As your customer base grows, so do operating costs, which include expenses for third-party service providers. Integrations allow for the fast and cost-effective addition of specific features. However, at some point, it becomes more profitable to develop a custom tool for specific tasks instead of paying for a third-party service.
The same applies to KYC. In addition to a one-time integration payment, you may have to pay regular subscription fees or charges per user verified. This adds up to a financial burden, as your customer base grows. Have you considered custom KYC development? In this article, we will explain the distinction between KYC and AML, explore how KYC impacts data protection, discuss the main sectors of implementation, and provide a comprehensive guide on building your own KYC verification system from scratch.
What is KYC verification?
Let’s start with the basics. KYC verification is imperative for organizations that are subject to legal requirements. It allows for the prevention of fraudulent activities and mitigating connected risks by determining and verifying customers’ identities. KYC is compulsory for most companies, especially those serving heavily regulated industries like finance. The KYC process usually involves gathering and verifying customer information, such as personal information, identification documents, proof of address, and financial records.
By carrying out a compelling KYC verification procedure, businesses can shield themselves and their customers from such risks as:
- identity theft and fraud
- money laundering
- terrorist financing
- regulatory non-compliance
- reputation and reputational risk
- counterparty risk
KYC vs AML
KYC (Know Your Customer) and AML (Anti-Money Laundering) are interconnected, but still distinct procedures in the realm of financial laws.
• KYC is the procedure that organizations handle to prove the identity of their customers and establish the legitimacy of their activities. KYC is one tool used within an AML program to eliminate the possibility of a financial crime.
• AML is a broad concept that comprises laws, regulations, measures, and procedures followed by businesses and organizations to fight money laundering and illegitimate earning that could be used for illicit activities. AML involves the following elements:
- Transaction monitoring. Financial institutions oversee transactions for dubious or suspicious activities by identifying and analyzing patterns and interconnections. If any unexpected or risky transactions are found, they set off further inspection.
- Enhanced Due Diligence (EDD). EDD is a more in-depth examination applied to higher-risk customers. It required collecting more information and handling detailed research to grasp the customer’s background, business activities, and risk factors. EDD may hold proving the source of funds, checking politically exposed persons (PEPs), or conducting site visits.
- Compliance education and internal supervision. Organizations educate personnel systematically to ensure they are aware of AML laws, regulations, and red flags for suspicious activities. They also set up strong internal supervision and control, guidelines, and procedures to prevent money laundering and comply with relevant regulations.
- Risk-based approach. AML practices evaluate risk factors such as customer profiles, products, locations, etc. Institutions adapt their AML methods to the degree of risk – the procedure is more stringent when it comes to higher-risk customers, high-value transactions, or specific jurisdictions.
- International cooperation. AML’s strategy requires international joint effort and information sharing between organizations, law enforcement institutions, and regulatory authorities to identify and prevent cross-border money laundering and maintain global AML measures.
While KYC software focuses on customer-facing procedures, AML concentrates on the organization itself and the actions it must take to resist financial crime and prevent money laundering. Both KYC and AML are fundamental for organizations to maintain the integrity of the financial system and prevent bankrolling illegal activities.
KYC integrations and data protection
Establishing a KYC integration enables companies to verify their customers’ identities and ensure the security of their personal information through diverse methods and measures:
- Secure data transmission. KYC software integrations often employ secure channels for data transmission: encryption protocols such as HTTPS or secure API connections.
- Data minimization. KYC integrations aim to collect and retain only the necessary data required for the verification procedure.
- Access control and authorization. Only authorized personnel with specific roles and responsibilities should have access to customer information. Access allowance should be allocated based on the principle of least privilege (POLP).
- Data encryption and storage. Customer data is typically hoarded using robust encryption methods. Encryption ensures that even if illegitimate access takes place, the data remains unreadable and unusable without the decryption keys.
- Compliance with data protection laws. KYC integrations should adhere to relevant data protection laws, such as the General Data Protection Regulation (GDPR) in the European Union or the California Consumer Privacy Act (CCPA) in the United States.
- Consistent security audits and assessments. KYC integrations should undergo regular security audits and assessments. It can carry out penetration testing, vulnerability scanning, code reviews, and internal and external audits to maintain the integrity and security of customer data.
- Data retention and destruction. Customer data must be retained only for as long as necessary to fulfill regulatory requirements. Once the retention period expires, proper data destruction methods should be applied to permanently erase information.
