In today's digital landscape, brokers, exchanges and payment services are facing an ever-growing risk of operational, legal, and reputational damage due to the prevalence of online scams and fraud. To combat this, regulatory authorities have developed KYC procedures. In this article, we will discuss what KYC is, how it is done, and its importance for businesses and clients alike.

What is KYC?

KYC stands for "Know Your Customer." This is a process used by businesses in the financial services industry to verify the identities of clients and prevent fraudulent activities. KYC typically involves collecting documents such as a driver's license, passport, proof of residence, birth certificate, and more.

It is important to mention that KYC is just one part of the broader Anti-Money Laundering (AML) framework. Financial institutions and governments use Anti-Money Laundering compliance as a tool to combat financial crimes. AML encompasses many controls and procedures, such as AML training, detection of suspicious operations, KYC checks, and reporting. These measures are essential in order to maintain a secure financial system free of undesirable activities and fraud.

A brokerage service requires customers to complete a Know Your Customer process before signing up. KYC is an essential part of compliance with all relevant securities laws and regulations, and customers are made aware of this when they begin any financial activities with their broker.

Why is KYC Important?

First of all, KYC can protect customers and help to build trust with the company. The implementation of the KYC policy can help foster trust between customers and the company. Although identity verification may add an extra step to the onboarding process, customers will appreciate that their accounts are secure from potential theft or takeovers. By verifying user identities and monitoring for suspicious activity, KYC helps protect customer data while providing a safe and reliable platform. This can create a positive, trusting relationship between the company and its customers.

Secondly, KYC procedures protect companies from illegal operations.

KYC processes are not a silver bullet to prevent fraud, but the ability of businesses to identify their customers can help them prevent criminal activities such as money laundering and terrorism financing. Knowing who you are dealing with is an important step in keeping your business secure.

Finally, KYC is mandatory.

Failure to comply with KYC/AML regulations can come at a hefty price. In 2021 alone, financial institutions were fined $2.7 billion for violation of KYC and AML requirements, suggesting these laws are taken seriously by both legal authorities and the public alike. For this reason, any business operating in the financial industry must ensure they have an up-to-date KYC and AML program in place to remain compliant. Doing so could save them from severe penalties and legal ramifications.

What are the Requirements and Components of KYC Compliance?

KYC verification processes vary from one business to another, with different requirements and steps being put in place based on the specific needs of each organization.

Moreover, the precise requirements for customer identification and verification vary among jurisdictions. In Germany, for instance, companies must conduct video interviews with customers before verifying their documents, whereas this is not a mandatory procedure in the UK or other locales.

However, generally, there are several important components to achieving KYC compliance.

Customer Identification Program

A Customer Identification Program, or CIP, is a major part of the onboarding process and a first step to help businesses verify the identities of their customers in order to ensure they are who they claim to be.

The CIP procedure itself consists of collecting a set of four personal identifying pieces:
• name,
• date of birth,
• address,
• identification number.

For higher-risk individuals or situations, additional layers of verification can be added by requesting a selfie, running PII through authoritative databases, and assessing other signals such as IP addresses.

CIP is quite flexible, allowing for customization based on the company's needs. If you run a business, you can adjust CIP according to the risk levels and the services you provide. For example, companies can choose what documentation to collect from customers, such as driver's licenses, passports, SSN cards, or utility bills. Additionally, companies may choose to add biometric selfies to further verify customer identities, as well as additional layer signals on top of submitted information, such as email risk reports. There are also different approaches to when KYC should be conducted — e.g., when customers are creating an account, withdrawing money, changing account details, etc.

Customer Due Diligence

Financial institutions are legally obligated to protect against money laundering and other forms of financial crime, so they must follow specific Customer Due Diligence (CDD) requirements. This process involves verifying customers' credentials, assessing their risk profile, and monitoring for suspicious account activity. CDD is enforced by the Financial Crimes Enforcement Network (FinCEN).

Customer Due Diligence efforts vary depending on the type of business — the procedure can range from simplified to standard to enhanced CDD and involve verifying the identity of customers, understanding monetary thresholds for reporting and record retention, as well as adhering to FinCEN rules pertaining to different types of transactions. Businesses are expected to take a proactive approach to understand their customers and the regulations in order to safeguard their financial transactions.

Enhanced Due Diligence

For businesses that require an extra layer of protection, enhanced due diligence is a necessary component of the KYC process. This is a more thorough form of Customer Due Diligence that can help companies detect risks not picked up by standard due diligence processes and provide greater security for high-risk accounts. At certain financial institutions, Enhanced Due Diligence procedures are employed on client accounts belonging to Politically Exposed Persons (PEPs), Special Interest Persons (SIPs), those on sanction lists, and those with a high net worth.

Ongoing Monitoring

Once the initial KYC process is completed, it is important for banks and financial institutions to continue monitoring customer activities in order to detect any potential fraud or money laundering activity.

How exactly is ongoing monitoring done? Unexplainable spikes in activity, especially in areas known for financial crimes like money laundering, should be red flags for financial institutions. They should also remain vigilant when it comes to ensuring that there are no new additions to PEP, sanction, or adverse media lists. After that, if suspicious activities are identified, they are reported to FinCEN as well as other appropriate authorities.

Ongoing monitoring is an essential part of compliance with Anti-Money Laundering regulations. Companies must stay vigilant when it comes to their customers' transactions, as any suspicious activity could result in serious legal consequences.

KYC and Cryptocurrency

It is no secret that cryptocurrencies are not regulated by any authority in most jurisdictions and are completely decentralized, which are often exploited for a variety of illicit activities such as money laundering and tax evasion.

Due to the irreversible nature of blockchain transactions and the anonymity of crypto wallets, there is a risk that funds can be lost or stolen without any way to retrieve them. Furthermore, as cryptocurrency taxation and legality are still uncertain in some regions, businesses must implement KYC checks to ensure that their operations always remain compliant.

Cryptocurrency exchanges, ICOs, and other related services have a unique challenge when it comes to KYC and AML compliance. Without a centralized authority or regular oversight, it is crucial that these businesses adhere to the necessary procedures to protect both their customers and themselves. Also, KYC helps protect the reputation of the industry, which is important for long-term success.

Bottom Line

KYC is a critical process for businesses to undertake in order to protect customers and themselves against financial crime. By understanding who their customers are and conducting ongoing monitoring, companies can detect any suspicious activity and ensure compliance with relevant regulations. Cryptocurrency exchanges and other crypto projects must take an even more proactive approach to KYC and AML compliance, as the risk of illicit activities is higher in this industry. Ultimately, KYC provides an important layer of security that safeguards both businesses and customers alike.