September 27, 2023

What is KYC? Understanding the Cornerstone of Regulatory Compliance in Financial Services

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In our increasingly interconnected world, ensuring transactions are done safely with the utmost level of care is essential. One of the critical components behind this is the Know Your Customer (KYC) process. Despite its widespread application across various sectors, especially in banking and investment management, many companies still use antiquated methods to gather this information.

Using methods like pen and paper or clunky, unoptimized software produces errors and can damage your customer experience. The wealth industry is so deeply relationship and trust focused that this is a critical issue for many players.

This article aims to demystify KYC, exploring its origins, relevance, components, and why it is indispensable in today's regulatory climate.

What is KYC?

KYC is a risk assessment strategy employed by financial institutions and related organizations to verify the identity of their clients. The process involves collecting various types of personal and financial data and documentation.

KYC's primary objectives are to ensure that clients are who they claim to be, assess the risks associated with those clients, and ensure compliance with local and international laws.

A properly executed KYC process also provides you with the essential data required to advise customers on their financial journey. It is also often the first impression clients have with your firm; it’s always best to wow them in that scenario.

The Genesis of KYC

The concept of KYC isn't new; it has its roots in the banking laws that date back to the early 20th century. However, the term gained significant attention recently, with issues like terrorism, cryptocurrency and cybersecurity becoming center stage.

Governments worldwide ramped up their anti-money laundering (AML) efforts and introduced more stringent customer identification programs. Over the years, KYC has evolved to become more than a security method, and wealth management firms use the gathered information to improve their services.

The Components of KYC

The KYC process generally consists of three critical stages:

Customer Identification Program (CIP): At this initial stage, customers must provide identification credentials, such as government-issued IDs and tax documents. The objective is to establish a factual basis for the customer's identity.
Customer Due Diligence (CDD): CDD involves a deeper customer profile analysis. It assesses factors such as the origin of the funds, business activities, and overall risk profile. Enhanced Due Diligence (EDD) is an extended form of CDD and is usually carried out for high-risk clients or complex business arrangements.
Ongoing Monitoring: KYC is not a one-time exercise. Financial institutions continually monitor transactions to detect any unusual activities, thereby updating the client's risk profile as necessary.

Regulatory Landscape

Various laws and regulations across jurisdictions mandate KYC procedures. In Canada, Know Your Customer (KYC) regulations are an integral part of the anti-money laundering (AML) and counter-terrorist financing (CTF) framework. The Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) is the primary body responsible for the monitoring and enforcement of AML and CTF regulations, including KYC norms.

The Bank Secrecy Act and the USA PATRIOT Act lay down comprehensive guidelines in the United States. Meanwhile, the European Union's Fourth Anti-Money Laundering Directive (AMLD4) offers a robust European framework. Non-compliance can result in hefty fines and, in extreme cases, the revocation of business licences.

Challenges and Controversies

The KYC process is not without its hurdles. It can be cumbersome for both businesses and clients, leading to longer onboarding times. There is also the issue of data privacy, as institutions collect and store sensitive information. Financial institutions must strike a delicate balance between stringent verification and customer convenience, all while safeguarding data against breaches.

The Technology Factor: Automation and AI

Modern-day KYC processes have moved beyond manual data entry and verification. Technology plays a significant role in streamlining KYC procedures. Artificial Intelligence (AI) algorithms can swiftly sift through vast databases, flagging any suspicious activities or inconsistencies in customer profiles. Automation tools can handle routine tasks such as data collection and verification, freeing up human resources for more complex decision-making tasks.

The main use case is automation and data replication for the various forms required by custodians and wealth management offices. This process allows clients to fill in their information only once, which is then stored in a database, providing a much better experience for the client, and a better working situation for advisors.

Navigating the Future: The Evolutionary Path of KYC Compliance

The importance of KYC cannot be overstated. While it serves as a regulatory mandate, its implications go beyond mere compliance. Effective KYC processes protect businesses from reputational damage, financial penalties, and legal complications. Moreover, they contribute to a safer and more transparent operating environment, fostering stakeholder trust.

Understanding the intricacies of KYC is essential for anyone engaged in financial transactions or management, be it an individual investor, financial advisor, or regulatory body. The technological advancement of the KYC process has completely changed the way customer information is gathered by wealth management firms.

For most players in the financial field, automating KYC and onboarding is often the first step in a much larger digital transformation effort. It is crucial to take on this journey with a partner prepared to understand your specific needs and requirements.

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Photo by Gabrielle Henderson on Unsplash

