The concept of identification has always been at the heart offinancial services processes. For banks to manage customers' moneysecurely, they must be certain they know who they are dealing with.It's a simple premise on the surface, but a hugely complex andcostly task in reality.

Financial institutions traditionally relied on physicaldocuments, such as drivers licenses or passports, to verify theidentity of individuals or institutions. However, relentlessdigitalization of banking services from payments to lending, alongwith the growing threat of cyber fraud, have driven the need forincreasingly faster, safer, and more efficient identitysolutions.

KYC, short for “Know Your Customer,” rules are intrinsic tomodern banking. They require banks to take a major leap forward inidentity management, in the effort to prevent fraud, terroristfinancing, and money laundering. As regulators around the worldcontinue to ratchet up the strictness and complexity of theirdomestic KYC rules, they've had an unintended consequence. Theinconsistent standards between regimes, duplicative processes, andlong turnaround times for checks to be completed have created majorinefficiencies in the global correspondent banking system.

Bank Response to Growing KYC Requirements

Since 2010, 28 major banks have been fined for breaching U.S.sanctions. Seven of these received fines exceeding US$500 million,of which the highest was US$8.9 billion. Moreover, a recentKnow Your Customer Survey conducted by ThomsonReuters shows that some financial institutions are still spendingup to US$500 million annually on KYC compliance and customer duediligence efforts.

In response, banks have moved to reduce their risk byterminating their relationships with particular institutions,countries, and regions. Many financial institutions have shedcorrespondent banking relationships in developing countries. Thehigh and rising risk of fines and the costs of increased scrutinyhave destroyed the tradition of banks extending services throughoutthe world. Not surprisingly, the poorest and mostdifficult-to-analyze regions have been hit the hardest.

This trend is exacting an enormous price on the growing numberof corporates in developing economies. As these markets evolve,many are creating new opportunities for businesses to expand, whichleads to increased demand for capital funding. However, thefinancial services trend toward de-risking means that these needsare not being met through the traditional banking system. Manycorporates are being forced to turn to sources of funding outsideof regulated markets, which are then harder to monitor.

Financial exclusion, driven by banks' de-risking, is a globalproblem. Still, regulatory requirements continue to get stricter,and regulators continue to remind financial institutions of theimportance of understanding customers and their transactions.

Banks must know where money is coming from and where it isgoing. Throughout the world, they are required to validatecustomers' identity, monitor all transactions, and reportsuspicious activity to a designated government body. To effectivelycomply, financial institutions need a clear picture of eachcustomer's profile, identity, and spending habits, as well as thekinds of transactions he or she is likely to engage in.

No matter the size of the bank, KYC is not easy. Collecting andmanaging all the requisite data requires a dedicated team ofspecialists and a transformation of processes, includingverification of massive amounts of non-standard data anddocumentation. Inefficiencies in domestic processes can beextremely costly, and the problems multiply when transactions crossnational borders. Issues with the current cross-border paymentsystem include inaccurate client information, lack of completevisibility over customer activity, jurisdictional differences withcommon identity standards, and data and privacy concerns.

KYC Registry on the Blockchain

The good news is that it's a problem blockchain technology can help solve. That'sbecause data on a blockchain platform's distributed ledger isverifiable and immutable, providing increased transparency torelevant participants.

Regulators impose fines and penalties on banks that do notconduct appropriate due diligence on the entities and individualsthey deal with. The more readily a bank in a developed country canaccess information on end users and banks in developing parts ofthe world, the more comfortable it will be with facilitating thetransaction. The shared nature of blockchain technology lendsitself naturally to providing a single, unified registry of KYCinformation for affected banks around the world.

A recent trial of a new KYC application built on a blockchainplatform recently facilitated more than 300 transactions during acollaborative four-day trial with 39 financial services firms, aswell as various central banks and regulators. In this test, banksthat were parties to the transactions were able to request accessto KYC data on the individuals and entities that were involved.Meanwhile, the individuals and organizations participating in thesetransactions were able to update their test data, whichautomatically updated for all banks that had permission to accessit.

By providing a single version of the truth, a blockchain-basedtool can reduce duplication of effort across banks, eliminating theneed for each institution to individually attest and update KYCrecords on individuals and organizations they work with. Thistechnology presents the potential for banks to spend more timeanalyzing, rather than collecting and verifying, the data theyreceive. This may accelerate new-customer on-boarding. And becauseall data is fully standardized, the system significantly reducesthe time, cost, and resources required to manage it.

Moreover, because such a system can provide a single, unifiedview of the on-boarding documentation from foreign correspondentbanks, financial institutions in the developed world may gain theconfidence to re-engage with customers in higher-riskjurisdictions.

With the support of regulators and the intelligence community,financial technology companies have the opportunity to leverageblockchain's unique approach to digital identity. More broadly,moving payment transfers onto a blockchain platform could generatea holistic view of the payment system, enabling banks to moreeasily identify money laundering and terrorist financingactivities. The right blockchain technology design, coupled withKYC and AML standards that are consistent across regions, willsignificantly increase traceability to support financial inclusionfor the countries and regions whose development hinges on access tothe global banking network.

Abbas Ali is anassociate director at R3, which built the Corda blockchain platformunderlying the recent 39-firm KYC application trial. The companycontinues to develop the solution, which is scheduled to go live in2019. To learn more, contact [email protected].