By Matthijs de Vries, CTO and Co-founder of AllianceBlock, the first globally compliant decentralized capital market
Know Your Customer or KYC is a regulatory requirement that underpins today’s global economy, but its current processes are inefficient and outdated. Across the globe, financial institutions must conduct time consuming, cost-heavy checks in order to verify their customers’ identities. Not only do they face massive fines if they fail to comply with existing regulations but they often have to navigate between many different regulatory borders, as well as storing and protecting huge swathes of user data.
In new ways, technologies that underpin the foundations of DeFi are being used to provide solutions for problems that traditional financial institutions face. Blockchain can help to reshape outdated KYC processes by allowing for the effective outsourcing and decentralizing of personal data, while also allowing the owner of the data to maintain full control over their data. In order to evolve and tackle ever-increasing regulatory requirements, institutions must look to innovative technology to develop their existing processes.
Banks and other financial institutions are required to carry out KYC checks in order to verify customers’ identity and ensure they are not entangled in illegal activity such as bribery or money laundering. The actual KYC processes vary across the board. On a basic level, everyday processes such as opening a bank account or sending payments require you to meet certain criteria and the onus of verifying that you do falls totally on the institutions offering services. In these instances customers may simply be asked to provide a passport photo and address.
Elsewhere however, institutions may require customers or companies to provide billing documents or locator forms to establish their base or residency or even provide details of the origin of funds you are using. The higher the stakes, the greater the scrutiny, meaning that transactions of significant value often require in-depth checks. In cases where customers may have political affiliations or are associated with countries linked to fraud or money laundering, the checks are often far greater.
When the stakes are very low, however, the implementation of effective processes can be costly respective to the stakes, for instance when a smaller institution has to spend a lot of resources on a few checks. Best practices in these scenarios are often not carried out and processes such as KYC are effectively ignored, resulting in ineffective verification processes.
There are clearly huge benefits to these processes, which protect our financial services and ensure the legitimacy of our economies. However, the labour-intense and resource heavy nature of KYC make it a bug bear for institutions the world over. There are significant risks attached for companies that fail to comply with KYC regulations. In 2020 alone, global institutions were fined $10.4 billion related to anti-money laundering (AML), KYC and data privacy issues. This seems colossal, but when you begin to unpick the complex and relentless requirements it becomes apparent how many regulatory hoops there are for institutions to jump through. KYC checks are not a one-stop process where institutions can verify a person’s identity and then continue to provide services. In fact, institutions are required to conduct checks and monitor customer transactions on an ongoing basis, which takes up significant time and resources.
Institutions must also ensure compliance with all applicable regulations, which can be cumbersome when facilitating transactions across borders and regulatory zones. When you consider the different regulations that are in place globally, which are often filtered through wider legislative nets (GDPR and MiFID II amongst many), the huge breadth of compliance processes becomes apparent. From a consumer perspective, existing protocols mean individuals are required to hand over a significant amount of personal information in order to clear checks.
The risks of this are far reaching and we need only consider the recent Facebook data leak of over 500 million users’ private information to see the serious economic and social implications of not adequately protecting user data. Business owners are often keen to obstruct access to certain information or hide the source of assets in the likes of offshore bank accounts and shell companies, all of which makes the adherence to KYC more difficult for institutions.
Current KYC processes often rely on an intermediary to verify user identity, which adds another layer of data sharing and risk to the interaction. Trustless blockchain technology offers a solution to this outdated practise, allowing users to prove their identity in a protected manner while still retaining control of their data. Institutions are increasingly looking for ways to outsource these hugely time and resource consuming checks. Data intelligence firms such as GBG are leading the way in establishing effective compliance management and identity verification processes. To continue this progress, innovators must continue to implement blockchain technology into KYC processes.
Going forward, we are likely to see an increase in institutions employing trusted operators to perform KYC checks. This will require a certain level of buy-in from regulators who will need to approve operators and ensure that they meet the requirements of the institutions they are vetting. One massive benefit of using external operators is that through facilitating the use of decentralized digital identities, they can reuse KYC data on an individual from a prior check because their digital identity will include not only all of their KYC data, but also transaction history, preferences, and profile.
Subsequent checks can verify existing investor’s data without having to disclose their full identity, creating a further layer of data protection. The implications of this solution extend beyond the world of traditional finance into DeFi, as investors use these decentralized identity verification processes to clear unknown operators and allow them to invest within more regulated realms.
The existing KYC processes are defunct and a natural progression is occurring, whereby data intelligence and blockchain technology are coming forward as alternatives. The benefits are undeniable and companies must look towards blockchain for the effective outsourcing and decentralizing of personal data. The use of trustless mechanisms to reduce the resource heavy identity verification processes that are required of traditional financial institutions will reflect how the gap between DeFi and TradFi can be bridged in a way that is mutually beneficial for both.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.