KYC compliance

Know Your Customer (KYC)

Know Your Customer (KYC) refers to the identity verification process businesses use before establishing any relationship with their customers. Initially implemented in the financial industry, KYC laws have since been extended to include non-financial businesses as well. Depending on the industry, it is also referred to as Know Your Client, KYP (Know Your Patient), KYB (Know Your Business), KYT (Know Your Transaction).

What is KYC compliance?

KYC compliance is a regulatory requirement for both financial and non-financial organizations. This process involves verifying a customer’s identity, assessing their financial activities, and determining their level of associated risk. These entities must implement customer identification processes and verify their customers regularly, in line with regulatory guidelines. Know Your Customer requirements help businesses avoid penalties, combat fraud, and mitigate financial crimes such as money laundering and terrorist financing.

Who is obliged to comply with KYC regulations?

KYC compliance laws apply to a wide range of businesses across various industries. Common entities required to comply with KYC regulations in most global markets include:

• Financial Industry: Banks, insurance companies, brokerage houses, mortgage lenders, etc.
• Fintech: Crypto companies, online payment solutions, digital loan/mortgage providers, etc.
• Real Estate: Real estate agencies, property management firms, etc.
• Healthcare: Hospitals, healthcare facilities, pharmacies, online care and drug providers, in-home care providers, etc.
• Gaming: E-gaming platforms, poker/lottery businesses, etc.
• Legal: Law firms, legal advisors, etc.
• Precious Metals & Art Dealers: Art galleries, jewelers, antique dealers, etc.

Global KYC laws and programs

The following are some of the most influential pieces of KYC legislation that exist globally.

Financial Action Task Force (FATF): Comprising 38 member jurisdictions, representing most major financial centres around the globe, this intergovernmental body sets international anti-money laundering and counter-terrorist financing policy standards. These standards are periodically updated to address emerging threats.

United States Bank Secrecy Act: Requires financial institutions (especially banks) to verify customers and report suspicious activities to the Financial Crimes Enforcement Network (FinCEN). Banks are required to adopt KYC programs according to the provisions of the US Patriot Act.

United States AML Act of 2020:  This legislation introduced more stringent Ultimate Beneficial Ownership (UBO) requirements and expanded the powers of FinCEN to enforce KYC regulations in the USA.

European Union AML Directives: Imposes strict customer due diligence (CDD) requirements on member states to identify UBOs and increases scrutiny on those who pose a high risk for money laundering such as political exposed persons (PEPs) and those with unusual transaction patterns.

Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA): As overseen by the Financial Transactions and Reports Analysis Centre of Canada, financial institutions are required to have thorough KYC identity verification procedures, report suspicious transaction reports (STRs) with FINTRAC, and maintain detailed transaction and customer records for at least five years.  

AML/CTF Act (Australia): Implemented by AUSTRAC, it outlines KYC and AML compliance guidelines for individual and corporate customer verification and, similar to Canada, requires institutions to maintain transaction and customer records for a minimum of seven years.

Core Elements of KYC

There are three key components of KYC that help to create a solid foundation for protecting against various forms of fraud and dangerous transactions.

1. Customer Identification Program (CIP)

CIP involves collecting the most basic identifying information about a customer, such as: full name, date of birth, and address. A key component of CIP is the inclusion of official identification documents (e.g., passport, driver’s license, National ID card) and can vary significantly between regions. These must be verified for authenticity using reliable technology solutions to differentiate between official and counterfeit documents.

2. Customer Due Diligence (CDD)

There are three types of due diligence done depending on the risk level associated with the customer. 

• Simplified Due Diligence (SDD) is applied to customers with a low risk of money laundering or terrorist financing and therefore the level of verification required is minimal. 
• Regular Due Diligence (RDD) is the standard approach for new customers who’s risk level is normal or unknown and involves understanding the purpose of the relationship and checking against sanction lists and Politically Exposed Persons (PEP) lists. 
• Enhanced Due Diligence (EDD) is used for customers who are deemed to be high-risk such as those who have done business in high-risk jurisdictions, are PEPs, or have been involved in a large or unusual transaction. EDD tends to involve further examination of the customer’s business history, closer analysis of their transactions, and assessing their source of wealth.

3. Ongoing Monitoring

Once customers are onboarded, institutions are obligated to continuously monitor their transactions and activities in order to identify and flag suspicious behavior. When new risks appear, the customer’s risk level must be reassessed with increased scrutiny. 

Evolving KYC Requirements and Emerging Trends

1. Real-Time ID Verification

Technological advancements allow for the verification of customer identities in real time with Artificial Intelligence (AI) based KYC solutions. Biometric verification (e.g., facial recognition or fingerprint scanning) are commonly used to reduce manual processing and improve accuracy.

2. AI and Machine Learning

AI is now integral to detecting anomalies and suspicious patterns by utilizing machine learning to quickly analyze large datasets to identify unusual behaviors or transactions which in turn enhances the accuracy and efficiency of KYC compliance efforts.

3. Digital Identity and eKYC

Electronic KYC (eKYC) allows customers to verify their identities through secure channels, allowing for fast and remote onboarding. This approach is growing in popularity amongst institutions that solely exist online such as online marketplaces, fintech platforms, and cryptocurrency exchanges. 

Challenges in KYC Compliance

1. Complex Global Regulations

When businesses expand internationally, they are confronted with navigating the complex array of KYC compliance regulations that exist around the world. These regulations vary both country to country as well as industry to industry meaning companies must continuously adapt, creating new KYC procedures as needed, or potentially face severe penalties or legal consequences.

