KYC vs. KYT: Which Holds The Key To The Crypto World’s Future?

As the cryptocurrency market continues to evolve and gain mainstream acceptance, regulatory compliance has become a focal point for governments and financial institutions worldwide. The two pillars of regulatory compliance such as KYT and KYC serve distinct purposes in the crypto landscape, each wielding significant implications for the industry’s future trajectory.

In this article – which we carefully crafted together with product team from Global Ledger – we delve into the fundamental differences between KYC and KYT, exploring their respective roles, challenges, and the potential they hold in shaping the future of the cryptocurrency world.

Table of Contents:

1. KYC at identity verification processes
2. KYT at transaction monitoring
3. Garantex – a real-life example of KYT value
4. KYC and KYT: Pros and cons
5. KYT vs. KYC: do they complement each other?
6. Summary

The crypto world is steadily moving to wider adoption. Each year we see how people use cryptocurrencies for new purposes. Nevertheless, risks associated with cryptocurrencies also rise. A striking example is the Tron case, where criminals exploited mining to engage in money laundering. Incidents like this demonstrate the dark side of crypto, which provides new avenues for illicit activity.

In this article, we will discuss the shared goal and different approaches of KYC and KYT. Both frameworks play essential roles in safeguarding the crypto space, but each serves a distinct purpose. So let`s discuss them in detail.

KYC aims at identity verification processes

KYC originates from financial regulations focused on identifying individuals involved in criminal activities. This concept traces its roots to the U.S. Bank Secrecy Act of 1970. This legislation marked an early and crucial progression toward the development of KYC, mandating financial institutions to maintain specific records to aid in detecting and preventing money laundering and fraud.

It is noteworthy to highlight the Financial Action Task Force on Money Laundering (FATF) recommendations, specifically addressing the oversight of crypto asset activities and their service providers. These guidelines hold global recognition as the standard for anti-money laundering and counter-terrorist financing.

Cryptocurrencies are anonymous and decentralized. This motivates fraudsters to increasingly use them for money laundering as well as other fraudulent activities. Here, KYC serves as a bulwark, enabling virtual asset service providers (VASPs) to ascertain their users’ identity, thus helping preserve the system’s credibility.

KYC consists of 5 steps

Here is what KYC usually looks like:

• VASP asks for the user’s full name, address, date of birth, and ID.
• It checks the provided ID, like a driver’s license or passport.
• The identity is verified using official records.
• VASP evaluates if the user might be involved in financial crimes.
• If all checks are clear, the user can use the service; otherwise, access is denied.

Indeed, registering on an exchange without KYC is possible. However, access will be restricted. Currently, the KYC requirement is primarily applicable to centralized services. Decentralized services, on the other hand, are in the process of establishing adequate regulations. Some of them, like Uniswap, have already added a tool allowing developers to implement KYC in its DeFi protocol.

For example, Binance cooperated with Israeli authorities to share data regarding Hamas-related accounts and block them. Earlier, Blockchain.com and Crypto.com announced they stopped providing services to Russian nationals. Without KYC [data, this would have been a daunting task.

KYT aims at transaction monitoring

At some point, it became clear that concentrating solely on the identity of the parties involved was not enough.

KYC primarily centers on verifying customer identities when initiating a business relationship. However, once this verification is complete, KYC offers limited insights into ongoing processes. While KYC ensures awareness of the identities of those involved, it lacks continuous oversight of their activities over time. This is how it allows deviations from typical transaction patterns to go unnoticed.

Traditional KYC systems face challenges in keeping up with innovations. Particularly for businesses dealing with a high volume of daily transactions, manually reviewing each one becomes impractical.

The Know Your Transaction method is a new wave in financial oversight, focusing on understanding the nature and purpose of transactions. It can operate in real-time, monitoring every transaction as it occurs to ensure that suspicious activities are detected and flagged immediately. Moreover, it assesses patterns and links between transactions, providing a comprehensive view of potential risks.

How does KYT work?

