cryptocurrencies are disrupting financial systems in jurisdictions all over the world. Cryptocurrencies – or the digital tokens that represent them – may be exchanged directly between blockchain users, or via crypto exchange platforms which facilitate transactions in both fiat and digital currencies. 

However, because cryptocurrencies are cryptographically secured on their blockchains, transactions between users are generally anonymous and take place in seconds. The speed and anonymity of cryptocurrency transactions is an attractive opportunity for criminals seeking to evade conventional AML/CFT controls: research shows that illicit cryptocurrency transactions totalled around $14 billion in 2021 – a rise of 79% from $7.8 billion in 2020. As of 2022, it is estimated that around $10 billion in cryptocurrency is held in illegal addresses.

What does KYC in Crypto mean? Crypto Exchanges and Digital Compliance

The Know Your Customer process is a foundation of AML/CFT compliance regulations around the world and requires financial institutions to both identify their customers and work to understand the nature of the business in which they are involved. 

The conventional KYC process involves a range of due diligence measures, along with ongoing screening and monitoring as customers engage with the services that a particular firm offers. KYC is important in financial contexts because criminals employ a range of strategies to evade AML/CFT controls: by building a rich, and accurate risk profile of each individual customer, financial service providers are much better equipped to detect customers that are misusing their services, and to prevent crimes like money laundering and terrorism financing. 

Know Your Customer (KYC) is the first anti-money laundering (AML) due diligence stage. When a financial institution (FI) onboards a new customer, KYC procedures are implemented to identify and verify the customer’s identity, these processes enable financial institutions to assess the customer’s risk profile based on their propensity for financial crime.

Now that cryptocurrency exchanges and wallet providers are regulated as financial institutions, they must integrate KYC processes into their AML programs.

KYC refers to the process that cryptocurrency exchanges must go through to:

Confirm their end users’ and customers’ personal information

Acquire a better understanding of the activities of their potential customers and verify their legality.

Determine the probability their customers pose money laundering risks.

WHY DOES KYC’s MATTER

Risk-based compliance: Following Financial Action Task Force (FATF) recommendations, crypto exchanges should adopt a risk-based approach to KYC compliance. Risk-based compliance requires firms to perform risk-assessments of individual customers, and then implement a proportionate AML/CFT response. If an assessment finds that a customer is high risk, the crypto exchange should deploy more intensive compliance measures – as opposed to simpler measures for low risk customers. Risk-based compliance enables crypto exchanges to deploy their AML/CFT resources more efficiently, while protecting customers from negative experiences, as far as possible.

In practice, digital KYC compliance means that ‘traditional’ KYC practices should be adjusted for the specific challenges that crypto exchanges face – and include the following measures and controls:

Identity verification: In order to build accurate risk profiles, crypto exchanges should be able to build accurate risk profiles for their customers. With that in mind, exchanges must obtain and verify identifying information from their customers, including names, addresses, birth dates, and relevant corporate information.

Customer monitoring: Exchanges should monitor their customers’ transactions on an ongoing basis, paying special attention for signs of criminal activity – which may include unusual transaction patterns, or transactions involving high risk customers and locations.

Screening: Exchanges must screen their customers to ensure that they are not subject to international sanctions, or that they are politically exposed persons (PEP), and therefore at higher risk of being involved in money laundering.

Adverse media: Customer risk profiles may be informed by adverse news stories before the same information appears in official sources. Exchanges should screen on an ongoing basis to detect customer involvement in adverse media.

Crypto Exchange KYC Risks

KYC compliance in the cryptocurrency space is complicated by an evolving regulatory landscape, and by relatively novel criminal methodologies. Accordingly, cryptocurrency exchanges should be aware of the following vulnerabilities and risks when developing and implementing their KYC solution:

Anonymous transactions: Cryptocurrency exchange transactions offer money launderers a degree of online anonymity. Accordingly, exchanges should seek to inform their identity verification process with digital controls, including obtaining biometric customer information such as face, voice, and fingerprint scans.

