Crypto's balancing act: anonymity and KYC

Fourthline Forrester TEI thumbnailBy The Fourthline Team
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Cryptocurrency was purposefully created to go against the traditional financial grain.

But as the technology has advanced and its ecosystem has developed, it has begun to transition from niche to the mainstream. To gain this more widespread acceptance and ensure the future of the new digital asset class, virtual currency providers have had to find the balance between retaining crypto’s core benefits and achieving regulatory compliance.Cryptocurrency is a decentralized peer-to-peer trading tool that is open to all, regardless of geographic location or position in society. It offers its users the ability to bypass financial intermediaries, such as banks, and to retain privacy in the form of anonymous transactions. These very benefits, however, create problems for regulators: removing intermediaries means less control while anonymity can help foster illicit financial funding.Recognizing the growing use of crypto, and the loopholes it can create for bad actors, regulators have stepped up measures for virtual currency providers over recent years, largely in the form of Know Your Customer (KYC) related processes. At the same time, banks and fintechs are increasingly looking to add Bitcoin and other cryptos to their service and are recognizing that regulators must play a role. Crypto service providers must therefore work hard to ensure that both clients and regulators are happy with the balance they achieve between anonymity and KYC.

Is total anonymity viable?

Cryptocurrency’s desire to be a viable financial tool means it must make some concessions towards regulators, and total anonymity is considered one of these concessions. But the notion of having a financial system where you can send and receive money with full anonymity should immediately raise red flags for illicit use cases, the funding of terrorism, and money laundering. And these flags have already been raised against cryptocurrencies on countless occasions, giving rise to the need for KYC as a direct solution.Of course, Bitcoin, the original cryptocurrency, was never created to be anonymous for illicit uses. As time has gone on, the cryptocurrency space has sought to maintain the financial privacy it was designed to offer while still appealing to mainstream adoption and the regulatory framework that comes with it. But, in reality, the anonymity associated with the crypto blockchain is often misunderstood. Despite its privacy features, cryptocurrency is transparent - it is this transparency that builds trust and creates the level playing field its founders set out to achieve. But it does not fully shield the identity of the user. The Bitcoin blockchain is more accurately described as a pseudo-anonymous network because the transactions are accessible and transparent to all but the author is anonymous.Bitcoin achieves anonymity in the sense that the components of this financial system, such as addresses, private and public keys, and transactions, are all read in text strings that do not directly link to a user’s identity. Although Bitcoin addresses do not have names registered to them, they can, if needed, still be linked to real-world identities because every user must log their personal information before they buy the currency on an exchange. It is only when an address is used on an exchange that implements KYC that the address can be linked to a real-world identity in this way, and it only becomes necessary to make use of these connections when there is suspicion of illicit financial transactions.This is the crux of the balancing act. The majority of general crypto users, those who have joined the ecosystem through its mainstream acclimation, are users of major exchanges where KYC is the standard identity verification process. They still maintain general crypto anonymity and privacy through their transactions, but there are KYC protections in place to stop illicit uses of the currency.

Regulatory clarity drives adoption

While the implementation of KYC rules for crypto has raised privacy concerns, growing interest among institutional investors is positively correlated to increased regulatory clarity.Since anti-money laundering (AML) and counter-terrorist financing (CTF) rules were tightened and defined in the proposed regulation of Markets in Crypto-Assets (MiCA) large, established companies have begun to add Bitcoin and other cryptocurrencies to their balance sheets. Visa, Meta (formerly Facebook), and Tesla have all invested in the crypto space this year while Paypal allowed UK customers to hold leading cryptocurrencies in their accounts for the first time. All these developments work to legitimize the digital currency, encouraging consumer confidence and bringing it closer to mainstream adoption.Meanwhile, certain jurisdictions have become development hubs for the sector. And this is not due to a lax regulatory framework, quite the contrary – Switzerland and Singapore, for example, have relatively robust rules but are clear on what providers must do to meet those requirements.

Where does the balance lie today?

In the early days of Bitcoin, its main use case was as a financial tool for the dark web. A lot has changed since then, and the cryptocurrency ecosystem that has spawned from there has also moved with the times.Mainstream adoption cannot happen without regulatory compliance, and companies that have acknowledged this early on have had much more success. On the other hand, the burden of compliance can prove a heavy and those that have failed to meet requirements have suffered the consequences. In August this year, BitMex received a $100 million penalty for illegal trading and AML violations - one of the biggest settlements ever made against a crypto exchange. In the same month, the world’s largest crypto exchange Binance overhauled its AML framework, introducing KYC for all users following a series of publicized issues surrounding its AML practices across the globe. Binance said compliance was its top priority, acknowledging the need for effective KYC to enable ‘crypto’s rise to the mainstream’."We're going through a pivot from a technology innovator into a financial services company, so we need to be fully compliant,” said Binance’s CEO Changpeng Zhao in an interview with Bloomberg TV.There are still cryptocurrencies, such as Monero and ZCash, that operate in areas where no KYC is followed. The most common way to buy currencies like these without verifying your identity is via decentralized exchanges (peer-to-peer marketplaces and automated market makers). Although these platforms still have security measures in place to prevent fraud, they typically carry more risk for the user than centralized cryptocurrency exchanges.By prizing anonymity over KYC and regulatory compliance, these coin and service providers are putting themselves at a disadvantage in terms of gaining mainstream traction.For providers, knowing how they can best implement KYC requirements while still giving clients the level of financial privacy they expect has become the best route forward.Every crypto currency provider manages KYC differently but, even for those opting for full KYC compliance, their users can still enjoy a high degree of anonymity and financial privacy compared with traditional finance - if it is correctly managed.

Moving with the times

Cryptocurrency’s growth and advancement are known to be rapid and innovative, leading to the development of new subsets and ecosystems. DeFi is a prime example - it takes the basic premise of Bitcoin and expands on it to create a digital financial service world on public blockchains.As these new facets of the financial ecosystem develop there will be new areas for regulators to step in, and new dimensions for the crypto service providers to tackle if they are to keep furthering adoption.Aspects of crypto that rely on anonymity will always attract more scrutiny from regulators but companies looking to offer crypto services should be able to rely on KYC as the fulcrum in the balancing act. KYC is vital for regulated institutions but for customers it does not have to mean a big sacrifice in financial privacy.As crypto moves with the times and regulators work to safeguard its place in the mainstream financial space, service providers must also keep apace of requirements while protecting their customers’ financial sovereignty. The right KYC process is the solution to both - detracting from financial privacy only when there is cause to do so and providing a sturdy safety net for the financial policing of digital assets.For a cryptocurrency business, an effective KYC process can become a competitive edge, enabling compliance for the company itself while also offering regulatory certainty and data protection to customers who can be assured of its integrity.Bridging the gap from periphery to mainstream and providing access to crypto for millions of people means answering their desires while balancing the demands of regulators. This is not an easy task to do while focusing on your core business. That is why many choose to outsource this service to compliance specialists.To discuss how Fourthline can support your crypto business with a frictionless KYC solution reach out below.

Serkan Ünal, Head of Strategic Partnerships
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Get in touch with Serkan Ünal, who brings years of investment banking and econometrics expertise to his role as Head of Strategic Partnerships.