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Kareem Basyouni
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Why Should You Pay Attention to KYC Before Trading Crypto?

KYC, or Know Your Customer, is a set of procedures that require financial institutions and crypto exchanges to verify the identity of their customers.

While traditional financial institutions have adopted KYC rules, crypto exchanges need to catch up. Crypto exchanges are slow to react because KYC policy goes against the nature of blockchain platforms. It’s unusual for crypto exchanges to go against the concept of decentralization to ask clients who wish to be anonymous for KYC verification.

However, regulators want crypto exchanges to adopt KYC so that authorities can trace illegal transactions. They’re hoping that KYC will likely help identify every transaction in the age of the Internet and blockchain.

Believe it or not, KYC crypto can be beneficial for traders. For instance, it allows organizations to prevent hacking, restore hacked accounts and protect customer assets.

What Is “Know Your Customer” (KYC)?

Financial institutions and crypto exchanges use KYC to identify customers and analyze their risk profiles. Organizations usually validate the identity of their customers by asking them to provide proof such as an ID card, credit card and utility bill. This verification helps stop money laundering and financing of illicit terrorism.

Based on the risk profile of a customer and the guidelines set by various financial institutions, KYC can be divided into two risk mitigation layers:

  • Customer Due Diligence (CDD): These are basic guidelines to identify a customer. CDD usually includes basic verification, such as asking customers to upload their photo, details and ID card. Based on the type of customer account, it can also include background checks and verification of credit history.
  • Enhanced Due Diligence (EDD): As the name suggests, this is a more rigorous approach to customer verification. EDD is usually conducted by skilled compliance officers who verify the identities of high-net-worth clients of offshore and private banks.


The Need for KYC Crypto in the Age of Blockchain

Beyond the lucrative returns for some cryptos, one of the primary reasons traders look into crypto investment is due to the fact that opening a crypto trading account is fuss-free. In many instances, crypto exchanges don’t require customers to verify their identities. As a result, customers can remain anonymous because that’s one aspect of what blockchain and crypto are, to begin with.

Whereas blockchain and crypto offer anonymity, there’s a growing debate over the potential benefits of allowing individuals and investors to trade without revealing their identities.

One of the dilemmas of anonymous trading is the ability of people to carry out illicit money transfers through crypto exchanges. Since exchanging cryptocurrency requires nothing more than a crypto wallet to conduct potentially huge transactions, there is no paper trail or physical trace of a person. The lack of a money trail can abet criminal activity.

To tackle money laundering and illicit crypto trading, regulators encourage financial institutions and crypto exchanges to institute KYC and comply with anti-money laundering (AML) regulations. CFT, or combating the financing of terrorism, is one such set of rules introduced after the 9/11 incident. Likewise, crypto KYC refers to rules implemented in the wake of illicit transactions on blockchain networks.

Why Is KYC Increasingly Important in Crypto?

Crypto trading is primarily fueled by public demand and crypto exchanges offering the services. Some crypto exchanges are in tax havens and offshore locations, giving them a free hand in conducting their transactions free of regulatory restrictions.

The lack of regulatory compliance worldwide has allowed individuals to bypass AML regulations and engage in money laundering using cryptocurrencies. According to Arachnys, an AML RightSource company, approximately $3.8 billion was laundered through Bitcoin and crypto transactions in 2019. This figure is growing and is likely to grow further if rules such as KYC crypto aren’t implemented.

Accordingly, KYC is becoming increasingly important because it offers the opportunity to identify criminals. Here are some other reasons why KYC is in the news.

Pressure from Financial Regulators

Regulators are forcing crypto exchanges to implement KYC procedures. The United States is leading the way in enforcing AML and KYC rules. These new rules encourage crypto exchanges in the U.S. to actively monitor fiat-to-crypto and crypto-to-crypto transactions.

In Europe, certain privacy laws are hindering progress, but regulators are vigorously pushing for strict compliance on par with the U.S. The trend is also beginning in Asia and Africa as they move toward AML compliance.

In fact, large crypto trading exchanges headquartered in far-off locations such as the Seychelles archipelago are also implementing KYC rules.

