Blockchain: Know Your Client and Know Your Provenance

July 1, 2021

Can Blockchain Help with Growing Anti-Money Laundering Regulations?

By Andrea Canzano.

The continued growth of New Media Art, including Non-Fungible Tokens (“NFTs”), online exhibitions, and online sales of physical works has shifted the art market into new territories. Similarly, the growing suspicion of money laundering in the market and the regulatory response have added further implications as Art Market Participants (“AMPs”) vie to remain relevant on an international scale. With the acceptance of NFTs as art and cryptocurrencies as payment, the new technology may offer an opportunity to consolidate compliance required while transacting in art.

As of 2021, the European Union and the United Kingdom require AMPs to register and conduct Anti-Money Laundering Customer Due Diligence audits while maintaining Know Your Client recordings. In the United States, as of January 1, 2021, only antiquities dealers are subject to Anti-Money Laundering (“AML”) regulations; however, it is likely that works of fine art will soon also fall under the purview Anti-Money Laundering Act of 2020.^[1] There are platforms currently available to assist AMP with auditing customers and tracking transactions for AML purposes. The secondary layer of AML compliance is to establish the artwork’s provenance yet authentication and establishing a continuous chain of title remains a challenge.

Similar to AML platforms that have been created directly for the purpose of easing the Customer Due Diligence and Know Your Client component of AML regulations, multiple platforms using blockchain have arisen to track provenance of artworks. Blockchain, often defined as an “incorruptible digital ledger”, offers a secured “digital passport” that contains all pertinent information regarding the artwork’s history and previous transactions.^[2]

The combination and integration of these applications may ease the compliance requirements for AMPs as current options primarily address a single aspect, yet both are important, not only for AML compliance but also general trust in the transactions.

Overview of AML Requirements

European Union and United Kingdom

The international concern over money laundering within the art market culminated in 2018 with the passing of the Fifth Anti-Money Laundering Directive (“5AMLD”) in the European Union (“EU”). Member states were required to implement the directive by January 10, 2020; however, the jarring effect of the pandemic on the art trade offers an explanation as to why only approximately 70% of members are currently in compliance.^[3] The Sixth Anti-Money Laundering Directive (“6AMLD”) implementation date passed on June 3, 2021, while making no specific mention of the art market participants, imposed significantly stricter standards for aiding and abetting money laundering, in hopes of forcing a harmonized compliance across the EU.^[4] Upon exiting the EU, the United Kingdom quickly went to work amending The Money Laundering, Terrorist Financing and Transfer of Funds Regulations 2017 to include the provisions of the 5AMLD applicable to the art market. The guidance requires that AMPs register with Her Majesty’s Revenue and Customs (“HMRC”) by June 10, 2021.^[5]

In general, each of the regulations requires a greater understanding of the persons behind the transactions, including their individual identity and their source of wealth, particularly when the individual is located in a high-risk country.^[6] The EU and UK regulations require that any “persons trading or acting as intermediaries in the trade of works of art,” including auction houses, galleries, and freeports, who complete a transaction or a series of transactions valued over EUR 10,000, must complete Customer Due Diligence (“CDD”) prior to sale.^[7] Any corporation or trust acting as an intermediary within a sale is required to complete proper CDD and must provide accurate information regarding the true beneficiary of the artwork.^[8] However, the UK clarified this definition stating that artists themselves will not be considered AMPs for the purpose of AML regulations. Further, AMPs must take into consideration if the beneficiary is a politically exposed person and must continually conduct CDD for already existing clients, ideally recording each audit to create the Know Your Client (“KYC”) record.^[9]

United States

On the other side of the ocean, the US joined this trend on January 1, 2021 with the passing of the Anti-Money Laundering Act of 2020 (“AMLA”), a small portion of the National Defense Authorization Act for Fiscal Year 2021. The Act requires antique dealers to follow standards imposed by the Bank Secrecy Act (“BSA”) and conduct a study regarding the scope and manner in which AMPs, in general, may be brought under the regulation. Similar to its EU and UK counterparts, antiquities dealers in the US are now required to conduct KYC due diligence, which includes determining the true beneficiary, verifying their identity, and cross-checking for any potential risk factors.^[10]

Implementing CDD and KYC

For those transacting with clients located European Union and the UK, implementing procedures to comply with CDD/KYC requirements have data security implications and reporting should the sale involve suspicious activity. International registration and reporting mandates have different requirements and all regulations require continual CDD despite having an established relationship with a customer. This requirement likely will make compliance more difficult for small to mid-sized AMPs attempting to compete on the global scale.

