What Is KYC (Know Your Customer)?

Key Takeaways:

 

As businesses continue to expand in the digital space, financial transactions can now be completed in seconds. However, not all transactions are legitimate. Some involve stolen funds, identity fraud, bribery, or terrorist financing, creating significant financial and security risks.

To address these risks, governments and regulatory bodies have enforced strict policies designed to protect the integrity of financial transactions. One such policy is Know Your Customer (KYC), which requires businesses to verify customer identities before processing financial transactions.

What Is KYC (Know Your Customer)?

KYC involves three primary components:

1. Customer Identification Program (CIP)

The Customer Identification Program (CIP), introduced under the USA Patriot Act of 2001, requires financial institutions to collect and verify customer information. This typically includes:

• Name
• Date of birth
• Address
• Identification Number

In some cases, companies may also collect additional information, such as:

• Phone numbers, email addresses, or biometric data (selfies, fingerprints, etc.)
• IP addresses and additional verification for high-risk individuals

2. Customer Due Diligence (CDD)

Customer Due Diligence (CDD) goes beyond identity verification to assess the potential risks associated with a customer. Regulated by FinCEN (Financial Crimes Enforcement Network), CDD includes:

• Verifying customer identities (matching against CIP records). This is crucial, as the Customer Identification Program (CIP) ensures businesses accurately collect and verify key personal details to confirm a customer’s identity.
• Analyzing ownership structures (for businesses).
• Assessing customer transactions to detect risk patterns.
• Ongoing monitoring for financial crime indicators.

Levels of Customer Due Diligence (CDD)

The level of scrutiny depends on the customer’s risk profile:

• Simplified Due Diligence (SDD): For low-risk customers, minimal verification is required, and ongoing monitoring is limited.
• Basic Due Diligence (BDD): Standard verification process applied to most customers during onboarding.
• Enhanced Due Diligence (EDD): Required for high-risk customers such as politically exposed persons (PEPs), high-net-worth individuals (HNWIs), and businesses operating in high-risk regions. EDD involves extra verification, continuous transaction monitoring, and risk-based scrutiny.

3. Ongoing Monitoring (OM)

Ongoing Monitoring ensures that customer transactions remain compliant over time. If a financial institution detects suspicious behavior, it must file a Suspicious Activity Report (SAR) with FinCEN within 30 days. Institutions can have up to 60 days in total to investigate and file the report, ensuring that suspicious activities—such as large or unusual transactions—are flagged promptly.

What Are the Objectives of KYC Verification?

The main objectives of KYC verification are:

• Verify customer identities: Ensure that businesses confirm the identity of clients to prevent fraud and unauthorized transactions.
• Confirm the legitimacy of customer funds: Help financial institutions verify the source of funds and detect money laundering activities.
• Reduce the risk of financial crime: Align with Anti-Money Laundering (AML) protocols to combat identity fraud, money laundering, and terrorist financing.

Implementing effective KYC verification also helps protect businesses and customers against KYC fraud, which occurs when individuals or groups provide false or stolen identities to bypass security measures. This is crucial for preventing financial fraud and ensuring legitimate transactions. KYC fraud undermines the entire financial system, which is why robust, effective KYC processes are essential to maintaining trust and security in the financial ecosystem.

Benefits of KYC Compliance

KYC compliance offers several advantages for businesses, including:

• Stronger Customer Insights: KYC verification helps businesses understand customer identity, risk profiles, and transaction behavior. This information enables companies to offer more targeted services and build better customer relationships.
• Fraud Prevention and Risk Mitigation: KYC safeguards businesses and customers from identity theft, financial fraud, and unauthorized transactions. This reduces exposure to cyber threats and mitigates repuational risks.
• Regulatory Compliance and Legal Protection: Many industries, particularly financial institutions, are legally required to comply with KYC regulations. Adhering to KYC and Anti-Money Laundering (AML) compliance helps businesses avoid hefty fines, legal penalties, and operational restrictions.

What Is eKYC (Electronic Know Your Customer)?

eKYC (Electronic Know Your Customer) is a digital alternative to traditional, in-person KYC verification. It enables businesses to verify customer identities remotely, making the process more efficient with digital authentication methods.

Unlike manual KYC, which typically requires physical documentation, eKYC uses AI-driven verification tools, biometric authentication, and real-time document scanning to authenticate users quickly and securely.

Advantages of eKYC vs. Traditional KYC

• Faster Verification: By automating identity checks, eKYC significantly reduces onboarding time.
• Lower Costs: eKYC eliminates the need for paperwork and manual verification processes, making KYC more cost-effective.
• Enhanced Security: eKYC utilizes advanced fraud detection algorithms to identify forged documents and prevent fraudulent transactions.
• Higher Customer Retention: A survey by Fenergo found that 48% of banks lost clients due to slow onboarding. eKYC helps address this by speeding up the process.

Who Needs To Be KYC Compliant?

KYC compliance is mandatory for businesses operating in regulated industries, including:

• Banking & Financial Institutions: This includes banks, credit unions, payment processors, and fintech companies.
• Insurance Providers: KYC ensures the verification of customer identities to prevent fraud and financial crimes.
• Regulated Industries: This includes online gambling, casinos, and betting platforms.
• Digital Wallet & Payment Providers: KYC helps ensure secure transactions for e-wallets and digital payment apps.
• Real Estate Agencies: Prevents property-related fraud and money laundering.
• Asset Management Firms: Ensures compliance with investment regulations.
• High-Value Goods Dealers: Businesses selling luxury assets like gold, jewelry, and fine art need to comply with KYC regulations.
• Trust Formation Services: Required for legal compliance and fraud prevention.
• Cryptocurrency Exchanges: These exchanges are subject to AML and KYC laws to prevent financial crime in the crypto space.