Transaction speed: Cryptocurrency funds can be moved between accounts in a matter of seconds, often outpacing AML/CFT controls. Exchanges should ensure that their own AML/CFT checks and monitoring processes can be completed before funds are transferred to user wallets.

Structured transactions: Money launderers may attempt to evade reporting thresholds by structuring their transactions in small amounts, across multiple accounts. Crypto exchanges should ensure their controls prevent the creation of multiple accounts and share information with other financial service providers to detect and prevent structuring strategies.

Money muling: Money launderers may seek to further exploit the vulnerabilities of cryptocurrency transactions by coercing or incentivizing third parties – known as ‘money mules’ – to engage with crypto exchange services on their behalf. Exchanges should work to detect money mules by performing suitable due diligence and identifying customers whose profiles do not match their wealth or expected financial behavior.

Negative customer experiences: Beyond the regulatory risks, crypto exchanges with inadequate or unsuitable KYC procedures also risk negatively affecting their customers’ experience of their services. Under a risk-based approach, KYC enables exchanges to build detailed risk profiles – and subsequently adjust their AML/CFT controls to better suit individuals. With that in mind, effective KYC is a way to optimize experiences for lower risk customers, ensuring service speed and efficiency where onerous AML/CFT scrutiny is not required.

Automating the KYC Process

AML/CFT compliance regulations require crypto exchanges to collect, analyze, and store vast amounts of digital customer and transaction data. In order to manage that obligation, crypto exchanges should seek to integrate a suitable software solution: in addition to automated speed, efficiency and accuracy, software solutions help firms add depth to their KYC procedures, and build out richer, more detailed risk profiles for their customers.

Automated KYC processes also help crypto exchanges remain agile in a rapidly changing regulatory environment. As new criminal methodologies emerge, and governments implement new cryptocurrency legislation, KYC software may help exchanges adapt to their regulatory environments and make important risk-based decisions quickly. Similarly, with the benefit of machine learning systems, exchanges may be able to perform deeper levels of analysis on historical data to reveal unforeseen vulnerabilities or unexpected diversions from expected financial behavior.

Regulators counter that financial crime is a big, urgent problem – the United Nations Office on Drugs and Crime has estimated, for example, that between $800 billion and $2 trillion is laundered by criminals every year. But a trove of leaked FinCEN documents last month showed that large banks flagged trillions of dollars of suspicious transactions to authorities but continued to do business with those customers. 

What’s more, the high cost of compliance means those bigger banks, along with well-established money transmitters such as Western Union, enjoy a barrier to entry against digital startups, for whom upfront compliance costs can be virtually insurmountable. 

In sum, a AML-KYC dragnet with huge holes in it serves the interests of incumbents. It does little to stop sophisticated big criminals from moving money around but prevents honest little guys from participating in transactions, all while protecting outdated financial dinosaurs from competition. 

Enter Bitcoin

Bitcoin was, in part, inspired by a desire to challenge this model. By resolving the trust problem and creating the digital equivalent of cash, it enabled peer-to-peer online payments between strangers. No longer did you need to identify yourself, no longer did you need an intermediary. 

This terrified law enforcement, which relies on financial intermediaries to do its police work. So, amid ongoing accounts of criminals using bitcoin, regulators went after the centralized, custodial exchanges that people use to move crypto funds in and out of the fiat banking system, and developed rules that roped that industry into the surveillance system. The multilateral Financial Action Task Force’s new “travel rule” has now internationalized this approach. 

Meanwhile, U.S. authorities have demonstrated they will apply the BSA to crypto software providers, most notably with the giant fine imposed this week on coin mixer Helix, whose privacy-protecting features were allegedly used by AlphaBay, the defunct “darknet” market.

That case underscores the far-reaching power this international system affords the U.S. government. The dollar’s reserve status means foreign banks need to maintain correspondent banking relationships with U.S. banks, which then become the gatekeepers of the world – and, effectively, agents of Washington’s interests. 

Now, crypto-inspired technology is providing more tools for people, and even governments, to avoid the U.S. gatekeepers. This week, Russia’s central bank said it could use a digital ruble as a tool to avoid U.S. sanctions. 

