Know Your Client (KYC)

What Is Know Your Client (KYC)?

The Know Your Client or Know Your Customer is a standard in the investment industry that ensures investment advisors know detailed information about their clients' risk tolerance, investment knowledge, and financial position. KYC protects both clients and investment advisors. Clients are protected by having their investment advisor know what investments best suit their personal situations. Investment advisors are protected by knowing what they can and cannot include in their client's portfolio. KYC compliance typically involves requirements and policies such as risk management, customer acceptance policies, and transaction monitoring.

Understanding Know Your Client (KYC)

The Know Your Client (KYC) rule is an ethical requirement for those in the securities industry who are dealing with customers during the opening and maintaining of accounts. There are two rules which were implemented in July 2012 that cover this topic together: Financial Industry Regulatory Authority (FINRA) Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability). These rules are in place to protect both the broker-dealer and the customer and so that brokers and firms deal fairly with clients.

The Know Your Customer Rule 2090 essentially states that every broker-dealer should use reasonable effort when opening and maintaining client accounts. It is a requirement to know and keep records on the essential facts of each customer, as well as identify each person who has authority to act on the customer’s behalf.

The KYC rule is important at the beginning of a customer-broker relationship to establish the essential facts of each customer before any recommendations are made. The essential facts are those required to service the customer’s account effectively and to be aware of any special handling instructions for the account. Also, the broker-dealer needs to be familiar with each person who has the authority to act on behalf of the customer and needs to comply with all the laws, regulations, and rules of the securities industry.

Suitability Rule

As found in the FINRA Rules of Fair Practices, Rule 2111 goes in tandem with the KYC rule and covers the topic of making recommendations. The suitability Rule 2111 notes that a broker-dealer must have reasonable grounds when making a recommendation that is suitable for a customer based on the client’s financial situation and needs. This responsibility means that the broker-dealer has done a complete review of the current facts and profile of the customer, including the customer’s other securities before making any purchase, sale, or exchange of a security.

Requirements for KYC Compliance

The U.S. Financial Crimes Enforcement Network (FinCEN) has set baseline requirements for KYC in conjunction with the core requirements for the due diligence program. To prevent money laundering, financial institutions are required to conduct deeper assessments of their clients' risk profiles.

FinCEN requires that financial institutions verify the identities of their customers and their respective beneficial owners⁠ — owners with at least 25% ownership⁠. For entities with a high anti-money laundering and terrorism finance (AML) risk, additional scrutiny is required and the threshold for ownership is lowered.

FinCEN requires financial institutions to understand the type and purpose of the customer relationship when developing the customer risk profile. This risk profile is created when the customer relationship is established and is used as a baseline for detecting suspicious activities.

When using third parties to collect and verify customer profiles, financial institutions must verify that the third party employs specific risk controls and has an appropriate governance structure. To remain in compliance, they must secure AML and customer identification program (CIP) certificates from a third party each year.

Lastly, financial institutions must also maintain current and accurate customer information and continue to monitor their accounts for suspicious and illegal activities. When detected, they are required to promptly report their findings.

Establishing a Customer Profile

Investment advisors and firms are responsible for knowing each customer's financial situation by exploring and gathering the client's age, other investments, tax status, financial needs, investment experience, investment time horizon, liquidity needs, and risk tolerance. The SEC requires that a new customer provide detailed financial information that includes name, date of birth, address, employment status, annual income, net worth, investment objectives, and identification numbers before opening an account.

KYC and Cryptocurrency

Cryptocurrency is wildly praised for being decentralized and a medium of exchange that promotes confidentiality; however, these benefits also present challenges in preventing money laundering. Criminals see cryptocurrency as a means of furthering their illegal activities and as a vehicle to launder money; as a result, governing bodies are looking for ways to impose KYC on cryptocurrency markets, requiring cryptocurrency platforms to verify their customers much like financial institutions. Although not yet required, many platforms have implemented KYC practices.

Exchanges are classified as either crypto-to-crypto or fiat-to-crypto. Because crypto-to-crypto exchanges don't deal with traditional currency, they do not have the same pressures to employ KYC standards as with exchanges that deal with fiat currencies.

Fiat-to-crypto exchanges facilitate transactions involving fiat currencies and cryptocurrencies. Since fiat currency is the official currency of a nation, most of these exchanges employ some measure of KYC. Fortunately, financial institutions should have already vetted their customers according to KYC requirements.

$60 million

The penalty assessed against Bitcoin mixer Larry Dean Harmon for violating anti-money laundering laws.

In early 2021, FinCEN proposed that cryptocurrency and digital asset market participants submit, maintain, and verify customers' identities. This proposal would classify certain cryptocurrencies as monetary instruments, subjecting them to KYC requirements.

KYC FAQs

What Is KYC Verification?

The Know Your Client or Know Your Customer (KYC) verification are a set of standards and requirements used in the investment and financial services industries to ensure they have sufficient information about their clients, their risk profiles, and financial position.

What Is KYC in the Banking Sector?

KYC in the banking sector involves bankers and advisors identifying their customers, beneficial owners of businesses, and the nature and purpose of customer relationships, as well as reviewing customer accounts for suspicious and illegal activity. Banks must also maintain and ensure the accuracy of customer accounts.

What Are KYC Documents?

Requirements differ in different jurisdictions. However, account owners generally must provide a government-issued ID as proof of identity. Some institutions require two forms of ID, such as a driver's license, birth certificate, social security card, or passport. In addition to confirming identity, the address must be confirmed. This can be done with proof of ID or with an accompanying document confirming the address of the record.

The Bottom Line

Know Your Customer (KYC) are a set of standards and requirements investment and financial services companies use to verify the identity of their customers and any associated risks with the customer relationship. KYC also ensures investment advisors know detailed information about their clients' risk tolerance and financial position. The U.S. Financial Crimes Enforcement Network (FinCEN) prescribed rules financial institutions must follow when verifying the identity of customers and their beneficial owners, if any. They must verify the circumstances around the customer relationship, as well as monitor and report any suspicious or illegal activity. Focus is shifting to cryptocurrency markets as pressures to conform to KYC standards increase.