The Importance of KYC for Crypto Exchanges

The cryptocurrency market continues to grow. According to a report from Fortune Magazine, the total value of the global cryptocurrency market hit $2 trillion earlier this year. Cryptocurrency exchanges—the platforms on which you can buy, sell, and trade crypto—are becoming an ever more important part of global financial markets. There are many opportunities out there for exchanges.

Developing and growing crypto exchanges is complicated. Not only is there a lot of volatility in the industry, but there are complex financial regulations that exchanges must be aware of. In the United States, crypto exchanges are subject to KYC requirements. In this article, you will find an overview of know-your-client/know-your-customer (KYC) practices for cryptocurrency exchanges.

What Is KYC and How Does It Apply to the Financial Industry?

As a starting point, it is important to understand what KYC is and how it affects the financial industry as a whole. KYC stands for ‘know-your-customer’ or ‘know-your-client’. The term refers to the broad set of standards that banks and other financial institutions must follow when it comes to accepting new clients/customers.

In effect, KYC states that financial services providers have a basic legal responsibility to know who they are working with and to ensure that clients/customers have a legitimate purpose. KYC regulations exist to help stop financial fraud, the financing of terrorism, and other illicit criminal activities.

For U.S. institutions, the current KYC standards come largely from the  USA Patriot Act of 2001 and the anti-money laundering provisions (AML) of the Bank Secrecy Act of 1970. The United Kingdom, the European Union (EU), and other countries have their KYC regulations.

U.S. Law: Crypto Exchanges Are Subject to KYC Standards

Cryptocurrency is still a relatively new innovation. For a while, crypto exchange has been somewhat of a “gray area” for financial regulations. However, that is quickly changing in the United States, United Kingdom, and the European Union.

In October of 2019, the leaders of the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and the Financial Crimes Enforcement Network (FINCEN) issued a joint statement on cryptocurrency and anti-money laundering requirements.

The regulatory guidance clearly states that the United States government considers crypto exchanges to be money service businesses (MSBs). As such, they are subject to KYC standards and AML requirements. Exchanges that fail to comply with these regulations could face stiff penalties.

The Bottom Line: Crypto exchanges in the United States are now largely subject to the same know-your-customer and anti-money laundering standards as more traditional financial institutions.

Know the Risks: Regulators Are Cracking Down on KYC Violations by Crypto Exchanges

For crypto exchanges, the risks associated with KYC and AML violations are well-demonstrated by the recent sanctions imposed on BitMEX. BitMEX is a cryptocurrency exchange and derivative trading platform with its main headquarters in Seychelles. On August 10th, 2021, the CFTC announced that the company was paying a 100 million dollar fine for, among other things, anti-money laundering violations. The U.S. government determined that BitMex did not have the proper KYC protocols in place.

Cryptocurrency Exchanges Face Unique Challenges

For crypto exchanges, know-your-customer compliance is especially challenging. In some ways, the verification that comes with KYC is thought of as antithetical to the spirit of crypto—which puts a premium on anonymity and decentralization. Indeed, some of the top exchanges pushed back against these regulations. On the other hand, some proponents of digital currency contend that these types of safety measures are necessary to help continue to bring crypto to the mainstream.

The reality is that it currently does not matter where your crypto exchange is based. If your company accepts American-based customers, it is required to comply with U.S. financial regulations, including KYC verification requirements and AML standards. Crypto exchanges that can develop a strong KYC system that conforms to U.S. law while also making the process as seamless as possible for customers can protect their firm against liability risk while also securing a market advantage.

Protect Your Exchange: Three Principles of Effective KYC for Crypto Exchanges

For crypto exchanges operating within the United States, strong and comprehensive KYC practices are important for several different reasons. It starts with the fact that crypto exchanges must comply with federal law. Beyond that, most customers feel safer and more secure when there are well-considered KYC practices in place. At Integrity, we provide KYC compliance verification for a wide range of clients, including crypto exchanges. Here are three key principles for financial entities operating within the cryptocurrency industry:

1. Identify Customers/Clients

Identification is the building block of a know-your-client strategy. The federal regulations that now apply to cryptocurrency exchanges require firms to develop and implement an adequate Customer Identification Program (CIP). CIP should require prospective clients/customers to provide some basic identifying information to prove that they are who they say that they are.

2. Thorough Due Diligence

Identifying a client/customer is the only first step in KYC verification. From there, crypto exchanges should be prepared to conduct comprehensive due diligence. What due diligence entails can vary based on the specific circumstances. It may include: Collecting data on a prospective client/customer from available sources, making an evaluation of the safety of a client/customer, and assessing the nature of a client’s activities.

3. Ongoing Monitoring

Finally, KYC verification should generally include some form of ongoing monitoring—especially for all customers/clients that present a heightened risk. A customer can present a heightened risk for a wide range of different reasons. Crypto exchanges should have a well-developed system in place for identifying, monitoring, and, if necessary, addressing high-risk clients.

Integrity Is a Leader in Identity Verification for Crypto Exchanges

A division of Aristotle, Integrity is a trusted market leader in global identity verification. Crypto exchanges must have the proper KYC protocols in place. If you have any questions or concerns about know-your-client procedures for cryptocurrency exchanges, we are here as a resource. Contact us today to find out more about how our team can help.


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