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

The Financial Action Task Force (FATF) released his long awaited guide on virtual assets, setting standards that have the potential to reshape the crypto industry in the United States and around the world. The guide addresses one of the biggest challenges for the crypto industry - convincing regulators, legislators, and the public that it doesn't facilitate money laundering.

The guide is particularly related to the parts of the crypto industry that have recently caused significant regulatory uncertainty, including decentralized finance (DeFi), stablecoins, and non-fungible tokens (NFTs). The guidance largely follows the emerging approach of US regulators towards DeFi and stablecoins. On a positive note to the industry, the FATF appears to be less aggressive towards NFTs and arguably asks for a presumption that NFTs are not virtual assets. However, the guide opens the door for members to regulate NFTs if they are used for "investment purposes." We hope this guide adds fuel to the NFT rally that has been underway for most of 2021.

Related: FATF Guidance Draft Targets DeFi with Compliance

Expanding the definition of virtual asset service providers

The FATF is an intergovernmental organization whose mandate is to develop policies to combat money laundering and terrorist financing. While the FATF cannot create binding laws or policies, its guidance exerts significant influence on anti-terrorist financing and money laundering (AML) laws among its members. The United States Department of the Treasury is one of the government agencies that generally follows and implements regulations based on FATF guidance.

The long-awaited FATF guidance takes an "expansive approach" to broadening the definition of virtual asset service providers (VASPs). This new definition includes exchanges between virtual assets and fiat currencies; exchanges between multiple forms of virtual assets; the transfer of digital assets; the custody and administration of virtual assets; and participate in and provide financial services related to the offer and sale of a virtual asset.

Once an entity is labeled as a VASP, it must comply with the applicable requirements of the jurisdiction in which it operates, which generally includes implementing anti-money laundering (AML) and anti-terrorism programs, be licensed or registered with your local government. and be subject to the supervision or monitoring of that government.

Separately, the FATF define virtual assets (VA) in general terms:

"A digital representation of value that can be traded or transferred digitally and can be used for payment or investment purposes." But it excludes "digital representations of fiat currencies, securities, and other financial assets that are already covered elsewhere in the FATF Recommendations."

Taken together, the FATF definition of VA and VASP apparently extends AML, counter-terrorism, registration and monitoring requirements to most players in the crypto industry.

Impact on DeFi

The FATF guidance regarding DeFi protocols is unclear. The FATF begins by stating:

"The DeFi application (that is, the software program) is not a VASP under the FATF standards, as the standards do not apply to the underlying software or technology ..."

The guide doesn't stop there. Instead, the FATF then explains that the creators of the DeFi protocol, owners, operators or others who maintain sufficient control or influence over the DeFi protocol "may fall under the FATF definition of a VASP where they are actively providing or facilitating VASP services. ". The guide goes on to explain that VASP qualifying DeFi project owners / operators are distinguished "by their relationship to the activities performed." These owner / operators can exercise sufficient control or influence over the project assets or protocol. This influence can also exist by maintaining "an ongoing business relationship between them and users", even when "exercised through a smart contract or, in some cases, voting protocols."

In keeping with this language, the FATF recommends that regulators not simply accept claims of "decentralization and instead carry out their own diligence." The FATF goes as far as to suggest that if a DeFi platform does not have an entity to run it, a jurisdiction could mandate that a VASP be established as an obligated entity. In this regard, the FATF has done little to move the needle on the regulatory status of the majority of players in DeFi.

Related: DeFi: Who, what and how to regulate in a world without borders and governed by codes?

Impact on stablecoins

The new orientation reaffirms The organization's previous position that stablecoins (cryptocurrencies whose value is tied to a store of value like the US dollar) are subject to FATF standards like VASP.

The guide addresses the risk of "mass adoption" and examines specific design features that affect AML risk. In particular, the guidance targets "stablecoin central governing bodies" that "will generally be covered by FATF standards" such as a VASP. Relying on its approach to DeFi in general, the FATF argues that claims of decentralized governance are not enough to escape regulatory scrutiny. For example, even where the governing body of stablecoins is decentralized, the FATF encourages its members to "identify reporting entities and ... mitigate relevant risks ... regardless of institutional design and names."

The guidance asks VASPs to identify and understand AML risk of stablecoins prior to launch and on an ongoing basis, and to manage and mitigate risk before implementing stablecoin products. Finally, the FATF suggests that stablecoin providers should seek to obtain a license in the jurisdiction where they primarily conduct business.

Broadcast: Regulators are coming for stablecoins, but what should they start with?

Impact on NFTs

Along with DeFi and stablecoins, NFTs have exploded in popularity and are now a major pillar of the contemporary crypto ecosystem. In contrast to the expansive focus on other aspects of the crypto industry, the FATF cautions that NFTs “are generally not considered [virtual assets] under the FATF definition. "Arguably, this creates a presumption that NFTs are not VAs and their issuers are not VASPs.

However, similar to its approach to DeFi, the FATF emphasizes that regulators must "consider the nature of the NFT and its role in practice and not what marketing terminology or terms are used." In particular, the FATF argues that NFTs that are "used for payment or investment purposes" may be virtual assets.

While the guidance does not define "investment purposes", the FATF is likely intended to cover those who purchase NFT with the intention of selling it at a later time for profit. While many buyers buy NFT because of their connection to the artist or work, a large part of the industry buys them because of their potential to increase in value. Therefore, while the FATF's approach to NFTs is apparently not as broad as its guidance for DeFi or stablecoins, FATF countries can rely on the language of “investment purposes” to impose stricter regulation.

Related: Non-fungible tokens from a legal perspective

What the FATF Guidance Means for the Crypto Industry

The FATF guidance closely follows the aggressive stance of US regulators regarding DeFi, stablecoins, and other important parts of the crypto ecosystem. As a result, both centralized and decentralized projects will come under increasing pressure to meet the same AML requirements as traditional financial institutions.

Moving forward, DeFi projects, as we are already seeing, will delve into DeFi and experiment with new governance structures, such as decentralized autonomous organizations (DAO) that are approaching "true decentralization." Even this approach is not without risk because the expansive definition of VASP from the FATF creates problems with key signers of smart contracts or private key holders. This is particularly important for DAOs because the signers could be classified as VASPs.

Given the expansive way the FATF interprets who "controls or influences" projects, crypto entrepreneurs will have an uphill battle ahead not only in the United States but also around the world.

This article was co-authored by Jorge pesok Y John bugnacki.

The views, thoughts and opinions expressed here belong solely to the authors and do not necessarily reflect or represent the views and opinions of Cointelegraph.

This article is for general information purposes and is not intended to be and should not be construed as legal advice.