What is KYC?
We do not let strangers into our homes without confirming who they are, and airports don’t allow us entry without valid identity proof. In the same way, businesses and banks should not transact with an unknown counterparty, and the only way to familiarise themselves with a new business partner or customer is through the Know Your Customer (KYC) process.
Know Your Customer (KYC) is the process of validating the identity of an entity or individual and is usually undertaken by businesses that require a high level of trust about the counterparties with whom they are doing business (for e.g., banks and financial institutions). In the B2B space, KYC is sometimes known as Know Your Business (KYB).
Entities need to vet and verify counterparties across borders, tax regimes, and regulatory environments. To be effective, the KYC or KYB needs to be comprehensive; this involves scouring through business identity and registration documentation, statutory and tax filings, ownership data pertaining to Ultimate Beneficial Owners (UBOs), and reams of financial statements.
By complying with KYC regulations, entities can ensure that they are not caught up in money laundering, terrorist financing, and various other fraudulent activities. Verifying the identity of counterparties during onboarding, and thereafter monitoring their transactions, helps banks, financial institutions and businesses detect suspicious activities with much greater accuracy and speed.
KYC is also imperative for an entity to decide whether it is permitted to do business with other entities in various jurisdictions, depending on local and international laws. For several decades, the KYC process has been a key legal prerequisite to comply with Anti-Money Laundering (AML) laws.
It is a myth that KYC is only meant for new customers or suppliers and is a one-time exercise. In reality, it is mandatory to conduct regular ‘renewal’ KYC checks, especially in the financial services industry to maintain updated records.
Why has KYC gained importance in recent years?
Ever since the 9/11 attacks in the US, there has been increased scrutiny of the money trail in terms of money laundering and terrorist financing activities. Very often, terrorist financing comes from illegal businesses such as the drug trade or organised crime. Therefore, to combat illegal activities that use the financial services industry (including some dubious banks) to move or hide money, governments and banking regulators all over the world have been tightening KYC policies.
The other key benefit of conducting KYC checks is the transparency it creates about the connections and networks between financial organisations and corporations across the world. The collapse of Lehman Brothers in 2008 put the spotlight on this need, as regulators and financial institutions were unable to quickly quantify the real extent of losses that emanated from this development due to the tangled web of institutions owned or associated with Lehman across the world.
What are the components of KYC?
There are 3 components or parts of the KYC process:
1. Counterparty Identification: This involves detecting and verifying the identity of the counterparty. For businesses, it also includes screening, identifying, and verifying the identity of the ultimate beneficiaries and validating parent companies and subsidiaries. The information collected includes the entity’s name, statutory registration number, registered office, and principal place of business; the list of its board of directors (or members of the equivalent management body); names of its senior management; the law to which it is subject; and its legal and beneficial owners.
The documents collected can include articles of association or other governing documents; proof of legal existence (certificate of incorporation or registration); documents disclosing beneficial ownership structure (articles and memorandum of association); address proof, etc. These are then verified using statutory sources and databases to ascertain their validity. In many cases, KYC also includes physical verification of the counterparty premises.
2. Counterparty Due Diligence: In comprehensive KYC checks, entities may also carry out due diligence of their counterparties. This requires understanding the nature of the counterparty’s business, its attendant risks, financial statements, and ownership structure so as to develop a meaningful risk profile of the business and its owners.
3. Regular Updates: Conducting KYC is not a one-time exercise. Regularly updating the business partner’s details is crucial to avoid becoming an unwitting victim of fraud or illegal activities.
What are the advantages of Know Your Client (KYC) for businesses?
As explained earlier, KYC is a gatekeeper of sorts when an entity does business with the outside world, and it helps in various ways:
- First and foremost, KYC fights money laundering. One of the biggest challenges in the financial industry is money laundering, which means the conversion of illegally obtained money through crimes and corruption into legitimate money. Therefore, stringent Anti-money Laundering (AML) regulations are in place globally. One of the prerequisites of the AML process is KYC, which validates that counterparties are who they claim to be legally. As a part of the rigorous KYC process, any individual or entity that is using a fake or stolen identity is identified and filtered out from becoming a business partner. It is critical that any institution (bank, NBFC, forex dealer, broking platform, etc.) that can be potentially used for laundering money should have a strict KYC compliance process to verify the identity of those who deal with it.
- Conducting KYC checks at the beginning of a new business relationship helps avoid becoming a victim of fraud. New B2B relationships often come with the risk of various types of fraud if the counterparty is not properly vetted and verified. Some types of fraudulent businesses that KYC checks help weed out are:
- A business that is inoperative posing as an operative one
- A business that is actually involved in restricted/prohibited activities posing as a legitimate business
- A bogus storefront set up to utilise fraudulently obtained credit lines without the intention of repayment (bust-out-fraud)
- A business that uses a stolen identity (identity theft)
- A business that is on an AML or terrorism financing watch list
- A business that is owned or operated by Politically Exposed Persons (PEPs)
- Following a detailed KYC process helps detect statutory non-compliance: Detailed KYC checks include checking the compliance of counterparties with statutory requirements of various government departments and regulators (e.g., corporate registry, tax departments, employee provident fund, central bank, securities and capital market authorities, etc.). Non-compliance by counterparties can be investigated further.
