Crypto compliance: Understanding AML and KYC regulations

Know your customer (KYC) and anti-money laundering (AML) are umbrella terms for a set of processes and regulations implemented by financial institutions to prevent and detect financial crimes or other illegal activities in different countries worldwide. KYC, an identity check procedure, is the first step of a customer identification process, normally followed by monitoring and other activities within the scope of the more extensive AML controls. Customer due diligence (CDD) is a critical component of KYC practices, involving identifying and verifying customers and assessing their associated risk factors.

Although the legal specifics of KYC and AML regulation differ from country to country, they are mainly aimed at any company recognized by that jurisdiction as a financial institution, such as electronic money, payment institutions, money transmitters, and money service businesses. Under this precedent, crypto exchanges are nominally included. Nonetheless, emerging regulations, such as MiCA in Europe, focus more specifically on virtual asset service providers (VASP) and will bring more specific KYC and AML requirements to the market.

KYC has existed in one form or another since the 1980s and 1990s. The emergence of the Financial Action Task Force (FATF), an international policy-making body, in 1989 was an important step. Its recommended standards for combating money laundering are regarded mainly as setting global standards for AML and other financial crimes, and many of the first AML laws across the globe followed after that. FATF has also recently recognized standards for VASPs across member states, prompting crypto businesses to collect and transmit originator and beneficiary information. However, the onus to specify crypto regulations is on the member states.

Understanding KYC in crypto: from customer identification to continuing compliance

As previously stated, regulations and compliance standards regarding crypto exchanges differ from jurisdiction to jurisdiction. Nonetheless, most countries recognize crypto companies as money transmitters or money service businesses, making KYC and other AML procedures obligatory.

Typically, KYC is performed during a new user’s registration, known as the customer onboarding process. This includes identifying and verifying a user’s identity and evaluating their risk profile. Customer Due Diligence (CDD) is a critical component of KYC procedures, emphasizing the importance of identifying and verifying customers’ identities to prevent fraud and other illegal activities.

How KYC works for crypto exchanges

The KYC process for crypto platforms involves four main steps:

1. Customer identification and verification
2. Screening against sanctions lists, PEP lists, and for identifying adverse media.
3. Customer risk evaluation is based on risk factors such as the customer’s geographical location, type of business, and UBO (if applicable). This involves understanding the nature and purpose of customer relationships to develop customer risk profiles as part of the Customer Due Diligence Program.
4. Continually monitoring customer information and financial transactions as part of the CDD process.

AML in crypto: understanding money laundering processes and risks

AML procedures, of which KYC is a part, encompass all financial and regulatory compliance activities. With more individuals and businesses adopting cryptocurrencies, it is crucial to comprehend the significance of AML in combating financial crime and ensuring the legitimacy of the crypto space.

Financial institutions, including banks and crypto exchanges, must comply with AML regulations to prevent financial crimes. Further, failure to adhere to compliance measures results in reputational loss, regulatory sanctions & the enabling of criminal activities.

Implementing AML in crypto monitoring

Numerous technological tools exist to help with AML processes. Any comprehensive AML solution should include the following:

1. A device to recognize and authenticate documents
2. A tool for recording live biometrics and face gestures
3. Automated screening tools for identifying PEPs, sanctions, and adverse media hits
4. Blockchain analytics and transaction screening

A comprehensive AML program is essential for preventing criminal activity and ensuring crypto exchanges adhere to regulatory requirements.

Challenges and tech solutions in AML and crypto

Balancing user privacy with AML requirements

Challenge: Most cryptocurrency users cherish their privacy, a major issue when dealing with strict KYC policies.

Solution: Many exchanges use a system where the KYC measures are based on the user’s activity level.

For example, customers with low turnover (below Є1000) may be subjected to fewer checks. Similarly, exchanges might use a questionnaire to determine a risk profile and likely turnover before determining if further checks are required.

Sophisticated fraud schemes

Challenge: Criminals are becoming more creative and sophisticated in evading AML procedures.

Solution: Use AI and machine learning techniques to efficiently identify anomalous activities and fraud. Nonetheless, it is crucial to understand that a) existing solutions have not yet achieved a competitive advantage over some more complex fraud schemes, and b) that AI outputs may involve certain biases, depending on the quality of training data.

