Originally published in the ChangeNOW blog
It has been more than a decade since Bitcoin has been invented in 2008. The cryptocurrency industry encompasses more than 7500 tokens and has a market cap of nearly $400 billion. We think it’s fair to say cryptocurrencies are gradually moving towards mass adoption.
However, the industry is yet at a nascent stage in comparison to the other sectors of the financial ecosystem. While there are multiple advantages of digital currencies, they are sometimes used for illicit practices.
One of the most important procedures used by financial industries to secure themselves and their clients against illegal behavior are called KYC and AML. Both of them are becoming especially relevant in the cryptocurrency field as well. In this article, we’ll take a closer look at them, their relevance within the crypto domain, and their advantages.
What is AML?
ALM (anti-money laundering) encapsulates a lot of laws and regulations created by the government to prevent stealing and illegally storing funds.
Does crypto get laundered, too? Although it’s still far more common to launder cash, attackers have found some ways to skim money via cryptocurrency transactions as well.
Stages of Money Laundering
Let’s take a look at the stages of money laundering.
Usually, you purchase cryptocurrencies with cash or by swapping it with other cryptocurrency. Typically, exchanges perform thorough identity verification, but there are still some services that may not be compliant enough.
Placement is about putting “dirty” money into a legitimate financial system. Money launderers do this by opening digital currency exchange accounts within systems that accept fiat currencies.
- Layering or Hiding
Criminals typically use anonymizing services to hide the place where the illegal funds come from. Yes, it is possible to follow crypto-based transactions using blockchain, but criminals are able to break the links so that both the users and funds can’t be traced.
- Integration or Extraction
This is the last stage criminals do to be able to use the money and pass it off as a legal transaction. For that, criminals traditionally recruit fake employees; they also manipulate different loans and pay dividends to shareholders as a means to mask the funds. The main goal is to make the stolen crypto seem like an income of a profitable business. Alternatively, criminals can turn to an offshore bank that accepts crypto payments.
Risks of AML in Crypto
Unfortunately, crypto is not proof against criminals. Continuously evolving technologies make it particularly difficult for law enforcement officers to track and stop anti-money laundering activities.
- Illicit Goods Trafficking
Some cryptocurrencies give criminals a quick way for paying for illicit goods and services: human trafficking, child pornography, drugs, and a wide range of products and services from the dark web.
- Market Abuse
As it has been mentioned earlier, blockchain allows crypto users to monitor and trace their transactions. However, market abuse that involves unregistered ICOs (initial coin offerings) and VEs (virtual currency exchanges) is still quite poorly controlled. Criminals can take advantage of these offerings to manipulate markets and conduct fraudulent transactions.
Once a criminal hacks into a crypto wallet account, it becomes quite easy to transfer holdings to anonymous addresses. Liquidating these funds is also fast. Also, it’s almost impossible to reverse these transactions once they are carried out.
What is KYC?
KYC (Know Your Customer), is a procedure used by businesses and companies (especially financial institutions) to verify the identity of their customers. KYC procedures have become crucial in reinforcing AML.
Anti-money laundering KYC is an essential precautionary measure that all financial institutions should follow. New users or customers fill out a KYC form and submit official IDs and documents to the system. The process is similar to that one carried by banks and other financial institutions. Once the new customer submits the documents, the company starts regularly updating information and monitoring all the transactions.
Some of the documents a new customer may be asked to submit include a valid ID with a photo, a driver’s license, a national passport, a social security number, and a voter ID card. In some cases, the company may also ask to provide them a couple of utility bills, bank statements, or rental agreements.
How is KYC Performed?
Here are some ways in which exchanges and other institutions perform KYC.
Most exchanges typically ask a new customer to give them some basic info. Initially, there’s no need to undergo the complete KYC procedure. However, upon any withdrawals, a new customer may be asked to verify their identity by providing certain documents.
Other exchanges don’t require the full KYC procedure unless a customer needs to buy and sell crypto. Some of these exchanges employ biometric facial recognition to speed up the process.
AML legislation for these cases varies heavily depending on where you live. For example, the situation is completely different in Europe and in the USA, where KYC is currently expected to be introduced for the most crypto-to-crypto exchanges.
- CAP & CIP
In the CAP (customer acceptance policy) stage, crypto exchanges identify their target audience and key documents for customer identification. Then, in the CIP (customer identification program) stage, they determine whether the customer matches the CAP.
- Risk Level Assessment
Crypto KYC is also about assessing risk levels both for new and existing customers. For that, an exchange has to check whether a customer is from a banned or sanctioned country. Apart from this, the specialists check if the customer is affiliated with any terrorist groups. Also, they check if they deal with a politically exposed person (PEP).
- Monitoring of Transactions
Apart from assessing risk levels, crypto exchanges monitor their clients’ transactions and behavior in general. In compliance with AML and CFT regulations, their teams pay special attention to suspicious transactions and any activities considered to be high-risk. It is crucial to identify risks before they become threats.
- Enhanced Due Diligence
All transactions undergo a basic check. Also, there are three risk levels that transactions and customers may be designated (low, medium, or high). Low-risk transactions pass this check almost immediately; there are typically no further checks needed in these cases. If the risk is medium or high, the specialists will start the EDD (enhanced due diligence) procedure that includes monitoring customers and their transactions as well as reporting the most suspicious ones.
The EDD scenario is usually triggered by any sudden change in one’s activity or behavior. Also, there are certain patterns that may be considered suspicious.
Cryptocurrency KYC in 2021
Since the very KYC introduction, there have been many changes to its principles offered by various exchanges and financial institutions. In 2021, there is a great need to update the policies once again to keep them relevant. In particular, specialists are talking a lot about implementing an automated approach.
- Advantages and Prospects
In 2021, the number of people looking into cryptocurrencies is constantly growing. Among them, there are various investors looking for projects with strong anti-money laundering policies. Within some systems, customers can even help fight money laundering!
- Risk Assessment
Anti-money laundering and KYC policies ensure that users can get the maximum benefit possible without having to be subjected to any malicious activity. Thanks to KYC, in the nearest future cryptocurrency exchange providers are expected to become even more safe for their customers.
- AML/KYC Building User Trust
Crypto exchanges are to a great extent built upon their users’ trust. Customers should feel confident while performing transactions and be sure there are no fraudsters or criminals involved. KYC and AML are to better the trust rates as well; with these policies implemented, the whole crypto world will become even more safe.
Certainly, the world of cryptocurrencies offers both individuals and institutions a wide range of benefits. Although this field is sometimes used for criminal purposes as well, the specialists are doing their best to implement reliable protocols aimed at protecting regular users. By getting some info on their customers, exchanges learn how to filter suspicious and fraudulent transactions and combat money laundering.