Know Your Transaction (KYT) Explained: Understanding its Role in Financial Compliance

From money laundering and terrorist financing to cybercrime and fraud, these illegal activities erode trust, disrupt markets, and hinder development. This interconnectedness of the financial system has created new pathways for criminals. Anonymity online allows them to operate across borders with relative ease.

According to Reuters, In 2023 alone, illicit cryptocurrency addresses received at least $24.2 billion worth of crypto. These crazy figures highlight the urgent need for financial institutions to have robust tools and protocols in place to combat this threat.

Traditional methods are like trying to catch a cyber-shark with a fishing net.  Financial institutions need some serious firepower to see through the smoke and mirrors and stop criminals in their tracks.

In this article we’ll explore the KYT (Know Your Transaction) approach which offers deeper intel and stronger defenses, keeping your finances safe and sound.

What is KYT in crypto?

KYT is a process used in the cryptocurrency space to understand the nature and origin of a digital asset transfer.

While KYC (Know Your Customer) verifies the identity of those involved in a transaction, KYT delves deeper, aiming to identify the source and destination of crypto funds, as well as the intended use of those funds. This additional layer of scrutiny helps to combat illegal activities like money laundering and terrorist financing within the crypto ecosystem.

By analyzing transaction patterns, origin of funds, and the risk profile of involved parties, KYT solutions can flag suspicious activity and provide valuable insights to regulators and financial institutions. While Know Your Transaction procedure is still evolving, it’s gaining traction as a tool to promote transparency and responsible use of cryptocurrencies.

Who needs KYT and why is it important?

Businesses like crypto exchanges, regulatory bodies, security firms, NFT marketplaces, and dApps have a heightened responsibility to implement robust Know Your Transaction procedures due to the inherent risks associated with digital assets.

By continuously monitoring transactions, KYT plays a vital role in:

• Combating money laundering (AML): Criminals often employ sophisticated methods to “wash” dirty money, making it appear legitimate. KYT helps identify these attempts by analyzing transaction patterns and identifying red flags.
• Preventing terrorist financing: Know Your Transaction plays a crucial role in disrupting financial networks by identifying suspicious transactions. This could involve monitoring for transfers to known terrorist entities, individuals on watchlists, or locations associated with terrorist activity.
• Protecting financial institutions from reputational damage and financial loss:  KYT’s proactive approach safeguards institutions from hefty fines, potential lawsuits, and ultimately, protects their reputation within the financial sector.
• Maintaining financial system integrity: A healthy financial system thrives on trust and transparency. Know Your Transaction contributes significantly to this by deterring criminal activity and preventing the infiltration of illicit funds.
• Enhancing Customer Due Diligence (CDD): KYT goes beyond just monitoring transactions; it complements Customer Due Diligence processes. CDD focuses on verifying customer identities and understanding their risk profiles.
• Optimizing resource allocation:  By effectively identifying suspicious transactions, KYT allows financial institutions to prioritize their resources. This means investigation teams can focus their efforts on high-risk situations rather than wasting time scrutinizing routine transactions.

How exactly does Know Your Transaction work?

Data collection

Know Your Transaction starts by gathering data on all your transactions. This includes things like:

• Sender and receiver information (names, account numbers)
• Transaction amounts and currencies
• The purpose of the transaction (e.g., invoice payment, salary transfer)
• Location of the transaction (where it originated)

Analyzing transactions

Once the data is collected, Know Your Transaction systems analyze it for suspicious patterns. They use complex algorithms to identify red flags that might indicate potential money laundering, terrorist financing, or other financial crimes. These red flags could include:

• Large, unexpected transactions
• Transactions with high-risk countries
• Frequent transactions with the same recipient from unknown sources
• Inconsistencies between the stated purpose of a transaction and the sender/receiver profiles

Risk scoring

Based on the analysis, the Know Your Transaction system assigns a risk score to each transaction. This score indicates the likelihood that the transaction could be linked to a crime. Higher scores trigger further investigation.

Investigation and alerting

If a transaction receives a high-risk score, human investigators will take a closer look. They might contact the sender or receiver for additional information, verify the legitimacy of the transaction, or even report it to the authorities if necessary.

Continuous monitoring

Know Your Transaction isn’t a one-time process. It’s continuous monitoring that keeps track of your transaction patterns over time. This allows the system to identify changes in behavior that might suggest a shift towards risky activity.

Remember: Know Your Transaction procedure protects both you and the financial system. By cooperating with your financial institution during investigations, you can help ensure your account remains secure and free from fraudulent activity.

