While these modern means have given the masses the benefits of financial access, they’ve created opportunities for fraudsters to conduct crypto-based crimes.
To address this, governments classify blockchain and crypto service providers as VASPs and impose Anti-Money Laundering (AML) regulations. This requires crypto companies to implement thorough Know Your Customer (KYC) processes to scrutinize their clients.
In simple words, brands must implement diligent identity verification procedures. So how to stay safe and conduct proper KYC checks to avoid hefty compliance fines?
Get ready to stay ahead of the game in the crypto world with our ultimate guide to KYC in 2023! We’ll cover the following highlights:
- What is KYC in blockchain?
- How to implement KYC?
- What is AML in blockchain?
- Why do crypto startups need KYC?
- How are crypto exchanges performing KYC?
- What are the benefits of KYC for crypto startups?
- How to tackle the challenges of KYC checks?
- What’s the future of crypto with KYC?
What is KYC in Blockchain?
Companies that use blockchain technology, like crypto exchanges, NFT trading sites, and online marketplaces, must follow KYC rules set by the government in their area.
Key facts to remember:
- KYC is the get-to-know-your-client procedure blockchain financial services conduct before allowing potential users to transact via the platform.
- KYC is not a bypass procedure for blockchain financial services.
- The use of KYC in blockchain fintech products poses a necessity for customer due diligence (CDD).
What is Customer Due Diligence?
CDD allows brands to identify their customers and understand who they are. Through the process of client validation/KYC, brands get to know those eligible by comparing provided legal documents with rules and regulations set aside by the governments.
The legal documents involve data such as:
- Full name
- Date of Birth
- Phone number
- Country and address of residence
- Identification cards
- OTP validation
While the mentioned lists seem to be basic, there are regions that enforce stricter compliance to crypto exchanges, such as stated by the Financial Crimes Enforcement Network (FinCEN) in 2019 that it expects cryptocurrency exchanges to follow the Travel Rule.
Before the Travel Rule: Companies that did wire transfers with regular money flow had to share certain information.
Today: This rule now requires financial companies and VASPs to gather and share information about who is sending and receiving funds in a transaction. This also refers to crypto transactions.
Interesting fact: The Travel Rule is similar to regulations that already exist in other countries, such as the Bank Secrecy Act in the US, which requires sharing data for transfers worth $3,000 or more.
What are the Main KYC Processes?
KYC processes have various use cases and can be implemented through three main processes explained below:
- Customer Identification Program
This is the first set of data collations gathered from customers who show interest in using the platform by signing up. This process can include legal document identification, facial recognition, address verification, and risk scoring. Meanwhile, bigger companies might need to tender special documents as set aside by regulations before giving access to a user.
- Customer Due Diligence
This process becomes more critical when users begin to transact suspiciously. CDD becomes more effective when users are from high-risk countries or transact an amount bigger than their limits. Necessary processes for validating this type of event are implemented to ensure customers are not breaking the rules.
- Continuous Monitoring
This procedure concentrates on how users or customers can change with time, for example, customers could have fallen on the government sanction list offline after a successful onboarding process on the crypto exchange platform.
To read more about continuous monitoring, check out our AML Screening and Ongoing Monitoring guide.
What is AML in Blockchain?
AML in blockchain ensures all funds that are being traded in a blockchain firm remain legal.
Blockchain provides users with the use of a pseudonymous identity which could be a web3 naming service or the native alphanumeric wallet addresses.
This could make malicious workers carry out illegal activities easily and become untraceable. Thankfully, using AML schemes and following regulations puts all customers in check via specialized models, which include monitoring transactions, vetting accounts, and using an adaptable risk-based strategy.
Why Do Crypto Companies Need KYC?
To stay safe and build a safe tool in the crypto space, regulating bodies in Europe expect crypto and crypto service providers to comply with its AMLD5 and AMLD6 legislation. Also, in the USA, FinCEN clarifies that virtual currencies and platforms which they trade are subject to anti-money laundering legislation.
And there’s a good reason for that. Companies involved in illicit activities or those that avoid sticking to compliance regulations risk can even end up being charged. Let’s look at some examples below.
Lessons Learned from Recent Non-Compliance Cases
The Bitzlato Case
The recent Bitzlato experience is one of the major reasons why crypto companies need KYC. The cryptocurrency firm owner and some key shareholders were charged with processing 700 million dollars in illicit funds.
The main reason was the deficient KYC procedures that paved the way for criminals to launder money from drugs and ransomware easily.
