Table of Contents
    Home / Crypto / Learn / KYC in Crypto, Explained
    Learn 9 min read

    Mobile phone trading interface connected with a photo ID card

    Key Takeaways
    • KYC in crypto is the process of confirming your identity by using official documents. These verify details like your name, address, date of birth, and government ID.
    • KYC safeguards against money laundering and applies to financial institutions. It is a requirement for centralized crypto exchanges, requiring them to perform identity checks on new clients and monitor trading activity.
    • Anonymity and a lack of oversight in crypto can be exploited for crime. KYC mitigates these risks by ensuring user accountability and transaction traceability.
    • KYC strengthens security, fosters trust among users and institutions and promotes a more legitimate and regulated cryptocurrency market.

    If you understand how cryptocurrency works, you’ll know crypto transactions are pseudonymous – they contain no data regarding the transacting party. However, regulations are changing that, and one area seeing increased focus is Know Your Customer (KYC). As the Federal Trade Commission highlighted, crypto fraud and scams have hastened calls for regulatory management.

    Just like traditional finance, centralized crypto platforms must now verify users’ identities during onboarding. This shift raises questions: Why is KYC crypto important? How does it impact users, and how is it enforced? We’ll explore these questions as we discuss KYC in crypto.

    What is KYC in crypto anyway?

    KYC, or Know Your Customer, is a process used to verify clients’ identities. It applies to all financial institutions, including banks, building societies and investment brokerages. 

    In the context of cryptocurrency, KYC means that centralized cryptocurrency exchanges (CEXs) require users to provide identification. This verification is crucial in preventing fraud, money laundering, and other illegal activities. By ensuring that users tie all their activity to a real-world identity, CEXs can maintain regulatory compliance and enhance the security of their platforms.

    Here’s a summarized breakdown of KYC in crypto. 

    For crypto users, it means:

    • Verifying your identity when you sign up for a CEX to buy or sell crypto.
    • Providing personal information to comply with legal requirements.

    You might be asked for:

    • Government-issued ID such as passport or driver’s license
    • Proof of address through utility bills or a bank statement
    • Recent photo or selfie
    • Social Security Number (SSN) or equivalent

    Transitioning from KYC, let’s discuss Anti-Money Laundering (AML) regulations.

    Fast Fact
    According to Chainalysis, illicit transaction volume rose in 2022, hitting an all-time high of $20.1 billion

     

    What’s AML in crypto?

    Anti-Money Laundering (AML) measures are crucial for preventing criminals from using cryptocurrency to fund their ill-gotten gains. AML is an umbrella term that includes Know Your Customer (KYC) checks among its various security measures. AML’s primary goal is to thwart money laundering, terrorist financing, and other financial crimes by ensuring all financial transactions are transparent and traceable.

    Crypto’s pseudonymous nature makes it attractive for illicit activities, such as hiding the origins of illegally obtained funds. To combat this, AML regulations specifically target cryptocurrency exchanges and custodial services, because these are the last interface between the fiat world and blockchain. These services are under a legal obligation to monitor transactions for suspicious activities and have a way to link that activity with a real person.

    Governments worldwide have implemented AML regulations, making it a standard practice for centralized crypto exchanges.

    How does KYC verification work in crypto?

    When you sign up for a new centralized crypto exchange, KYC will be part of the process of getting started. It involves submitting personal identification documents and, in some cases, a selfie for facial recognition. Though the process varies between countries and platforms, the goal is to identify and certify users. Here’s an overview of how it works.

    1 – Customer verification

    Customer verification is the first step in the KYC process. It requires reliable and objective data to validate the customer’s identity. Below are the documents most platforms require:

    • Legal name
    • Date of birth
    • Address
    • Government-issued ID, e.g., driver’s license or passport
    • Business licenses and articles of incorporation for enterprise customers

    The process involves submitting these documents through the exchange’s platform for verification.

    2 – Due dilligence

    Due diligence involves assessing the risk associated with a new client or business relationship. Financial service providers rate account risks based on background checks, surveys, and transaction history. Through due diligence, companies can identify potential risks related to money laundering or other illegal activities. The proactive approach helps ensure compliance with regulatory standards and enhances overall security and trust within the cryptocurrency industry.

    3 – Continuous monitoring

    Continuous monitoring is essential for maintaining compliance and preventing illicit activities. It entails ongoing scrutiny of transactions to detect any suspicious behavior indicative of money laundering, fraud, or other criminal activities. 

    Implementing robust KYC processes is integral to this framework. It ensures that exchanges can verify the identities of their users and maintain detailed records of their activities. Exchanges must file suspicious activity reports when they detect questionable activity.

