Understanding Know Your Customer Requirements for Cryptocurrency Exchanges
Like financial services, cryptocurrency exchanges have legal requirements to Know Your Customer (KYC). The goal is to better protect and maintain the assets and privacy of consumers in the onboarding processes.
What Is KYC?
KYC is a set of procedures critical to assessing customer risk and is legally required to comply with Anti-Money Laundering (AML) laws. KYC involves knowing a customer’s identity, financial activities and risk.
What Is KYC Crypto?
KYC for crypto is a set of steps cryptocurrency exchanges take during onboarding to verify customer identity and perform due diligence to understand their financial activities and risks. Those steps are legally required and, when executed correctly, should be relatively quick and secure.
During the KYC process, the crypto company obtains identifying information such as:
- Legal name
- Birthdate
- Address
- National ID number
Each country has different KYC requirements. Some call for ID documents. Others require customers fill out an online form to get an account.
Behind the scenes, the crypto company uses an identity verification service to ensure the identity is legitimate. Those identity procedures help protect the exchange and the financial system from money laundering, fraud and other financial crimes.
Crypto exchanges are often legally obligated to preserve account information with advanced security technology. Applying KYC for a crypto account is a standard and safe process.
What Is AML for Crypto?
Crypto Anti-Money Laundering (AML) covers the requirements for regulated exchanges to prevent criminals from performing transactions. The goal is to stop illicit funds from entering the legitimate financial system.
KYC is part of AML, which also includes creating and enabling policies, training, designated responsibilities and review procedures. Screening accounts against watchlists, monitoring transactions and deploying an adaptable risk-based approach to verification helps ensure an exchange is compliant with AML regulations.
What Are KYC Standards?
KYC standards help safeguard regulated organizations — such as banks, credit unions, financial firms and crypto exchanges — against fraud, corruption, money laundering and financial terrorism. KYC measures also inform investment advisors about a client’s risk tolerance and financial position.
Essentially, crypto exchanges must ensure their clients are who they claim to be. Several steps comprise KYC measures:
- Establish customer identity
- Understand the nature of clients’ financial activities and the legitimacy of their funding source
- Assess money laundering risks associated with customers
The KYC process can include digital identity verification, biometric identification and ID document verification.
KYC procedures are essential to ensuring transactional security between crypto exchanges and their clients by assessing and monitoring risk and potential illegal activity. Exchanges may pause a business relationship or refuse to open an account if a client fails to meet the minimum mandatory KYC requirements.
The pressure to conform to KYC standards increases as crypto becomes more mainstream and regulators ramp up penalties and fines.
Are Crypto Exchanges Money Service Businesses?
In the U.S., AML and KYC measures are mandatory for most crypto exchanges because they are defined as money service businesses (MSBs) under federal regulations. According to the Financial Crimes Enforcement Network (FinCEN), the Bank Secrecy Act (BSA) applies to companies that involve cryptocurrencies.
“The definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies,” according to FinCEN. “Accepting and transmitting anything of value that substitutes for currency makes a person a money transmitter under the regulations implementing the BSA.”
MSBs must register with FinCEN and are subject to AML controls and regulatory compliance regarding record keeping and reporting requirements.
KYC and Crypto Exchanges
Crypto exchanges enable fast digital financial transactions. But with ease of use comes vulnerability to illicit activity and privacy invasions.
That increases the need for powerful, efficient KYC. But it can be challenging because:
- Regulations differ around the world and are constantly evolving
- Different identity verification solutions use different technology
- Global markets and decentralized channels create loopholes and uneven enforcement
KYC does not have a single definition or rigidly accepted course for compliance across different countries and institutions, making for varying and often confusing verification requirements.
With hundreds of providers in the market, deciding which crypto trading platform to use can be challenging. But exchanges with strong KYC steps demonstrate they understand compliance requirements and take those obligations seriously. The top crypto exchange platforms require identity verification procedures to meet KYC requirements.
Some other crypto exchange considerations include:
- Ease of use
- Security and privacy measures
- Reasonable trading fees and requirements
- Coin availability
What’s Next for KYC and Cryptocurrency?
KYC regulations are evolving to defend against illegal financial activity and better protect the digital transaction space. Those regulations continue to adapt as crypto expands and innovates and new threats emerge.
Travel Rule
Following Financial Action Task Force (FATF) recommendations, regulators are increasing requirements for the Travel Rule, which would establish rules around originator and beneficiary information to monitor transactions.
Different industry groups are working to create coordinated systems to comply with those rules.
Decentralized Finance
Decentralized finance (DeFi) uses smart contracts to perform functions that were the sole domain of financial entities. The World Economic Forum has cited DeFi proponents’ views of the DeFi benefits.
“Open-source technology, economic rewards, programmable smart contracts and decentralized governance might offer greater efficiencies, opportunities for inclusion, rapid innovation and entirely new financial service arrangements,” according to a World Economic Forum report.
But DeFi protocols that enable financial transactions without KYC could open the door to money laundering or other illicit financial activities.
Non-Fungible Tokens
Non-Fungible Tokens (NFTs) are mathematically provable as unique, and their ownership is verifiable on a public blockchain. NFTs aren’t just fancy digital collectibles. They’re a way to bring foundational business concepts such as ownership and contracts into developing web 3.0 platforms.
Without KYC, though, money launderers could convert tainted funds into NFTs to hide their assets or cover a money trail with multiple transactions.
Custodial vs. Noncustodial Crypto Wallets
A customer’s crypto holdings reside on a blockchain, but how can a customer access them? A crypto wallet contains a customer’s private keys to keep crypto assets secure and accessible.
People can use a custodial or noncustodial wallet to store their assets. Most crypto wallets are custodial, in which a third party controls the private keys and holds more responsibility for fund security.
In eliminating third-party control, noncustodial wallets give consumers total control over their private keys and funds. They also provide anonymity because they don’t require registration with regulated exchanges.
KYC requirements around anonymous crypto wallets are not defined, but both the U.S. and the EU are starting to investigate.
The Metaverse
As the use of virtual worlds increases, how will people interact and transact safely?
“I think cryptocurrency will become the coin of the realm for the metaverse,” said Hal Lonas, Trulioo chief technology officer. “It just makes sense. And all those same concerns will travel with crypto into the metaverse. As we look at that financial bridge, as money moves across the boundary,” it will require scrutiny.
Why KYC Is Essential to Cryptocurrency’s Longevity
KYC regulations protect cryptocurrency systems by decreasing customer risk factors, enhancing fraud prevention and prioritizing AML standards. A comprehensive identity verification platform helps secure digital transactions for people and businesses. Compliance with KYC regulations also can increase customer confidence in crypto by creating a sense of trust and safety.
It’s up to exchanges to protect the privacy of their clients. As regulations become clearer about information that must be legally disclosed, exchanges that focus on privacy, security and compliance could find a competitive advantage and opportunities for growth.