KYT and regulatory frameworks

While there’s no single global law solely focused on Know Your Transaction (KYT), it’s deeply intertwined with existing anti-money laundering (AML) and counter-terrorism financing (CTF) regulations. These regulations vary by country, but all financial institutions must adhere to the specific guidelines set by their national authorities. Here’s a breakdown of how Know Your Transaction principles are embedded within various regulatory frameworks:

The United States

• Key regulatory body: Financial Crimes Enforcement Network (FinCEN)
• Legislation: Bank Secrecy Act (BSA), The USA PATRIOT Act
• Key points:
  • FinCEN mandates effective transaction monitoring systems to identify and report suspicious activities. This involves ongoing due diligence on customer transactions.
  • The USA PATRIOT Act requires financial institutions to implement AML compliance programs, including risk-based procedures for ongoing monitoring. These procedures ensure suspicious transactions are detected, reported, and customer information is updated regularly.

The European Union

• Key legislation: Anti-Money Laundering Directive (AMLD)
• Key points:
  • The AMLD establishes requirements for customer due diligence, risk assessments, and transaction monitoring.
  • These measures focus on identifying and verifying client identities, monitoring ongoing transactions, and reporting suspicious activities.
  • The AMLD is regularly updated to address evolving risks associated with money laundering and terrorist financing.

The global landscape

• Organization: Financial Action Task Force (FATF)
• Focus: Global standards and recommendations for AML and CTF measures
• Key point: Although FATF primarily focuses on Know Your Customer (KYC), ongoing monitoring and understanding of customer transactions are emphasized for effective AML/CFT programs.

FATF risk-based approach

FATF has identified four major risk areas that financial institutions should be actively checking for:

• Products, services, and transactions: Assessing the inherent risk associated with specific financial products and services.
• Customer-related risks: Evaluating the risk profile of individual customers based on their background, activities, and source of funds.
• Geographical risks: Identifying countries and regions with higher money laundering and terrorist financing risks.
• Distribution channel risks: Assessing the risk associated with different channels used for transactions (e.g., online banking vs. in-person transactions).

Reporting suspicious activity

In jurisdictions with robust AML and CTF frameworks, promptly reporting any suspicious transactions upon detection is a legal requirement.

So, Know Your Transaction is basically built into those AML/CTF rules to keep an eye on things 24/7. It’s all about catching suspicious activity and keeping criminals out. By understanding these regulations, financial institutions can stay squeaky clean and avoid any money laundering or terrorist financing headaches.

Know Your Transaction: use cases

Here are some real-world examples across diverse industries where companies implement Know Your Transaction, highlighting specific problems within each scenario.

Decentralized Finance (DeFi) platform

Imagine a DeFi platform witnessing a surge in trading activity for a new token. While this might seem like a positive development, it could also indicate a potential “pump and dump” scheme. Know Your Transaction can help identify red flags through:

• Token analysis:
  • Identifying a low number of token holders could suggest a lack of liquidity and potential manipulation.
  • Tracing the owner’s address could reveal a history of suspicious activity.
• Trading analysis:
  • High commissions for purchases can be a deterrent for legitimate investors, whereas low or no selling commissions could be a sign of a planned pump.
  • Verifying if the trading tax can be modified by the token contract raises concerns about market manipulation.
• Malicious analysis:
  • KYT can identify if the token is a copy of another legitimate token, a common tactic in “copycat” scams.

By analyzing these factors, the DeFi platform can flag the token and take appropriate action, such as restricting trading or issuing warnings to users.

Crypto exchange

A crypto exchange experiences an influx of new users depositing specific NFTs. KYT can be utilized to ensure the legitimacy and safety of these NFTs through:

• NFT malicious analysis:
  • KYT can identify duplicate NFTs, a tactic used to deceive users into purchasing fake assets.
  • Cross-referencing with sanction lists can prevent the trading of NFTs associated with sanctioned individuals or entities.
  • KYT can detect malicious airdrops that might contain malware or exploit vulnerabilities in users’ wallets.

Non-Fungible Token (NFT) marketplace

An NFT marketplace aiming to establish a credible environment for creators and collectors can leverage Know Your Transaction for the following:

• Contract analysis:
  • Verifying the legitimacy of the contract owner and deployer helps ensure the platform doesn’t host fraudulent or malicious NFTs.
  • KYT can detect the presence of “poison addresses” programmed to steal funds from unsuspecting users.
• Transaction analysis:
  • Know Your Transaction can identify wash trading, a manipulative technique where users artificially inflate the value of NFTs through self-dealing.
  • Tracking suspicious addresses involved in transactions can help uncover rug pulls, where creators abandon a project after raising funds.

Traditional financial institution (FI)

Financial institutions exploring cryptocurrency adoption can leverage KYT to ensure regulatory compliance and mitigate risk:

• Transaction analysis:
  • KYT can detect phishing transactions attempting to steal user credentials or funds.
  • Identifying honeypots, fake websites designed to trap unsuspecting users, helps protect FIs and their customers.
  • Tracking token approvals by users helps identify unauthorized access or suspicious activity.

Know Your Transaction platform by PixelPlex: what is it and how to use it?

What if you had a powerful tool to not only stay ahead, but also ensure airtight security and regulatory compliance for your transactions? PixelPlex’s Know Your Transaction platform – your one-stop shop for mastering the flow of your digital assets.

