Know Your Customer and Anti Money Laundering, KYC and AML for short, are two of the basic fundamental requirements that regulators in the United States want every crypto exchange to adhere to if they want to establish their business within the United States boundaries.
There are many other legalities that each crypto-related organization has to follow and fulfill, but we are focusing on these two. They are discussed most of the time by the general audience, especially KYC, since these are the details every new crypto investor or trader has to submit before they are allowed to trade on any crypto exchange.
So, what are these two requirements, and why do they matter in the world of crypto? We are going to discuss them here.
What is KYC?
Know Your Customer (KYC) is an identity check in which any person who is opening an account on a crypto exchange for the first time is required to provide all his credentials to a financial service provider so that they can verify their identity.
The KYC process is a part of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) compliance, which means that this information is required to eliminate the potential of any financial crimes being committed on the crypto exchange platform.
The other purpose of asking customers to fill in this information in the respective KYC portal of any exchange account is to ensure that the customers do their due diligence.
The KYC process is more of a proactive approach because the exchanges collect all the necessary information required from the customer before they allow them to trade on their platform, so these customers know that they have nowhere to hide if they commit any illicit activity on the exchange.
On many platforms, you can create your account on a crypto exchange without filling out the KYC section, but you won’t be allowed to trade on the platform. Rather, you utilize the account as a viewing window for all the cryptocurrencies listed on the exchange and see what price action is occurring at any given time.
Suppose you are wondering how KYC can ensure that a person would think twice before doing anything they aren’t supposed to. In that case, the answer is that when the customer provides all their personal information, including legal government-issued IDs, they know that they have equipped them with all the tools necessary to track them if they think of running away from the law.
These are the potential list of verifications you may asked to provide when completing the KYC process on the exchange:
- Government ID.
- Driving License.
- Passport.
There are different levels to the KYC requirements set by various exchanges. The reason for providing these different levels is that at intensives, users can give more details like their bank statements and tax records, and in return, they would be allowed to make larger withdrawals.
For example, if we look at the KYC tiers of Binance exchange. Then, they have three different tiers.
Verified (Tier 1): This is the basic level of verification, requiring only your government-issued ID and a selfie. It allows you to deposit and trade up to 2 BTC per day.
Verified Plus (Tier 2): This level requires additional information like proof of address and facial recognition verification. It increases your daily deposit and trading limit to 20 BTC.
Enterprise Verification: This is a custom tier for businesses and institutions with higher volume needs. Requirements and limits are negotiated on a case-by-case basis.
How is KYC compliance regulated?
KYC regulations may vary across different countries, but there is a mutual understanding among countries for some basic level information requirements. In the United States, the Bank Secrecy Act and the 2001 Patriot Act outline the various AML and KYC processes seen in today’s crypto landscape.
Countries in Europe and the Asia-Pacific region have their own sets of regulations when it comes to establishing KYC requirements. Still, they do share some similarities with the U.S.-defined rules as well.
The primary foundation for regulatory frameworks in European Union (EU) countries is established by the EU Anti-Money Laundering Directive (AMLD) and PSD2 regulations. On a global scale, the Financial Action Task Force (FATF) plays a crucial role in facilitating multinational collaboration concerning regulatory conditions.
Why do we need KYC in crypto?
If crypto exchanges or organizations don’t ask users to fill out their KYC requirements, then some users might take advantage of the situation.
The crypto world has the inherent nature of allowing users to use pseudonyms instead of their actual identities to conduct transactions and transfer funds to different accounts, which is against the financial guidelines of any country.
They can also indulge in criminal activities like money laundering or tax evasion and get away with it because no one would know which person is committing these crimes. With proper verification, they would be able to trace that person as well.
Requiring KYC procedures in blockchain transactions also addresses the challenge of irreversible transactions.
KYC checks help connect real-world identities to cryptocurrency addresses, promoting accountability and reducing the risk of fraudulent or mistaken transactions.
In case of issues, identities that are verified through KYC assist in investigating and resolving problems, offering a layer of protection for users in the absence of a central authority to reverse transactions.
By confirming a customer’s identity and financial history, lenders can streamline the assessment of risk. Using this approach promotes responsible lending practices and enhances overall risk management procedures.
Lastly, KYC procedures contribute to building trust between users and crypto platforms. Knowing that adequate measures are in place to verify user identities can attract more users and investors to the crypto space.
Criticism of KYC Practices
While we have shown you why KYC requirements are necessary and why, as a responsible member of the crypto community, you should adhere to fulfilling these requirements, some critics are against this concept.
The regulators believe that there are no justifiable objections regarding why anyone would critique the necessity of the KYC process. Still, these critics argue that the KYC process impacts their privacy and is an added cost that they need to appreciate. What they mean by that is:
- KYC checks incur additional costs for crypto exchanges and financial institutions, including expenses related to verification processes, personnel, and technology. These operational costs are often passed onto customers by wrapping them as a part of fees charged by the exchanges.
- Certain individuals may lack permanent addresses, which can prevent them from using the services of any crypto exchange simply because they can’t fulfill the KYC requirements that the exchange demands from them.
- Those exchanges that lack essential data security measures pose a risk of a possible data breach, which means that confidential customer information may get leaked and could potentially be used for identity theft and various crimes.
- Critics also argue that KYC undermines privacy and the core principles of decentralization, as it introduces a level of centralization by requiring users to disclose identifiable information.
What is AML?
Anti-money laundering Laws were introduced in the financial sector to combat the illicit activities of converting black money into white money.
In other words, it is a battle against those entities that acquire money through illegal processes and then wash it or convert it into white money, which means they show that the money they possess is earned in a perfectly legal and ethical manner when, in reality, it was acquired through illegal means.