Increasing Data Exploitation

Financial institutions often use data in the public domain to extract new information about their clients. This data is present in the form of social media channels, news, web cookies and more. KYC allows crypto exchanges to use information and data in the public domain to increase their knowledge of their customers.

They can also use data for video profiling and face recognition, preventing incidents of large-scale illicit transactions. In fact, crypto exchanges and financial institutions are already using KYC and public data to minimize the operational costs related to verification.

Prevention of Terrorism Financing

In 2015, German media company Deutsche Welle reported that a crypto wallet belonging to ISIS received $23 million in a single month. Similarly, Ghost Security Group identified numerous ISIS-related crypto wallets containing millions of dollars.

To stop terror funding, regulators want crypto platforms to devise KYC procedures to help identify every customer. Therefore, you can expect your trading platform to implement KYC if they haven’t already done so.

How KYC Helps with Anti-Money Laundering

KYC is a part of the enhanced rules and procedures designed to stop money laundering. It is among the first vital steps during the onboarding process, which ensures that corporations and financial institutions can identify, screen and monitor the activities of their clients.

KYC verification and related procedures help financial institutions stop money laundering by ensuring that the institution can prevent an individual from carrying out illicit financial transactions. Without KYC, anyone can transfer large amounts and carry out dubious inside trades without a trace.

FATF (Financial Action Task Force) is a global intergovernmental organization pressuring governments worldwide to implement strict rules regarding money laundering. It has already put forward global standards for AML and CTF (counter-terrorist financing) guidelines. All of its member states, and every country that does business with these states, have to abide by FATF guidelines.

As of 2021, over 200 jurisdictions around the world have committed to implementing FATF guidelines. Since the main objective of FATF is to stop illegal means of money transfers, crypto exchanges are feeling the heat to become compliant.

How KYC Benefits Crypto Traders

Crypto trading seems attractive because you can open an account and start trading crypto without revealing your identity. Before global regulations became stricter, anonymity was the norm among blockchain networks.

Now, AMDLs (anti-money laundering directives) in Europe and FinCEN’s Final Rule in the U.S. have made things trickier for crypto traders, sparking debates around social media regarding the potential hardships they may face.

To deal with this phenomenon, many crypto trading platforms have started educating their clients about the potential benefits of KYC. The following are just a few of these benefits.

Enhanced Flexibility

Whenever a customer provides personal information, they can access benefits such as higher withdrawal limits, fewer fees and other trading privileges. In fact, it’s becoming a common practice among crypto platforms to impose a limit on trade that’s lifted once the customer completes the simple verification process.

Experts believe most customers won’t mind sharing their basic profiles with their trading company. KYC verification can also help traders place large blocks of trades and conduct substantial transactions without worrying about additional verification and delays.

Asset Protection

Unknown to many traders, KYC procedures also help protect clients’ assets. While a blockchain network is hard to hack, it’s not impossible to gain access. As early as 2019, there were reports of hackers stealing customer assets from blockchains. As hackers use more sophisticated techniques, there will be more hacking attempts.

If a personal account is hacked on a blockchain, there is theoretically no way for the customer to recover their assets. It is because the company doesn’t have any information about the client or the other party involved in a trade.

In contrast, customers will likely feel safer if KYC rules are implemented, allowing crypto exchanges and financial institutions to trace the trail and reimburse funds.

Safer Trading Environment

If you’re serious about crypto trading, it’s better to open an account with a crypto platform that performs KYC verification. This is important because regulators around the world want to ensure that every major crypto exchange performs KYC. Soon, KYC crypto will become the norm as it will likely become impossible to run a large-scale crypto trading business without getting compliant.

Already, most large-scale offshore entities require verification. Trading anonymously without revealing your identity is becoming difficult. It’s also risky because traders are at a disadvantage when they open accounts with unregulated companies that may not have sophisticated security frameworks and asset protection schemes.

Crypto Exchanges That Need KYC

According to blockchain analysis firm CipherTrace, more than half of cryptocurrency exchanges don’t currently comply with KYC regulations and are transforming into decentralized exchanges to avoid KYC. Many of them believe that KYC is costly, in addition to which they may not feel the regulatory pressure to get compliant. However, the growing need to implement KYC is also increasing the pressure on DEXs to follow KYC rules.

