My mother had this problem with a cousin of mine. He would come over and try to steal stuff that belonged to my brother and I and make a point of defying any little 'no soda on the carpet' rules and that sort of thing. His parents would object quite angrily when my mother would call him on that sort of behavior, but she would do it anyway. He hasn't turned out to be a very pleasant individual...
Ultimately, it's your house, and you aren't forcing them to stay there. You set the rules, and if they don't like them, they can leave. I think my parents came down on my cousin because they didn't want the other kids in the family to think that his sort of behavior was ok, but without any kids of your own, that isn't an issue for you.
It isn't your job to parent this kid, but you're inevitably going to be the adult-in-charge sometimes. Try to agree with your sister on a set of rules that you can both enforce to some degree of uniformity. If she really just wants to let him do whatever he wants to at 3 years old that's her decision as a parent, but you've got a pretty heavy voice in this too as the provider of housing.
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