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So in my view an appropriately diversified portfolio should have enough exposure to different asset classes, that its able to withstand a wide range of market disruptions. Usually, it’s some kind of negative or positive event… they’ll affect different asset classes differently. So by having your eggs in different baskets you’ll be well insulated from major risk. For example, there’s some kind of change in the housing market… both by having some exposure to it, you won’t miss out on the opportunity to make money. But if it’s something negative, you’re also not going to lose all your money if all of it were in the housing market for example. So at a high level, a properly diversified portfolio should grow in a growing market and yet not be at risk of major losses in a declining market.
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You asked also about an efficiently diversified portfolio, and I would say that that’s a portfolio that achieves those goals with a minimum of different positions. There’s a lot of good reasons to have fewer positions in your portfolio. Being less complex means a portfolio is easier to rebalance and administer. Every time part of your portfolio goes up or down, you're going to need to rebalance it a little to make sure that it stays with the right allocations and the fewer positions you have, the easier it is to do that..the less trading fees you incur doing that.
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There is a tradeoff between being completely diversified and being efficiently diversified. If you were completely diversified then you’d have a proportional segment of absolutely everything you could invest in under the sun, like shares of palm oil futures or something like that. I don’t think everyone should have palm oil futures in their portfolio but I’m not a wealth manager. I think it comes down to your portfolio and how large it is (probably the Canada Pension Plan has a proportion of palm oil futures in it). You’re going to have to talk to your advisor and choose a degree of complexity that’s right for your portfolio.
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CN: Let’s just take a step back - what does a typical portfolio look like and has that changed over time?
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RB: Yeah, so I'm not entirely sure what a typical portfolio looks like these days because it's actually changed quite a lot over time. I think common wisdom used to be that the classic balanced portfolio was 60% public stocks and 40% bonds. These days that's ancient history. Most would say that the bond allocation should be a lot lower these days in this age of unprecedented low-interest rates. These days it’s the stock portfolio that’s been driving a lot of the growth. I think a well-diversified portfolio in the modern era should absolutely include exposure to all kinds of alternative assets (that aren't even really that alternative but still kind of fall out of that traditional bucket). So you know I mentioned real estate, private companies, maybe for example commodities or other types of investments. So I think that there are a lot of things that you can invest in and your advisor can guide you on what’s appropriate for you.
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CN: Yeah that makes a lot of sense. Talking about alternative investments, we’ve heard a lot this year about ESGs, impact investing, alternative investments… do you think there’s more of an appetite today for these types of investments than in the last ten years?
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RB: Yeah that’s a topic that’s close to my heart having previously started an impact investment company. It’s definitely been a gigantic increase in interest. I think when I started my previous company we were speaking to large wealth managers and having them say “we’re barely getting a grip on early ideas.” Like not including gun manufacturers or tobacco companies, and now these same companies are launching impact portfolios and marketing this aggressively. So there’s definitely been a seat change, it’s a real industry, and there’s a lot of studies out there and data showing that ESG or impact investing can equal or outperform non-impact investments. So I think it’s a huge part of the market these days. That said, one of the things that’s driving it is people’s interest in it. I think that one of the stories of the investment industry has been the personalization of it. People’s portfolios are being tailored to their own needs and circumstances. Impact investing is definitely a piece of that. People are environmentalists, but an institution is not an environmentalist. It doesn’t live and breathe the impact on the environment the way an individual does. The person who is active in the David Suzuki Foundation for example is going to be active as an impact investor and it’s appropriate for them to be.

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That’s a great question. I think there's a lot of advantages and you gain a lot with an automated platform. For me, it's a lot easier to manage. I have some of my money in one of these platforms and I barely think about it. It's being rebalanced all the time. The costs are much lower in terms of expense ratio for the same kind of rebalancing. Again you're missing a lot with that, but on just the mechanical portfolio rebalancing you're getting a great deal there. I would say that two other advantages are up-to-the-minute reporting, so you always have that login where you can see your position, see how your portfolio is doing historically. And finally, this is an advantage for me and anyone who doesn't love doing taxes, but typically they’ll take care of your tax forms for you, and end up with much simpler tax forms, so it kind of works out what your cost basis was and how much you have to report.
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CN: So let's talk about the other side of the coin then...what are the risks of not having a seasoned professional managing your money?
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RB: I wouldn’t exactly phrase the question that way. You know it's more what’s the benefits of having a real wealth manager? Some of the clients of robo advisory firms may not even be aware that they're missing out. A wealth manager isn't just balancing your stocks and bonds, that's kind of the very lowest mechanical level of what you get out of the wealth manager. Really they're your advisor on your life. Intimately intertwined with you because you're thinking about retirement planning, on planning for college for your kids, when is the right time to buy a house, and when should you get life insurance, for example. An advisor can help you with all of those decisions and they can connect you with service providers like a mortgage broker when you may be in need of one. So I think that you get a lot of value out of having one of these advisers, particularly when you get to a stage in life when these kinds of services are more about the long-term and your life circumstances are far more critical.
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CN: There are clearly pros and cons and two sides of the story depending on who you're asking. Like you said, what stage of their life they’re in ...but do you think the platforms that we’re seeing emerging like to Qtrade, Wealthsimple, and all the rest will ever become status quo?
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RB: Yeah, I do actually. I think that similarly to how you know we’re using online platforms to automate everything for us (I can’t think of the last time I used to travel for example), everything you’re going to be trying to do with your money is going to be automated, and it’s going to be appropriate to be handled by one of these one of these platforms. In particular, for most people at an early stage in their lives that have few assets to manage, not a lot of complexity, not a very extended personal family circumstance, it’s gonna make a lot of sense to have a low fee robo worry about it. But at some point their life circumstances are going to get more complex and you’re gonna get married, or maybe you’re not, or you may have other objectives that you may want some advice on and at that point it may make sense to either supplement the robo advisory portion of your portfolio, or graduate to a more holistic wealth management view.
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CN: Thank you so much Raph, these answers were great. It’s always insightful chatting with you so thanks for sharing those answers with us today.
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RB: It’s my pleasure.

Mako Fintech Team

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