The introduction of Anti-Money Laundering (AML) laws can be traced back to various points in time, as different countries implemented measures to address the growing concern of money laundering.
The Financial Action Task Force (FATF), an intergovernmental organization founded in 1989, played a significant role in shaping and promoting global AML standards.
In the United States, the Bank Secrecy Act (BSA) of 1970 was one of the earliest pieces of legislation focused on combating money laundering. Over the years, numerous countries have enacted and updated their AML laws to address evolving threats and align with international standards.
With the evolution in technology, the methods through which money can be laundered have also evolved as perpetrators have found new ways using modern methodologies to launder their money.
These activities necessitated the introduction of anti-money laundering (AML) software that flags activities like significant fund transfers and repeated inflows into the same account and cross-checks these transactions against established watchlists. If the accounts used in these activities are on the watch list of the financial authorities, then they may ask the exchanges to intervene.
It’s important to note that AML regulations extend beyond cryptocurrencies, encompassing all assets and fiat currencies.
What is the difference between AML and KYC?
| Feature | KYC (Know Your Customer) | AML (Anti-Money Laundering) |
| Focus | Customer identification and verification | Preventing money laundering and terrorist financing |
| Objective | To mitigate fraud, identity theft, and financial crime by understanding who customers are | To detect and prevent the flow of illicit funds through financial systems |
| Regulations | Varied by country and industry, but often driven by FATF recommendations | Primarily international treaties and national laws |
| Requirements | Collect and verify customer information (name, address, ID) | Monitor transactions for suspicious activity, report to authorities |
| Data used | Customer personal information | Transaction data, source of funds, beneficiary information |
| Outcome | Verified customer profile, risk assessment | Detection and reporting of suspicious activity, prevention of illicit funds movement |
| Enforcement | Fines, sanctions, reputational damage | Fines, imprisonment, seizure of assets |
| Example | Verifying identity with government ID before opening a bank account | Identifying and reporting large cash transactions |
What is money laundering, and how do people do it?
Money Laundering is the process that criminals use to disguise illegal funds acquired through various illicit activities as legitimate earnings. Activities like drug trafficking, terrorism, bank fraud, etc, are normally the source of these activities from where criminals usually gather their money.
Different laws across the globe are designed to combat this issue, and work is being done by various regulatory authorities led by the Financial Action Task Force (FATF) to align these rules across different jurisdictions.
Three principal steps are involved in the money laundering process:
- Placement, which is introducing illicit funds into the financial system.
- Layering, which involves moving funds to obscure their origin. Using cryptocurrencies has become increasingly popular among these actors because it offers increased anonymity.
- Integration, which involves reintroducing money cleaned through laundering back into the financial landscape through legal investments.
Traditional methods include using cash-based businesses with fake receipts, but the rise of digital currencies and online payment networks like PayPal adds complexity. Anonymizing tools such as VPNs further challenge tracking, making it difficult to pinpoint individuals involved in laundering.
Strategies like following blockchain trails and monitoring exchanges aim to counteract this. Still, the use of online gambling sites has emerged as a favored method, allowing criminals to legitimize funds through bets, often using multiple accounts to avoid suspicion and Anti-Money Laundering (AML) checks.
How does AML measure work?
There are different ways anti-money laundering processes are carried out to ensure that users who want to exploit their use are stopped from conducting these illegal activities.
- The first step in implementing AML laws is to flag suspicious activities on accounts that are seeing large inflows and outflows of funds. If the transaction history of these accounts doesn’t suggest that these activities are normal or if they are not known to have carried such a balance before, then these accounts are subjected to investigation to ensure nothing illegal is going on.
- Another step in implementing AML laws is to block the user’s account, which means you are blocking his access to deposit or withdraw more funds. If the transactions are legitimate, then the user will have no objection to confirm their source and fulfill the legal obligations to reopen his access. If not, then the step can prove vital to stop further laundering activities. Investigators also make a Suspicious Activity Report (SAR), documenting their findings and notifying relevant authorities about the potential illicit activities associated with the user’s account.
- Lastly, the evidence gathered from activities that are flagged illegal are provided to relevant authorities along with the evidence. Two actions can take place from here. The first is to find and investigate the entity that is responsible for carrying out these illegal transactions. The other is that if these illicit or stolen funds are found, then they can be returned to either the original owners or confiscated by the state.
Cryptocurrency exchanges are required to adopt a proactive stance towards Anti-Money Laundering (AML) measures.
Given the considerable regulatory scrutiny faced by the crypto sector, exchanges are expected to exhibit a level of vigilance and caution that surpasses the mandated requirements.
The primary tools employed in combating money laundering schemes are thorough transaction monitoring and the implementation of enhanced due diligence.
If you have any doubt about the regulatory pressure on these exchanges, then the recent case of Binance getting fined by the U.S. DOJ will give you a detailed picture of how failing to adhere to these regulations will result in heavy fines.
Among the transgressions Binance was charged with, not implementing proper AML was also the reason why the exchange was fined heavily.
Final Thoughts on KYC and AML in Crypto
The implementation of Know Your Customer (KYC) and Anti-Money Laundering (AML) measures within the crypto landscape serves as a crucial safeguard against fraud, money laundering, and illicit activities.
KYC ensures user accountability, builds trust, and aligns with international regulatory frameworks. Simultaneously, AML acts as a formidable deterrent against the misuse of cryptocurrencies for criminal endeavors.
While some critics argue about privacy concerns and operational costs, the undeniable need for these protocols is underscored by the global efforts of regulatory bodies.
Striking a balance between security and user privacy, KYC and AML collectively fortify the integrity of cryptocurrency exchanges in a rapidly evolving financial landscape.