    Does KYC apply to crypto wallets?

    KYC requirements apply to custodial wallets, for example those associated with centralized exchanges or custodial services. While not all wallets necessitate KYC, platforms managing these wallets may mandate identity verification to meet regulatory standards and mitigate risks such as money laundering and fraud. However, decentralized wallets, where users have sole control over their private keys and transactions, do not require KYC verification. 

    Is KYC verification safe?

    KYC verification poses no direct threat to your cryptocurrency. The process typically involves submitting government IDs or proof of address, not your private keys or recovery phrases, which are crucial for accessing your crypto holdings. Additionally, reputable institutions transmit these documents through secure connections, minimizing the risk of interception.

    However, your data security ultimately depends on how the institution stores it. Database breaches are possible, so choosing a platform with robust security measures is vital. Despite the potential risk, KYC verification enhances the crypto industry’s security by deterring criminal activity.

    Why do we need KYC in crypto?

    Crypto has built a reputation for facilitating money laundering and scams, and for funding criminal activities. This is not only damaging for the victims, but for the crypto industry itself, as users distrust this pioneering technology with many potential use cases. Incorporating KYC as part of the on-ramping process adds a security layer, creating transparency and accountability. 

    The majority of new crypto users on-board via a central exchange. By requiring users to identify themselves as they pass this gateway, KYC  enables all their subsequent transactions to be linked back to their true identity.

    Importantly, the areas below highlight why KYC is a must-have in crypto.

    Crypto is pseudonymous

    Unlike banking transactions, which are linked with a real person, blockchain obfuscates the identity of the transacting parties. While this opaque system appeals to many users, it has sometimes created opportunities for illegal activities, such as money laundering and terrorist financing. This is especially true since blockchain facilitates fast, cross-border payments. The lack of identity verification made it easier for criminals to exploit these systems without detection.

    Crypto facilitates cross-border transactions

    Borderless transactions can obscure the source and destination of funds, complicating efforts to prevent illegal activities. KYC helps by maintaining records of users’ identities, enabling better tracking and monitoring of international transactions.

    No central authority

    Without a central authority, law enforcement faces difficulties in investigating and seizing assets involved in illegal activities. KYC procedures empower exchanges and custodial services to collect and share information with regulatory bodies, aiding in identifying and prosecuting criminals.

    Advantages of KYC

    KYC offers several benefits to the cryptocurrency ecosystem, enhancing security and trust.

    • Fraud prevention: KYC reduces fraud and identity theft in the cryptocurrency ecosystem by verifying user identities by collecting and confirming personal information, such as government-issued ID and address. This deters malicious actors and safeguards the platform and its users.
    • Regulatory compliance: Implementing KYC ensures cryptocurrency platforms comply with AML and CTF regulations, preventing misuse for money laundering and terrorist financing. Following KYC procedures allows platforms to detect and report suspicious transactions, ensuring legal compliance and avoiding severe penalties.
    • Enhanced security: Enforcing KYC regulations improves cryptocurrency platform security by monitoring user activities to detect threats early. This surveillance deters bad actors or fraudsters, increasing trust among users, regulators, and financial institutions in the platform’s security and compliance measures.
    • Increased trust: KYC builds trust among users, regulators, and financial institutions by verifying identities and ensuring legal compliance, enhancing platform security. This trust encourages engagement and supports a healthier, more reliable cryptocurrency ecosystem.

    Disadvantages of KYC

    While KYC offers benefits, it also raises concerns:

    • Reduced privacy: KYC protocols reduce the privacy valued by cryptocurrency users by requiring personal information submission, compromising the anonymity fundamental to the crypto space. This intrusion is a significant drawback for those prioritizing anonymity.
    • Barriers to entry: Cumbersome KYC procedures can create significant barriers to entry, potentially discouraging new users, especially in regions with stringent regulations. This can hinder cryptocurrency adoption and slow industry growth.
    • Centralization: Another concern with KYC is its potential to push the cryptocurrency industry towards centralization, undermining the core decentralized principles valued by the crypto community and forcing companies to comply with centralized control. This obscures one of crypto’s key attractions.
    • Security concerns: and of course, big companies such as crypto exchanges keeping personal data for thousands of customers creates a potential risk. This volume of personal data is a honeypot for hackers seeking to exploit the company or simply gain access to your personal information.

    Closing thoughts

    While it may feel at odds with the anonymity-focused past, KYC strengthens the industry over all, and protects users. Though challenges like privacy remain, KYC paves the way for wider adoption and a more secure future for cryptocurrency. As regulations develop, finding the right balance between security and user privacy will be crucial for the continued growth and mainstream acceptance of crypto.