- A strong KYC framework enables better risk management: KYC can also include detailed due diligence, wherein the financial statements of the counterparty are obtained and analysed. With this information, it is possible to identify high-risk counterparties and avoid financial risk exposure to them.
- A centralized KYC process facilitates business continuity and prevents data leakage: KYC processes are usually managed by a central team in an organisation. Any new supplier, vendor, customer, distributor, or dealer should ideally go through the KYC process before dealing with the procurement and sales teams. In such a mechanism, the KYC data of counterparties is systematically captured in a central database facilitating business continuity. Also, since sensitive counterparty data is securely stored at a central location, data leakage is prevented.
- You can avoid your counterparty data from becoming obsolete by conducting periodic KYC: In today’s fast-moving world, companies undergo swift changes. Sudden management or ownership changes can bring a company to the brink of a crisis. Therefore, regularly updating KYC information is vital to spot important changes in counterparties that could change their risk profile.
- Onboarding after a thorough KYC process helps build a foundation of trust in a business relationship: A robust KYC process helps an entity collect vital information about a counterparty. If the counterparty is found to be compliant, it creates an environment of trust and allows a strong business relationship to be built.
What are the challenges in performing KYC manually?
Manual identity verification takes time as well as effort, as it involves voluminous document checks. It also carries the risk of missing critical data elements.
Manual KYC is often a frustrating experience for a customer or supplier, who may not have the patience to wait for the process to be completed.
Further, a manual process means that costs are higher due to increased manpower deployment. Moreover, it is not very easy to detect identity fraud through manual checks in the absence of strong technology-based identity validation tools and software. Very often, non-compliant businesses fall through the cracks during manual checks. Manual KYC checks of overseas counterparties are also logistically difficult and very expensive to undertake.
What types of solutions should be used during KYC?
Companies, banks, insurers and financial institutions can deploy technology to handle identity check tasks. Video KYC and eKYC solutions that leverage AI are now commonly used in KYC processes. These tools use proprietary Application Program Interfaces (APIs) which can retrieve company information from government registries, regulatory, and other statutory data sources. They can even cross-reference the data within a short time frame. As awareness about these solutions and their capabilities rise, their adoption is growing as well. According to NVIDIA’s “State of AI in Financial Services” survey, fraud detection for KYC and AML compliance was one of the top areas for the implementation of AI solutions in 2022. Only 7% of the respondents had invested in AI-based fraud detection for KYC and AML in 2021, but the number rose to 23% in 2022.
The Video and eKYC process can also be outsourced to third-party, digital risk management platforms that offer identity checks and verification solutions that are efficient, quick, and cost-effective.
How does the Legal Entity Identifier help in KYC?
The Legal Entity Identifier is a global reference code that uniquely identifies every legal entity or structure that is a party to a financial transaction, in any jurisdiction. It simplifies the KYC and/or identity checks process because the identity of an entity with an active LEI has already been validated and verified against statutory identity documents, such as tax identity numbers, incorporation certificates, etc., by the Local Operating Unit (LOU) in a jurisdiction, before issuing the LEI.
Currently, banks globally may use many different identifiers while onboarding new clients; this KYC process can take a couple of days. It can sometimes lead to inconsistencies that need to be resolved resulting in considerable cost overhead and an adverse impact on customer service. However, all that time, money, effort, and goodwill can be saved by using the LEI as the identifier in the KYC process.
How can KYC benefit the business information industry, in concrete business information providers like FEBIS members?
Apart from helping FEBIS members know about the identity of their counterparties and deal safely with them, KYC presents a unique opportunity for business growth. As part of the KYC process, counterparties are asked to furnish a range of information about their operations, directors/owners and other key individuals. These are then validated through open-source databases and any supplemental information is noted.
The KYC data elements are also compared with various statutory and third-party databases:
- To ensure that the counterparty legally exists
- To ensure that the counterparty or its directors/ owners do not feature on any watch lists for Money Laundering or Terrorism Financing
- To check if the counterparty or associated individuals are subject to any international sanctions
- To identify entities and individuals that are Politically Exposed Persons (PEPs)
This KYC process can be time-consuming and costly unless it is technology-enabled. The problem is further compounded by the fact that this is not a one-time exercise. Company details and government regulations governing KYC checks evolve, as do information sources. This means an organisation must contact its business partners periodically to request KYC information. This imposes a burden on the counterparty as well and may put a strain on the business relationship.
Therefore, there has been some movement internationally towards creating KYC Registries, which are repositories that store and update the necessary KYC information about entities. Those wishing to do counterparty KYC checks can subscribe to such registries and access the verified information when they need it. Such a standardised exchange of all the necessary KYC information will greatly reduce the burden of the KYC process for an entity as well as its counterparties.
We believe that KYC Registries can be an important revenue stream for the business information industry. FEBIS members can certainly consider setting up or operating KYC Registries in their own jurisdictions.
If you prefer to listen to this content, please check the latest episode of the FEBIS Podcast.
Write a comment