Know-Your-Customers: Theory and Practice of KYC Compliance in 2023

Yulia Landbo

Yulia Landbo

Last updated: Jun 16, 2024 4 min read

Know-Your-Customer (KYC) compliance has emerged as a response to a rapidly growing technological development, which opened various digital opportunities for businesses to buy and sell around the world.  The other side of the medal, however, is that criminals were granted similar powers for their illegal activities.

According to the International Compliance Association, financial crimes achieved 3.6% of the global GDP and continue to grow. Corresponding to a stunning amount between $3.5 and $4 trillion, this sum perfectly illustrates and supports the need for robust compliance processes. Today we’ll take a close look at the “Know-Your-Customer” practice to understand its importance and other basics.

Understanding KYC and Compliance

Some Basic Definitions

Know-Your-Customer is a set of procedures to check and verify customer identity information to detect and prevent money laundering, terrorist financing, and other financial crimes. In other words, this is a fundamental practice to protect organizations from different kinds of fraud related to illegal transactions and possible resulting losses

Being a KYC-compliant company, in turn, means that this company strictly adheres to special procedures aimed at the customer identification in order to reduce risks of relationship with them.

Despite the fact that this practice is aimed at saving enormous stakes of money, this is a preventive measure. That’s why businesses that haven’t ever been victims of financial criminals require additional evidence of importance for this practice.
  

Importance of KYC and Compliance

In today's rapidly evolving financial landscape, staying compliant has become more crucial than ever. By complying with the Know-Your-Customer regulations, businesses aim to effectively mitigate the risks associated with financial crimes. 

  1. The Know-Your-Customer practice allows businesses to identify their clients and then check their operating history, reducing the risk of fraud by filtering out clients with tarnished reputations. 

  2. The information received under the practice about the client helps better identify risks and monitor specific transactions for this client, achieving higher fraud-proof with less effort.

  3. Next, requirements fulfillment is the only way to stay compliant with the anti-money laundering and counter-terrorist financing regulative authorities (like AMLA in EU) and avoid penalties. 

  4. KYC verification, being conducted inappropriately, may result in heavy reputational damage. 

  5. And vice versa, thoroughly established verification is visible to your existing and potential clients and builds an atmosphere of trust.

Industries Covered by KYC

Compliance started as a mandatory practice for financial companies. However, a boom in online transactions made the number of involved industries much wider.  

Apart from the already mentioned banks and fintech, this includes insuranceonline gambling, crypto exchanges, online retail, crowdfunding, telecommunications, healthcare, as well as travel and hospitality. All of them face rapid growth of revenue opportunities via digital channels, as well as the equally increased fraud activities potential using similar channels.

Once we’ve found out some important aspects, let’s continue piecing things together with regulations forming its legal landscape.

EU and Global Regulations towards KYC

EU-Wide Regulations

Anti-Money Laundering Directives No. 4, 5, and 6 are currently regulating the requirements for application of this practice. These three directives have consistently tightened the requirements for financial institutions and other businesses affected.

These three anti-money laundering directives impose the following requirements for Know-Your-Customer:

  1. The first basic requirement for businesses affected, forming an integral part of compliance with anti-money laundering and particularly Know-Your-Customer, is Customer Due Diligence (CDD).

  2. All the affected businesses must identify and check the identity of their customers before doing any business with them, especially before doing any financial transactions.

  3. Businesses must clearly understand the purpose and nature of any business relationship in which they are involved.

  4. For each customer, there are certain risks of money laundering or terrorist financing, and these risks must be evaluated.

  5. Businesses must continuously monitor customer activity for suspicious transactions and restrain them on time.

  6. Businesses report each suspicious transaction to the relevant legal authorities.

  7. Businesses must keep a record of all the data related to customer identification and transactions. 

  8. For effective detection and prevention of money laundering and terrorist financing attempts, businesses must develop their internal policies, procedures, and measures of control.

  9. Businesses must educate their employees on KYC compliance. 

GDPR is another EU-wide regulative act with an influence on KYC compliance requirements. Under the GDPR, KYC means personal data processing based on consent or one of the other five legal basis types defined in Art. 6 of GDPR. This consent must be given freely and informed, be specific, etc. Businesses must also store and process this data in compliance with GDPR, as well as keep a record that proves legality.

