Know Your Client (KYC) is a crucial standard in the investment industry that ensures advisors can verify a client’s identity and understand their investment knowledge and financial profile.
Core Components of KYC
Three primary components of KYC include the Customer Identification Program (CIP), Customer Due Diligence (CDD), and Enhanced Due Diligence (EDD).
Key Takeaways
- Know Your Client (KYC) is a standard used in the investment and financial services industry to verify customers and understand their risk and financial profiles.
- Three components of KYC include the Customer Identification Program (CIP), Customer Due Diligence (CDD), and Enhanced Due Diligence (EDD).
- The SEC mandates detailed financial information from each new customer before opening an investment or banking account.
Understanding Know Your Client (KYC)
The Know Your Client (KYC) rule is an ethical requirement for the securities industry, dealing with customers during the initial setup and ongoing maintenance of accounts.
It is implemented at the onset of the customer-broker relationship to establish a comprehensive personal profile of each customer before making any financial recommendations. Customers are also informed about compliance with all industry laws, regulations, and rules.
KYC Requirements
Customer Identification Program (CIP)
CIP requires financial firms to obtain four key pieces of identifying information about a client: name, date of birth, address, and identification number.
Customer Due Diligence (CDD)
CDD involves collecting all of a customer’s credentials to verify their identity and evaluate their risk profile for suspicious account activity.
Enhanced Due Diligence (EDD)
EDD is applied to customers with a higher risk of infiltration, terrorism financing, or money laundering. Additional information collection is often necessary.
KYC Compliance
Financial Industry Regulatory Authority (FINRA) Rules
Two rules governing KYC include FINRA Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability).
- FINRA Rule 2090: Requires broker-dealers to use reasonable diligence when opening and maintaining client accounts, know the profile of each customer, and identify authorized persons acting on the customer’s behalf.
- FINRA Rule 2111: Brokers must have a reasonable basis to believe that a recommendation is suitable based on the client’s financial situation and needs.
AML and KYC
The U.S. Financial Crimes Enforcement Network (FinCEN) mandates that customers and financial institutions comply with KYC standards to prevent illegal activities like money laundering. Anti-Money Laundering (AML) encompasses various measures and processes for regulatory compliance. KYC is a key component of AML.
FinCEN requires financial institutions to understand customer relationships and develop customer risk profiles for detecting suspicious activities. Financial institutions must also maintain updated and accurate customer information and monitor for illegal activities, reporting their findings promptly.
KYC and Cryptocurrency
The cryptocurrency market, known for providing decentralized exchange mediums that promote confidentiality, faces challenges in preventing money laundering. Criminals see cryptocurrency as a laundering tool, prompting governing bodies to impose KYC regulations.
Many cryptocurrency platforms are considered money services businesses (MSBs) and must comply with AML laws, including KYC programs and certain reporting and recordkeeping procedures.
Fiat-to-crypto exchanges facilitate transactions between fiat currencies and cryptocurrencies, employing KYC measures as financial institutions vet their customers per KYC requirements.
Example: Enforcement Actions
In December 2020, FinCEN proposed rules to ensure that cryptocurrency and digital asset market participants verify customers’ identities. This regulation classifies certain cryptocurrencies as monetary instruments, subjecting them to KYC requirements. Enforcement actions are expected to be finalized by February 2024.
Practical Insights into KYC
What Is KYC Verification?
KYC verification is a set of standards and requirements in the investment and financial services industries to ensure brokers have adequate information about their clients, including risk profiles and financial positions.
KYC in the Banking Sector
KYC in banking entails identifying customers, beneficial owners of businesses, and the nature and purpose of customer relationships. Banks must review customer accounts for suspicious activities, maintain accurate records, and ensure account compliance.
KYC Documents
Account owners typically need to provide a government-issued ID as proof of identity, often requiring additional documents like a driver’s license, birth certificate, social security card, or passport to confirm identity and address.
The Bottom Line
Know Your Client (KYC) is a set of standards and requirements used by investment and financial services companies to verify the identity of their customers and assess associated risks. KYC ensures advisors are informed about their client’s risk tolerance and financial status.
Related Terms: Customer Identification Program, Customer Due Diligence, Enhanced Due Diligence, AML, Financial Crimes Enforcement Network, cryptocurrency regulations.
References
- Dow Jones. “Understanding the Steps of a ‘Know Your Customer’ Process”.
- U.S. Securities and Exchange Commission. “Customer Identification Programs for Broker-Dealers”.
- Federal Register. “Books and Records Requirements for Brokers and Dealers Under the Securities Exchange Act of 1934”.
- Financial Industry Regulatory Authority. “Obligations to Your Customers”.
- Financial Industry Regulatory Authority. “Customer Identification Program Notice”.
- Financial Industry Regulatory Authority. “2090. Know Your Customer”.
- Financial Industry Regulatory Authority. “FINRA Rule 2111 (Suitability) FAQ”.
- Financial Crimes Enforcement Network. “Information on Complying with the Customer Due Diligence (CDD) Final Rule”.
- Financial Crimes Enforcement Network. “FinCEN Guidance”, Pages 1-3.
- Federal Deposit Insurance Corporation. “Bank Secrecy Act, Anti-Money Laundering, and Office of Foreign Assets Control”, Page 5.
- Congressional Research Service. “Cryptocurrency: Selected Policy Issues”. Page 19.
- Congressional Research Service. “Cryptocurrency: Selected Policy Issues”. Page 25.
- Cointelegraph. “What Is KYC, and Why Do Crypto Exchanges Require It?”
- U.S. Treasury Financial Crimes Enforcement Network. “First Bitcoin ‘Mixer’ Penalized by FinCEN or Violating Anti-Money Laundering Laws”.
- Federal Register. “Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets”. Pages 83840-83847.
- Federal Register. [“406. Requirements for Certain Transactions Involving Convertible Virtual Currency [“1506–AB47"]”](https://www.govinfo.gov/content/pkg/FR-2023-02-22/pdf/2023-02032.pdf). Page 11281.
- Federal Deposit Insurance Corporation. “FFIEC BSA/AML Examination Manual: Customer Identification Program”. Pages 3-5.
