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The J5 NFT Marketplace Red Flag Indicators Intelligence Bulletin

On April 28, 2022, the Joint Chiefs of Global Tax Enforcement (‘J5’) issued a risk and red flags bulletin that highlighted significant and moderate fraud risk considerations with regards to Non-Fungible Tokens (NFTs).

What is the J5?

Since being formed in 2018, the J5 have been committed to combating transnational tax crime through increased enforcement collaboration. Key efforts include working together to gather information, share intelligence, conduct operations, and build the capacity of tax crime enforcement officials. The J5 focuses on crypto (the threat of cryptocurrencies to tax administration), professional enablers (highly harmful, high-end facilitators of tax evasion), and platforms (developing effective tools and platforms enabling each country to share information in a more organized manner). The J5 is comprised of the following countries and agencies:

CountryAgency
AustraliaAustralian Taxation Office (ATO)
CanadaCanada Revenue Agency (CRA)
NetherlandsFiscale Inlichtingen- en Opsporingsdienst (FIOD-the Fiscal Information and Investigation Service)
United KingdomHer Majesty’s Revenue & Customs (HMRC)
United StatesInternal Revenue Service Criminal Investigations (IRS-CI)

Background knowledge: Common types of Crypto Assets

Common types of Crypto Assets may include:

  • Cryptocurrencies or otherwise referred to as payment tokens: used as an alternative to fiat, as a medium of exchange or a store of value;
  • Platform tokens: support decentralized applications (dapps) on blockchain platforms;
  • Utility tokens: offer the right to use a product or service;
  • Security Tokens: represent an investment product and most likely fall under securities laws;
  • Stablecoins: pegged to an underlying currency or asset;
  • Central Bank Digital Currencies (CBDCs): issued by a central bank and denominated in an existing unit of account, which serves both as a medium of exchange and a store of value;
  • Non-Fungible Tokens (NFTs)

NFT Definition and Background

NFTs are cryptographic assets that have unique characteristics, cannot be reproduced, thus each NFT being one of a kind, allowing it to be clearly distinguished between other virtual assets. “Contrary to fungible and inter-exchangeable tokens such as Bitcoin (any Bitcoin is similar, can be exchanged for another Bitcoin, which cannot be distinguished from one another), NFTs have unique properties, can be distinguished from one another, and cannot be duplicated.” Nevertheless, similarly to fungible tokens, NFTs can be easily transferred from one digital wallet to another, while ownership of NFT owners can be easily tracked via the blockchain. NFTs are important, since due to their unique properties, they can be associated with digital art, collectibles, in game items, real estate properties etc. allowing the tokenization or fractional ownership of an underlying asset. Popular digital art marketplaces include: OpenSea, SuperRare, Nifty Gateway etc. and in-games items include: Axie Infinity, Decentraland, Enjin, OpenSea, etc.

A large percentage of NFTs are presently created on the Ethereum and Polygon blockchains. Contrary to the majority of cryptocurrencies which are quoted, traded and discussed in fiat currency (i.e. the price of Bitcoin is quoted in USD/EUR etc.), NFTs are purchased at an agreed upon value using a corresponding cryptocurrency dependent upon which blockchain is being utilized. Taking examples from celebrities having purchased NFTs, Heidi Klum a supermodel, producer and a television host, purchased CryptoPunk NFT #3653 in Dec 2021 for 80 ETH (equivalent to $260,000). Canadian Grammy award winning artist Justin Bieber purchased Bored Ape Yacht Club NFT #3001 in Jan 2022 for 500 ETH (equivalent to $1.31 million).

CryptoPunk #3653 owned by Heidi Klum
CryptoPunk #3653 owned by Heidi Klum
Bored Ape Yacht Club #3001 owned by Justin Bieber
Bored Ape Yacht Club #3001 owned by Justin Bieber

J5 Intelligence Bulletin on Non-Fungible Token Risks and Red Flags

On April 28, 2022, the J5 released a first of a kind intelligence bulletin, titled “J5 NFT Marketplace Red Flag Indicators”. The bulletin warned banks, law enforcement personnel, and private citizens of certain risks when dealing with NFTs.