Implementing KYC depends on the respective business model and geographical location. There are primarily two business models: fiat-to-crypto exchanges and crypto-to-crypto exchanges.

Fiat-to-crypto exchanges allow users to buy cryptocurrencies with traditional currencies, such as the euro and US dollar. In contrast, crypto-to-crypto exchanges solely rely on different types of cryptocurrencies to do business.

For example, U.S. and Canada laws require both types of exchanges to adhere to strict KYC verification rules. U.S. authorities are also rigorous with any foreign entity that does business with U.S. residents. This is one of the reasons why many crypto companies operating outside the U.S. don’t allow their residents to open an account with them.

Laws in Europe may not be as stringent, but crypto exchanges need to comply extensively with anti-money laundering regulations. EU laws are somewhat relaxed because cryptocurrencies are broadly considered legal. Despite this, each EU member state is free to add additional limitations. Accordingly, most EU-based crypto exchanges have some sort of KYC mechanism in place.

The need for KYC outside North America and the EU is mostly defined by the regulatory environment of each country. Countries like Singapore, Japan and Australia are known to offer progressive laws related to cryptocurrencies. In the past, both fiat-to-crypto and crypto-to-crypto exchanges there have thrived without requiring KYC. On the other hand, countries such as China, Korea and India are examples of economies that have yet to legalize cryptocurrency.

Similarly, the legality of crypto exchanges and the need to implement KYC procedures vary across so-called tax havens. While Malta recently regulated cryptocurrency, the legal framework in Seychelles is still underdeveloped. This is in marked contrast to Gibraltar, where cryptocurrency is not considered legal tender but crypto exchanges are legal.

What Are Standard KYC Procedures?

KYC procedures are steps taken to verify and manage a customer’s profile. Depending on the business model, there are usually three steps to effective KYC compliance:

Identification: Regulators want crypto KYC to achieve minimum requirements for identity verification. These include asking customers to provide information about their name, date of birth and address, and a government-issued ID card. In certain circumstances, they may ask for more personalized info, such as a recent utility bill, in order to verify the address or photo of a person holding a passport.

Due diligence: After the onboarding process, the company needs to ensure that it can trust its customers. Based on the level of risk, due diligence may include asking for additional info from individuals who want to carry out large transactions, or who hold large amounts of funds.

Monitoring: Ongoing monitoring is critical to stop money laundering. Compliance officers should look carefully at suspicious activities even if the customer has provided personal info. Spikes in financial transactions, unusual cross-border activities and negative media publicity relating to someone are examples of risk-based monitoring.

Depending on how you define KYC procedures, the identification process can also involve additional steps.

In the first step, personal information from the client is collected. In the second step, the company asks the customer to verify the information by uploading relevant documents. After documents are uploaded, they’re verified using OCR technology. Afterward, AML screening is performed to filter out high-risk individuals. The last step involves ongoing monitoring of financial transactions to prevent money laundering.

M2’s Effort to Comply with KYC Regulations

With hackers utilizing technology to execute highly advanced crypto scams, KYC is now more critical than ever in the crypto space. M2 values our customers greatly and began verifying both individual and business/corporate accounts. This implementation protects against fraudulent activities and assures customers that any funds they entrust to the platform will be kept safe. Anyone who wishes to register an account on M2 must submit a request for mandatory identity verification (e.g., passport identification, utility bill verification) to unlock all the features at M2.

Disclaimer:
It is highly recommended to conduct thorough research prior to making any financial decisions. Please note that this article's purpose is solely for educational purposes and the author and the organization, M2, do not influence the reader's investment or trading choices.

Kareem Basyouni
Author

Kareem comes with 19 years experience in Operations and Customer experience with extensive global exposure in various fields and fintech. In 2019 Kareem discovers the crypto world in depth and becomes an enthusiast while he believes crypto is the future and financial freedom. Joined M2 in 2022 and is leading the Global Customer Experience for the exchange.

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