Blockchain Technology and AML and KYC Compliance. Part II

 

Introduction

In the first part we studied what is regulatory compliance for the financial industry, which is subject to a wide range of regulations, let's say we focused on 4:

  • Anti-Money Laundering (AML) compliance.

  • Know Your Customer (KYC) compliance.

  • Compliance knows your transaction (KYT).

  • Privacy and data security.

In this second part, we will address the first two:

 Money laundering (AML):

AML regulations vary from country to country, but include provisions on:

  • Customer identification.

  • Transaction monitoring.

  • Record keeping.

  • Reporting to authorities.

Know Your Customer (KYC):

Financial institutions usually apply the following measures:

  • Customer identification.

  • Customer due diligence.

  • Continuous monitoring.\Registry maintenance.

We can see that both compliances are intertwined, so the solutions that blockchain technology (TB) has will be for both.

 

Blockchain technology, know your customer (KYC) and anti-laundering.

of money (AML)

To know how this regulation is complied with, we must identify where crypto assets are bought and sold:

Cryptocurrency exchanges:

These are online marketplaces (websites or apps) where cryptocurrencies can be bought and sold. Exchanges can be:

  • Centralized (CEX).

  • Decentralized (DEX).

 

Centralized cryptocurrency exchanges

A CEX is a company that through a platform (website) allows users:

  • Buy, sell, and exchange cryptocurrencies for other digital assets or fiat money, such as the US dollar.

  • The exchange operates as a central authority, which means that it acts as an intermediary between buyers and sellers.

  • Controls the private keys of users' wallets and has the power to manage, execute and settle transactions.

  • On a centralized exchange, users deposit their assets in the custody of the exchange, and it is responsible for maintaining the safety of the funds.

  • The exchange provides a user-friendly interface and a high level of customer support.

  • They obtain their own liquidity by offering a % return to those who invest or deposit their cryptocurrencies.

  • Are subject to government regulations and may have to comply with various rules and requirements, such as Know Your Customer (KYC) and Anti-Money Laundering (AML) laws.

  • Two disadvantages:

  • Because the funds are held by the CEX, in a security breach, there may be losses (some CEX offer insurance to users).

  • The strength of the CEX and the reputation of its executives are essential to avoid bankruptcies due to mismanagement such as in the case of CEX FTX.

Binance example. To illustrate how the CEXs comply with KYC and AML, we will do it with the highest CEX by traded volume every 24 hours:

According to the web platform Coinmarketcap, Binance is the world's largest crypto exchange with a daily trading volume (as of Feb 12, 2023) of USD 12 billion and total assets valued at USD 56 billion. Binance on its website requires:

  • Client Verification: Binance requires users to provide personal information, such as their full name, address, and government-issued identification, to verify their identity. This information is used to verify international sanctions lists and detect any potential money laundering risks.

  • Transaction Monitoring: Binance closely monitors all transactions on its platform and flags any suspicious activity, such as large and frequent transfers, for further review.

  • Risk Assessment: Binance uses various risk assessment tools and algorithms to detect any unusual patterns of behavior that may indicate money laundering or other illegal activities.

  • Record keeping: Binance maintains records of all customer information and transactions for a minimum of five years, as required by AML regulations.

  • Cooperation with Authorities: Binance cooperates with law enforcement agencies and financial regulators to detect and prevent illegal activities on its platform.

 

Decentralized cryptocurrency exchanges

A DEX is a platform that allows users to buy, sell, and trade cryptocurrencies without the need for a central authority or intermediary.

  • Without executives to control it but operated by Smart Contracts.

  • Users retain control over their assets and private keys.

  • Transactions are executed directly between users through smart contracts on a blockchain network.

  • Because users have full control over their assets, they are not at risk of losing their funds if the exchange is hacked or suffers a security breach.

  • Adds a high level of security, privacy, and even anonymity, when operating in this type of exchange.

  • They do not comply with know-your-customer (KYC) and anti-money-laundering (AML) compliance regulations, as they do not have a central authority that can be regulated.

Two disadvantages:

  • They can be more difficult to use than CEXs, especially for those who are new to trading cryptocurrency.

  • They may also have lower liquidity and slower transaction speeds compared to centralized exchanges.

Uniswap example: To illustrate how DEXs work, we will do it with Uniswap, the largest DEX by volume traded every 24 hours:

  • According to the web platform Coinmarketcap.com/Uniswap, Uniswap is the world's largest crypto decentralized exchange (DEX) with a daily trading volume (as of February 12, 2023) of USD 72 million and total assets valued at USD 1 billion. USD.

  • It is a DEX built on the Ethereum blockchain. It works like an automated market making (AMM) platform.

  •  Allows users to trade cryptocurrency tokens without the need for an order ledger or central authority.

 

How to add liquidity to a DEX:

  • When someone uses token A to buy token B on a DEX, they do so in A/B liquidity pairs provided by other users who have created the pair.

  • If we buy token B, there will be less in the pool and the price of B will increase. It is the simple economics of supply and demand.

  • Liquidity pools are smart contracts containing locked tokens provided by platform users.

  • They are self-executing and do not need intermediaries to work.

  • They have other pieces of code, such as Automated Market Makers (AMMs), which help maintain balance in liquidity pools using mathematical formulas.

 

Final remarks:

  • If a financial institution develops a project with blockchain technology, whose purpose is digital asset transactions, it must do so with a centralized CEX exchange, because it is the only one that allows compliance with KYC and AML regulations.

  • A CEX can automate compliance with smart contracts, which can be programmed to automatically enforce anti-laundering and financial authorities' rules and regulations.

 
Carlos Sampson