What is Know Your Customer (KYC) and Why is it Important?

KYC refers to the process of verifying a customer's identity before or during the time they start doing business with financial institutions. It originated in the early 2000s after the 9/11 attacks, when U.S. regulations like the USA PATRIOT Act mandated stricter controls on financial transactions to combat terrorism and money laundering. KYC forms a critical part of Customer Due Diligence (CDD) procedures, ensuring that institutions know who they’re dealing with. Over time, it has become a global standard, embedded in international anti-money laundering (AML) frameworks.

KYC is one element within a comprehensive compliance structure that includes:

• AML (Anti-Money Laundering): Measures to prevent illegal money from entering the financial system.

• CTF (Counter-Terrorism Financing): Efforts to stop funding for terrorist activities.

• CDD (Customer Due Diligence): Process of verifying customer identity and assessing risks.

Together, these ensure institutions not only meet regulatory requirements but also reduce business risks. In decentralized finance (DeFi), platforms now integrate KYC as part of hybrid security models.

By enforcing identity verification, KYC helps in:

• Detecting fake identities

KYC ensures that individuals provide valid IDs, making it difficult for criminals to use fake identities in financial transactions.

• Preventing money laundering

By verifying identities and monitoring transactions, KYC helps identify and stop suspicious activities that could involve laundering illicit money.

• Halting terrorist financing

According to the Financial Action Task Force (FATF), KYC helps track and block funds that might support terrorism by identifying and monitoring high-risk individuals or entities. 

Many crypto exchanges and fintech platforms have adopted automated KYC procedures to keep up with fast onboarding while complying with international standards.

Beyond preventing fraud, KYC fosters trust between businesses and their customers. When users go through identity verification:

• Businesses Gain Confidence: By ensuring that customers are verified, businesses can be more confident they are dealing with legitimate, trustworthy individuals. This reduces the risk of fraud, chargebacks, and other security threats, allowing companies to offer services with peace of mind.

• Customers Feel Secure: For customers, knowing that the platform has verified others enhances their confidence. They feel assured that they are interacting with real, verified users, reducing the risk of scams, fraud, or unauthorized activities. This sense of safety encourages more engagement and loyalty.

As a result, KYC doesn't just protect businesses; it also strengthens the overall reputation of platforms, making them more attractive to potential customers who value security and trust.

This is the first step and usually includes:

• Government-issued ID (passport, license)

• Proof of address (utility bill, bank statement)

• A selfie or biometric verification

Institutions cross-check this data with public databases and blacklist registries. The process has now evolved to include AI-driven facial recognition and liveness detection for added security.

KYC isn’t a one-time event. Businesses must continuously monitor customer behaviour to detect:

• Suspicious transactions Unusual or large transactions that may indicate fraud or money laundering.

• Activity spikes Sudden increases in transactions or behavior that deviate from a customer’s usual pattern.

• Changes in risk profile Shifts in a customer’s behavior, like new sources of funds or different transaction patterns, signaling higher risk.

Modern platforms employ automated tools to handle risk-based assessments, flag inconsistencies, and generate real-time alerts. This not only ensures regulatory compliance but also guards against emerging threats.

One of the main criticisms of KYC is the intrusion into user privacy. People worry about:

• Data leaks

• Misuse of personal information

• Identity theft

Hence, platforms must follow strict data protection regulations like GDPR and CCPA, ensuring that collected information is securely stored and only used for legitimate purposes. 

To meet the demands of both compliance and user experience, companies are increasingly turning to RegTech (Regulatory Technology). This includes:

• Blockchain identity verification

• AI and machine learning

• Digital onboarding platforms

• Zero-knowledge (ZK) proof-based verification

Such solutions drastically reduce KYC processing time and enhance accuracy. According to a report by Deloitte, RegTech adoption has increased by over 60% among financial institutions since 2020.