Know Your Customer (KYC) is the process used by companies and institutions to verify the identity of their clients. This process is integral in the financial sector, particularly, to help prevent identity theft, financial fraud, money laundering and terrorist financing.

KYC also plays a major role in legal compliance in the European Union, through such legislation at the Payments Services Directive (PSD2) and iterations of the EU’s Anti Money Laundering Directive (AMLD).

Key Elements of KYC

• Identity verification: This is the first step in the KYC process. It involves confirming the client's identity using documents such as passports, driving licenses or national ID cards.

• Address verification: The institution must also confirm the client's residential address. This can be conducted by using utility bills, bank statements or official government correspondence, for example.

• KYC screening: By taking part in KYC screening, you create a risk profile of your customer by seeking out all the available information on that client.

• Due diligence: Customer due diligence (CDD) involves assessing the risk level of a client by understanding who the client is, who the beneficial owner’s identity and establishing what is the type and purpose of the business relationship. This is standard due diligence, but there are looser and more strict versions too:

  • Simplified due diligence (SDD): Used for lower-risk scenarios, such as when working with a client that already has to disclose its own anti money laundering policies.

  • Enhanced due diligence (EDD): Applied in higher-risk cases and involves more in-depth background checks. Reasons for using EDD include when dealing with a politically exposed person or when a client operates in high-risk third countries.

• Ongoing monitoring: Regular reviews of client activities to ensure continued compliance with KYC regulations.

Steps to KYC compliance

1. Customer identification

Verify the customer based on independent and trusted evidence so you can be sure the customer is who they say they are.

2. Customer due diligence

Look into the potential customer and check them against black and grey lists for evidence of criminal behavior. You should also check all publicly available information, including the media, for reputational issues, as well as monitoring transactions on an ongoing basis.

3. Enhanced due diligence

In certain circumstances, you might need to carry out enhanced due diligence It might be that the ultimate beneficial owner (UBO) is a politically exposed person (PEP) or the client has a history of complex or unusual transactions, for example.

Dangers of not having a KYC process in place

Increased risk of money laundering and terrorist financing

Without KYC, it's challenging to trace the origins of funds, making it easier for criminals to launder money or fund terrorism through the financial system.

Fraud and identity theft

KYC protocols involve verifying the identity of customers. Without these checks, institutions are more vulnerable to fraud and identity theft, as they cannot accurately verify who is accessing their services.

Legal and regulatory penalties

Financial institutions are required by law to implement KYC measures. Failure to comply can result in hefty fines for the organization and possibly prosecution.

Operational risks

Not knowing your customer can lead to engaging in business with individuals or entities involved in illegal activities, which can disrupt operations and lead to financial loss.

Reputational damage

Being associated with money laundering, fraud or terrorist financing can severely damage a business's reputation, leading to loss of customer trust and potential future business.

Related terms

Regulatory Framework in the EU

The European Union has a robust regulatory framework for KYC. There is a direct line between KYC and institutions avoiding being used as a vessel through which criminals conduct money laundering or terrorist financing.

Key directives include:

• The Fourth Anti-Money Laundering Directive (AMLD4), which enhanced the due diligence process and increased transparency.

• The Fifth Anti-Money Laundering Directive (AMLD5), which extended KYC checks to virtual currencies and prepaid cards, among other areas.

• The Sixth Anti-Money Laundering Directive (AMLD6), which extended the scope for activities that count as money laundering. In addition, parties that enable money laundering are also culpable, meaning your KYC procedures must be more robust.

KYC Technologies

Here are some of the technological tools that companies can use to bolster their Know Your Customer (KYC) procedures.

• Biometric verification: Use of fingerprints, facial recognition and other biometric data for identity verification.

• Document verification: Scanning and verifying documents digitally.

Electronic identity verification (eIDV): Using digital databases to confirm client identity

*Disclaimer: This content does not constitute legal advice. The suitability, enforceability or admissibility of electronic documents will likely depend on many factors such as the country or state where you operate, the country or state where the electronic document will be distributed as well as the type of electronic document involved. Appropriate legal counsel should be consulted to analyze any potential legal implications and questions related to the use of electronic documents.