The J5 document highlights that most cryptocurrency owners and those purchasing NFTs, are doing so for righteous reasons; however, the space is changing fast, and it may attract criminals to look at ways to exploit new technologies. The document lists the best practices from the five countries in the J5 from their dealings with NFTs in various investigations, and highlights potential red flags in NFT marketplaces.

The purpose of the bulletin was to provide insight to banks, law enforcement partners, and private industry participants regarding potential red flags indicative of fraud in NFT marketplaces. It also provides a set of strong and moderate indicators that in isolation may not be sufficient; however, when more than one indicator is present, may be a definite indication for a fraud.

Significant Red FlagsModerate Red Flags
Newly minted or secondary market transactions of > USD $100,000 with no observable community.Smaller amounts broken down into Multiple transactions such as > USD $10,000 × 5, for a period, with no observable community. Caution should also be exercised when looking at this indicator in isolation as this might also be caused by software testing.
A network of sending and receiving parties to the same transaction or group of transactions. (sending each other NFTs back and forth)Re-used code within the NFT. It is also important to note that it is common to share code in the software development community, so this indicator alone is not definitive.
Newly minted NFTs held by subjects being sold at high price points immediately which is not in line with others in the collection (potentially hiding the true reason for purchase).Minting an NFT, buying it at an inflated price and selling for a considerable loss. For instance, a buyer acquires an NFT for $1M and sells it for $750K in a very short time. This might also be due to general volatility of the markets, so extra considerations would need to be made before coming to a conclusion.
NFTs being sold for large sums and reacquired from the same party or a third party for smaller amounts would be a strong indicator.No Thumbnail on marketplace profile. Note, like the other indicators above, this indicator in isolation is not definitive.
The turnover of low value NFTs quickly. For example, on Top Shots with the NBA you see a lot of low value (i.e. sub $10K) NFTs being bought in the same day with owners only holding their position for minutes. This could be a way to wash funds – so owning for very short periods.

No checkmark for verification on market profile (Note, like the other indicators above, this indicator in isolation is not definitive):

  • Verified accounts with a blue checkmark (OpenSea). However, legitimate accounts can be hacked by illicit actors who then use the accounts for their laundering/scams.
Clearly overpriced/underpriced NFT that is traded frequently in short time windows.Non-existent contract address (Ethereum) for traceability on the project (Note: some legitimate projects have also exhibited this).

  • No clarity on when and where the NFT was minted.
Wash trading – artificially increasing sale value with each sale, between linked accounts.Properties and project description fields of the NFT are empty or not clearly stated. (Note: some legitimate projects have also exhibited this).
Incorrect Mint Address – contract address doesn’t match address provided on project website.Significant number of sales in a collection purchased from same or clustered wallets
Requiring seed phrase from Ethereum wallet in addition to the MetaMask wallet address for a transaction to be executed.
Phishing scams: fake offers on NFTs, sent via email.
Fake token giveaways/airdrops.
Social media impersonation – unverified accounts that also have no active followership and engagement.
Similar NFT collections – copy to exploit for fraud
Significant number of sales in a collection purchased from a mixer
NFT collection from high-risk area
Price – If there is a huge price gap, normally lower, between the site and a legitimate marketplace then there is reason to believe it is a scam.

Impact of the NFT Market

Volume-wise, “IntoTheBlock’s” year-to-date chart shows that the global trading volume of NFTs grew almost 8-fold only in one year, from $830 million (May 23, 2021), to $61+ billion (May 23, 2022). Nevertheless, this volume represents only a fraction of the total capitalization of all crypto estimated at $2 trillion and a fraction of global GDP, estimated at $102.4 trillion (2021).

The United Nations Office on Drugs and Crime (UNODC) estimates that money laundering is between 2 and 5% of the global GDP, which is between $800 billion and $2 trillion each year. Compared to NFTs (and highlighted risks which still remain low), some argue that fully regulated and monitored traditional financial institutions get fined for millions of dollars each year, as they struggle to update the AML compliance processes and results.

Looking forward, it is anticipated that as more regulators regulate this fast-changing space, it will lead to customer confidence and credibility, a dimension which will push forward crypto adoption aggressively.

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