KYC/AML Compliance for Fintechs: Best Practices

Key takeaways:

KYC/AML compliance is critical for fintechs in an increasingly demanding regulatory environment, with implementation costs reaching $28 million per company in 2022.

A risk-based approach allows fintechs to optimize resources and improve effectiveness in detecting suspicious activities by adapting to the risk profiles of products, customers, and geographic locations.

The essential components of a robust KYC/AML program include customer identification, due diligence, AML screening, transaction monitoring, and regulatory reporting, supported by advanced technologies.

Effective implementation of KYC/AML compliance programs not only prevents sanctions but also becomes a competitive advantage for fintechs, strengthening the trust of customers and regulators.

KYC/AML compliance for fintechs has become a real challenge for financial companies. According to a report by Fintech Alliance, the global average cost of KYC/AML compliance for financial institutions skyrocketed by 19% in 2022, reaching nearly $28 million per company.

The industry evolves every day, and financial digitalization brings new opportunities but also new risks associated with fraud and money laundering. Fraud prevention and identity verification are crucial in this context. For example, in Spain, where the fintech sector grew by 16% in 2023, the need to implement KYC verification processes and anti-money laundering (AML) prevention is a reality. Local regulations are prepared for it.

The Sixth European Anti-Money Laundering Directive (AMLD6), whose full implementation is scheduled for July 2027, has raised the bar for regulation, requiring fintechs to implement much more robust compliance measures. The alternative: facing multimillion-dollar fines, license revocations, or other sanctions that could jeopardize the future of your company.

How can fintechs ensure KYC/AML compliance without sacrificing innovation and user experience? Discover the keys in this article and learn how to turn regulatory compliance into a competitive advantage for your company.

The regulatory landscape of KYC/AML compliance for fintechs

The regulatory landscape of KYC/AML compliance for fintechs is a complex and constantly evolving terrain. Fintech companies must navigate between different global and regional regulations designed primarily to combat money laundering and terrorist financing. Understanding this difficulty is crucial for financial companies to develop effective compliance strategies, protect the financial system, and avoid sanctions.

At a global level, the standards of the Financial Action Task Force (FATF) establish KYC and AML policies. These 40 recommendations, which are not legally binding, are widely accepted as a framework for combating money laundering and terrorist financing. Member countries of this organization, as well as many other nations, base their regulations on these recommendations, taken as international standards.

Closing the circle on the regional scope, for example, the European Union's Anti-Money Laundering Directives have been instrumental in creating a regulatory framework for fintechs operating in Europe. All these regulations have evolved over the years, based on new threats and technologies that have emerged.

Region-specific regulations that fintechs must comply with

As we have seen, in addition to global and regional standards, fintechs must adapt to the specific regulations of each country in which they operate. These regulations can vary significantly from one jurisdiction to another, adding even more complexity to regulatory compliance.

In the United States, the Bank Secrecy Act (BSA) of 1970 and the USA PATRIOT Act of 2021 are fundamental pillars within the regulatory framework. These laws require financial institutions, including fintechs, to implement robust KYC verification programs, monitor suspicious transactions, and report potentially illicit activities to the competent authorities through Suspicious Activity Reports (SARs). To comply with these regulations, fintechs must adopt a risk-based approach, conducting periodic risk assessments and applying due diligence measures proportional to the level of risk identified.

For its part, the European Union has toughened sanctions and expanded criminal liability for money laundering offenses with the Sixth Anti-Money Laundering Directive (AMLD6). This directive, which came into force in December 2020 (although it will not be fully implemented until 2027), requires fintechs to implement stricter customer due diligence measures, including the verification of the identity of beneficial owners and the continuous monitoring of business relationships. In addition, AMLD6 introduces stricter requirements for fraud prevention, such as the obligation to report suspicious transactions within 24 hours.

In the United Kingdom, on the other hand, the Money Laundering Regulations 2017 (MLRs) transpose the Fourth European Union Anti-Money Laundering Directive into British law. These regulations establish detailed requirements for customer verification, risk assessment, and record-keeping, obligations applicable to both traditional financial institutions and fintechs. In this regard, it will be necessary to scrutinize the evolution of this regulatory framework after Brexit.

Sanctions for non-compliance

Failure to comply with KYC/AML regulations can have completely devastating consequences for fintechs. We are talking about multimillion-dollar fines, but also other damages that are difficult to quantify, such as reputation, criminal actions against executives, or the revocation of licenses.

In fact, in recent years, we have witnessed some events that should serve as a wake-up call for the entire financial sector. In 2022, for example, a cryptocurrency exchange was fined $50 million by the U.S. Securities and Exchange Commission (SEC) for deficiencies in its KYC and AML programs.

This case is not unique, but it does reflect (with the multimillion-dollar fine) the importance of fintechs having a robust, adaptable, and up-to-date KYC/AML compliance program.

