How do Crypto exchanges prevent money laundering; What are KYC and AML?

[TL;DR]
The massive adoption of crypto, its ease of use, and its lack of regulation have attracted criminal elements.
These bad characters use cryptos' privacy-oriented operational style to launder illegally obtained funds and finance terrorism and other activities that jeopardize global security.
Hence governments and regulatory bodies have set up AML and KYC policies like the EU’s AMLD5 and USA”s FinCEN money service business final Rule to mitigate such activities.
So far, prominent exchanges have taken great care to comply with these regulations, while others are still lax about it.
One can only hope that these KYC policies, which many find cumbersome and invasive, do not undermine the value for which crypto stands.

Keywords: AML, KYC, Anti-Money Laundering, Know your customers, crypto exchanges, FinCEN, AMLD5.



Introduction

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Cryptocurrencies were introduced to facilitate permissionless and private transactions where traditional finance made the process cumbersome. Among the issues crypto was meant to solve are the speed and ease of transactions, transparency, and provision of users’ anonymity. Because crypto has managed to proffer solutions to all these challenges, it has gained massive adoption. People now look to crypto when they need to exchange, transfer, trade, and invest funds without stress. Therefore, to cater to the growing market, crypto exchanges rose to the task, some centralized and others decentralized.

There are currently hundreds of crypto exchanges, each providing services that are the crypto equivalent of traditional banks and financial institutions. However, Coinmarketcap only lists 252, including notable platforms like Gate.io, Binance, Coinbase, FTX, Kraken, KuCoin, etc. Notably, one of the major attractions of virtual assets is that users can trade anonymously. And so many of these platforms used that as a big selling point to attract their customers.

Now, anonymity might be good for legitimate individuals and businesses trying to keep their activities secret. But it also served as the perfect cover for criminal entities looking to cover their tracks through money laundering. So far, these malicious groups have thrived in the crypto space because it has remained largely unregulated till quite recently. However, things are rapidly changing as regulators, noticing this dangerous state of things, are setting up policies to mitigate them. These measures are under Anti-Money Laundering or AML.



What Is AML, And Why Is It Important?

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Anti-money laundering, or AML for short, are those policies put in place by regulators to curb the promulgation of criminal activities through ill-gotten funds. Money laundering in itself describes the activities criminal minds use to cover up the source of their dubious funds. What is more dangerous is that these funds are rarely used for good. Sometimes, they are used to facilitate pursuits that threaten global security, such as terrorism, gang violence, etc. Hence state governments and financial institutions pay careful attention to passing strict legislation that prevents money-laundering activities. AML This is where KYC comes in.


What Is KYC, And Why Is It Important?

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KYC, or Know Your Customer is a requirement of Anti-Money laundering regulations. It is the first step of any financial institution's due diligence on new customers. KYC involves a process that gathers customers' info that identifies who they are and what they do. It also seeks to determine the legitimacy of their source of income.
HYC procedures typically require customers’

1. Legal name
2. Email address
3. Social security Number
4. Address
5. Date of Birth
6. Passport or driver’s License

Although it differs from platform to platform, these requirements are generally similar. And they are invariably to prevent fraudulent activities by properly identifying the customer.
Subsequently, these platforms use collected information to verify their customers' legitimacy. They use official databases to evaluate the risk level of entities and also to determine if they have sanctions against them. Anti-Money Laundering regulations have been a pillar of the security of the global financial system for a long time. KYC, to be specific, was introduced in the USA in the 1990s and regulatory bodies simply updated it to encompass crypto.



AML Regulations For Crypto Exchanges And Custodial Services

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AMLD5: This is one type of Anti-Money Laundering regulation used in the EU. It encompasses all the policies institutions have to put in place to prevent the use of crypto for money laundering. According to the directive, crypto wallets and exchanges must be listed with their regional regulatory body. Furthermore, they must present evidence that they are AML and KYC compliant. Notably, the rules differ for different types of exchanges. For crypto-to-fiat transactions, institutions must implement KYC, while crypto-to-crypto transactions do not require it.

FinCEN Money Service Business Final Rule: This Anti-Money laundering regulation emerged in the USA in 2011. It covers a broader spectrum because it embraces every entity that identifies as a money service business. Additionally, it classifies “any value that substitutes for currency,” which includes crypto and virtual currencies under money. Like with AMLD5, the final rules require crypto exchanges and custodial services to be listed on FinCEN. AML programs must specify what info they need for KYC, oversee transactions, and identify and report dubious activities. Interestingly, the FinCEN money service final rule does not differentiate between platforms, unlike AMLD5. It covers a broad spectrum of crypto businesses, including crypto ATMs, token-selling DApps, Mixers, etc., and crypto-to-crypto and crypto-to-fiat exchanges alike.





How Major Crypto Exchanges Prevent Money Laundering

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Although many crypto exchanges and custodian services are still lax in their execution of AML regulations and KYC, some have stepped up to the challenge. These regulation-compliant businesses all have relatively similar AML methods. They usually require customers' Personal Identifiable Information (PII); their legal name, address, and date of birth. Some also ask for social security number and an authentic government-issued ID like a driver's license or passport to withdraw funds.

In some cases, the exchange gives users a specific daily withdrawal limit for No-KYC transactions, for example, up to 2 BTC per day. Any transaction beyond the specified limit would then require KYC or account verification.

Alternatively, some exchanges like Gate.io will allow you to make deposits without completing the verification process. But to withdraw, you would have to fill in the KYC requirements; otherwise, your withdrawal attempts might be flagged as suspicious activity.

Another way exchanges implement AML policies is by employing the services of a digital ID solution to help verify customers. These solutions sometimes complete their verification process with the help of biometric facial recognition and liveness detection.

Finally, it is essential to note that not all crypto money service businesses require KYC. Some give their customers the option to verify their accounts or not. However, these platforms do not operate within the US. And they usually do not serve US citizens to avoid complying with its KYC policies.


Final Words

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Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations protect crypto users and the world from harmful criminal activities. But one can’t help but wonder if they do not defeat the very purpose for which cryptocurrencies were created. Virtual assets are supposed to promote decentralization, ease of use, and privacy. Now, these regulations seem to be fighting those very values squarely. We can only hope that decentralized finance and these regulators come to a mutually beneficial conclusion. By definition, that would mean a solution that promotes the principles that underlie decentralized finance without jeopardizing global security.



Author: M. Olatunji, Gate.io Researcher
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* This article represents only the views of the observers and does not constitute any investment suggestions.
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