AML (anti-money laundering) and KYC (know your customer) regulations are commonplace in the financial sector. Most financial institutions must conduct due diligence checks on customers to prevent illicit funds from entering the system illegally. However, AML and KYC crypto laws are somewhat divisive. While some analysts maintain that these laws prevent blockchains from being censorship-resistant, others argue that they are essential for blockchain adoption and legitimacy. Nonetheless, AML and KYC crypto laws are among the most prominent topics of conversation within the Web3 community.
In this article, we’re going to explore AML and KYC crypto regulations and how they operate. Also, we discuss how these laws could affect the blockchain industry and their impact on Web3 adoption.
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What is KYC?
Before we dive into AML and KYC crypto laws, we should start with the basics. Thus, let’s take a moment to understand how these laws work more broadly. Companies conduct KYC (know your customer) checks to verify the identity of clients. Further, KYC regulations exist to ensure that companies remain compliant and help prevent online fraud. Regarding finance, insurance, and real estate, companies traditionally get to know new clients prior to onboarding them. Companies must be certain that the client is who they claim to be and that they are not impersonating anyone else. They must also make sure that they’re not obfuscating their identity. Though this process has existed for many years, it is only recently that online KYC has become a staple in the crypto world.
Although KYC requirements vary between regulators, they generally follow a common theme. This involves providing proof of identity documents such as a passport, driver’s license, ID card, or utility bill. When opening an account with a crypto exchange, the platform will request this information to validate your identity before giving you access to services. Also, you will likely need to update or reiterate this information periodically to remain compliant.
Furthermore, many prominent crypto exchanges require new users to upload selfies and take dynamic photographs via the app to further protect against fraud. Once a company has removed all doubt about the identity of a new client, it may ask questions to try and understand the intentions of the customer. For example, some crypto exchanges will ask you how much you expect to invest in a given period. Though this may seem intrusive, it gives the exchange an understanding of what may constitute “suspicious” activity on your account.
What is AML?
Money laundering refers to the processing of funds in a bank or financial institution with the aim of disguising the illicit nature of their origin. Furthermore, anti-money laundering (AML) processes include a series of procedures that aim to uphold the laws and regulations around money laundering. Moreover, AML laws aim to prevent the illegal processing of funds from activities such as tax evasion, the sale of narcotics, human trafficking, and terrorism.
AML legislation originates from the expansion of the financial sector and the easing of capital controls in global financial markets. The growing complexity of financial instruments presents criminals with many opportunities to legitimize funds gained by illicit means. Once dirty funds are “in the system” and cleaned up, it can be extremely difficult for authorities to trace. Furthermore, estimates suggest that around 2.7% of global GDP in 2020 resulted from money, making it a high priority for policymakers worldwide.
Nonetheless, AML laws address this issue by making it more challenging for criminals to conceal their dirty money and make them appear legitimate. Moreover, financial institutions must execute due diligence to ensure they can promptly report any suspicious activities. In the US, the 1970 Bank Secrecy Act stipulates that banks must report cash deposits of over $10,000 to regulators. Similar frameworks exist worldwide, each attempting to prevent the legitimizing of criminal proceeds.
How Does AML Work?
AML laws aim to prevent illicit funds from entering the financial system. One of the ways they do this is by implementing an AML holding period. During this period, deposits stay in the initial depositing account for at least five days. After this, funds are transferable to other accounts. Also, all financial institutions must develop a robust AML strategy and hire an AML compliance officer.
In the US, citizens must report deposits of over $10,000 in cash to the IRS. The same rule applies to multiple related parties depositing $10,000 or more within 24 hours. In 1989, FATF (financial action task force) was formed to establish international standards for preventing money laundering. Also, IMF (International Monetary Fund) was formed at Bretton Woods in 1949 following the de-pegging of the dollar from the gold standard. Both of these organizations aim to prevent money laundering and the financing of international terrorism.
Moreover, United Nations are implementing AML regulations to tackle drug trafficking and corruption. Other notable frameworks include the Anti-Money Laundering Act of 2020 and the Corporate Transparency Act, which make it difficult for shell companies to wriggle out of sanctions and AML laws.
How are AML and KYC Related?
Though there are key distinctions between KYC and AML, the two frameworks work in tandem and cover much of the same ground in terms of preventing illegal financial gains from entering the system. Most banks and financial institutions begin their compliance procedures with KYC. Banks need to create a profile of their clients by establishing their identities and the banking activities they are likely to undertake. Also, financial services providers can check the names of new clients against known criminals. Plus, they can screen them to flag suspicious individuals or organizations.
Any political figure or their immediate family could come under scrutiny during KYC. Once banks verify the legitimacy of client funds, they are free to enter the financial system. At this point, AML procedures can proceed. When illicit currency enters the banking system, it can be transacted multiple times in a way that disguises the origins of the funds. This process is what we call “layering”. Once funds are successfully layered and “clean”, they can be funneled into real estate and other financial instruments.
