KYC, or Know Your Customer, is now a mandatory practice across financial institutions. Be it banks or stock purchasing platforms. KYC is a necessary and compulsory element. However, KYC with respect to crypto exchanges is a much more complicated topic. Unlike other financial institutions, crypto exchanges are not dealing with a regulated, centralized asset class.
But first, we need to understand what KYC is. Then we need to understand why crypto exchanges face an acute challenge when it comes to KYC. In the end, we’ll discuss what crypto exchanges can do to deal with this challenge.
What is KYC and why is it important for crypto exchanges
Money laundering and terrorism financing are the two most pertinent issues for financial regulators across the world. Cryptocurrencies play a big role in global money laundering and terrorism financing.
Mainstream media and a section of politicians like to make the issue even bigger than it is due to a fear of crypto taking over other financial institutions.
The primary purpose of KYC is to ensure that the people engaging with a financial institution does not have a criminal background or are not using the platform for illegal transactions. It is standard practice across the world and comes with its own benefits.
However, crypto exchanges face a unique challenge with respect to KYC. To understand the challenge, we need to better understand the nature of cryptocurrencies.
What is KYC?
Identity theft refers to a situation where one person impersonates someone else and carries out illegal transactions with that alias.
The purpose of KYC is to combat this. While KYC cannot guarantee against money laundering, it can make detection easier.
Every financial institution performs KYC to know their customers better. It helps in a variety of things, be it anti-money-laundering measures or reporting suspicious activities.
In KYC, institutions typically collect certain information from the customers. It often includes a government-approved identity card, biometric signatures, address, and contact information. With the help of this information, financial institutions can easily track suspicious activities and report the same to authorities.
With regulated and centralized entities, KYC does not pose many problems. Since all centralized institutions are regulated by the same laws, there is no confusion about what to do to ensure KYC compliance. With crypto exchanges, it is a completely different story.
Why is KYC a problem for cryptocurrency exchanges?
There are more than 600 crypto exchanges in the world, and it is very difficult to have them all follow the same rules. More so because the cryptocurrency ecosystem does not like rules.
Cryptocurrency exchange Kraken had complained about the cost of ensuring compliance. Hodl Hodl, another crypto exchange, allows users to trade cryptocurrencies without any KYC. There are a number of crypto exchanges, especially outside the United States, that do not follow KYC requirements.
The core argument against KYC is that it gives a lot of power to the governments. Since the very purpose of cryptocurrency is to eliminate governments from financial transactions, KYC is not something that early crypto adopters would like. KYC goes against the core principles of cryptocurrencies.
There have been multiple incidences of exchanges getting into trouble for bypassing KYC regulations. BitMex’s $100 million settlement with the United States Securities and Exchange Council is the most famous example.
On the other hand, crypto exchanges like Binance and Crypto.com have adopted KYC measures without much resistance. Globally, more and more established crypto exchanges have moved towards the adoption of KYC. Overall, it shows a sign of the market becoming more mature and mainstream. Though it goes against the core ideal of crypto, it is better for the average investor who wants to make money off cryptocurrencies.
Why KYC is essential for crypto exchanges
Cryptocurrencies are not the safest investment, primarily because of the existence of hundreds of illegitimate exchanges.
If a crypto exchange is not accountable to its customers, it can get away with almost any crime. Moreover, crypto being an unregulated asset class means investors do not get any official protection.
One of the main reasons many people stay away from crypto is the security question. While crypto is very volatile, it is not the primary reason behind people not investing in it.
With so much regulatory scrutiny, many people do not feel confident with crypto investments.
KYC is a small step towards changing this. KYC gives legitimate customers a chance to hold the exchange accountable in case something goes wrong. Most reputed cryptocurrency exchanges have adopted the practice along with other steps like insurance and investor background check.
However, managing KYC is not easy for cryptocurrency exchanges. The availability of KYC tools solves this hurdle to a great extent. These tools are designed to make the KYC process easier and more seamless.
In 2020, investors lost more than $350 million to cyber attacks and hackers. It goes on to show the importance of KYC and investor protection. KYC gives both regulators and exchanges a chance to battle cryptocurrency scams and frauds. Without KYC, there is no way to trace a crime and get to the perpetrator.
What crypto exchanges can do to comply with KYC regulations
Crypto exchanges face a huge challenge when it comes to KYC. The biggest challenge comes in the form of cost and time. It takes a lot of money and time to ensure KYC processes for all customers. Many criminal activities can take place by taking advantage of this time gap.
However, crypto exchanges are tightening their own measures to ensure seamless KYC procedures. In countries with a strong regulatory framework, undergoing KYC is easier for both customers and exchanges.
The problem lies with overseas crypto exchanges that leverage loose laws to their advantage. Seychelles is a great example of this phenomenon.
Many exchanges operate out of Seychelles because the country does not have any robust regulatory framework in place. BitMex is one of the crypto exchanges that tried to bypass KYC by setting up its headquarters in Seychelles.
While ensuring KYC is challenging, it is far from impossible. The good news is that many companies and startups are working in this area, trying to make KYC easier for exchanges. With the widespread adoption of these tools, KYC will no longer be a challenge for crypto exchanges.
In the long run, KYC practices help crypto exchanges in gaining public trust. As a result, they get more investors. However, it also loses customers who do not want to disclose their identity. Such customers would often go with decentralized exchanges (DEX) that do not require KYC.
Conclusion
KYC might not be a perfect solution to all problems, but it is better than most other options.
The crypto community has mixed opinions about it. While some believe it does injustice to the central purpose of cryptocurrencies, others feel it is a sign of a mature market.
No matter which argument you agree with, crypto exchanges need to ramp up their KYC measures.
Be it Europe, North America, or Asia, KYC rules are in effect in most countries. In the future, the extent of KYC adoption will increase even more. Crypto exchanges that have ignored KYC for so long can no longer afford to do the same.