KYC and Regulation: Solving the Problem of Financial Crime in Crypto

Anonymity is one of the main features of cryptocurrencies, this is the main reason why there are so many discussions around Know-Your-Customer (KYC) procedures and their importance or damage to crypto.

While I don’t deny the idea of anonymity, in order to avoid being biased, let’s have a look at the following details.

Each quarter, crypto users were losing over $200,000,000 in hacks, scams, and other fraudsters. Of these losses, 94.3% account for hacks, and only 5.7% account for fraud which actually could have been prevented if all users were required to pass a KYC. Even though the percentage is not that high, if you calculate, you will see that the sum amounts to approx. $100 mln.

Do you think that the situation was much better earlier? If yes, look at this.

So, only in the USA, people lost over $2.3 B in crypto scams, which is over $86,000 per victim. That’s a lot indeed.

Can KYC Help to Prevent Crypto Scams?

KYC aims to identify a customer before letting him access a crypto service. The basic information required during this process is:

• the client’s full name

• address of residence

• date of birth.

  
  

Normally, this data is sufficient to perform the basic operations, the sums that such a client can transfer are limited. However, the majority of crypto services would require to complete more steps:

• identification - the client provides personal data

• liveness check - the service determines whether the client is a real person

• verification - the service compares the data provided by the client with the government-issued documents

• address verification - the service determines whether the client lives at the provided address

• risk scoring - the service determines the client’s risk category based on the data provided above.

  
  

While KYC would not be able to eliminate crypto scams at all, their number would probably reduce significantly.

And indeed, whoever would make an effort to steal crypto if there were no opportunities to benefit from it without being detected and punished for the crime? If everybody is required to pass a KYC, it will be impossible to withdraw illegal crypto. And thus, it will be impossible to use it in the real world.

Yes, criminals will be still able to move stolen coins from one non-custodial wallet to another. However, the majority of crypto coins can be tracked on a blockchain. There are efficient AML tools that detect coins that may have been involved in illegal activities, and crypto services normally block funds that don’t pass AML checks. Thus again, withdrawing crypto that has been involved in illegal activities or was stolen becomes almost impossible if proper KYC and AML practices are applied. It means that the existing regulations actually help to prevent crypto scams. But before making any conclusions, let’s have a look at more data.

Does the Existing Regulation Help?

Now, when MiCA entered into force, all crypto assets service providers in the EU will have to implement KYC for their clients.

In the USA, the SEC is coming down hard on crypto and it looks like in the coming years, the pressure will be growing.

These are the two most developed regions, and it would be logical to assume that the crypto adoption rate is the highest there. Thus, the introduction of strict regulatory norms in these regions would protect the majority of crypto owners from crypto scams and hacks.

However, the situation is not so simple. The highest crypto adoption levels are not in the high-income countries but in the lower middle-income countries, based on the research made by Chainalysis.

Among the LMI countries, Ghana and India are the leaders in the crypto adoption level.

It means that even if proper regulatory measures are applied in the USA and EU, a lot of crypto users will still stay vulnerable to crypto scammers.

For example, in Ghana, crypto is not regulated, and thus, legal bodies do not offer any protection to crypto investors and users.

The relationship between the Indian authorities and cryptocurrency is difficult. While there is no specific crypto regulation in the country, India was trying to ban private coins, and recently, Financial Intelligence Unit India (FIU IND) has issued compliance Show Cause Notices to nine offshore Virtual Digital Assets Service Providers (VDA SPs) with a request to Ministry of Electronics and Information Technology to block URLs of the nine entities operating illegally without complying with the provisions of PML Act in India. Among these offshore agencies, such leading exchanges are listed as Binance, KuCoin, and Kraken, along with 6 others.

So, Can KYC Help Indeed?

To make the right conclusions, let’s have a look at the level of financial scams in traditional finance.

In the USA only, money was stolen in scams from financial institutions, with an average loss of $102mln from an institution on average. 62% of surveyed institutions reported the increase in the scam volumes.

Now, have a look at the types of scams.

Almost a half of financial scams are committed by unauthorized parties - those who took over the account of a victim or those who misused the victim’s account info. So, it means that one passes all the KYC procedures, and still, a criminal can take over a verified account to commit a crime. Of course, it is not only up to KYC but depends on the security measures taken by an individual and a financial institution that holds the account, however, as we can see, KYC on its own doesn’t protect from scams as much as we may want.

And one more detail, just to think about. The rate of identity theft crimes is increasing. In the USA only, traditional identity theft losses amounted to $24bln in 2022, with more than 15 mln US consumers being affected.

Why Is There no Solution Yet?

KYC is useful, there is no doubt in it. However, the technology is developing rapidly, and financial institutions do not always keep it up to protect their clients properly, while criminals use the latest technology developments to steal money. When speaking about regulation, it takes several years to adopt a law, while creating a new financial crime scheme takes much less time.

When it comes to crypto, existing regulations can help to some extent to customers and users in specific regions only. But crypto is borderless. One can buy (or steal) coins in one country, and withdraw them in a country where there is no regulation. This is another challenge when it comes to crypto regulation: all countries shall coordinate their efforts to create a consistent regulation framework that would work globally.

But even if it is created at some point, there is still no guarantee that it will help to stop financial criminals. We see on the example of traditional finance that even the strictest regulation doesn’t protect customers from financial crimes. Thus, the introduction of a comprehensive regulatory framework would help to some extent but would not solve the problem completely. Or as an option, development and introduction of blockchain ID validation also may help to solve the problem.

What Is the Solution Then?

As usual, I insist that only ethical growth of humankind would solve the problem of financial crime and enable crypto mass adoption. Once we stop using technological achievements to benefit illegally, we will be able to benefit from all the advantages that the anonymous nature of crypto is offering.