Know your customer (KYC) refers to a financial institution’s obligation to carry out certain identity and background checks on its clients before allowing them to use its platform or products.
Understanding the term
KYC is a background checking process that is part of a broader set of measures that regulators around the world use to fight money laundering. The process is mandatory for traditional banks and other financial institutions when opening an account or doing business with them. They have to make sure that their clients are genuinely who they claim to be.
KYC is also one of the biggest regulatory hurdles that cryptocurrency firms have to face. This is why many crypto-only exchanges block US citizens from accessing their services because of stringent KYC requirements. This results in many cryptocurrency firms not identifying who their customers are, which is something that regulators find unacceptable.
KYC requirements do not apply to decentralized exchanges as the trades are organized through smart contracts instead of a central trading desk. DEXs can dodge the regulation as they are not considered financial intermediaries or counterparties. For a cryptocurrency user, it is thus advantageous to sign up and use a DeFi application rather than using traditional finance systems.
Enforcing KYC is one of the biggest challenges that some cryptocurrency firms face, as it directly contradicts the decentralized and anonymous nature of their activities. Some cryptocurrency exchanges shift their bases to countries with softer regulatory environments to avoid KYC requirements.