UK-Wide Regulations

In the United Kingdom, specific business obligations are defined in the Money Laundering Regulations (MLR) 2007. The regulative act is quite close to the purpose and contents of the EU’s Anti-Money Laundering Directives. These two regulations, however, have some differences, like MLR 2007 has a much narrower scope, and less harsh legal criminal liability, as well as some differences in terminology.

Worldwide Regulations

A global regulator and setter of global standards for anti-money laundering and counter-terrorist financing (CTF) is an intergovernmental organization called the Financial Action Task Force (FATF). The FATF Methodology for assessing compliance includes 40 Recommendations, an international standard committed by more than 200 jurisdictions. Compared with AMLD, FATF has a narrower scope, less severe legal penalties, and a primary focus on an entire country and its compliance.

Key Elements of KYC

Three main steps of a plan for establishing compliance with Know-Your-Customer practice are to identify a customer, then check their information in order to detect suspicious actions and further activity monitoring. 

Customer Identification Program (CIP)

CIP includes a set of procedures aimed at the identification of a user, as well as assuring these are genuine personal data belonging to exactly the same user. This process is usually tied to governmental-issued personal documents to verify whether the personal data provided by a user is identical to the data from documents.

Customer Due Diligence

The goal of customer due diligence (CDD) is identity and legitimacy verification. For this purpose, the personal data collected at the previous stage (like information about the customer's source of funds, occupation, income sources, net worth, etc.) is checked against watchlists. 

Watchlists used for customer due diligence are the lists of high-risk individual persons or entities: Politically Exposed Person (PEP) lists, Sanctions Lists, Regulatory Enforcement Lists (REL), Adverse media data, etc. The desired outcome for customers is a lack of matches, once a match means the customer poses a high risk of financial crimes.   

Ongoing Monitoring of Customer Activity

Ongoing monitoring of customer activity is an approach to effectively wait for a crime and catch them with guile. To detect suspicious transactions indicating money laundering or fraud, businesses must monitor the accounts and activities of their customers. The most common way is to monitor unusual and unfamiliar transactions outside of expected or declared patterns of activity. Each suspicious action is then put under the microscope of highly attentive compliance officers who definitely find fraud if there was fraud.

Technologies That Can Automate Know-Your-Customer

Achieving Know-Your-Customer compliance is usually tied to high amounts of customers, and their data must be processed continuously. That’s why automation tools are highly welcomed in this process. Let’s take a look at what and how it can be automated.

Document verification using OCR

Optical character recognition (OCR) technology is aimed at scanning documents and images with further recognition of what’s displayed. Recognizing scanned documents makes it possible to extract required data like first and last name, ID, address, and others and then save this data in the database in a textual form. Reducing manual input on a scale helps raise keeping compliance efficiency and cover more customers with the same workforce.

Video KYC

Using video conferences, compliance officers can verify identities faster and more accurately. This doesn’t just raise the performance of the compliance team but also increases the satisfaction rate of users, who can faster verify their personalities and get access to your goods or services.

Biometric Authentication

Face, fingertips, or iris scans are not just among the most reliable types of customer identification and authentication. Such pieces of biometric data can also be gathered remotely and processed almost instantly. Well, this highly accurate and secure authentication method improves both the customer experience and compliance.

Fraud Detection Tools

AI and ML tools open brand new heights of fraud detection efficiency. The process is usually built upon detecting implicit patterns that people will likely outlook, and then following such cases to manual analysis. 

Benefits of Automated KYC

In conclusion, staying KYC compliant in 2023 and further is paramount for businesses aiming to streamline financial security and ensure regulatory compliance. By adhering to Know-Your-Customer regulations, organizations can effectively identify and understand their customers, enabling them to filter out high-risk individuals and protect against fraudulent activities. And with fraudulent activities, unfortunately, becoming smarter, there is no reason to postpone getting compliance with KYC requirements.

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This article was developed for information purposes only. For legal advice, contact your trusted advisor. Alternatively, Whistleblower Software can connect you with a local legal expert.

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