Knowing your customer (KYC) made easier with blockchain for banks

What is KYC?
KYC stands for “know your customer”. It consists of a set of procedures and documentation, to know the customer with whom any financial institutions plans to do any sort of business. It is mandated by strict government regulations globally. In the USA, after the promulgation of Patriot Act, banks and other financial institutions should properly identify their clients, their sources of income and their transaction patterns. This is done to stop usage of banking channels for criminal activities. Although, banks have to invest a lot in performing KYC procedures (estimated at around 25%), but this is justified as strict regulatory actions can be taken against them by government agencies if they move money around which has an illegal source or is used for illegal purposes.

What are AML and CFT?
AML stands for anti-money-laundering and CFT is countering the financing of terrorism. With regards to blockchain technology, these two terms constitute the analysis and pattern recognition of financial transactions. Idea is to understand the sources of wealth, business interests and usage of such financial resources to stop funding of criminal activities especially cross-border terrorism.

Significance of Blockchain technology
Blockchain technology is based on distributed ledger methodology, it relies on several network nodes to reach a collective agreement before any data can be written or updated. This distribution of key records and parameters makes tempering of record virtually impossible, without any other node detecting the change. This increases transparency and reduces conflicts. The data is consistently validated due to distributed nature of blockchain and can be timely referenced when needed.
This can also eliminate the need for unnecessary ‘trusted’ intermediaries. Assets in blockchain technology are held in the cloud and are associated with personal identities rather to sureties provided by trusted intermediaries. All these advantages lead lesser infrastructure requirements for contracting and greater democracy within the whole system.

Advantages offered by blockchain for AML and KYC

According to World Bank estimates, the volume of global money laundering is between $2.0 tn to $3.5 tn. Only 1% of it detected, according to third-party data. Total AML compliance cost borne by banking sector is around $18 billion which also includes regulatory penalties of around $8 billion. Blockchain technologies can help in bringing down these cost by pooling resources of different financial institutions.

Current AML procedures and associated pain points

AML procedures do get good sized budgets from different financial institutions but most of it is dedicated to compliance personnel, who have to manually check every suspicious transactional activity and perform laborious new client onboarding activities. Here are some of the processes which involve complex AML procedures.

Onboarding
When a client wants to open an account, banks have to perform lengthy KYC procedures to verify the identity of the customer, cross-check their data against government sanctions lists. Mostly these steps are done manually.

Monitoring
After getting their clients onboard, banks have to perform real-time surveillance of every transaction using data analytics software. Around 2%-5% of them are flagged as suspicious by the monitoring software, which is then further analyzed manually by the compliance personnel. In those flagged transactions, there is 99.9% false positive rate.

Reporting
Banks have to maintain all the necessary record on transactions. This is helpful with swift compliance of regulatory requests by government agencies.

Two major problematic areas with regards to KYC and AML are listed below

Lack of data consolidation between banks leading to effort duplication
With every new client getting onboard, it is estimated that $15k-$50k have to be spent on KYC procedures alone. This is due to lack of mutualization between different banks in this process. All the banks have to independently verify the identity of each customer resulting in duplication.

High False-Positive rates due to lack of account information digitization
Banks rely heavily on transaction monitoring software. Around 2%-5% of all transactions are screened by them and then manually checked, which has a very high false-positive rate (around 99.9%). This is mostly due to lack of complete transaction data (sender/receiver details) instead of any shortcomings in the monitoring software. This manual reconciliation process costs around $6 billion.

Role of Blockchain in AML

Secure Distributed Database of client information
Blockchain can help banking sector in reducing duplication of KYC procedures by providing a secure, distributed and mutually agreed database of client information. Though it may not completely eliminate the KYC expenditures for the other financial institutions but it will surely reduce the number of manual steps required during onboarding process for new clients.

Distributed ledger will simplify auditing and record-keeping
Blockchain technologies can be used by financial institutions to create a database of all the transactions, on behalf of the clients. As all the activities related to a particular client can be traced automatically, it will make auditing processes easier. In the case of regulatory investigation regarding AML procedures, blockchain will help banks in the provision of solid transactional evidence.

Codification of account details
Transparency of financial transactions can be improved by using blockchain’s distributed ledger technology, as it can provide a codification of rules tied to the completion of client account information. It will also reduce the amount of manual labor involved in the reconciliation of software triggers and underlying money laundering activities.

Quantified estimates for opportunity
According to a Goldman Sachs Report, Case Study 7 , banking sector can achieve 10% headcount reduction with the introduction of blockchain in the KYC procedures. This amounts to around $160 million in cost-saving annually.
Transaction monitoring headcount can be reduced by 30% which amounts to $1.4 billion in savings. Tracking on unique client identifiers and distributing them across a shared and secure platform will lead to significant reduction in false-positive rate.
Blockchain will also reduce the amount of budgetary resources allocated for employee training, there will be 30% headcount reduction amounting to $420 million.
Overall operational cost savings are estimated to be around $2.5 billion dollars. AML penalties will also be reduced by estimated amount between $0.5 to $2 billion dollars.
References
Schenider, J. (2016). BlockChain : Putting theory into Practice. Goldman Sachs.