- Vendor due diligence. If utilizing a third-party KYC software solution or integration, handling accurate vendor due diligence is important.
How does KYC verification work?
Let’s explore the KYC verification process step-by-step:
- Customer onboarding. Customers must provide the required and relevant information, such as proof of address, occupation, and source of funds.
- Document submission. Customers must submit the required documents.
- Initial audit. Submitted documents are checked to ensure they are complete and valid. This includes checking if the documents are up to date and if the data provided meets the requirements.
- Backend identity verification. The documents are reviewed and cross-checked against authorized databases and external sources.
- Risk assessment. Customer reliability is assessed by checking their background, country of residence, occupation, source of funds, and the nature of the banking relationship.
- Enhanced Due Diligence (EDD). High-risk customers may require more thorough background checks, including the collection of additional information.
- Decision making. Once the KYC review is completed, a final decision is made.
KYC solutions and processes may vary between companies depending on their size, customer base, and technological capabilities, and may involve a combination of methods.
The Sectors Subject to KYC Laws
When it comes to KYC, fintech, banking, and similar industries come to mind first. However, what about other sectors?
KYC is widely used in insurance to authorize and verify the identity of policyholders, as well as to determine their risk profiles. In addition, KYC procedures enable insurance companies to detect and prevent fraud, which is a dominant issue in the industry.
Securities and investments
Brokerages, investment advisors, mutual funds, and other organizations in the securities and investments sector also perform KYC procedures. This helps identify and verify investors, understand their investment objectives, confront money laundering, and conduct decent due diligence.
Gaming and online gambling
Online gambling platforms are obliged to handle KYC procedures to verify the identity and age of players and comply with corresponding gambling regulations.
In some regions, real estate transactions are subject to KYC regulations. Developers, agents, and brokers may need to enforce KYC procedures to verify the identities of buyers and sellers participating in high-value property transactions.
KYC in crypto
In the crypto sphere, KYC is widely used to fight money laundering, terrorist financing, and other illicit activities. However, KYC can be more intricate in the crypto sphere than in other fields due to the global reach of cryptocurrency transactions, parties’ anonymity, and the difficulty of establishing the true owner of a crypto wallet. To deal with these hurdles, some companies are considering the use of blockchain technology to enhance KYC procedures. Let’s further explore this topic.
Key problem areas of KYC in crypto
As mentioned previously, KYC requirements in the crypto industry can be more challenging than in traditional banking systems. Below, we explore the major complications.
Anonymity and pseudonymity
Cryptocurrencies were designed to offer users high levels of anonymity and pseudonymity for transactions to be made without revealing parties’ real-world identities. However, this feature poses challenges for KYC procedures as it can be difficult-to-impossible to link a user’s crypto wallet or address to their real-world identity. Therefore, alternative and efficient KYC procedures are needed to enable accurate user identification without compromising their privacy.
Decentralization and lack of central authority
Cryptocurrencies operate on decentralized networks that are not controlled by a central authority. This makes crypto more private and secure. However, it also complicates the process of setting up a clear way to conduct KYC and ensure consistent compliance across various crypto platforms and exchanges.
Cryptocurrencies have brought accessibility and safety to international transactions. However, due to varying regulations across countries and the potential for cryptocurrencies to evade traditional identification methods, it can be challenging to carry out decent KYC checks. Addressing this issue requires a more advanced KYC approach.
Lack of standardization
Compliance with regulations can be complicated due to varying requirements and verification procedures. Inconsistencies and potential security gaps can compromise user information and assets. Standardization of KYC procedures can promote consistency, create a more secure environment, and foster trust in the industry.
Cryptocurrency regulations are constantly evolving, and companies must keep up with changes and understand each jurisdiction they operate in. This requires thorough research and analysis, as well as the ability to adapt quickly.
Blockchain technology for KYC
Blockchain technology allows for enhanced KYC verification due to its ability to securely store customer data in a decentralized manner. Cryptography adds an extra layer of protection, reduces redundancy, and increases security. It also enables customers to reuse their verified information across different entities, reducing repetitive verification. Blockchain-based KYC also provides a transparent and auditable trail of customer onboarding and verification activities, making compliance easier for businesses and regulatory authorities.
Let’s explore the key benefits that implementing KYC processes using blockchain technology can offer.