Risk-based approach: a solution for KYC/AML compliance in fintechs

The risk-based approach has become a fundamental pillar for many fintechs to ensure KYC/AML compliance. This method allows companies to allocate resources more efficiently, focusing on areas of higher risk and adopting their controls accordingly. For many fintechs, especially those startups operating with limited resources, applying this approach is crucial to maintaining effective compliance without compromising innovation or growth.

This risk-based approach allows fintechs to optimize resources to concentrate their efforts on other areas of higher growth, improves effectiveness by adopting controls to detect suspicious activities, and facilitates scalability, as they can be adjusted proportionally.

AML risk assessment according to products or services offered by fintechs

Not all financial products or services carry the same level of money laundering risk. Some of the highest-risk products are:

• International transfers: High risk due to the possibility of moving funds between different jurisdictions. Fintechs must implement robust KYC and transaction monitoring controls to mitigate the risks associated with international transfers, especially when they involve high-risk countries (we will see what they are below).
• Cryptocurrencies: With their decentralized nature and lack of uniform regulation, they become tools vulnerable to money laundering. Fintechs offering cryptocurrency-related services must apply enhanced due diligence measures, including verifying customer identity and monitoring transactions for suspicious patterns.
• P2P loans: They can be used to structure transactions and conceal the real origin of funds. Fintechs facilitating P2P loans must implement controls to verify the identity of borrowers and lenders, as well as monitor transactions for suspicious activities, such as loan splitting to evade reporting thresholds.

In addition to these high-risk products, fintechs must also carefully assess the risks associated with other services, such as mobile money accounts, prepaid cards, and online payment services. Each product must be thoroughly evaluated based on how vulnerable it is to money laundering, and proportional controls must be implemented to the level of risk identified.

Different customer profiles and their impact on risk assessment

The customer profile is another factor that must be taken into account when developing a risk-based strategy in fintechs. Some of the most prominent profiles are:

• Politically Exposed Persons (PEPs): They require enhanced due diligence due to the higher risk of corruption. You can read more about PEPs on our blog. Fintechs must implement processes to identify PEPs, including the use of checklists and automated detection tools. Once identified, enhanced due diligence measures must be applied, such as verifying the source of funds and continuous monitoring of transactions.
• High net worth customers: They may present additional risks due to the complexity of their transactions and financial position. Fintechs must apply enhanced due diligence measures for high net worth customers, including verifying the source of wealth and monitoring transactions for unusual or suspicious activities.
• Companies with complex ownership structures: They make it difficult to identify the beneficial owner, increasing the risk of money laundering. This is one of the issues that the Travel Rule seeks to address. Fintechs must implement processes to identify the beneficial owners of companies with complex ownership structures, including obtaining supporting documentation and verifying the information provided.

In addition to these high-risk profiles, fintechs must also consider other important factors, such as the customer's occupation, the purpose of the business relationship, and the expected transactional behavior. By developing comprehensive customer risk profiles, fintechs can apply proportional due diligence measures and detect suspicious activities more effectively.

The geographical location of customers and its relevance in risk assessment

The location of our customers and the transactions they carry out (of which they are issuers or beneficiaries) is also a crucial factor in the AML risk assessment for fintechs.

What aspects should be considered? According to the FATF, there are high-risk countries due to their deficiencies in their anti-money laundering systems. The focus is also on offshore financial centers, which can present a very high risk due to the opacity of regulators and having more "lax" regulations. It is also important to monitor areas in conflict or political instability, as they are often hotspots for money laundering risk.

Fintechs must implement processes to identify and manage the risks associated with the geographical locations of their customers and transactions. This may include:

• Maintaining updated lists of high-risk countries and applying enhanced due diligence measures for customers and transactions related to these jurisdictions.
• Monitoring cross-border transactions for suspicious patterns, such as frequent transfers to high-risk countries or transactions that do not fit the customer's profile.
• Obtaining additional information on the purpose of transactions and the source of funds for transactions involving high-risk jurisdictions.
• Training staff on the specific risks associated with different geographical locations and how to identify and report suspicious activities.

By incorporating geographical location into their risk assessments, fintechs can adapt their KYC/AML controls to address the specific risks associated with different jurisdictions and ensure compliance with local and international regulations.

Developing a risk assessment methodology

To implement an effective risk-based approach, fintechs must develop a robust risk assessment methodology. This methodology should include the following key steps:

1. Risk identification: The first step is to map all possible money laundering risks associated with the fintech's products, services, customers, and geographical locations. This involves conducting a thorough analysis of potential vulnerabilities and considering how they could be exploited by criminals.
2. Risk assessment: Once the risks have been identified, the fintech must assess their likelihood and potential impact. This involves assigning risk levels (e.g., low, medium, high) to each identified factor, based on predefined and consistent criteria.
3. Risk mitigation: Based on the risk assessment, the fintech must develop and implement controls proportional to the level of risk identified. This may include measures such as enhanced due diligence for high-risk customers, more frequent transaction monitoring for high-risk products, and specialized training for staff handling high-risk situations.
4. Monitoring and review: Risk assessment is not a one-time exercise, but an ongoing process. Fintechs must establish processes to periodically review and update their risk assessment, taking into account changes in their business, the regulatory landscape, and money laundering trends.