Moreover, the goal of KYC is to prevent illicit deposits. This process includes ongoing due diligence, whereby customer records get checked periodically for accuracy. Due diligence allows banks and financial institutions to create risk assessments for each client and identify compliance risks. Sometimes, high-risk individuals can be cross-referenced with AML and sanctions lists during the due diligence processes. Also, due diligence checks help to identify the nature of transactions and any beneficiaries from suspicious activities.
How Do AML and KYC Help Crypto Adoption?
Cryptocurrencies such as Bitcoin are renowned for facilitating financial freedom outside the traditional constructs of modern finance. However, to achieve mass adoption, Bitcoin and other cryptocurrencies must be safe and easy to use. Compliance may not be the number one priority for most investors. Nonetheless, the institutional adoption of blockchain and Web3 rely heavily on a robust regulatory framework.
These frameworks help to improve the public image of cryptocurrencies and blockchain. AML and KYC crypto procedures help Web3 companies to remain compliant and operate without fear of being shut down. Also, these procedures help legitimize the industry by keeping users safe and preventing illicit funds from being “washed” using crypto assets. Customer due diligence enables crypto exchanges to screen for potential criminals and monitor the activity of those deemed “high risk”.
Scams and hacks are commonplace in the crypto landscape. Regulatory frameworks such as AML and KYC help to minimize these threats. Also, it prevents users from falling victim to malicious activities. By improving the public image of the blockchain industry, KYC and AML could help to attract more investment into Web3. Further, it could provide a building block for enterprise blockchain solutions.
The Downsides of KYC and AML Crypto Laws
Anyone who’s read the Bitcoin whitepaper or been active on crypto Twitter over the past few years will likely understand the freedoms that peer-to-peer currencies can provide. Although not every crypto asset works in the same way, the general consensus among investors is that crypto should operate without intermediaries. The Bitcoin whitepaper states that the protocol aims to facilitate online payments “without going through a financial institution”. This may still be the case regarding how transactions execute on the blockchain. However, when regulators and law enforcement agencies can oversee and monitor transactions on the blockchain, it removes some of the guiding facets of the Web3 ethos that attracted many investors to the space in the first place.
Also, AML and KYC crypto laws threaten to disrupt the anonymity and trustlessness that many crypto investors enjoy. To some, these laws are antithetical to Web3 and should be avoided wherever possible. Furthermore, these regulations are often slow to catch up to recent trends. As such, they may struggle to keep up to date with the evolving threats that they aim to address.
Crypto Mining and Sustainability Laws
In September 2021, China announced it would ban cryptocurrency mining. Chinese lawmakers cited environmental concerns as the driving factor for the ban. As a result, it caused shockwaves throughout the industry. Moreover, two months later, the peak of the 2021 bull market preceded several months of disruption throughout the crypto markets. Nonetheless, the crypto mining industry reacted quickly to the news, particularly in North America.
A “crypto gold rush” is upon several parts of the US and Canada. In Texas, access to cheap energy and an abundance of disused natural gas plants are enabling a wave of new crypto mining operations to thrive. However, the regulatory framework for sustainable mining fails to meet the goals of those looking to improve the environmental footprint of the blockchain industry.
Moreover, the concentration of hash power held by these mining operations could threaten the decentralization of blockchain networks. Regulators and policymakers will need to address some of the sustainability issues around crypto mining in the near future if the industry is to avoid further backlash over the environmental impact. You can learn more about sustainability in Web3 by reading the Moralis environmental sustainability policy. Also, check out the Blockchain & Bitcoin 101 course at Moralis Academy! There, you can learn more about crypto mining!
AML and KYC: How it Helps Blockchain Adoption – Summary
The crypto realm has been largely unregulated for many years. Although regulators and policymakers appear to be making blockchain more of a priority than ever before, a lot is yet to be established in the regulatory landscape. Not only is regulation slow to catch up to innovation, but the evolving nature of blockchain and Web3 makes it challenging for regulators to know where to place their efforts.
While some argue that AML and KYC crypto regulations jeopardize the financial freedoms that brought cryptocurrencies into the spotlight, others argue that they are essential for the mass adoption of blockchain and Web3. Though these regulations may appear to be stifling for the libertarians and the anonymous transactors, the vast majority of crypto users stand to benefit from higher levels of security and regulations.
Institutional blockchain adoption is already happening. The utility of blockchain extends far beyond meme coins, DeFi, and NFTs. Moreover, big money players are likely to be the ones driving this next wave of crypto adoption by creating compliant financial products. Accordingly, AML and KYC crypto laws will likely become more comprehensive in the coming years.
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