Here is how KYT typically works:

1. KYT begins with analyzing individual transactions: studying the transaction amount, frequency, and pattern.
2. The tools gather contextual data about a transaction: timestamps, involved parties (addresses), and transaction paths. 
3. KYT platforms can develop user behavioral profiles by continuously monitoring transactions.
4. KYT systems assign risk levels to transactions based on predefined criteria. For instance, a sudden high-value transaction from a previously low-volume account might be flagged as high-risk.
5. KYT tools can trace the origin and destination of funds, establishing links between different entities to detect potential money laundering schemes or other illicit activities.
6. If a transaction deviates from established patterns or fits the criteria for suspicious behavior, KYT platforms can generate real-time alerts. 
7. KYT systems can generate detailed transaction reports for regulatory and internal review purposes.

Based on specifics in some crypto projects, the described KYT process can add new steps or delete the mentioned ones.

Garantex – a real-life example of KYT value

The Garantex case, researched jointly by the IdeaSoft and Global Ledger teams, is a prime example of KYT value. The exchange was sanctioned on April 5, 2022. However, it managed to survive and even flourish. Nevertheless, KYT allowed researchers to detect the scheme Garantex used to circumvent sanctions. KYC would not have aided in identifying the patterns.

By directing crypto assets into “proxy” clusters, Garantex mixed them with clean assets. This led to a significant reduction in the perceived risk score. Such a change poses challenges as VASPs may not flag these funds as high risk, enabling the blacklisted exchange to operate. 

KYC and KYT: Pros and cons

IdeaSoft team works closely with Web3 and fintech projects and often deals with KYC and KYT approaches because both are critical compliance measures used in the financial industry to prevent money laundering, fraud, and other illicit activities. That is why, we have prepared a quick comparison table for KYC vs. KYT for you to understand them better.

KYC is widely used in banking, international trade, online payments (e.g., PayPal), insurance companies, securities exchanges, and crypto exchanges (Binance, Coinbase, Huobi, etc.). The purpose of KYC is to help companies collect information about customers to protect them from financial fraudsters while KYT helps identify and manage the potential risks associated with particular transactions the person does.

KYT vs. KYC: do they complement each other?

Yes, KYT and KYC complement each other. Here’s why a combined KYC and KYT strategy proves more efficient in addressing the challenges of the crypto space:

1. Pseudonymity. While every transaction is recorded on a public ledger, associating those transactions with real-world identities is not straightforward. KYC provides the initial layer by associating real-world identities with specific wallet addresses, adding a layer of accountability.
2. Real-time monitoring. Given the speed and volume of crypto transactions, real-time monitoring becomes imperative. KYT can instantly flag suspicious activities, making the system resilient against potential threats.
3. Cross-border transactions. Cryptocurrencies are not bound by national borders or banking hours. This global reach makes them susceptible to a broader range of financial crimes. KYC and KYT ensure that every transaction’s identity and nature are scrutinized, regardless of origin or destination.
4. Regulatory compliance. Adhering to KYC and KYT protocols ensures compliance and fosters trust with regulatory agencies, potentially influencing positive regulatory frameworks in the future.
5. Integrative insights. Crypto offers a wealth of data. By combining the static data from KYC with the dynamic data from KYT, VASPs can better understand their users’ behavior, leading to better service offerings and risk management.
6. Protecting users. While privacy is a core tenet of crypto, ensuring that platforms are not misused for illicit activities is crucial for the broader adoption of cryptocurrencies. A KYC + KYT framework protects legitimate users from potential backlash due to the actions of a few.

FATF’s guidance advocating for a risk-based approach to virtual assets and VASPs emphasizes the necessity of ongoing monitoring. This involves verifying whether transactions align with the VASP’s (or other obliged entity’s) information about the customer and the nature and purpose of the business relationship. Notably, this recommendation falls within the “Customer due diligence” section, positioning KYT as an evolutionary step beyond KYC principles.

Summary

KYC provides a robust framework for verifying and understanding market participants. KYT ensures real-time transaction monitoring, spotlighting suspicious financial movements. Together, they constitute the front line against illicit crypto activities.

Relying solely on one is comparable to using a sieve instead of a net—too many undesired elements slip through. An integrated approach using both KYC and KYT is not just beneficial. It is essential. A more secure and trustworthy digital financial environment can be established by ensuring both the legitimacy of participants and the transparency of their transactions.