Sustainable system?

This system is broken. It has become a leviathan – too big, too comprehensive. Giant fines have skewed the risk-versus-payoffs for banks, which impose compliance on everyone regardless of size. (This is despite AML guidelines typically allowing ID exemptions for transfers of up to $1000, and in the U.S. up to $3,000.)

It’s time to scale down, not up.

“There is a principle in design that in order to optimize the system, to maintain the most positive outcome, we have to sub-optimize the sub-systems,” crypto compliance expert Juan Llanos said during this week’s episode of the Money Reimagined podcast. “That means we may have to learn to live with a little money laundering. We might have to live with the risk that someone in Somalia might be a criminal trying to get through the cracks.”

A more open mind from regulators toward cryptographic technologies that help regulators manage system-wide risks without imposing strict identity requirements on everyone would also be welcome. Research by the MIT-IBM Watson AI Lab into how to identify system risks within otherwise anonymous bitcoin transaction flows offers one potential way forward. 

The test is whether policymakers can respond to the human cost of the existing approach.

“Is this the system that really promotes prosperity in our world?” C-Labs General Counsel Brynly Llyr asked during the same podcast episode. “I mean, yes, money laundering is very serious, tax evasion is very serious, but when we look at the remittance markets and the folks who are relying on … transfers of $50 and $100 … is this really what we want our system to be cracking down on? Is this the best use of our resources?”

Battling global currencies

Bitcoin surged over $13,000 this week and, for once, the move was fueled not by the “risk-on” inflow that follows a rise in equity prices, but by some real news: PayPal’s announcement it would allow people to use cryptocurrencies inside its payment app. Still, the bigger meta-narrative around digital currencies remains tied to the fate of the world’s dominant fiat currencies. As Money Reimagined has explored previously, much will depend on the titanic monetary battle between China and the U.S. 

So, I decided to check in on two charts of each country’s currency, using the best non-correlated measures available. That meant avoiding the circular relationship in which the Chinese yuan is quoted in U.S. dollar terms and vice versa and, instead, using a standardized measure of each currency’s performance against a trade-weighted basket of multiple currencies. What that gave me was a lesson in how powerful central banks are.

The first chart, courtesy of Shuai Hao, CoinDesk’s data visualizer, concerns the dollar:

The image above is of the Federal Reserve’s trade-weighted dollar index. It offers an unsurprising but telling story: After the initial COVID-19 panic of mid-March, when a global scramble for dollars sent the greenback soaring against all currencies, the Fed’s unprecedented monetary expansion efforts sent it back down again. 

What’s remarkable is that, with the world still in a deeply troubled pandemic-choked state, the dollar has continued to fall. Does this reflect waning international confidence in the U.S. or merely a belief that the Fed will keep the money printer in overdrive but save the world in the process? Too soon to say.

Now, the yuan:

This one is based on the trade-weighted yuan index produced by the China Foreign Exchange Trade System (CFETS), the trading and foreign exchange division of China’s central bank. The index’s spike in March might seem odd to the uninformed observer because that’s when the world wanted dollars. Those panicked investors weren’t scrambling to stockpile the illiquid currency of the country then worst-affected by the pandemic; they only wanted greenbacks. 

But the explanation is quite simple: the People’s Bank of China’s interventionist management of its currency has for decades been dictated by a tightly managed “dirty peg” to the dollar. So when the dollar spikes against everyone else, the yuan does as well.

Why, then, did the yuan index rise after the mid-summer, even as the dollar continued to fall? Because the PBOC deliberately intervened to boost the local currency versus the dollar. Sure enough, the USD-CNY exchange rate has dropped from CNY 7.17 in late-May to CNY 6.66 now. 

Is this to discourage capital outflows? Maybe it’s to offset the need for softer domestic interest rates to boost local lending, which by extension equates with a Chinese bet on the domestic economy rather than on the nation’s exporters, which favor a weaker currency. Or is China trying to take advantage of waning trust in American global leadership to assert the strength and appeal of the yuan and boost its own international standing? Or, all of the above? 
What’s notable is that the yuan’s rising value coincides with the rollout of China’s digital yuan, which, although only in its experimental phase, is making waves worldwide. Stay tuned.