The essential components for implementing a robust KYC/AML program for fintechs

The specific characteristics of fintechs and their risk with respect to money laundering make KYC/AML compliance programs essential. These serve to protect the business, comply with regulations, and avoid fines.

Although some details may vary depending on the jurisdiction and the specific business model of the fintech, there are some key components that all fintechs must include in their regulatory compliance programs.

Customer Identification Programs (CIP)

In any KYC/AML program, secure customer identification and verification is the first step. It's the point prior to initiating any business relationship. What should customer identification programs (CIP) include?

On one hand, companies must have reliable identity verification methods. It's not enough for a user to tell us their name is John Doe; they must have some identity document (mainly) issued by the government of their country or region that allows ensuring and verifying the identity of individuals.

Here, technology plays a fundamental role. The automation of KYC processes helps fintechs make this process much more secure. Developments such as document verification, to validate originality and extract data, or facial recognition, with biometrics and liveness tests to authenticate the user, allow KYC verification to be performed remotely and in a few seconds, providing an unparalleled user experience and ensuring regulatory compliance.

At Didit, we offer a free, unlimited, and forever KYC service. Why? Because in times of fraud, such as deepfakes and generative artificial intelligence, verifying that who is on the other side of the screen is actually a human should not be a luxury but a fundamental right.

Customer Due Diligence (CDD)

After verifying the identity of new customers, fintechs must perform due diligence to understand what associated risks are linked to each customer profile. In this way, those customers who present a higher risk of money laundering, such as Politically Exposed Persons, will undergo enhanced due diligence (EDD).

CDD involves collecting and analyzing information about the customer's economic activity, the source of their funds, and the purpose of the business relationship. For high-risk customers, EDD may include a more thorough verification of the source of wealth and more frequent transaction monitoring.

Sanctions and PEPs Detection (AML Screening)

AML Screening tasks are fundamental in any fintech compliance program. These processes will detect which customers and transactions may be subject to sanctions or present a higher risk of corruption.

AML Screening, among other tasks, is responsible for identifying Politically Exposed Persons by cross-checking different lists and databases; while detection against sanctions lists aims to verify customers and their transactions against various lists issued by national and international organizations to ensure compliance with legal obligations.

Transaction Monitoring

Effective transaction monitoring helps fintechs detect and report suspicious activities. In this way, fintechs can identify patterns of suspicious activities that could potentially end up in different forms of money laundering.

Fintechs should implement automated monitoring systems that use scenario-based rules and behavioral analysis to detect unusual transactions. These systems should be able to adapt to customer risk profiles and emerging trends in money laundering.

Regulatory Reporting

When suspicious activity is detected, fintechs must report to the competent authorities in a timely and complete manner. Each country or territory has its own competent authority. In Spain, for example, it is SEPBLAC (Executive Service of the Commission for the Prevention of Money Laundering and Monetary Offenses); while in the United States it is FinCEN (Financial Crimes Enforcement Network); in the United Kingdom, the National Crime Agency (NCA); in Germany, the Financial Intelligence Unit (FIU); or in France, Tracfin (Treatment of Intelligence and Action against Illicit Financial Circuits).

Fintechs must be familiar with the reporting requirements in all jurisdictions where they operate and have processes in place to submit Suspicious Activity Reports (SARs) or their equivalents in a timely and accurate manner.

Continuous Training and Compliance Culture

A crucial component that is often overlooked is continuous staff training and fostering a culture of compliance throughout the organization. Fintechs must ensure that all employees, from the executive level to front-line staff, understand the importance of KYC/AML compliance and are aware of the latest regulations and best practices.

Effectively implementing these components will not only help fintechs comply with regulations but will also provide them with a competitive advantage by building trust with customers and regulators.

Conclusion: KYC/AML compliance is a fundamental pillar for fintechs

The landscape of KYC/AML compliance for fintechs is a complex and constantly evolving terrain, but its importance cannot be underestimated. We have explored the essential components of a robust compliance program, from customer identification to transaction monitoring and regulatory reporting. We have also analyzed how a risk-based approach allows fintechs to optimize their resources and adapt to a changing regulatory environment.

The proactive implementation of a robust KYC/AML compliance program is not only a legal obligation but also a competitive advantage. It protects the company from costly sanctions, strengthens the trust of customers and regulators, and allows fintechs to innovate safely. In a sector where trust is fundamental, robust compliance becomes a key differentiator. Fintechs that adopt this approach will not only be better positioned to navigate regulatory challenges but will also be building a solid foundation for sustainable and responsible growth in the changing world of digital finance.

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