Know Your Customer (KYC) is a crucial onboarding process that many new investors face for the first time when joining the crypto space. Filing KYC usually takes place when registering an account on a centralized exchange. But due to recent regulatory pressure, some decentralized protocols from the DeFi sector began incorporating KYC as well.
Giving out your personal information to online platforms dealing with digital currencies might sound strange or scary. But the truth is that KYC represents an important step in staying legally compliant, keeping the industry safe, and protecting users.
What is KYC, and should you trust exchanges or other crypto platforms with your personal information? Find out why KYC is so important and how it helps the industry stay clean by adhering to AML and CTF laws.
What Is KYC (Know Your Customer)?
Know Your Customer (KYC) is an important process that involves sending personal information and identification documents – such as ID cards or passports – to a crypto company for the purpose of verifying one’s identity. KYC helps exchanges know which clients they’re serving – achieving regulatory compliance and establishing customer due diligence.
From a user’s perspective, KYC grants the ability to tie your personal identity to an exchange account or a crypto protocol. Doing so establishes a clear link between you, your funds, and the regulatory jurisdiction that you adhere to.
Compliance is important in this context because you may or may not be allowed to use certain financial instruments or products. For example, the French government has recently banned futures trading for its citizens, forcing Binance to disable the product for French users. As a result, some have flocked to other exchanges or stopped trading.
In the previous example, those who haven’t filed KYC could potentially continue trading futures on the exchange by utilizing VPNs. Doing so allows the customer to present themselves as if they’re from a jurisdiction that supports futures. However, doing so is illegal and may carry legal repercussions.
Your Typical KYC Process
The typical KYC process involves the following generic steps, with little to no exceptions:
- Upload a picture of the front side of a document identifying your identity. Such documents include passports, ID cards, and drivers licenses.
- Upload a picture of the back side of the same document you used in the first step.
- Upload an image of yourself. This step is not part of every KYC process, but it’s practically on every important crypto platform. It may also involve taking a live picture via a webcam or holding a piece of paper with a string of characters written on it for the purpose of additional verification.
- File additional personal information. You will have to write your name, address, country of residency, nationality, phone number, and more.
How strict the KYC process is depends a lot on the KYC model that an exchange or crypto platform incorporates. Stricter KYC processes typically yield far more features – unlocking futures trading for example – and drastically increase deposit and withdrawal limits.
Why Is KYC Important?
KYC helps combat money laundering, terrorist financing, fraud, and similar criminal activities. Proving your identity is important especially in a sector such as crypto – where decentralization and pseudoanonymity rule.
Allowing everyone to transfer money without being monitored by a government entity sounds cool on paper, but it creates too much space for bad actors to thrive. Without KYC criminals would have the ability to transfer large swaths of money from multiple addresses with little to no chance of being tracked down.
KYC is also important for securing a better spot for the crypto industry. Staying regulatory compliant improves the reputation cryptocurrencies have. Apart from combating crime, it also achieves establishing user security as blockchain technology makes transactions anonymous and irreversible.
The many ways of protecting investors include:
- Preventing identity theft
- Limiting fraudulent activities
- Encourages adoption by bringing trust, security, and accountability
- Allows lenders to better assess risk
The Problems With KYC
KYC brings several disadvantages to a traditionally anti-government and anti-banking community. The process prevents anyone from having easy access to alternative banking systems. Anyone can create a wallet and transfer crypto assets while retaining full anonymity – KYC enforces limitations that prevent a fully anonymous experience.
The problems start when investors want to access more complex financial instruments. Centralized exchanges adopting KYC means that no one can trade futures or options without verifying their identity. It also means not being able to buy crypto from a local ATM without having to file KYC documents with the local exchange first.
There’s also the problem with securing the privacy of investors. Data leaks take place. And if a hacker makes use of an exploit, he gains access to an enormous data bank full of personal documents, ID cards, passports, driving licenses, and so on. Such an event paradoxically leads to even more identity theft.
Some document requirements also make it difficult for certain crypto investors to file KYC. Upon registering on a centralized exchange, I was asked to send any document showing ‘Proof of Residence.’ Having no such documents that indicate a fixed residence of mine, and are not older than 90 days, made it impossible for me to complete the KYC process.
And then there’s the biggest problem: the surge of KYC compliance in DeFi. Investors have grown accustomed to DeFi being a safe haven for all things decentralized. The sector is anonymous and non-custodial. However, KYC enforcement is putting a stop to these blessings. And more and more DeFi protocols start to look like centralized exchanges.
Conclusion: To KYC or Not to KYC?
Know Your Customer is a process involving the investor conducting his due diligence and adhering to regulatory laws by verifying his personal identity when creating an exchange account. KYC is important because it helps the industry, governments, regulators, and banks combat money laundering, terrorist financing, fraud, and similar criminal activities.
KYC also prevents identity theft and helps investors stay more secure in a sector that’s anonymous, decentralized, and whose transactions are irreversible. However, the same process is problematic when observing KYC from the perspective of a traditional crypto adopter seeking alternative ways of utilizing financial services.
Blockchain networks are inherently pseudoanonymous, private, and decentralized. The introduction of KYC greatly limits all three factors. Nevertheless, the positive outcomes create a “for the greater good” effect where the negative sides are outweighed by the benefits.
The average investor doesn’t care much about KYC. The more involved and experienced investor might be bothered by the limiting factors that KYC creates. However, there is much reason to presume that both groups will become disheartened by KYC as it becomes an ever important part in DeFi.
Regulating DeFi will at some point involve introducing AML and CTF compliance, which in return introduces mandatory KYC. KYC might make it impossible for DeFi to continue being permissionless, anonymous, and non-custodial. For these reasons, many hope that regulators will treat DeFi differently than centralized exchanges – but the likelihood for that is low.