto ecosystem. They have gained popularity alongside stablecoins and DeFi. Contrary to other aspects of crypto industry, the FATF states that NFTs “generally are not considered to be [virtual asset] under the FATF definition.” This could create a presumption NFTs and their issuers not to be VASPs.

The FATF, however, emphasizes the same approach to DeFi. It says regulators must “consider the nature and function of the NFT in practice” and not just what marketing terminology is used.

Although the guidance doesn’t define “investment purpose”, the FATF likely intends to include those who purchase NFTs with the intention to later sell them for a profit. NFTs are often bought by people who have a connection to the artist or their work. However, many others buy them for their potential value. The FATF’s approach to NFTs may not be as broad as that for stablecoins or DeFi, but FATF countries could rely on the language “investment purposes” to impose more regulation.

Similar: Legal perspective on nonfungible tokens

What the FATF guidance means to the crypto industry

The FATF guidance closely follows the aggressive U.S. regulators’ stance regarding DeFi, stablecoins, and other important parts of the crypto ecosystem. Both centralized and uncentralized projects will be under increasing pressure to adhere to the same AML requirements that traditional financial institutions.

As we already see, DeFi projects will continue to expand into DeFi. They will also experiment with new governance structures, such as decentralized autonomous organisations (DAOs), that approach “true Decentralization.” However, this approach comes with risks. The FATF’s broad definition of VASPs poses problems with key signers of smart contract smart contracts and holders of private keys. This is especially important for DAOs as signers could be considered VASPs.

The FATF’s expansive interpretation of who “controls” or influences projects means that crypto entrepreneurs face a difficult battle not only in the United States, but around the globe.

Jorge Pesok, John Bugnacki co-authored this article

These views, thoughts, and opinions are solely those of the authors and do not necessarily reflect the views or opinions of Cointelegraph.
This article is intended for informational purposes only and should not be construed as legal advice.
Jorge Pesok is general counsel and chief compliance officers for Tacen Inc. (a top software development company that develops open-source, blockchain-based software). Jorge Pesok joined Tacen after gaining extensive legal experience advising technology firms, cryptocurrency exchanges, and financial institutions in front of the SEC, CFTC and DOJ. John Bugnacki is Tacen Inc.’s policy lead and law clerk. John is an expert in governance, security, and development. His research and writing have been focused on the crucial intersection of history, politics, economics, and other fields to produce effective analysis, dialogue, and engagement.

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