Data management and security for financial institutions

Challenge: Gathering and storing a lot of users’ personal information securely.

Solution: Ensure the appropriate security measures are implemented, such as encryption, safe storage of data, and periodic security checks. Lastly, ensure that a user identifying information is limited among personnel on a ‘need to know’ basis.

Privacy coins and mixers

Challenge: Some cryptocurrencies, such as privacy coins, and crypto services, such as crypto mixers, increase anonymity, which could aid criminal activity.

Solution: Typically, exchanges don’t allow (or have delisted) privacy coins on their platforms. Regarding mixers, platforms need to use blockchain analytic tools to detect cases where users use mixers to hide illicit activities. 

Transparency and traceability: blockchain’s AML advantages

While crypto is often associated with financial crime, it is important to remember that fiat money is still the preferred choice for money laundering (800x that of crypto). Rather than being because financial criminals are slow to evolve, blockchain technology offers several unique advantages for AML efforts.

Immutable ledger:

– Every transaction is permanently recorded and cannot be altered

– This chronological unalterable trail facilitates easier fund tracing

Public accessibility:

– Most blockchain networks are public and viewable by anyone.

– This allows for real-time monitoring without requiring information from multiple institutions. 

Pseudonymity vs anonymity:

– Many mainstream cryptocurrencies, like Bitcoin and Ethereum, are pseudonymous rather than fully anonymous.  

– This means a user’s identity is not provided in the blockchain transaction. However, all transactions can be traced; thus, if a wallet owner is identified, all transactions can be associated with them.

However, some challenges remain:

– Privacy coins like Monero and mixing services such as Tornado Cash can complicate tracing efforts

– Linking transactions to real-world identities still requires additional investigation

Despite these challenges, blockchains’ transparent and traceable nature provides a strong foundation for AML efforts. As the technology evolves and adoption grows, we can expect a more sophisticated use of blockchain features in combating financial crime.

How to build a trusted and compliant crypto environment

Prioritize compliance from day one

The best thing any crypto platform can do is to be compliant from the start. In other words, compliance should be part of your business’s strategic plan and day-to-day activities. This way, compliance will always be in the foreground of your business, and you are unlikely to get caught off guard later.

Financial services companies must prioritize KYC and AML compliance to prevent fraud and ensure regulatory adherence.

Stay ahead of all regulatory updates

While some regulations, such as MiCA, make compliance in EU jurisdictions clearer, many crypto regulations across the globe are still in development or being discussed. It is thus important to keep an eye on regulations while they are still upcoming to ensure that the company and the product will be aligned. In addition to having someone monitor these changes, joining industry associations and being in contact with regulators is a must. It is always better to be compliant first than compliant last!

Be selective in cryptocurrency listings

Choose wisely which cryptocurrencies you allow on your platform. To do so, set out guidelines for listing new assets and ensure your team researches each new proposed listing. As a rule, it is advisable to avoid listing privacy coins outright.

Employ comprehensive AML and KYC tools

Ensure you use all the necessary AML tools, from blockchain and fiat transaction monitoring solutions to automated screening. In addition to ensuring all your tools are up to date, you must also be flexible with what tools you adopt in the face of unique or creative criminal activities.

Read more here:

Creative crypto compliance; Vasps, MiCA & evolving compliance standards

Controversy with the EU Transfer of Funds Regulation

Conclusion: The key findings

KYC and the AML process are incredibly important for any cryptocurrency exchange wanting to be a legitimate part of the wider financial industry.

Remember about the key takeaways and action points that stem from this guide:

1. KYC and other AML measures are required in most crypto exchanges across the globe because most fall under that jurisdiction-relevant category of money transmitter.
2. KYC checks involve customer identification, verification, and risk assessment. Other AML processes, such as fiat transaction and blockchain transaction monitoring, will then occur.
3. Blockchain technology benefits AML by providing transparent and unalterable records.
4. Staying current with regulatory changes is crucial to ensuring the platform fully complies with any new rule in its jurisdiction and is very selective about which cryptocurrencies are listed.
5. As the industry grows, it will be crucial to maintain strong AML measures to build trust with customers and authorities. This will make the crypto industry more legitimate to the mainstream and stable as more users onboard.

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