Headline: What are Know Your Customer restrictions and how do they relate to Anti-Money-Laundering efforts

Date: 3/30/2022

Body:  KYC, kind of sounds like a Midwest city with big ambitions.  But it’s not.  In the context of cryptocurrency, KYC is “Know Your Customer” or “Know Your Client.”  Even though cryptocurrency aims at a decentralized transactions, the exchanges still have to try to moderate the potential of money laundering.   Enter the KYC requirements.   Before you can open an account for some party, there are some details you need about them to ensure that they are a real entity, and they are the entity they purport to be.  This is all in an effort to minimize potential for money laundering and tax evasion.  If you refuse to give this basic information to the exchange, they could decide not to setup an account for you, or throttle you back as to how much cryptocurrency you can have in your account.

What will they ask me for?

They ask, generally, for the basics like birthdate, TIN or something similar.   They are also quite likely to ask for a government issued ID card.

What if I don’t want to identify myself?

If this is your preference, there are options.   There are Bitcoin ATMs, and you could use these.    The other option is a decentralized exchange (DEX).   The author used an apt comparison, DEX is kind of like Craig’s List for cryptocurrency.  You’re never really sure who you’re dealing with, and you are really trading at your own risk.

Another option is an AMM.   In these exchanges, no identity verification is required, but they can only trade one form of cryptocurrency for another.   They do this trading by executing computer code in the form of smart contracts.  While AMMs don’t require identity verification, you need to already have a crypto wallet with funds to trade. You can’t buy crypto using cash on these platforms. Many users opt to buy crypto with cash on a centralized exchange first. Then, they transfer that to a crypto wallet and connect it to an AMM to have access to a wider selection of cryptocurrencies.

What is the history of KYC?

For many years, the Federal Government has had rules, telling financial services companies that they must help to detect and prevent financial crimes. In 2001, as part of the USA PATRIOT Act, the United States Department of the Treasury detailed specific KYC processes that financial services firms must have in place.  In 2013, the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) published interpretive guidance FIN-2013-G001 that declared that administrators or exchangers of virtual currency are money services businesses under the Bank Secrecy Act and FinCEN regulations. (What is a money services firm?  Think money services businesses like quasi-Banks.  Examples would include check-cashing services and casinos.) Money services businesses are subject to the AML and KYC requirements of the Bank Secrecy Act.  In 2016, the Treasury elaborated on and applied these regulations to the FinTech sector.  (Don’t be put off by “FinTech.”   This is just a “cooler” way to include all the services that make online trading and other electronic services possible.)

So, What Is KYC?

AML regulations usually leave the specifics of the KYC process up to the regulated entities, using a risk-based determination of what rules are appropriate. These KYC programs generally include the following three basic components:

  1. Customer Identification Program (CIP): OK, first thing that an exchange has to do is identify you as you.  They will at least take your name, DOB, and physical address.     Some might ask for a SSN, driver’s license or passport.   Often, they will have a KYC template and the customer will simply enter all of the requested data there.
  2. Customer Due Diligence (CDD): This due diligence has but one purpose: determine the level of fraud risk you bring to the exchange.  More or less, this is a background check.
  3. Ongoing Monitoring/Risk Management: Essentially, this is looking for large, unusual or questionable transactions made by the customer, and yes, it is constantly on-going.  The idea is to catch any malfeasance early, and contain damages, both financial and reputational. 

How does crypto AML work?

The Financial Action Task Force (FATF) sets the standards for AML laws globally. FATF began publishing guidance on cryptocurrency AML in 2014, and policymakers in FATF’s member jurisdictions quickly took action; today, FinCEN, the European Commission, and dozens of other regulatory bodies have codified most of FATF’s cryptocurrency AML recommendations into law. 

From there, the baton gets passed on to virtual asset service providers (VASPs)—a group that FATF defines to include cryptocurrency exchanges, stablecoin issuers, and, on a case-by-case basis, some DeFi protocols and NFT marketplaces. These businesses do the heavy lifting to stop money laundering by employing compliance officers, requiring know-your-customer checks, and continuously monitoring transactions for suspicious activity.  When suspicious activity is observed, VASPs report this information to relevant regulators and agencies, which then use blockchain analysis tools like Chainalysis Reactor to investigate the flow of funds and link illicit activity to real-world identifiers.

By implementing a mandatory eKYC policy, crypto exchanges can guarantee a few things. The first and most important is that one singular account can be created per person.   This is important because each individual person has only one true character.   They might have (validly) several different addresses, but despite some changes, their character remains the same.  (This is made a little more complex in Europe where there is a “right to be forgotten.”   This is the idea that after a certain period of time, data about you should drop off the internet.  Under this law, the company can only retain these records online for a set period of time, and then the only copy allowed is an encrypted version held in cold storage, offline.)

The Verdict

Money laundering is a very large problem in today’s world, and deserves attention.    While it is true that we have very sophisticated computers to track transactions, these transactions can now go worldwide, in less than the blink of an eye.  This puts an onus on the financial regulators in all of these countries to work together as money laundering almost never stays within one jurisdiction.  This is made even more difficult because each financial institution involved desperately needs the revenue from customers, and those looking to launder money often have more than enough financial resources to make them appetizing targets for hungry banks.  Perhaps the pandemic taught major countries that it is possible to work together to protect citizens of this world: We can only hope.






Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

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