In the European Union, regardless of the currency invoiced, the EUR 10,000 threshold is based on the invoice cost (taxes, service fees, etc…) and not the work’s value being sold.^[11] Second, an AMP must register prior to completing transactions that fall within the scope of the regulations.^[12] Once registration has occurred, the AMPs must verify the customer’s information and if red flags are found, i.e. purchaser is a politically exposed person or from a high-risk country, the AMP is required to make a risk-based assessment if the transaction should continue. This process is called Enhanced Due Diligence and recording how and why the decision is made is crucial for protecting oneself.^[13] If there is a decision to not continue with the sale, a Suspicious Activity Report should be filed within the respective jurisdiction. Finally, as a high-level overview, the requirements of CDD are a continuous process and are often suggested to be performed on an annual basis.^[14]

There has been a multitude of art-centric CDD and KYC software that has been established in response to these needs, such as ArtAML and Arcata. ArtAML is a “platform designed for the specific needs of Art Market Participants” as it pertains to Anti-Money Laundering regulation, formally launched in December 2020. ArtAML is currently focused for the UK, however is broadly applicable to EU jurisdictions, and has plans to expand to the US as regulations develop. Arcarta is a similar platform created specifically for AMPs, however, is focused more specifically on the EU regulations. These platforms may assist in easing the burden of compliance and help protect the Money Laundering Reporting Officers and senior management from real consequences should a compliance audit be conducted and standards not reached. However, CDD/KYC compliance is not enough. For example, in the UK HMRC’s and the British Art Market Federation’s compliance guide reminds AMPs of the Proceed of Crime Act requirements, which includes not transacting in stolen goods, such as Nazi-looted art, or works whose acquisition may have come from criminal activity.^[15] Therefore, the provenance of an artwork or antiquity is of importance when complying with AML regulations, yet, has often proven more difficult.

Blockchain, Regulations, and “Practical” Application to Establishing Provenance

Virtual currencies are already being studied to formally come under AML regulations: the recent 6AMLD prompts member-states to ensure any risks associated with virtual currencies are “addressed appropriately.”^[16] It is also important to note that the EU is conducting a study regarding subjecting transactions carried out using virtual currencies and assets held by custodian wallet providers to AML regulations outright, the final report is set to be published January 11, 2022.^[17]

In the US, certain cryptocurrency exchanges are already subject to BSA legal requirements. Further, AMLA requires that “value that substitutes for currencies” and businesses who transact using these substitutions will be subject to AML regulations.^[18] With this in mind, the ability of blockchain technology to track transactions associated with digital or analog artworks may also be able to assist in maintaining accessible provenance for the purposes of AML compliance.

Currently, The Responsible Art Market’s Art Transaction Due Diligence Toolkit suggests that artwork provenance be established by compiling ownership and exhibition documentation, verifying the work’s authenticity, and cross-referencing databases such as the Art Loss Register or the Getty Provenance Index.^[19] According to Artnet’s Spring 2021 Intelligence Report, during the pandemic, there was a 1,056% jump in online sales and there is a high likelihood that transactions will continue digitally, apace.^[20] In adjusting, major brick and mortar auction houses and online platforms’ terms and conditions include a disclaimer of warranties, including claims regarding the listed provenance. From a historical perspective, this is likely to indemnify themselves from any instances of fraud or forgery or subsequent legitimate claims to an artwork’s title due to gaps in its recorded provenance. Hence, an accessible provenance tracking has AML implications for both the AMP and buyer in the transaction.

Notwithstanding, blockchain’s full dependency on user-inputted data and hence the availability of authentic provincial documentation, it may afford some practical assistance regarding AML compliance and provenance concerns. “‘Blockchain’ is literally a chain or stack of digital blocks containing information about a particular transaction, where each new transaction adds another block to the chain.”^[21] These blocks of substantiated historical provenance may be directly associated with the artwork and continuously accessible to AMPs and buyers. These “blocks” also afford the owner a place for subsequent documents to be stored, such as appraisal or contracts guaranteeing an NFT-based artwork will be continuously maintained and accessible by the seller. As the chain follows the artwork itself, either via a physical adhesive seal accessible via a phone or using an online database search, each subsequent transaction may be added as an additional block and its history is readily available.

The anonymity of the parties, in private sales, may also be protected. Currently on the OpenSea.io trading platform, pseudonyms are used and sellers and buyers are completely anonymous, yet each trade of an asset is recorded with the work so its entire ownership history is publicly available. As applied to the more traditional art world, platforms like Artory, Blockchain Art Collective, Deloitte Luxembourg, and Versiart have developed solutions to maintain the anonymity of the parties.

To begin, the quality of information is important and AMPs should confirm submitted registrations are verified as accurate representations of the work’s provenance in order to assist with their AML compliance.^[22] Similarly, blockchain offers a consistent ledger that notes any changes to already existing information on the artwork, providing an additional layer of reliability if implemented correctly.^[23] Finally, platforms such as CXIP Labs, are being developed to verify a minted artwork “offering greater security for buyers and artists alike” as well as noting when the artwork is being sold directly by the artists versus an intermediary.

In order to maintain anonymity between parties and maintain AML compliance AMPs and provenance platforms may utilize a public vs. private key. The public key is what can be seen by anyone, such as a buyer checking to see if an artwork of interest has a verified provenance while the owner may remain fully anonymous.^[24] But what happens when an asset transfers? The private key affords a verification that one anonymous user is the actual transferor to another anonymous user.^[25] As seen in Artory’s Terms of Service, collectors are provided with a “random vault log-in key” and the collector’s anonymity will remain intact to the extent of the user-directed communication within the site, as furthered by their Privacy Policy.