User-friendly control for businesses of all sizes

Real-time API integration seamlessly connects KYT to your existing systems, granting you airtight control over your operations. Here’s a simpler way to understand how our KYT platform benefits different participants in the DeFi world:

• For crypto wallets and DApps: helps fight crime, speed up investigations, and track suspicious transactions.
• For marketplaces and DEXs: makes it easier to follow anti-money laundering and counter-terrorism financing (AML/CTF) rules, keeps more customers, and gives them strong tools to monitor transactions.
• For custodians: helps assess the risk of transactions and spot possible fraud, which improves how well you check out your customers (due diligence).
• For financial institutions: offers real-time transaction monitoring, automatic compliance checks, and reliable data analysis.

Deep dives into blockchain data: powering insights and compliance

Know Your Transaction doesn’t just collect data – it transforms it into actionable intelligence. The platform delves deep into the world of crypto assets, wallets, transactions, contracts, and interactions on the Ethereum blockchain. This comprehensive data collection extends to newly added blocks, ensuring you have access to the most up-to-date information.

Delegating risk detection: empowering smart decisions

PixelPlex’s KYT platform takes the burden of risk detection off your shoulders. The solution continuously monitors transactions, mapping hundreds of millions of addresses.

You can configure real-time alerts tailored to your specific AML compliance policies. This allows you to proactively identify high-risk actors and safeguard your business from potential threats.

Conducting in-depth investigations with confidence

KYT empowers you to delve into the specifics of any transaction or entity. This allows you to conduct comprehensive business scenario analyses based on user-defined patterns. Utilize Know Your Transaction to trace digital footprints and fund flows, assess risks associated with specific activities, and identify potential links to real-world entities.

Seamless compliance – one platform for peace of mind

Maintaining regulatory compliance can be a tedious task. Our KYT platform streamlines this process by efficiently screening transactions across numerous wallets. The platform integrates seamlessly with your existing systems, incorporating risk policies into alerts, dashboards, and operational workflows. This allows you to effortlessly maintain compliance and demonstrate transparency to regulators.

Securing your DeFi experience – a holistic approach

Gain complete transparency into DeFi projects, protocols, contracts, addresses, and transactions with know your transaction procedure. The platform empowers you to carefully vet projects and users, ensuring you only engage in secure and trustworthy interactions.

Possible challenges associated with KYT implementation

Here’s what should you consider when implementing Know Your Transaction (KYT):

Data integration and management

Know Your Transaction relies on a vast amount of data from diverse sources, including financial transactions, customer information, and third-party databases. Integrating and managing this data can be a complex task. Different formats, inconsistencies, and incomplete information can hamper smooth operations. Streamlining data collection, standardizing formats, and implementing robust data management platforms can help overcome this hurdle.

Resource constraints

KYT implementation requires investment in technology, personnel, and training. Smaller institutions may find it difficult to allocate the necessary resources. Cloud-based solutions and managed services can offer cost-effective alternatives for resource-strapped organizations.

Regulatory uncertainty

The KYT landscape is evolving, with regulations varying across jurisdictions. Keeping up with changing regulations and ensuring compliance can be a significant challenge. Collaboration with industry bodies, seeking expert advice, and implementing flexible Know Your Transaction solutions adaptable to future regulatory changes are crucial steps.

False positives and alerts

KYT systems are designed to identify suspicious activity, but they can generate false positives that lead to unnecessary investigations and delays. Fine-tuning algorithms, establishing clear risk profiles, and implementing human oversight can help minimize false alerts.

Customer onboarding friction

Know Your Transaction processes can lead to longer and more complex customer onboarding experiences. Balancing security with customer experience is vital. Implementing streamlined onboarding procedures, leveraging automation, and providing clear communication to customers can help mitigate this challenge.

Privacy concerns

KYT involves collecting and analyzing a vast amount of financial data, raising concerns about data privacy and security. Implementing strong data security measures, complying with data privacy regulations like GDPR (General Data Protection Regulation), and ensuring customer transparency in data utilization go a long way in addressing these concerns.

Conclusion

In conclusion, Know Your Transaction (KYT) offers a powerful suite of advantages for businesses of all sizes. By streamlining compliance processes and enhancing transparency, KYT empowers you to build trust with partners, reduce the risk of financial crime, and ultimately gain a competitive edge. However, navigating the complexities of Know Your Transaction procedure and integrating it seamlessly into your existing systems can be a challenge.

This is where our expertise comes in. As seasoned blockchain consultants, we possess a deep understanding of KYT principles and the latest blockchain technologies that underpin them. We can guide you through every step of the Know Your Transaction implementation process, from initial strategy development to system integration and ongoing maintenance. Our team will work closely with you to tailor a KYT solution that meets your specific needs and regulatory requirements.

Don’t let the challenges associated with KYT prevent you from reaping its substantial benefits. Partner with us today and unlock the full potential of Know Your Transaction for business.