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The cryptocurrency and blockchain world is rapidly evolving and more mainstream adoption is being witnessed daily. While this fast-paced uptake continues, it has attracted the attention of regulatory authorities in various jurisdictions, prompting them to look into the sector as they aim to regulate it. The efforts to regulate the digital currency sector are no less geared at preserving the existing financial infrastructure as well as protecting investors. These efforts birthed what is today known as the KYC/anti-money laundering (AML) regulations.
Sharply contrasting with what is possible in traditional finance, the almost non-existent barriers in the cryptocurrency space are considered a huge advantage, since this kind of autonomy permits free entry and exit for investors. As much as this is one of the touted advantages of cryptocurrencies, it is also a downside because it gives room for bad actors to wreak havoc on the unsuspecting and inexperienced investors who attempt to profit from cryptocurrencies, especially during the bull seasons. This, among many other factors, is the reason why KYC is still important today.
What Does KYC Mean?
KYC means know your customer or know your client, and it consists of a set of regulations that are aimed at verifying a customer's identity. These regulations are adopted by financial institutions, such as banks and stockbrokers, yet cryptocurrency exchanges are also within the purview of financial institutions. KYC has always been a longstanding protocol in traditional financial institutions in that the identity of each customer is confirmed before he can enjoy the services provided by them.
Essentially, KYC aims to ascertain that a customer is who they claim to be, while preventing unlawful activities like money laundering, terrorism financing, and tax evasion. Until recently, cryptocurrency exchanges were not required to comply with KYC requirements given the decentralized and private nature of digital currencies, including in relation to blockchain technology. However, KYC measures have become mandatory for crypto exchanges as cryptocurrencies continue to gain more attention from the mainstream. Even now, the credibility of a crypto exchange is determined by how seriously it takes KYC regulations.
While it may be possible to create an account on certain crypto exchanges without satisfying KYC requirements, there are downsides to this that include restrictions being placed on the account. These restrictions be incurred in response to activities like withdrawals or trading. In fact, a few cryptocurrency exchanges place restrictions on deposits or purchases of digital currencies like Bitcoin (BTC).
How KYC Works Within Cryptocurrency Exchanges
The KYC process differs in relation to every cryptocurrency exchange. These exchanges help facilitate the trading of digital currencies among other services like staking, crypto payments, and storage of digital assets. In the past, users enjoyed these services under the condition of anonymity. Currently, most digital currency exchanges require users to reveal their identities before they are allowed to gain unrestricted access to crypto-based services on these platforms. They are required to submit details and documents that point to some personal information about them. Some of these details include real names (usually first name and last name), a cellphone number, their date of birth (DOB), a selfie, a physical address, their country of residence, and their social security number (in countries where this is available). The documents that users are required to submit include and are not limited to: a government-issued form of identification (could be driver's license, state identification card or a passport), and tax reports. These documents are usually submitted to the exchange in a photographic format. After these documents have been submitted along with the necessary details, the crypto exchange then goes ahead and verifies the user's identity. The timeline for the completion of identity verification varies on crypto exchanges; some complete identity verification within a few minutes, while others do so after several weeks. This is usually dependent on how busy the exchange is.
KYC requirements are only operable on centralized cryptocurrency exchanges, meaning users do not need to fulfil KYC requirements when using their decentralized crypto counterparts. This is because a decentralized exchange or DEX lacks a central authority, unlike centralized exchanges or CEXs. DEXs utilize a peer-to-peer network to facilitate crypto transactions.
Alternatively, users can trade on automated market makers (AMMs), which are powered by smart contracts. In a DEX, user anonymity is the priority, which aligns with the original intention of the creator of Bitcoin, Satoshi Nakamoto. On the basis of avoiding the centralized structure in traditional finance, they adopted the idea of decentralization while creating the first digital currency (Bitcoin); in turn, this ended up bringing to light the concept of decentralized finance (DeFi).
Why is KYC Important?
Although Bitcoin and other cryptocurrencies are private forms of money and are meant to protect the financial activities of their users from third parties, it has become vital to adopt measures that not only protect users from bad actors but also ensure that digital currencies and blockchains—the underlying technology that bolsters them—are not used for illegal activities. KYC serves two purposes which include:
Preventing the Illegal Use of Bitcoin and Other Digital Currencies
Cryptocurrencies provide criminals with the tools to carry out unlawful actions like money laundering, terrorism financing, and ransomware attacks. Several incidents have been reported where criminals facilitated their activities by employing cryptocurrency as a tool. However, with KYC, the authorities can identify who spends what, how much was transferred from a cryptocurrency wallet, and the reason this transfer took place; thus, it becomes easy to monitor illegal transactions and discover the identities behind such nefarious activities. In some cases, cryptocurrency exchanges make it mandatory for users to fill in an AML form.
Reducing Tax Fraud
In some jurisdictions, including the US, citizens are mandated to submit annual tax reports. As part of this requirement, it is also mandatory for them to attach capital gains from financial activities, including in relation to cryptocurrencies, to their reports. Using tax reports, authorities can track the crypto-related activities of investors and tax them accordingly. Nonetheless, regulatory bodies have been unable to effectively enforce compliance on investors as they hide under the cover that crypto assets provide to perpetrate tax frauds.
KYC on Algorand
Launched in 2019, Algorand’s blockchain has been a useful platform for the creation of decentralized applications (DApps), most of which are used for activities in DeFi. The blockchain's highly scalable, secure, and low-cost functionality is currently piloting several DApps, such as Algofi and Folks Finance. Algorand is one of the leading green and carbon-negative blockchains in the DLT ecosystem. While the blockchain supports the building of financial applications with decentralized infrastructure, there is also room for KYC with respect to staking activities. In 2019, the Algorand Foundation launched a staking reward program to distribute 200 million $ALGO—Algorand's native token—to staking participants. Staking participants were mandated to perform KYC on a specified date as one of the conditions for receiving their rewards, but those who failed to fulfill these requirements were not eligible for them. Algorand’s blockchain utilizes a pure proof-of-stake (PPoS) consensus model, which requires $ALGO to be used to secure the network. The consensus model consumes less energy, unlike the proof-of-work (PoW) model. This is what has earned Algorand its status as a green and carbon-negative blockchain.
Conclusion
KYC affects decentralization and anonymity, which are two of the most valued features of cryptocurrencies and blockchain technology; however, its impact is only felt within centralized exchanges. Decentralized exchanges prioritize users' anonymity, although this comes with huge risks, such as the loss of funds. As these disruptive innovations continue to be adopted in the mainstream, regulatory measures like KYC are needed to control the activities of users.
