What Does KYC Mean for Crypto?

Know Your Customer has been used in traditional financial sectors to prevent fraudulent behavior and protect customers and the financial institutions that serve them. 

As cryptocurrency continues to mature, KYC serves a similar role for crypto platforms and the customers who use them.

This article covers the objectives of KYC, a quick history of Know Your Customer, and why it’s important. We’ll discuss how KYC federal regulations benefit compliant crypto exchanges and their users by improving security and mitigating risk.

Key Points About KYC

• KYC means “Know Your Customer,” and is the process of verifying customer identities. 

• The Know Your Customer standards are a part of the broader federal Anti-Money Laundering (AML) regulations required of all financial institutions. 

• KYC is an essential practice for all asset classes and regulated institutions around the world. 

• Outside of traditional financial products and processes, this requirement also applies to companies who deal in the cryptocurrency space.

What Is the Objective of a Know Your Customer Program?

The overarching goal of Know Your Customer (KYC) rules is to discern, with a high degree of confidence, that customers are who they say they are. The KYC process helps to identify and prevent money laundering, terrorist financing, and fraud. It works in concert with Anti-Money Laundering (AML) regulations.

Why Is Know Your Customer Important?

Know Your Customer and related AML regulations can benefit both financial institutions and their customers. These rules mitigate risk, improve security, protect institutional integrity, and keep bad actors off the books. 

In turn, regulators are satisfied, and customers can feel reassured and more trusting of the companies they do business with. If used effectively, KYC can also help replace obsolete verification systems, perform necessary services — like screening and registering new users — and ensure that high-profile transactions are fully compliant.

The History of Know Your Customer in the U.S.

The U.S. government has had regulations asking financial services companies to help them detect and prevent financial crimes for decades. Over time, regulatory processes have become more stringent, and regulatory agencies have responded and adapted to the modern challenges and risk factors in the financial industry. 

Timeline of Federal Regulations

• In 2001, as part of the USA PATRIOT Act, the United States Department of the Treasury detailed specific KYC processes that financial services firms must have in place.

• In 2013, the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) published interpretive guidance FIN-2013-G001 that declared that administrators or exchangers of virtual currency are money services businesses under the Bank Secrecy Act and FinCEN regulations. 

• In 2016, the Treasury elaborated on and applied the regulations to the FinTech sector. 

Now that we’ve explained the general timeline of federal regulations, the outcome of these requirements is that money service businesses are subject to the AML and KYC requirements of the Bank Secrecy Act.

3 Key Components of KYC

AML regulations usually leave the specifics of the KYC process up to the regulated entities, using a risk-based determination of the appropriate rules. These KYC programs generally include the following three essential components:

• Customer Identification Program (CIP): 

As part of a CIP, a firm identifies a potential customer and verifies the customer’s identity via reliable and independent data. 

The specific features and documents that need verification vary depending on the local jurisdiction. At a minimum, a firm gathers a client’s name, date of birth, and address. 

Other possible data include a social security number, driver's license, and passport. Some firms require videos or selfies as part of their identity verification, and others provide customers with a Know Your Customer form or template as the first step in verifying their identity.

• Customer Due Diligence (CDD): 

This type of due diligence is essentially a thorough background check of a prospective client. CDD seeks to understand any risk a new customer could potentially bring to a business and exposes fraudulent behavior. 

If warranted, some companies will use an enhanced due diligence (EDD) process, simply a deeper dive into assessing a potential customer’s risk level. EDD procedures are usually conducted manually by trained compliance officers. The process for following these EDD procedures can be highly rigorous depending on the person being vetted and the financial institution’s desire for subjectivity.

• Ongoing Monitoring/Risk Management: 

Sometimes, firms separate continuing monitoring and risk management, with risk management becoming a fourth step. 

However, these two steps serve the same purpose –  to nip any suspicious behavior in the bud. Any financial services company must continue to oversee its customers and their transactions thoroughly and consistently, paying particular attention to large or unusual transactions.

What Are the Advantages of Know Your Customer?

Know Your Customer can have a range of benefits. Here are a few of the main advantages. 