KYC Regulations in the Cryptocurrency Industry

Until 2019, Know Your Customer (KYC) verification was not a regulatory requirement for cryptocurrency exchanges or the broader crypto industry. However, that changed when the SEC, FinCEN, and CFTC issued a collective statement classifying crypto exchanges as money service businesses (MSBs). This designation placed them under the regulatory scope of KYC and Anti-Money Laundering (AML) compliance, as outlined in the Bank Secrecy Act of 1970.

With this shift, cryptocurrency exchanges and other digital asset service providers had to verify user identities before allowing transactions. KYC compliance for crypto platforms now involves:

• Collecting personal identification information such as name, date of birth, and address.
• Verifying documents like passports, driver’s licenses, or government-issued IDs.
• Conducting risk assessments to prevent fraud, money laundering, and illicit financial activities.
• Implementing Ongoing Monitoring (OM) to track suspicious transactions and report them to financial authorities.

The Impact of KYC on the Crypto Industry

As cryptocurrency adoption grows, so does regulatory scrutiny. Governments worldwide have imposed stricter KYC verification rules to align crypto markets with traditional finance.

KYC and Crypto Regulations in the U.S.

• The U.S. Treasury Department’s 2020 rule requires users transferring $3,000+ in crypto to private wallets to disclose recipient details.
• Transactions over $10,000 in a day must be reported to FinCEN, mirroring traditional banking laws.
• Some states, like California, have attempted stricter crypto licensing, facing industry pushback.

Global KYC Compliance for Crypto Exchanges

• The EU’s Sixth Anti-Money Laundering Directive (6AMLD) mandates KYC for all crypto service providers.
• The Markets in Crypto-Assets Regulation (MiCA) requires identity verification and AML compliance for crypto exchanges in the EU.
• Asian and Middle Eastern regulators are introducing KYC rules to curb financial crimes tied to cryptocurrency.

Despite growing regulations, crypto platforms struggle to balance compliance, privacy, and user accessibility, fueling debate over KYC’s necessity in the industry.

Why Does the Cryptocurrency Industry Oppose KYC?

Although KYC (Know Your Customer) regulations are designed to prevent financial crimes such as money laundering and terrorist financing, they face strong resistance within the cryptocurrency community. Critics argue that KYC contradicts the fundamental principles of privacy, decentralization, and financial freedom that crypto was built upon.

Privacy Concerns

Privacy is one of cryptocurrency’s core advantages, allowing users to transact without exposing personal information. Blockchain technology enables pseudonymous transactions, offering a level of anonymity not found in traditional finance. However, KYC requirements mandate that exchanges collect and store user data, raising significant concerns about:

• Government Surveillance: Tying crypto transactions to verified identities makes it easier for authorities to monitor financial activity.
• Data Breaches: Centralized databases holding sensitive identity information become prime targets for hackers.
• Identity Theft & Fraud: If compromised, stolen KYC data can be misused for fraudulent activities, including financial scams and synthetic identity fraud.

For many crypto advocates, KYC undermines the industry’s goal of enabling trustless, permissionless financial transactions.

The Conflict Between KYC and Decentralization

Decentralization removes intermediaries, allowing users to transact freely without relying on centralized authorities. However, KYC requirements reintroduce centralized control by forcing exchanges to verify and store user identities, leading to several risks:

• Single Points of Failure: KYC compliance requires exchanges to maintain large databases, making them attractive targets for cyberattacks.
• Censorship Risks: Governments or institutions could restrict access to crypto services based on identity verification.
• Exclusionary Barriers: Users in developing regions without formal IDs may be unable to access crypto platforms, limiting financial inclusion.

How Decentralized Identity Enhances KYC Processes

Decentralized identity offers a way to meet KYC requirements across industries—including banking, fintech, and cryptocurrency exchanges—without compromising user privacy. Instead of submitting personal data to centralized databases, users verify their identity once through verifiable credentials stored in their self-sovereign identity wallet.

A trusted issuer, such as a bank or government agency, verifies the user’s identity and issues a credential proving their compliance. When completing a KYC process—whether for opening a bank account, accessing financial services, or using a crypto exchange—users can prove they meet the requirements (e.g., age, residency, or risk status) without revealing personally identifiable information (PII). This is where reusable KYC comes in: once a user’s identity is verified, they can reuse the same verified credentials across different services, simplifying and speeding up future KYC processes.

Rather than sharing copies of passports or other sensitive documents, users provide a cryptographic proof of verification, reducing the risk of data breaches and identity theft. This privacy-first approach ensures compliance with regulations while maintaining security, efficiency, and user control over personal data.

Identity.com 

Identity.com, as a future-oriented organization, is helping many businesses by giving their customers a hassle-free identity verification process. Our organization envisions a user-centric internet where individuals maintain control over their data. This commitment drives Identity.com to actively contribute to this future through innovative identity management systems and protocols.

As members of the World Wide Web Consortium (W3C), we uphold the standards for the World Wide Web and work towards a more secure and user-friendly online experience. Identity.com is an open-source ecosystem providing access to on-chain and secure identity verification. Our solutions improve the user experience and reduce onboarding friction through reusable and interoperable Gateway Passes. Please get in touch for more information about how we can help you with identity verification and general KYC processes.