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Know Your Customer (KYC)

| April 30, 2024

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Key takeaways

  • Abbreviated as KYC, these are verifications required by cryptocurrency exchanges and trading platforms to confirm the identity of their users.

What is Crypto Know Your Customer (KYC)?

KYC helps cryptocurrency platforms in verifying a user’s identity, typically by necessitating permanent information such as the individual’s full legal name, as indicated on a government-issued identification document like a passport, driver’s license, or other comparable forms of identification.

The purpose of KYC guidelines is to safeguard financial institutions and cryptocurrency exchanges, aiming to prevent their exploitation, whether intentional or unintentional, by criminal entities engaged in money laundering and various illicit activities.

How is KYC Implemented in Cryptocurrency Exchanges?

Meeting KYC requirements poses a complex compliance challenge for cryptocurrency exchanges. This complexity arises as companies must exert additional effort to verify customer identities through their digital services and gain a comprehensive understanding of the particulars involved in the transactions they facilitate.

1. Risk-Based Compliance –

In alignment with the recommendations of the Financial Action Task Force (FATF), cryptocurrency exchanges are encouraged to embrace a risk-based approach to KYC compliance. This approach involves conducting risk assessments on individual customers and subsequently implementing an anti-money laundering (AML) and counter-terrorist financing (CFT) response that is proportionate to the identified risks. Should a customer be deemed high-risk, the crypto exchange is advised to employ more rigorous compliance measures, contrasting with simpler measures reserved for low-risk customers. By adopting a risk-based compliance strategy, crypto exchanges can optimize the allocation of their AML/CFT resources, enhancing efficiency while endeavoring to shield customers from adverse experiences to the greatest extent possible.

2. Buying Cryptocurrency with KYC Verification –

Decentralized applications, such as decentralized exchanges (DEXs), typically operate without the obligation to conduct KYC on their users under the prevailing laws of many countries. This is because these protocols are not classified as financial intermediaries or counterparties. In a DEX, users engage in peer-to-peer trading directly through smart contracts. However, the acquisition of cryptocurrency involves using funds from a centralized exchange (CEX) or bank account, both of which necessitate KYC procedures.

Advantages of KYC in cryptocurrency:

Despite the operational adjustments and hurdles associated with KYC regulations, crypto exchanges can derive significant benefits from ensuring regulatory compliance. These advantages include:

1. Enhanced customer transparency and trust

Validating user identities not only enhances transparency but also fosters customer trust. When users are assured that your crypto exchange is implementing proactive and precautionary measures to safeguard their accounts, they are more inclined to maintain their usage of your service.

2. Mitigated risk of money laundering and scams

According to Forbes, there were over 80,000 cases of cryptocurrency fraud in the United States last year, marking a 24,000% increase from 2016. Rigorous identity verification can substantially diminish fraudulent activities, thereby bolstering the market reputation of the crypto exchange.

3. Mitigated legal risk

In the face of continually evolving legal expectations, the adoption of robust KYC policies positions companies ahead of the curve. Rather than scrambling to catch up, they can concentrate on enhancing conversion rates, streamlining transactions, and aligning with evolving international guidelines. Through the demonstration of KYC due diligence, companies can effectively diminish their exposure to legal challenges or regulatory penalties.

4. Safeguarding reputation in the aftermath of a security incident

In the event of a hack or data breach, exchanges adhering to KYC standards are better equipped to prevent fraudulent activities and protect their reputations. Exchanges that have implemented KYC  measures can promptly respond by freezing or closing accounts potentially associated with criminal activity.

5. Crypto wallets KYC compliance

No, there is generally no requirement for crypto wallets to comply with KYC. Most wallets, particularly non-custodial ones, operate without holding users’ private keys. In non-custodial wallets, users maintain complete control over their funds, eliminating the need to entrust a third party with their information.

Nevertheless, crypto wallets associated with exchanges often align with the KYC guidelines applicable to the exchanges themselves. Many non-custodial wallets, such as MetaMask, Liminal custod, MyEtherWallet, and Trust Wallet, operate without necessitating personal information from users. Additionally, certain hardware wallets like Ledger and Trezor also operate without requiring KYC, as they securely store users’ private keys offline, enhancing overall security.