The Tornado Cash Case
Also, in 2022, the US government punished a company called Tornado Cash for being involved in money laundering. The crypto mixer was said to have laundered 7 billion dollars worth of virtual currencies. Unfortunately, this landed the founder in jail.
Some of the laundered money was stolen by a group of hackers supported by the North Korean government. Apparently, the crypto business was also used to clean up money from two other hacking attacks.
What are the Benefits of KYC for Crypto Companies?
While there are still strong debates on if regulations should exist for blockchain services or not, major companies that venture into the field of onboarding customers via KYC processes tend to add a huge security benefit and increase their market value.
Here are some KYC examples explaining how identity verification can benefit businesses:
- Enhancing transparency and trust: KYC forms a trust bond between the users and the brand. Users are legitimately assured of data and funds safety. Illegitimate users won’t consider using brands that are KYC oriented so as not to get caught
- Reducing risks of identity theft: Robust identification service providers, including iDenfy, help instantly detect fraudsters who use fake and stolen identities to take advantage of any platform and launder money.
- Ensuring robust money laundering prevention: KYC processes make every single user identifiable and traceable, meaning their every transaction becomes traceable. When users bear this fact in mind, they take their fraudulent practices like money laundering to less secure platforms.
- Minimizing legal risks: When brands shy away from compliance and regulations, they become open to governmental risks and threats, which might lead them to paying outrageous fines. Consequently, identity verification helps ensure KYC compliance and prevents getting caught up in fraudulent activity.
Keep in mind that, like many digital spheres, cryptocurrency can be risky. People who own digital assets become victims of attackers who have the goal of stealing their money. This can also cause the prices of cryptocurrencies to change quickly, making the market unstable.
To be safe with crypto, it’s important to learn about it and take steps to protect your money. As for businesses, it’s vital to build a multi-step security system to prevent criminals from stealing funds.
How Are Major Crypto Exchanges Performing KYC?
In the world today, crypto exchanges are the easiest means by which users can buy or withdraw crypto. Regulations vary in different regions, and some exchanges have decided to get their brands registered with countries that do not enforce compliance laws.
So, what does that mean?
First of all, this, in effect, will only pose the companies with illegitimate financial transactions with an increased rate of dishonest users.
Second of all, some exchanges, such as Coinbase, allow users with basic means of identification to send and withdraw crypto, whereby they request full subjection to their KYC procedure when they want to buy and sell.
Also, let’s not forget Binance. It is another major exchange that gives users limited access to withdrawals without KYC. This means to enjoy and gain full access, the KYC process needs to be done.
Crypto exchanges that want to operate in the US region follow compulsory compliance by requesting users’ PII, valid government ID card, and SSN.
Tackling Challenges in KYC Checks
Manual and automated KYC checks are the main identity verification types out there. The use of manual checks amasses a lot of challenges for the brands and the users. Some of them are listed below:
- High costs: Manual KYC processes are highly expensive since abiding by regulations would require more hands to gather to verify and validate data relying on human speed. Small enterprises and medium-sized crypto companies that are not rich enough could run out of business if available funds become insufficient to pay staff.
- Lack of speed: Relying on human efforts, before all KYC could be duly validated, customers would have to wait and abide by time frames provided by such crypto companies.
- Human error: Malicious users could get so smart with legal documents or other means of identification which might be so difficult for humans to verify and authenticate. The use of human effort tends to point out a high rate of efficiency and thereby posing threats to such businesses.
Automated checks help to tackle all challenges amassed by manual methods. Through the use of automated KYC processes, financial institutions can foster onboarding, validating, and effortlessly making brands follow KYC and AML regulations without losing genuine customers and eliminating malicious users.
Future Trends of KYC in the Crypto Industry
The rise in high money laundering activity on both centralized and decentralized crypto platforms has only added up to the loss of customer funds and mistrust. All blockchain services that serve as financial instruments, stores of value, or are used on VASPs will be regulated for KYCs to curb malicious activities and make blockchain a safer tool.
The FATF update to the AML Travel Rule does require not only customer identification at the KYC level but also the details of transactions and the users involved.
Besides stricter rules and updates, users think regulations would bring centralization to decentralization and then politicize crypto-centralized services. And, despite this narrative, they are only seen as conspiracies because innovations like ZK proofs will most likely redefine how crypto companies can efficiently follow compliance rules and still satisfy users’ decentralization needs.
Would you like to find out how iDenfy can assist in maintaining KYC compliance at your crypto platform? Let’s continue the conversation.