Global town hall

ASIA’S AMAZON. A prediction from a cryptocurrency entrepreneur stood out this week. Not another bitcoin $100,000 forecast but this two-part one, which CoinFlip Chief Operating Officer Ben Weiss shared with Business Insider: The next biggest company in the world will be blockchain-powered and it will be based in Asia. While there are strong arguments why both parts of that of that bet could prove wrong, the logic behind it is interesting to unpack. 

Will the next Microsoft/Google/Amazon be built on blockchain technology? One of the problems with that is a proper public blockchain cannot be owned by a single company, and if one were to exist it would defeat the core purpose of multiparty governance. But, of course, applications that are built on top of a blockchain or which tap into users of one or more blockchains can be for-profit, which is essentially the model behind successful crypto companies such as Coinbase. 

Notwithstanding those successes, and despite the billions that venture capitalists have invested in blockchain startups, it’s fair to say the high-profit “killer app” hasn’t yet been uncovered. And a good reason for that is the open-source, public foundations of blockchain technology make it hard for entrepreneurs to develop businesses with defensible market positions. 

Yet, it took the internet’s original entrepreneurs some time to figure out how to make money on the web. If we believe that, in one form or another, blockchain technology will provide the scaffolding for the financial system of the future, then it’s reasonable to assume that someone will figure how to make a lot of money with it.

If so, where will this happen? Weiss argues the regulatory clarity in places like Singapore, as opposed to the ambiguity and sometimes hostility from regulators in the U.S., make for an environment that’s much more conducive to future blockchain businesses. Certainly, China is betting that by supporting a nationwide Blockchain Services Network, which includes links to public blockchains, it will create the landscape for the next big company – perhaps more of an Alibaba than an Amazon. 

Here, too, there are parallels with internet history. One reason why the internet took off in Silicon Valley is the U.S. government took proactive steps to open up innovation in the internet industry. First there was the 1996 Telecommunications Act, which forced telecommunications providers to open their networks to competitors, which meant startups could now use that infrastructure to offer broadband services upon which e-commerce could thrive. A similar effect was felt by the U.S. government’s antitrust lawsuit against Microsoft. There seems to be little such vision employed in the U.S. right now to pave the way for the financial transformation that cryptocurrencies and blockchain portend. 

It’s too early to say whether the big, new Department of Justice lawsuit against Google this week (see Relevant Reads) signals a pro-innovation U.S. strategy to force a more decentralized internet or more of an ad hoc action.  Either way, on balance, Asian governments like Singapore’s or China’s are proving to be far more assertive in laying out a path for a more decentralized future. This is not to say there won’t be another Gates, Jobs, Bezos and Zuckerberg emerging out of the U.S. But it would also be naive to assume the next wave of business innovation will be in the U.S. and not in some other region. 

ASIA’S EURO. Still with Asia, the uncertainty around the future of global finance and the rise of digital currency prototypes is reviving a two-decade idea: that the region should create a common currency akin to the euro. That’s the case made by Japanese economists Taiji Inui, Wataru Takahashi, Mamoru Ishida in the wonky economist blog Vox EU. The trio argue that although Asian countries have learned how to better weather currency volatility than they did in the late-1990s, they remain vulnerable to capital flow shocks because of the asymmetric power of the dollar in the global financial system. So, they’re calling for an “Asian digital common currency as a multilateral synthetic currency comparable to the euro.” 

If that sounds familiar, it should because former Bank of England governor Mark Carney, in a provocative speech last year, called for a similar solution to the problem of dollar dominance, but for the entire world. I’m not sure why, following the well documented problems the eurozone faced earlier this decade with the incompatibility between monetary union and political disunity, another region would want to replicate it. Perhaps regional governments would be motivated by geopolitical interests to keep China in check much as France supported the euro as a way to forestall German aggression. Either way, if it were to arise it would put a new spin on the idea that the post-dollar age will be marked by one of competing digital currencies: The battle might not play out between nations but between regions

To be continued