Reduces Financial Risk 

Know Your Customer was created for many reasons, and one important aspect of KYC is to reduce financial risk for the average consumer. There will always be some level of financial risk with any investment, but by putting regulations in place, this risk gets drastically reduced. 

Assures Regulatory Compliance

Several regulatory agencies are required to follow the processes set forth with KYC, so investors and consumers can rest assured that agencies must adhere to regulatory compliance as the standard. 

Allows for Customer Insights

A little insight into the customer’s needs and behaviors can go a long way, especially when there are standard requirements set up. This data can be used to understand customer needs better, and can help to shape new regulations and the use of technology. 

Improves Security and Builds Industry Trust

Everyone reaps the benefits of having a more secure financial environment. There will always be bad actors who will attempt fraudulent transactions or money laundering, but we are all safer with processes in place such as KYC.

Prevents Identify Theft

Unfortunately, identity theft is an ongoing issue, as well as other types of scams on consumers. Know Your Customer processes provide just one more deterrent for identity theft and similar criminal activity. 

Mitigates Money Laundering

Customer verification is just an extra step that helps to prevent money laundering behaviors. KYC processes deter money laundering, making it harder on criminals.

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What Are Some of the Limitations of Know Your Customer?

We’ve discussed some of the pros of Know Your Customer, but as with most regulatory processes and requirements, everything has its trade-offs. Let’s discuss the limitations of Know Your Customer. 

Lack of Standardization With Other Countries

One size does not fit all when it comes to standardizing KYC requirements across countries in various regions around the world. 

Cost Issues

Putting any regulatory process into place requires resources that require time and money. This is one of the downsides of having KYC requirements. These requirements involve operational costs and having the right technology in place as part of essential resources. 

Proponents of KYC argue that risk mitigation is worth the time and cost involved in the long run. 

Privacy Issues or Concerns

Because Know Your Customer requires customers to share their data, many people new to the process initially have concerns about the privacy surrounding that data. With fears surrounding data breaches or other ways data is misused, KYC has its share of privacy concerns. 

Customer Frustration

Even though it's known that KYC regulations protect customers and mitigate risks related to identity theft and fraudulent behavior, when a transaction gets flagged or delayed, it can be frustrating. 

When verification processes take extra time, customers can get impatient, and this is, unfortunately, a necessary part of the process. 

Creates Exclusivity Issues

Access to financial services is an ongoing concern. Those who are unbanked or lack the credentials to confirm identification can struggle to meet the criteria necessary for the regulatory processes with Know Your Customer. This can create exclusivity issues and has been cited as a con of KYC requirements. 

Know Your Customer and Cryptocurrency

Because the crypto industry is still relatively new, crypto regulations are still in the early stages of development both concerning their comprehensiveness and where and how they are applied. 

The reasons for KYC are the same as those behind KYC for more traditional financial institutions and businesses – to prevent illicit activities, such as fraud and any type of money laundering. 

Governments around the world are pushing for regulation and transparency for asset transactions that occur digitally, as is the case with cryptocurrency. 

Depending on their location, business principles, and licensing regimes, crypto exchanges conduct varying levels of Know Your Customer programs. Those cryptocurrency exchanges that comply with KYC regulations have a lower overall risk of fraudulent behavior occurring. This offers users a higher level of security and adds legitimacy to the crypto trading platforms that comply. 

Some cryptocurrency exchanges allow users to register an account without conducting a thorough KYC process, albeit with minimal functionality. These exchanges run the risk of regulatory noncompliance. Others allow onboarding new customers with an uploaded photo ID but with only a fixed small deposit and withdrawal limit. 

Crypto exchanges that want to permit the deposit, withdrawal, and transmission of large amounts of crypto, however, almost always need to vet their customers through a more comprehensive Know Your Customer verification process.

Proponents of strict KYC regulations in the crypto environment argue that these requirements contradict the decentralization and anonymity within the blockchain environment that makes it unique, compared to the more traditional finance sector. 

The role KYC plays in cryptocurrency is an important one and will continue to be, unless other types of guardrails are created to ensure security and trust. Discussions are ongoing about the balance of decentralization and privacy against security and trust within the crypto ecosystem.

To learn more about all things cryptocurrency, go to your trusted source, Gemini.