Conclusion

Regulations in the art market and digital sphere are rapidly evolving and colliding at a record pace for galleries, auction houses, and museums in both physical and digital art. The ability to provide integrated solutions will be important going forward particularly for the smaller players.

Blockchain technology is already being used in application for artist resale royalties and may be a way for beginning or mid-career artists to build a name for themselves while allowing the marketplace to set the value of works versus galleries and art appraisers. Further, platforms are being created to digitize information required for traveling exhibitions and intellectual property rights using Blockchain. Though there is still much work to be done, the consolidation of these types of platforms may be a welcomed ease in managing the growing legal mandates in the industry.

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Additional Reading:

• Art Transaction Due Diligence Tool Kit, The Responsible Art Market, (last visited June 30, 2021).
• Basel Art Trade Anti-Money Laundering Principles, Basel Institute on Governance (January 1, 2018).
• Sam Mire, 12 Startups Using Blockchain to Transform the Art Industry [Market Map], (December 25, 2018
• Sasha Shilina, Blockchain, Creativity and Arts Intertwine: Use Cases and Notable Projects, Medium (September 6, 2020).

Endnotes:

1. 31 USCA §5312 (a)(2)(Y) as amended by Pub. L. 116-283; Sheppard, Mullin, Richter, & Hampton LLP, Tokenized Art Legal Issues (2021). ↑
2. Louise Carron, Blockchain and the Visual Arts, Center for Art Law (2018). ↑
3. Directive 2018/843/EU of the European Parliament and of the Council of 30 May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, and amending Directives 2009/138/EC and 2013/36/EU, 2018 O.J. (L 156) 1. ↑
4. ComplyAdvatage The 6th Anti Money Laundering Directive (6AMLD): What You Need to Know (last visited June 4, 2021). ↑
5. Kingsley Napley LLP, Is the art world AMLD5 ready? (2021). ↑
6. Council Directive 2018/843, art. 18a(1)(c), 2018 O.J. (L 156). ↑
7. Id., art. 1 (1)(c); The Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017, SI 2017/692, art. 14 ¶ 1(Eng.). ↑
8. Council Directive 2018/843, 2018 O.J. (L 156),1. ↑
9. Id.; A politically exposed person ↑
10. 31 USCA §5318 (h)(2),(3); (i)(2)(B); (l)(2). ↑
11. British Art Market Federation, Guidance on Anti Money Laundering for UK Art Market Participants, 8 (2020). ↑
12. British Art Market Federation Guidance on Anti Money Laundering for UK Art Market Participants, 8 (2020). ↑
13. Artaml Ltd, How Well Do You Know Your Customer?: A Visual Guide to Anti-money Laundering for the Art Market for Private Sales (2020). ↑
14. British Art Market Federation, Guidance on Anti Money Laundering for UK Art Market Participants, 9 (2020). ↑
15. British Art Market Federation, Guidance on Anti Money Laundering for UK Art Market Participants, 12 (2020). ↑
16. Directive (EU) 2018/1673 of the European Parliament and of the Council of 23 October 2018 on combating money laundering by criminal law, 2018 O.J. (L 284), 1. ↑
17. Council Directive 2018/843, art. 1(2)(d), 2018 O.J. (L 156); art. 65 (1); AMLD6 came into effect on June 3, 2021, key changes may be found here. ↑
18. 31 C.F.R. § 1022.380; AMLA, § 6102. ↑
19. The Responsible Art Market is “a cross industry initiative formed in Geneva in 2015. RAM’s members span the entire spectrum of the art market from galleries, dealers, auction houses, advisors and service providers, to lawyers, academics and public prosecutors specialising in art related matters.” The Art Loss Register is “the leading due diligence provider for the art market, and maintains the world’s largest private database of stolen art, antiques and collectables.” The Getty Provenance Index “contains more than 2.3 million records taken from source material such as archival inventories, auction catalogs, and dealer stock books.” ↑
20. Julia Halperin, Data Dive, in Artnet News Spring 2021 Intelligence Report, 92 (Andrew Goldstein & Julia Halperin eds., 2021). ↑
21. Louise Carron, Blockchain and the Visual Arts, Center for Art Law (2018). ↑
22. Artory, How it Works (last visited June 4, 2021). ↑
23. Jacqueline O’Neil, How Smart Certificates Of Authenticity Improve Art Asset Management, MEDIUM (Jan. 17, 2019) (last visited June 4, 2021). ↑
24. Artory, Registration of Artworks and Using Your Vault (last visited June 4, 2021). ↑
25. Demiro Massessi, Blockchain Public / Private Key Cryptography In A Nutshell, MEDIUM (Oct. 15, 2018) (last visited June 4, 2021). ↑

About the Author: Andrea Canzano is a legal intern at the Center for Art Law and a second-year student at Brooklyn Law School, where she is the Vice President of the Art Law Association. She is also a Student Member of the New York City Bar Association, Art Law Committee. Prior to law school, Andrea worked in the industry and received her Master’s in Museums Studies from the City College of New York.