Cryptocurrencies have moved from the fringe to center stage. Once considered a novelty, they are becoming more integrated into global commerce, investment strategies, and governance systems.
However, this surge in acceptance and adoption has also cast a spotlight on a concerning issue: the growing sophistication of crypto fraudsters. A striking example is the Tron case, where criminals exploited mining to engage in money laundering. Incidents like this demonstrate the dark side of crypto, which provides new avenues for illicit activity.
Image illustrating the Tron phishing scheme researched by Global Ledger
Does it mean the Know Your Transaction (KYT) and Know Your Customer (KYC) procedures are ineffective? The question is more complex than it sounds. But let’s start from the very beginning.
Both frameworks are vital for securing the crypto space. What is the purpose of each?
KYC protocols serve as tools for maintaining financial security and integrity. They are not inherently crypto-related. The concept has its roots in financial regulations aimed at identifying individuals tied to criminal activities. The U.S. Bank Secrecy Act of 1970 was among the first essential steps toward what would eventually become KYC. It required financial institutions to keep certain records that could be helpful to detect and prevent money laundering and fraud.
Among the latest documents, we should mention the Financial Action Task Force on Money Laundering (FATF) recommendations for supervising crypto asset activities and their service providers. These guidelines are recognized as the global anti-money laundering and counter-terrorist financing standard.
Cryptocurrencies’ anonymous and decentralized nature makes them an attractive medium for illicit activities. Here, KYC serves as a bulwark, enabling virtual asset service providers (VASPs) to ascertain the identity of their users, thus helping to preserve the system’s credibility.
Here is a short breakdown:
* In fact, it is possible to register on an exchange without KYC, but a user won’t have access to all its services. Also, the requirement applies to centralized services so far. Decentralized ones still need to put in place proper regulations. However, some are on their way, like Uniswap, which added a tool allowing developers to implement KYC in its DeFi protocol.
We can take one of the exchanges as an example. For instance, Biteeu – a licensed and compliant exchange developed by the IdeaSoft team. For KYC check, it requires users to provide the following:
With this data, VASPs can profile their users and categorize them based on the risk they pose. It also acts as a barrier to potential fraudsters. The need to provide verifiable personal information deters many from attempting malicious activities, as it creates a clear trace back to the individual. In case of any investigations or regulatory checks, having comprehensive KYC data allows VASPs to cooperate fully and promptly with law enforcement agencies.
For example, Binance cooperated with Israeli authorities to share data regarding Hamas-related accounts and block them. Earlier, Blockchain.com and Crypto.com announced they stopped providing services to Russian nationals. Without KYC data, this would have been a daunting task.
At some point, it became clear that concentrating solely on the identity of the parties involved was not enough.
The Know Your Transaction method is sort of a new wave in financial oversight, focusing on understanding the nature and purpose of transactions. It can operate in real time, monitoring every transaction as it occurs to ensure that suspicious activities are detected and flagged immediately. Moreover, it assesses patterns and links between transactions, providing a comprehensive view of potential risks.
Here is how it typically works:
The Garantex case, researched by the Global Ledger team, might be a prime example. The exchange was sanctioned on April 5, 2022. However, it managed to survive and even flourish. And it was KYT that allowed researchers to detect the scheme Garantex used to circumvent sanctions. KYC would not have aided in identifying the patterns.
In a nutshell: By directing crypto assets into “proxy” clusters, Garantex mixed them with clean assets. This led to a significant reduction in the perceived risk score. Such a change poses challenges as VASPs may not flag these funds as high risk, enabling the blacklisted exchange to operate.
Screenshot from GL Vision showcasing the mechanism Garantex used to “obscure” the risk score. 22.04.2023
| Criteria | KYC (Know Your Customer) | KYT (Know Your Transaction) |
| Pros | – Reduces the risk of fraud by verifying customer identities. – Adheres to local and international standards. – Understands customer financial behaviors. – Assures customers of secure measures. |
– Oversees transactional data in real time. – Gives a comprehensive view of transactional behavior. – Accurate reporting to regulatory bodies. – Offers ongoing review post-onboarding. |
| Cons | – Might require significant resources. – Cumbersome onboarding process. – Risks of data breaches and misuse. – Potential lengthy verification processes. – Data provided by clients might be fake. |
– Challenges in distinguishing legitimate transactions. – Legitimate transactions might get flagged. – Requires constant updates. – Requires sophisticated tools for effective analysis. |
FATF guidance for a risk-based approach to virtual assets and VASPs requires ongoing monitoring, i.e., checking if transactions “are consistent with the VASP’s (or other obliged entity’s) information about the customer and the nature and purpose of the business relationship, wherever appropriate.” What is important is that this recommendation is part of the section “Customer due diligence.” Thus, KYT can be seen as a progression of KYC, evolving from its principles.
Of course, there are areas of potential conflict. For instance, while KYC might classify a customer as low-risk based on identity and financial history, KYT might flag their transactions as suspicious due to their pattern. But generally, a synergy of these two approaches is a golden mean. Let’s delve into why a combined KYC and KYT tactic is more efficient in addressing the challenges of the crypto space:
While KYC provides a robust framework to verify and understand the players in the market, KYT ensures real-time transaction monitoring, shedding light on suspicious financial movements. Together, they form the vanguard against illicit crypto activities.
Relying solely on one is akin to using a sieve instead of a net—too many unwanted elements slip through. An integrated approach using both KYC and KYT is not just beneficial—it is essential. A more secure and trustworthy digital financial environment can be created by ensuring both the legitimacy of participants and the transparency of their transactions.
The evolution of financial crimes will invariably match the pace of technological progress. As the crypto industry continues to mature, so will the mechanisms we employ to maintain its safety. KYC and KYT will remain paramount, ensuring that the crypto world remains a place of innovation, not exploitation.