In just 13 short years, cryptocurrencies have redefined money. Meanwhile, blockchains have made the exchange of information more secure than ever, and decentralized finance applications have introduced entirely new ways to store and transfer value. Innovation is everywhere.
But wherever there is innovation, there is also the risk of bad behavior. It’s no surprise, then, that cryptocurrencies—financial systems with no central authority that enable pseudonymous transactions via the internet—have in some cases been abused for crime. Over the past decade, there have been hundreds of high-profile cryptocurrency-enabled crimes, from the PlusToken Ponzi scheme to the money laundering operations of organizations like Suex.
Regulators, financial institutions, and law enforcement agencies combat these activities with anti-money laundering (AML) and know your customer (KYC) policies.
Below, we define AML and KYC, how they work, and why they matter for cryptocurrency.
- What is AML for crypto?
- Why is crypto AML important?
- What is Know Your Customer (KYC)?
- How does KYC work?
- Why is KYC Important for Crypto?
- Why crypto needs AML and KYC
What is AML for Crypto?
Cryptocurrency anti-money laundering (AML) encompasses the laws, regulations, and practices designed to stop criminals from converting illegally obtained cryptocurrencies into fiat money.
The Financial Action Task Force (FATF) sets the standards for AML laws globally. FATF began publishing guidance on cryptocurrency AML in 2014, and policymakers in FATF’s member jurisdictions quickly took action; today, FinCEN, the European Commission, and dozens of other regulatory bodies have codified most of FATF’s cryptocurrency AML recommendations into law.
From there, the baton gets passed on to virtual asset service providers (VASPs)—a group that FATF defines to include cryptocurrency exchanges, stablecoin issuers, and, on a case-by-case basis, some DeFi protocols and NFT marketplaces. These businesses do the heavy lifting to stop money laundering by employing compliance officers, requiring know-your-customer checks, and continuously monitoring transactions for suspicious activity.
When suspicious activity is observed, VASPs report this information to relevant regulators and agencies, which then use blockchain analysis tools like Chainalysis Reactor to investigate the flow of funds and link illicit activity to real-world identifiers.
Why is AML for Crypto important?
Cryptocurrency remains appealing for criminals due to its pseudonymous nature and the ease with which it allows users to send funds anywhere, even despite its transparent and traceable design. In 2020 alone, funds laundered through cryptocurrency exchanges topped $2.3 billion. Effective AML regulations have two important consequences: first, they make laundering schemes more risky and less profitable; second, they create new avenues by which investigators can catch and prosecute criminals.
Effective AML procedures among cryptocurrency businesses are just as essential: with continuous transaction monitoring, compliance officers can stop many of these schemes before they start.
What is Know Your Customer (KYC)?
KYC refers to a set of identity verification procedures required by law for money service providers, including VASPs. KYC processes are crucial for cryptocurrency AML because they enable criminal investigators to connect pseudonymous addresses to real identities in the event the address has been connected to crime, thereby enabling effective investigations.
In traditional finance, valid credentials include ID card validation, face verification, and biometric authentication. Additionally, many banks require proof of address (e.g. a copy of a recent utility bill).
In the cryptocurrency industry, KYC requirements are less standardized. Most exchanges require that new customers share their legal name, government-issued ID, and up-to-date address information, but this varies according to where the exchange operates and what services it provides.
This October, FATF clarified that NFT marketplaces, DeFi protocols, and stablecoin providers, depending on the activities in which they engage, may also be obligated to adopt KYC compliance and monitoring solutions.
How does KYC work?
KYC programs generally have three components: customer identification, due diligence, and continuous monitoring.
Customer Identification Program (CIP)
A customer identification program or ‘CIP’ uses reliable and independent data to ensure that the customer is who they claim to be. For individuals, this could include the client’s legal name, date of birth, address, and verifying documentation like a driver’s license or passport. For enterprise customers, business licenses and articles of incorporation are common requirements.
Customer Due Diligence (CDD)
Customer Due Diligence or ‘CDD’ is an assessment of the risks presented by a new client or business relationship. Financial service providers make use of background checks, customer surveys, and reviews of client transaction history to assign risk ratings determining how closely an account will be monitored.
Continuous monitoring is the ongoing review of transactions for criminal activity. When suspicious activities are detected, VASPs are obligated to submit Suspicious Activities Reports (SARs) to FinCEN or other relevant law enforcement agencies. Chainalysis Know Your Transaction helps businesses comply with these obligations by automatically detecting patterns of suspicious activity, sending real-time alerts, enabling in-depth investigations, and integrating into compliance team workflows.
Why is KYC important for Crypto?
With cryptocurrency adoption growing exponentially, cryptocurrency businesses need KYC processes to comply with regulations and stop illicit activity. Identity verification, risk assessment, and continuous monitoring are the best means to that end.
Moreover, by adopting new KYC procedures, cryptocurrency businesses can build trust with users and regulators without sacrificing their bottom line. When Binance, a global cryptocurrency exchange, made KYC mandatory for all of its customers, it found that “most people — 96%, 97% of users — go through KYC.” This minor reduction in registrations is a small price to pay for the ability to operate in hundreds of regulatory environments, serve millions of customers, and stop illicit activities of every type.
Cryptocurrency, meet AML and KYC
As cryptocurrencies have expanded and reshaped the global financial network, AML and KYC have become a basic need. That’s why Chainalysis helps cryptocurrency businesses stay compliant and government agencies stop crime: because AML and KYC minimizes the risks faced by businesses, protects users from illicit activity, and builds trust in cryptocurrency.