Cryptocurrencies, which are based on blockchain technology and provide access to creative new financial goods and services, are disrupting financial systems all over the world. Cryptocurrencies – or the digital tokens that represent them – can be traded between blockchain users or through crypto exchange platforms that allow for both fiat and digital currency transactions.
Transactions between users are generally anonymous and take seconds because cryptocurrencies are secured on their blockchains. The speed and secrecy of cryptocurrency transactions appeal to criminals looking to avoid traditional AML/CFT controls: according to research, illegal cryptocurrency transactions totaled roughly $14 billion in 2021, up 79% from $7.8 billion in 2020. Around $10 billion in cryptocurrencies is expected to be housed in illicit addresses by 2022.
Crypto exchanges must handle their AML/CFT compliance requirements now more than ever, as global regulators pay greater attention to cryptocurrency transactions. Crypto exchanges, in particular, must address concerns about anonymity in cryptocurrency transactions by having appropriate Know Your Customer (KYC) practices to identify who their customers are and how they use their services.
What is KYC?
The Know Your Customer procedure is a cornerstone of AML/CFT compliance rules around the world, and it requires financial institutions to identify their customers as well as learn about the nature of their business.
The traditional KYC process entails many due diligence steps, as well as continuing screening and monitoring as customers interact with a company’s services. KYC is important in financial contexts because criminals use a variety of strategies to get around AML/CFT controls: financial service providers are much better equipped to detect customers who are abusing their services and to prevent crimes like money laundering and terrorism financing by building a rich, accurate risk profile of each individual customer.
What does KYC mean in the context of cryptocurrency exchanges?
KYC may be a more difficult compliance challenge for crypto exchanges since firms must work harder to establish the identity of consumers who use their digital services and to comprehend the intricacies of transactions that they are enabling.
Risk-based compliance: Crypto exchanges should follow the Financial Action Task Force‘s (FATF) recommendations and use a risk-based approach to KYC compliance. Firms must make risk assessments of individual customers as part of risk-based compliance, and then develop a proportionate AML/CFT response. If a consumer is determined to be a high-risk customer, the crypto exchange should put in place more stringent compliance procedures, as opposed to simpler steps for low-risk customers. Risk-based compliance allows crypto exchanges to more deploy their AML/CFT resources while also shielding clients from poor experiences to the extent practicable.
In reality, digital KYC compliance entails adapting ‘conventional’ KYC standards to the unique issues that crypto exchanges confront, and incorporating the following safeguards and controls:
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Identity verification: Crypto exchanges should be able to create correct risk profiles for its consumers to establish accurate risk profiles. With this in mind, exchanges must collect and verify identifying information from their customers, such as names, addresses, birth dates, and other pertinent business data.
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Customer monitoring: Exchanges should keep a close eye on their clients’ activities, looking for signals of criminal behavior, such as strange transaction patterns or transactions involving high-risk customers and places.
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Customer screening: Exchanges must check their customers to ensure that they are not subject to international sanctions or are exposed persons (PEPs), who are more likely to be involved in money laundering.
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Adverse media: Adverse news articles may inform customer risk profiles before the same information surfaces in official sources. Customers who are involved in negative publicity should be screened on a regular basis by exchanges.
Risks of a Crypto Exchange’s KYC
A changing regulatory landscape, as well as new criminal tactics, make KYC compliance difficult in the bitcoin field. As a result, when building and implementing their KYC solution, cryptocurrency exchanges should be mindful of the following weaknesses and risks:
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Anonymity: Money launderers might enjoy the anonymity provided by cryptocurrency exchange transactions. As a result, exchanges should use digital controls to guide their identity verification process, such as gathering biometric client information like face, voice, and fingerprint scans.
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Speed: Cryptocurrency funds can be transferred from one account to another in a matter of seconds, far exceeding AML/CFT safeguards. Before funds are sent to user wallets, exchanges should verify that their own AML/CFT checks and monitoring processes can be performed.
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Structured transactions: Money launderers may try to avoid reporting thresholds by dividing their transactions into small sums and distributing them across many accounts. To detect and avoid structuring schemes, crypto exchanges should ensure that their rules prevent the creation of many accounts and share information with other financial service providers.
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Money muling: Money launderers may try to take advantage of the flaws in cryptocurrency transactions by coercing or enticing third persons – known as’money mules’ – to engage with crypto exchange services on their behalf. Money mules should be identified by completing appropriate due diligence and identifying consumers whose profiles do not match their wealth or expected financial activity.
Negative customer experiences: In addition to regulatory problems, crypto exchanges that use insufficient or inappropriate KYC procedures risk impacting their customers’ experiences with their services. KYC allows exchanges to construct complete risk profiles using a risk-based approach, and then alter their AML/CFT rules to better suit individuals. With this in mind, efficient KYC is a method to improve customer experiences for lower-risk consumers by assuring service speed and efficiency in areas where onerous AML/CFT inspection is not necessary.
Automated KYC
Crypto exchanges are required by AML/CFT standards to gather, analyze, and keep large volumes of digital client and transaction data. To meet this need, crypto exchanges can look to integrate an appropriate software solution: in addition to automating speed, efficiency, and accuracy, software solutions may help businesses add depth to their KYC procedures and create richer, more complete risk profiles for their consumers.
