Two key factors in many people’s original decision to begin using cryptocurrencies are their inherent security and anonymity. The blockchain technology upon which they’re built provides cryptographic encoding that assures these. Hence their name. Unfortunately, it’s these very benefits that have also attracted the attention of financial regulators.
The ability for users to stay anonymous unfortunately also leaves open a loophole for nefarious actors to circumvent conventional laws designed to curtail such activities. As a result, regulators across the world have turned their focus to crypto trading, and have introduced laws that oblige centralized crypto exchanges to become aligned with other money service businesses.
Users who are still concerned about their privacy for entirely innocent reasons can still buy cryptocurrency from decentralized exchanges. However, given the lack of regulatory oversight, this does come with the risk of being defrauded.
The headline takeaway is that the vast majority of crypto exchanges are subject to KYC (Know Your Customer) laws, which are a subset of broader AML (anti-money laundering) laws. KYC requires that they collect and verify all buyers’ personal identities.
At the same time, as crypto expert Kane Pepi has noted, there are still many trusted non KYC crypto exchanges available for traders. Furthermore, only custodial crypto wallets must comply with the KYC requirements. Self-hosted (or non-custodial) wallets like Argent are exempt in this regard.
How Does the KYC Process Work for Customers?
The Know Your Customer laws have been on the books for decades and were codified via the Bank Secrecy Act of 1970. They apply to any company that is defined as a money service business. When cryptocurrency exchanges first emerged, they weren’t covered by the relevant acts. This prompted the SEC among others to declare them money service businesses in 2019, thus making them subject to both KYC and AML laws.
The KYC compliance process is simple enough. It’s aimed at positively verifying each customer’s identity in order to make it more difficult, if not impossible, to launder money, evade taxes or finance outlawed organizations under the cloak of crypto anonymity.
In practice, this means that before anyone can open an account with a centralized crypto exchange, they need to provide their full name, date of birth, and current residential address. Some exchanges will allow accounts to be opened in advance of this, but they remain inactive and unable to trade before their identities are confirmed.
Having provided this information, the prospective customer has to provide positive proof that all the details are correct. Various types of government-issued documentation can be used, including passports, driver’s licenses, or other kinds of ID cards. This is all done digitally, as the user only needs to take a photo of the item and upload it.
Sometimes customers may also be asked for their occupations, and be required to provide proof of their physical address. The latter can be in the form of a utility bill. Not all crypto exchanges follow exactly the same processes. Some even go a step further, asking users to upload a selfie while holding a proof of identity. Others might request a confirmatory video call.
How Does the KYC Process Work for Exchanges?
Like any statutory process, the KYC regulations require a certain amount of upfront red tape. All centralized exchanges must register as money service businesses before starting to operate. A centralized exchange is one that is managed by a central entity, whereas decentralized exchanges do not have a central authoritative entity at their core.
The latter rely on smart contracts directly between traders. They do offer more privacy for users, but this usually comes at the cost of more complex trading mechanisms and lower liquidity in the system. The KYC process for a centralized crypto exchange is that, once it has received all the required user information, it obviously first needs to confirm that all the details match on the documentation.
After this there is a further requirement to check the person’s identity in various official databases. These include ones containing lists of people suspected of fraud or money laundering, sanctioned individuals, and those who have been tagged as Politically Exposed Persons.
This creates a broader picture of the person wishing to trade crypto, and the next step is to use this to determine the individual’s risk profile. This has nothing to do with being a credit risk. Once again, the aim is to proactively identify suspicious persons to help curb criminal activity through the regulation of crypto exchanges. Only once individuals have been fully vetted in this way are they legally allowed to trade on a crypto exchange.
Benefits of KYC for Crypto Exchanges
Besides staying on the right side of the law, crypto exchanges derive a few benefits of their own from complying with KYC and AML regulations. The first and perhaps most obvious is that they are themselves far less susceptible to scams and money laundering activities.
This sword can cut both ways: they could lose money directly, or perhaps more disastrously, if customers are worried about scams being perpetrated on an exchange, they won’t be too keen to use it. In the world of crypto, it can be nearly impossible to recover from this kind of reputational damage.
Linked to this point is that by being fully compliant with the strictest financial regulations that govern all other types of trading, an exchange fosters trust with its customers, and becomes more attractive to those who have yet to start their crypto trading journey.
Transparency is the very basis of blockchain technology, and the more users feel confident in the exchange’s commitment to it by adhering to KYC requirements, the more trustworthy and attractive it becomes.
Furthermore, money laundering and other illegal financial activity have the effect of destabilizing a crypto market. They create a sense of vulnerability and a lack of enforced parameters, which has the knock-on effect of causing significant fluctuations in the valuations of cryptocurrencies. There is already more than enough volatility in cryptocurrency exchanges, without the need for criminals to rock the boat even more.
Finally, another way that the KYC laws help to inhibit fraud exposure for crypto exchanges is by reducing the number of accounts set up using fake identities. If necessary, exchanges are allowed to examine individuals’ financial history, in service of verifying their bona fides to allow them to transact.
Monitoring Cryptocurrency Transactions
Cryptocurrency exchanges use other tools to protect themselves and their customers. These are also mandated by law and fall under the AML umbrella. Transaction monitoring is prime among these.
Companies use sophisticated software combined with AI analysis for this. This monitoring not only focuses on individual transactions but also examines longer-term patterns and trends in account activity. Exchanges are legally compelled to share any suspicious activity they detect with the relevant authorities.
What About Customer Privacy?
The requirement to provide this level of personal information to a third-party in order to trade in crypto might seem to violate the blockchain ethos and raise legitimate privacy concerns. However, the information is still subject to other privacy laws, and crypto exchanges have mechanisms to protect it from falling into other hands.
These include high-grade data encryption that protects your information where it’s stored, as well as while it’s being transmitted over the Internet. Databases are housed in physically protected locations, and the data is regularly audited to ensure integrity.
Typically only certain authorized personnel have access to these data server rooms. Finally, all information is protected by the standard privacy laws of the given jurisdiction, such as the General Data Protection Regulation (GDPR) in the EU.
A Balancing Act for Overall Security
The fundamental reality is that a balance needs to be struck between individual privacy and protecting society from criminal activity, not least the people who stand to lose the most—crypto users themselves. It’s a case of perhaps sacrificing complete anonymity in exchange for better protection when trading.
The underlying privacy protections also act as a safeguard for customers who might feel a little edgy about undergoing such rigorous scrutiny in order to trade in crypto. While there’s understandably sometimes a certain level of discomfort around this, the trade-off is a more user-friendly, secure, and ultimately more sustainable crypto exchange, which benefits everyone.
Traders who still prefer not to part with all of this personal information still have the option of using decentralized exchanges. However, this should be done with the full knowledge that without protections like the KYC process, bad actors could taint the exchange at best.
The risk of losing money to scammers is also a constant possibility. Further, the additional security measures necessary with smart trades usually result in longer transaction cycles and higher transaction fees.
Conclusion
KYC procedures fall under the broader set of AML laws. In terms of cryptocurrency regulation, despite the industry meant to act as an alternative to centralized currency and finance, these procedures have become necessary to protect crypto users, exchanges, and providers from scams and other risks like fraud or money laundering.
Where cryptocurrency exchanges aren’t regulated, though safe ones do exist, others are more at risk of these kinds of threats. In the broad sense, despite being cumbersome, KYC and AML provide greater stability for the crypto industry as a whole.
Also read: What You Should Do After Buying Crypto: A Beginner’s Guide
