The Importance of the Know Your Customer Process in Cryptocurrency Exchanges

Introduction

Cryptocurrency has taken the financial market by storm with the market having around 12000 different cryptocurrencies circulating, double that of last year. It is estimated that trillions worth of cryptocurrency is being circulated, making up around seven percent of the world’s money supply. 

What makes crypto so attractive to today’s generation is the speed at which transactions can go through, and the anonymity that comes with it. These digital currencies are hosted on blockchain systems, allowing for transactions directly between blockchain users or through crypto exchange platforms that provide a medium for fiat and digital currency exchange.

However, the caveat with fast and anonymous exchanges is the potential for criminal activity.

With illicit cryptocurrency transactions growing in number, as well as an increase in the value of crypto being held in illegal addresses, global regulators and governments are looking to crack down on illegal activity. This has called for crypto exchange platforms to address these issues and one such method is through the implementation of Know Your Customer or KYC crypto processes.

What is KYC?

The KYC process is a regulation system that has been adopted by financial institutions all over the world, building the foundations of Anti Money Laundering and Counter Financial Terrorism (AML/CFT) regulations. AML/CFT regulations are controls that combat money laundering and financial terrorism acts, alongside the illegal criminal activity that occurs.

The KYC process requires these institutions to identify both their customers and the nature of the financial business in which they are involved to establish legitimacy. It acts at the forefront of the AML/CFT regulations by preventing the opportunity for potential criminals from even being able to bypass other AML/CFT controls. Individuals are screened and a risk profile is built around each customer to ensure that financial institutions are equipped to handle and detect misuse of services by customers.

How Does KYC Fit Into Cryptocurrency?

Due to the nature of cryptocurrency, establishing compliance measures is much more challenging. When it comes to cryptocurrency, the anonymity and speed of transactions call for much more robust KYC processes to prevent the easy evasion of AML/CFT regulations by criminals. 

Whilst there are numerous forms of KYC processes, cryptocurrency platforms utilize a risk-based approach. This requires a financial institution, in this case, the crypto platforms, to carry out a risk assessment screening of each customer to build a risk profile to implement the appropriate AML/CFT countermeasures.

With crypto exchange platforms being different from your typical financial institutions KYC processes often have to be adapted to address the challenges that crypto exchange platforms face.

Building a risk profile that can prove legitimacy and remain accurate requires systems to be set in place to identify and validate the information provided by customers. This includes details such as personal particulars and relevant financial background information.

KYC in the context of crypto has to not only have an emphasis on identifying customers but also monitoring their activity in order to continuously build upon their risk profiles for even greater accuracy. Monitoring activity on a continuous basis would then help crypto institutions identify criminal activity with greater ease. This involves activities such as sudden transactions out of the norm or even transactions with other high-risk customers.

Screenings are key in gathering information that may be useful in labeling a customer as a potential high-risk customer. Customers with sanctions, or who have been previously identified to be politically exposed persons (PEP), may be at higher risk of being involved with criminal activity such as money laundering.

Risks to Take Note of When Implementing KYC Regulations

With cryptocurrency and blockchain technology continuously evolving, there come risks that have to be made aware of when implementing KYC processes. Improper implementation of KYC measures can result in vulnerabilities and risks developing in the long run.

One key trait of cryptocurrency exchange platforms is the anonymity that they offer their users when making transactions, especially useful for money launderers. However, to counter the potential misuse of this anonymity, the KYC process should be aiming to gather information regarding a user through the use of a verification process. Biometric data should be one of the key components of this verification process, ensuring validity in order to prevent misuse.

The vulnerability in cryptocurrency exchange comes as a result of one of its greatest strengths, its speed. Funds can be transferred between accounts in a matter of seconds. However, this often results in transactions going through faster than most AML/CFT countermeasures. This renders these measures ineffective against criminal activity.

KYC can help in prevention by building risk profiles and systems to ensure legitimacy, thus preventing criminal activity is going through. However, KYC has to work in conjunction with AML/CFT controls in order to be effective. This means that AML/CFT controls have to be updated in conjunction with KYC processes to ensure adequate security measures can be taken.

Money mules are third-party users who have been coerced or exploited into carrying out transactions on behalf of money launderers. KYC processes should be equipped to deal with such issues by detecting them as early as possible through analysis of information provided during the user risk assessment screening.

One way money launderers may try to evade being caught by the system is to carry out numerous small transactions across multiple accounts. In light of this, it has to be ensured that the creation of multiple accounts by a single user to achieve this has to be detected and prevented early on.

Conclusion

With the complexity of cryptocurrency and blockchain technology, AML/CFT as well as KYC measures are required to collect, process, and analyze tons of information within seconds to ensure the highest level of security and crime prevention possible. 

This potentially calls for the integration of artificial intelligence and automation technology to enable both efficiency and accuracy. An automated process built around self-learning will also enable constant adaptation to changes that are ever present when it comes to cryptocurrency.

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