- Enhanced security. Blockchain technology protects sensitive customer data by decentralizing the storage across multiple nodes and using cryptography to add an extra layer of protection.
- Data integrity and transparency. Blockchain allows for transparent and unalterable record-keeping, ensuring data integrity and reliability. Transparency promotes trust between businesses and their customers, as they can verify the accuracy and maintenance of their information on the blockchain.
- Cross-platform and interoperability. Traditional KYC requires customers to submit the same information to different entities. Blockchain-based KYC eliminates this repetitive process, as it securely stores data and shares it with authorized parties on demand. This enables interoperability among organizations and platforms, so customers can reuse their verified information with other participating entities, which eliminates the need for repetitive verification.
- Better CX. KYC processes designed with customers in mind create a streamlined, more convenient customer journey without the hassle of submitting physical documents, filling out forms, or undergoing extensive verification processes.
- Enhanced privacy control. Blockchain-based KYC grants customers more control over their data. They can provide access to specific details of their information while maintaining privacy and control.
- Compliance and auditability. Blockchain-based KYC systems simplify regulatory compliance by providing a transparent and auditable trail of customer onboarding and verification activities, making the audit process easier for regulatory authorities and businesses to demonstrate their compliance more efficiently.
Building your own KYC from scratch
Now that you are aware of all the essential details that may come in handy, it is time to explore the step-by-step guide on custom KYC development.
- Identify legal and regulatory requirements. Understanding your legal and regulatory obligations is crucial. This includes knowing the laws and governing bodies in your industry and jurisdiction, as well as any updates or changes that relate to and may affect your business. Staying up-to-date will help you avoid legal issues and penalties.
- Define objectives and requirements. The clearer the vision is at this stage, the better the outcome will be. Define the customer information you need to collect. Will it be basic or detailed? Will it include financial history and source of funds? You should also define verification level and risk assessment criteria to manage risks effectively. A basic scoring system can be implemented by assigning scores to specific criteria, such as age. For example, applicants who are under 21 or over 60 can receive a middle score, while those between the ages of 21 and 60 can receive the highest score.
- Gather documentation and information. Identify the required documents and information you need to collect from customers to verify their identity and assess the associated risks. This may include government-issued identification documents, proof of address, financial statements, business registration documents, and more.
- Establish verification processes. Define the methods that you will use to make sure the provided documents are real. This may involve manual checks or using automated document verification tools, third-party data providers, or identity verification services.
- Risk assessment and scoring. Develop a risk assessment framework to evaluate the risk associated with each customer. Define risk factors such as customer type, transaction volume, geographic location, and source of funds. Assign risk scores to customers based on these factors.
- Implement technology infrastructure. Set up the necessary technological infrastructure to support your KYC system. This may include database management systems, secure storage for customer information, encryption mechanisms, and access control measures to protect sensitive data.
- Data privacy and security. Establish robust data privacy and safety measures, such as encryption, access controls, audit logs, and regular security assessments.
- Develop KYC policies and procedures. Document the KYC policies and procedures that outline the step-by-step processes for customer onboarding, verification, risk assessment, ongoing monitoring, and reporting suspicious activities. Ensure these policies are aligned with legal and regulatory requirements.
- Personnel training. Train your employees on the KYC policies, procedures, and legal requirements. Educate them on recognizing red flags, conducting due diligence, and reporting suspicious activities. Regularly update their knowledge to stay abreast of evolving AML and KYC requirements.
- Ongoing monitoring and compliance. Implement mechanisms for ongoing monitoring of customer activities to identify any changes in risk profiles or suspicious behaviors. Establish processes for periodic reviews and updates of customer information, as well as compliance with regulatory reporting requirements.
Building your own KYC system has multiple benefits and is worthwhile if you expect your customer base to grow. However, it is a rigorous task that requires impeccable technical skills, deep industry knowledge, and relevant experience. In addition, it is important to keep in mind that building your own KYC system requires ongoing maintenance and updates to ensure compliance with evolving regulations and to address new risks. Therefore, it may be advisable to outsource KYC software development to an experienced team.
Itexus has been helping businesses leverage technology to solve challenges and reach goals since 2013. We have extensive hands-on experience in building software solutions across industries, including KYC for financial services. If you have a concept for a KYC solution or require guidance, we are here to assist you. Contact us to find out how we can help.
By Itexus Team