Know Your Customer (KYC) is the first anti-money laundering (AML) due diligence stage. When a financial institution (FI) onboards a new customer, KYC procedures are implemented to identify and verify the customer’s identity, these processes enable financial institutions to assess the customer’s risk profile based on their propensity for financial crime.

Most CEXs are regulated as financial institutions, so they must integrate KYC processes into their AML programs.

KYC refers to the process that cryptocurrency exchanges must go through to:

  • Confirm their end users’ and customers’ personal information
  • Acquire a better understanding of the activities of their potential customers and verify their legality.
  • Determine the probability their customers pose money laundering risks.

What is Crypto Transaction Monitoring?

A cryptocurrency transaction monitoring system helps crypto exchanges and FIs discover anomalous or suspicious activities to report to regulators and track criminals. Transaction monitoring observes the risk associated with a cryptocurrency wallet. Virtual asset exchanges use tools provided by companies like Chainalysis, Elliptic, Crystal Blockchain, Coinfirm, etc., to monitor transactions.

KYC Process

To comply with KYC measures, cryptocurrency exchanges must take the following steps:

  • ‍Step 1: Collect their customers’ personally identifiable information (PII), including their full name, place, date of birth, and address.‍
  • Step 2: Compare this information to their official government-issued identification, such as a passport or state-issued driver’s license, and proof of residence, such as a utility bill.
  • ‍Step 3: Verify the customer’s identity against official databases that contain information on Politically Exposed Persons (PEP) and sanctioned individuals.

These steps help financial institutions determine each client's virtual currency money laundering and financial crime risk. If everything checks out, the customer is permitted to engage in certain activities on the cryptocurrency exchange.

Benefits of Crypto KYC?

Despite operational adjustments and obstacles connected to implementing KYC standards, cryptocurrency exchanges benefit significantly from regulatory compliance for the reasons listed below:

  • Less money laundering and scams: A 2022 report from blockchain analytics company Chainalysis suggested that around $8.6 billion in cryptocurrency was laundered for nefarious activities in 2021. This is a 30% increase over the previous year. Vigorous identity verification can significantly reduce fraudulent activity and improve market reputation.
  • ‍Reduced legal risk: As legal requirements evolve, having robust KYC processes allows businesses to stay ahead of the curve. Once implemented, companies can focus on increasing conversion rates, expediting transactions, and assuring compliant transactions. Moreover, by proving KYC due diligence, businesses can reduce legal and regulatory risks.
  • ‍Increased market stability: The cryptocurrency market is notoriously volatile due to anonymous transactions that may be suspicious. KYC programs that feature increased identity verification contribute to the market’s overall stability and value growth.

The Gray Area

It is possible to purchase virtual assets without performing KYC. Crypto ATMs and decentralized exchanges (DEXs) don't require KYC. Crypto ATMs let users buy cryptocurrency using cash or debit cards, while DEXs are blockchain-based peer-to-peer markets that permit large-scale crypto asset trading. DEXs do this using automated algorithms rather than acting as financial intermediaries.

Exchanges without KYC

Uniswap and Bisq are widely used decentralized exchanges without KYC. On these platforms, cryptocurrency sellers are matched with buyers based on order prices and volume, adding and subtracting from a "liquidity pool." A liquidity pool is a pot of crypto assets utilized to clear purchase and selling orders that appear. End-users provide the assets rather than centralized liquidity providers.

Crypto Travel Rule

In 2019, the Financial Action Task Force, an intergovernmental body that initiates anti-money laundering (AML) policies for G-7 and an additional 30 developed countries, recommended a coordinated approach to combat money laundering and terrorist financing. The rule, formally known as FATF Recommendation #16, requires VASPs to communicate the information of the originators and beneficiaries of crypto transactions that exceed a certain threshold. More specifically, the regulations require VASPs to exchange information regarding the originator’s and beneficiary’s identities whenever the amount transacted is above $1,000.

In essence, whenever crypto worth over $1,000 is transacted between two parties, the crypto service provider of the sender is expected to communicate the personally identifiable information (PII) of the sender to the crypto service provider of the recipient and vice versa. While this is a given, member states can choose to interpret this guidance and implement versions that best suit their local crypto industries.

For instance, the threshold at which the crypto travel rule kicks in the U.S. is $3,000 (i.e., the regulations come into play when the value of the crypto transaction exceeds $3,000). In such cases, VASPs are required to exchange information regarding the amount transacted, the execution date and the identity of the crypto service provider.

In addition to the extra information required by individual regulators, FATF recommends the following data ought to be transmitted back and forth by VASPs:

  • The names of the sender and the recipient
  • The address of the sender
  • The account number of the sender and the recipient

The primary goal of this Rule is to prevent terrorist financing and money laundering and a second-order effect of the same is to integrate the crypto market into the existing financial industry, allowing for a more organized and mature class of assets to emerge.

The Drawbacks

  • Concerns regarding information confidentiality are the most visible backlash here. Privacy-based laws and the FATF Travel Rule may have a counter-productive impact and create perplexity, further downsizing the market.
  • Restrictions change from country to country. This regional nonuniformity in enforcing this legislation is known as ‘The “Sunrise Problem”. It has been re-iterated by various experts that solving the Sunrise Problem is one of the significant paths leading to crypto mass adoption.
  • The additional cost of compliance bore by the crypto corporations is a point of concern as this discourages new market entrants and further reduce the market size.

Cryptocurrencies have, from their beginning, focused on decentralization and freedom from intermediaries. As mentioned, anyone can make a wallet and hold crypto without providing details about themselves. However, for these reasons, crypto has become a popular method for laundering money.

Also, given the ambiguity within which lending and similar practices in DeFi operate, KYC can significantly help. Lenders can more easily assess their risk by establishing a customer’s identity and financial history. This process leads to more responsible lending and risk management.

KYC processes are an industry standard for financial services and crypto exchanges. It’s one of the most critical functions in the fight against money laundering and other crimes. KYC checks can feel like an annoyance, but they provide great security.