KYC Can't Prevent Financial Crime In Crypto But It's Valuable for Enhancing User Safety

Know Your Customer (KYC) legislation is unavoidable in crypto. If you're trading on a centralised exchange, you're going to have to complete KYC sooner or later. The days when traders could fly beneath the radar, moving between non-KYC exchanges at will, are over. In today's hyper-connected world, the powers that be want to know who's moving money, where and why.

Crypto traders who've hitherto carved out a pseudonymous existence are given to express concern when their favourite exchange introduces KYC. That's understandable: humans are hardwired to favour less intrusion into their affairs, not more. Be it from a privacy, security, or data perspective, there are grounds for having reservations about KYC. However, to assert that KYC is ineffective or even dangerous is inaccurate. The reality is more nuanced.

In the Beginning, There Was Nothing

When Bitcoin began, there was no KYC in place. It existed as an identification and compliance mechanism, but it wasn't applied to crypto, which was so new that it wasn't even classified as a monetary asset by lawmakers. For the first few years, Bitcoin – which pretty much was crypto up until 2013 – escaped scrutiny. The first major exchange, Mt Gox, had only the most basic identity controls in place, and the vast majority of the platforms that sprung up post-Gox followed suit.

On exchanges with names like Vircurex and Btc-e, users could sign up with nothing more than an email address and start trading assets like BTC, LTC and FTC. That's not to say KYC was nowhere to be seen: the fiat onramps required to enter the cryptosphere still had Know Your Customer controls in place.

Once inside the crypto arena, however, you were free to roam wherever you liked and trade whatever you liked with a few questions asked. It was a privacy purveyor's paradise. But it was also a gangster's paradise, and by 2016, the days of unregulated trading were numbered.

As crypto burst into the mainstream in 2017, with Bitcoin rocketing to almost $20 thousand and retail FOMO entering overdrive, some exchanges had to close their books. KYC had by now begun to be rolled out, but there simply wasn't enough customer support staff to process all of the applications. In the US, where financial regulation is tighter, exchanges such as Coinbase and Kraken were becoming fully compliant, even if there were lengthy lead times to get verified.

Eventually, the market mania dissipated as crypto entered a two-year-long bear market, providing ample opportunity for exchanges to regroup and for regulators to catch up. By 2020, as the market began to stir once more, there were two tiers of exchange running in parallel: those that enforced KYC, typically headquartered in highly regulated territories, and those that made it optional, which were typically based offshore.

From the standpoint of law enforcement, having just half of the world's crypto exchanges comply with KYC requirements is hardly an improvement over having none of them adhere to these regulations. After all, bad actors can easily gravitate towards platforms that do not require the submission of their identity documents.

There are still inherent risks associated with fraudulent documents and third-party manipulation, phenomena not unfamiliar even in the traditional banking sector. However, envisioning any other equally effective preventive measure becomes impossible without mandatory KYC serving as the entry point for users.

As the crypto industry has become more streamlined and compliant with global standards, certain procedures have become essential. Chief among these is KYC, mandated to ensure continued global operations and to provide security for users. The implementation of this policy should have minimal impact on most users who are seeking a trustworthy platform for trading. Exchanges that enforce KYC are generally more likely to be reputable and trustworthy custodians, which is conducive to instilling trust.

KYC Is No Silver Bullet But Necessary

The cryptocurrency industry routes billions of dollars of assets every day. Lawmakers may overstate the extent of money laundering that occurs within the industry, but it certainly exists. While KYC cannot unilaterally prevent this, it provides a starting point for investigating suspected crimes.

When hackers steal money from DeFi protocols, for example, the first clue to their identity often occurs when they try to cash out through a CEX. That's because centralised exchanges know who their customers are and are obligated to retain records associated with account usage including IP addresses that can help to deanonymise criminals – even when they're using false identities in an attempt to escape detection.

There's no denying that KYC can help identify criminals even if it doesn't guarantee the complete combating of financial crime. If crooks wish to use cryptocurrency to launder money, after all, they have plenty of non-custodial solutions to choose from.

Of course, determined criminals can circumvent KYC by using false documentation or finding means of cashing out that don't require verification. This isn't evidence that KYC doesn't work, however; merely that determined lawbreakers will always find a way to evade scrutiny. Here, though, the industry has taken the lead in championing new technologies that make it harder for criminals to evade KYC.

In the past, submitting fake docs was trivial for those with an incentive to cheat the system. Today, that loophole has closed, with the use of AI and facial recognition software significantly reducing fraud. This has ensured that customer records are more accurate, giving companies a real insight into who their users are and preventing criminal elements from plying their trade with impunity.

The gradual phasing in of KYC, which has been enacted by virtually all tier-one exchanges now, typically starts with high-volume traders before becoming mandatory for all users. This is a sensible way of introducing a policy that, while unpopular with some crypto traders, is accepted as inevitable.

Safety Without Surveillance

There's a sweet spot for exchange compliance that adheres to legal stipulations without violating users' right to privacy. If maintaining customer records is mandated, it should be done responsibly and securely to ensure that user data cannot be leaked. Moreover, exchanges have a duty of care to their customers. This means not egregiously targeting them through enhanced on-chain tracking and "Know Your Transaction" policies except where there is good cause to believe a crime may have been committed.

There are few certainties in life, but death, taxes and KYC are three. Know Your Customer policies are never going to earn plaudits from exchange users. But they're a small price to pay for living in a civilised society with the ability to trade hundreds of digital assets. With regulators, particularly those in the US, flexing their muscles, platforms have little choice but to fall into line.

Astute exchanges recognise which way the wind is blowing and the advantages of rolling out a user verification program. In addition to preventing their platform from becoming a dumping ground for hackers and scammers, such initiatives bring tangible benefits to the vast majority of law-abiding users. Exchanges that know their customers are able to offer enhanced products, from earning programs to token launches, housed within a legal framework that satisfies all stakeholders.

In this context, KYC can be a stepping stone to a better future in which innovation and greater security support global access to a diverse basket of financial services. When viewed through this prism, exchange compliance is a net good for crypto.

By Gracy Chen

Gracy Chen is the Managing Director of the crypto derivatives exchange Bitget, where she oversees market expansion, business strategy, and corporate development. Before joining Bitget, she held executive positions at the fintech unicorn company Accumulus and Foxconn-backed VR startup XRSPACE. Gracy was also an early investor in BitKeep, Asia's leading decentralized wallet. In 2015, Gracy was honored as a Global Shaper by the World Economic Forum. She graduated from the National University of Singapore and is currently pursuing an MBA degree at the Massachusetts Institute of Technology.