The rise of cryptocurrency presents unique regulatory compliance challenges for crypto exchanges and.. traditional banks (!). As regulated entities, they operate under stringent legal obligations driven by Counter-Terrorist Financing (CTF) and Anti-Money Laundering (AML) laws. When individuals seek to transfer cryptocurrency earnings to their bank accounts, they encounter a process akin to a security screening designed to ensure regulatory compliance. This guide is a short "white paper" that explores the critical role of Enhanced Due Diligence (EDD) in the regulated crypto space. It focuses on "Know Your Transactions" (KYT) and how it differs from traditional KYC. It outlines why KYT EDD is becoming crucial for all financial institutions, its key elements, and its limitations, offering a practical guide to navigating the complexities of crypto-related compliance.
Glossary: KYC, KYT, EDD
If you are a compliance professional, you can skip to point 2. If you are not, bear with me; we will set the scene.
KYC: Know Your Customer
While innovative, the crypto world often mirrors the traditional financial landscape. This includes the critical need for robust KYC procedures, which involve understanding the client's identity, address, profession, etc.
KYT: Know Your Transactions
While similar to traditional compliance, crypto introduces unique challenges. Blockchain's pseudonymous nature necessitates a shift in focus from the client's identity to the client's transaction history, particularly the Source of Wealth and Source of Funds. With KYT, institutions can gain deeper insights into client activities and mitigate risks by meticulously analysing transaction histories and patterns.
EDD: Enhanced Due Diligence
EDD is a comprehensive and more thorough investigation to mitigate risks associated with high-risk customers or transactions. It is essential to Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF) efforts.
We could risk the following simplification:
EDD KYC is required in traditional compliance when dealing with high-risk customers, high-value transactions and entities from high-risk countries.
EDD KYT is required when transactions show unusual patterns or suspicious activities.
However, in practice, EDD KYT augments the entire EDD, giving us a more holistic understanding of the case, especially when it is riskier or the transaction amount is large.
Enhanced KYT Due Diligence - why more frequent after MiCA?
The unique characteristics of cryptocurrency transactions make KYT EDD indispensable for clients with crypto wealth, i.e. for every fifth millennial.
While blockchain is not entirely anonymous, its pseudonymous nature obscures the link between crypto addresses and real-world identities, creating opportunities for illicit activities like money laundering.
The global and instantaneous nature of crypto transactions bypass traditional regulatory gatekeepers, facilitating rapid cross-border financial crimes.
Crypto markets operate 24/7 and demand constant vigilance to detect suspicious activity, unlike traditional banking, which has set business hours.
The lack of a central authority governing AML standards of cryptocurrencies complicates regulatory control and requires a proactive approach to identifying suspicious transactions.
These factors combined—pseudonymity, global reach, 24/7 operation, and the absence of standardized quality metrics for Anti-Money Laundering (AML) practices — make crypto-related transactions inherently riskier. As a result, frequent KYT EDD is crucial for mitigating risks associated with financial crimes in the crypto space. This is why the AML acts consider it not just a best practice but, in some cases, a hard regulatory requirement for crypto exchanges, but also for traditional banks that are now exposed to transfers from these crypto exchanges. See the European Banking Authority’s new AML guidance of 16/01 for more details.
Crypto-related Enhanced KYT Due Diligence - what is it?
EDD must be standardised, and businesses must follow a structured list of requirements and steps to implement EDD procedures for high-risk customers and transactions properly.
The checklist below outlines key considerations for conducting effective EDD on clients with crypto wealth purely from a KYT perspective:
Nature of Business or Activity:
Carefully assess the client's business model and the nature of their crypto-related activities.
Source of Funds:
Scrutinize the origins of the client's crypto holdings, ensuring legitimate and transparent sources.
Beneficial Ownership:
Determine the actual owners of the crypto assets, even if pseudo-anonymous.
Transaction History and Patterns:
Analyze blockchain data to identify unusual or suspicious transaction patterns.
Geographic Risk Assessment:
Evaluate the risk associated with the client's location and the jurisdictions they operate in.
Sanctions and Watchlists:
Screen transactions against relevant sanctions and watchlists.
High-Risk Indicators:
Be vigilant for red flags such as high-value transactions, complex or unusual trading patterns, and links to known illicit activities.
Customer Relationship History:
Maintain comprehensive records of all interactions with the client to identify potential risks or changes in behaviour.
Enhanced Monitoring and Reporting:
Implement robust monitoring systems to detect suspicious activity in real time and promptly report any concerns to relevant authorities.
Documentation and Record Keeping:
Maintain meticulous records of all EDD procedures, findings, and decisions to ensure compliance and facilitate audits.
Crypto-related Enhanced KYT Due Diligence - how?
Overwhelming.
Unfortunately, you're right; managing Enhanced KYT Due Diligence is incredibly demanding, especially without the right tools and resources. Relying solely on manual processes (excel?) and even a large team of KYT EDD officers is costly and prone to errors.
Rather than building a large, expensive team, firms should consider a more efficient and scalable approach: digitalising the process from the outset and leveraging the power of technology.
Furthermore, empowering crypto-holding clients to participate in the process using solutions that allow clients to securely and effortlessly provide the necessary EDD information.
Our organization, ChainComply, is dedicated exclusively to providing specialized KYT EDD technology, but our article here explains the broader considerations for choosing tools depending on risk exposure.
Limitations of Crypto-Related KYT EDD
While KYT EDD provides valuable insights into crypto transactions, it has limitations, particularly in addressing traditional KYC/KYB concerns.
Limited Personal Information: Blockchain transactions often lack direct links to real-world identities, making it challenging to verify whether the wallet belongs to the client
Pseudonymity: The pseudonymous nature of cryptocurrencies can hinder the identification of true beneficial owners.
Varying Regulations: Crypto regulations vary significantly across jurisdictions, making ensuring compliance with all applicable laws difficult.
Key Takeaway
KYT EDD is a valuable tool for analyzing crypto transactions in certain cases, but it should be used with other due diligence methods, including traditional KYC/KYB checks, whenever possible.
Acknowledging these limitations and implementing a comprehensive, multi-layered approach to due diligence can help businesses effectively navigate the challenges of operating in the crypto space while mitigating risks and ensuring compliance.
Next steps - digitalize it!
ChainComply provides crypto-related KYT EDD tools for obliged entities. Reach out to explore how to become MICA regulation compliant and seize the opportunity of the decade. https://www.chaincomply.io/about-us
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