2. High Operational Costs

KYC compliance systems can be expensive to run properly, as they are resource-intensive and tend to have high operational costs. This is even more so true when conducting EDD on high-risk customers, which often involves manually checking government-issued IDs, verifying addresses, and cross-referencing various sanctions lists. The challenge is magnified even more as businesses scale up and expand into new regions with varying KYC requirements.

3. Privacy Concerns

Companies now must also contend with new stringent data laws around how personally identifiable information is stored and handled, such as the General Data Protection Regulation (GDPR) in Europe and the California Consumer Privacy Act (CCPA) in the U.S. These regulations dictate how data is allowed to be collected, stored, processed, and shared in those jurisdictions which complicates how institutions are able to exchange information between departments, regions, and third-party service providers.

4. Evolving Threat Landscape

Criminals and fraudsters are constantly refining their techniques to evade security measures, leveraging new technologies like artificial intelligence, deepfakes, and automation to manipulate official documents and create synthetic identities. These new threats necessitate organizations to implement multi-layered approaches to their KYC screening process that incorporates biometric authentication, real-time transaction monitoring, machine learning algorithms, and behavior analytics to detect anomalies. To combat these challenges, companies must invest in advanced identity verification solutions that utilize emerging technologies to enhance their ability to detect and prevent financial crimes while at the same time maintaining seamless and secure customer onboarding.

5. False Positives

False Positives in the KYC process occur when legitimate customers are mistakenly flagged as potential risks by automated systems, leading to unnecessary friction, delays, and customer dissatisfaction. False positives can occur due to name matching errors where if a customer’s name closely resembles that of someone on a sanctions list, a false alarm might be triggered even if there is no connection. Overly conservative risk-scoring models can also incorrectly flag customers as they don’t always account for legitimate variations in behavior. These false positives are simultaneously frustrating for consumers, as they have to then reverify their identity, and companies, as they must manually review flagged cases which can then strain operational resources. Too many false positives can erode trust in the system, leading to customers seeking services elsewhere so it’s important for organizations to refine their KYC models to incorporate better machine learning for more accurate risk assessment.

Strengthening KYC Compliance

1. KYC and Beneficial Ownership

Regulatory agencies have recently intensified their focus on Ultimate Beneficial Ownership (UBO) in order to combat financial crimes and money laundering. Businesses are required to fully understand the ownership structure of their clients because criminals often use complex corporate structures, shell corporations, and nominee directors to obscure true ownership. By implementing EDD, automated ownership screening, and continuous compliance, businesses are able to uncover hidden interests and avoid doing business with bad actors.

Regulatory Spotlight

• EU 6th AML Directive (6AMLD): Requires companies to disclose UBO information to central registers, improving transparency and preventing shell company misuse.
• FinCEN’s Beneficial Ownership Database (US): Mandates reporting of beneficial owners for certain U.S.-registered entities, enabling authorities to track high-risk individuals more effectively.

2. KYC in Cryptocurrency and Virtual Assets

With the rapid adoption of cryptocurrency and digital assets in recent years, agencies like FATF, FinCEN, ESMA, and other regulatory bodies are putting KYC mandates in place on crypto exchanges, wallet providers, and other virtual asset services. These include:

• Customer Identity Verification: Mandatory ID checks before users can trade or withdraw assets.
• Transaction Monitoring: Continuous oversight of crypto transactions to flag potential money laundering patterns.
• Travel Rule Compliance: FATF’s Travel Rule requires transmission of sender/receiver information between VASPs for certain crypto transactions.

While these compliance measures do increase security and trust, they do present privacy concerns for users and can be difficult to implement in an industry that is decentralized and borderless.

3. Industry-Specific KYC Requirements

While financial institutions have historically been most associated with KYC regulations, other industries are now increasingly faced with KYC obligations of their own:

• Fintech and Neobanks: Must adopt fast yet rigorous ID verification to onboard customers digitally.
• Gaming and Gambling Services: Need to prevent underage gambling and money laundering via online betting.
• Real Estate: High-value real estate transactions can be exploited for money laundering; KYC helps expose questionable sources of funds.
• Insurance: KYC checks are essential for identifying potential fraud and suspicious policy withdrawals or payouts.

4. The Role of Regulatory Technology (RegTech)

KYC software solutions are now able to harness automation, AI, and data analytics to significantly enhance the efficiency and accuracy of compliance procedures. Key benefits include:

• Real-Time Risk Assessment: Automated alerts for suspicious activity or changes in a client’s risk profile.
• Cost and Time Efficiency: Reduced manual labor and fewer delays in onboarding.
• Audit Trails: Digital record-keeping that simplifies internal and regulatory audits.

By automating parts of the Know Your Customer process, RegTech enables organizations to better adhere to ever-evolving regulatory requirements while enhancing operational agility.

Conclusion

KYC compliance is an ever-changing field, driven by constantly evolving regulations and technological advances. It is crucial for any organization that’s subject to KYC compliance regulations to adopt technology-driven, forward looking, risk-based approaches to stay compliant and safeguard itself from legal risks. By thoroughly verifying the identity of clients, consistently monitoring transactions, and strictly adhering to data protection standards, businesses can uphold trust, meet regulatory requirements, and contribute to the broader fight against financial crime.

 

Suggested reads:

Shufti’s KYC Solutions 
Shufti’s e-IDV