Know Your Customer vs. Customer Due Diligence

Featured image by Photon photo

As financial companies increasingly exploit digital services, customer identification protocols have become more of a requirement and less of an option. As a result, Know Your Customer (KYC) has paved the way for “Customer Due Diligence” or CDD. Know Your Customer is pivotal in ensuring that customer information is correct and valid.

But what used to be strictly the purview of KYC are now CDD transactions. This article covers the roles of and relationship between Know Your Customer and Customer Due Diligence.

The Distinctions Between Know Your Customer and Customer Due Diligence

Financial organizations offering financial services use Know Your Customer as a means of identifying and preventing new and existing customer risk. The control processes in KYC provide the institution with significant information on the customer intending to open an account. Basically, the goal is to ascertain the risk level of the customer.

Know Your Customer coordinates checks at the onset of the customer relationship. These checks let the customer tell the institution who they are. Then the institution verifies that they are who they claim to be. Therefore, KYC is often a critical component of regulatory compliance.

Alternatively, the Customer Due Diligence procedure collects and evaluates vital information on potential customers. Financial institutions rely heavily on CDD to uncover their potential risks in dealing with an individual or organization through analysis of various sources.

But how do financial institutions determine risks per [potential] client? They do this by employing procedures to know their customers. Then they put the appropriate precautions in place. For example, money laundering and terrorist financing schemes are the most relevant risks.

Then, there’s the more serious issue of trade sanction checking. It’s integral in client onboarding. Moreover, non-compliance with trade sanctions is a strict liability offense with serious consequences. Regulators usually have zero tolerance for a breach of trade sanctions, making Customer Due Diligence a serious issue.

A bank may initiate customer identification procedure (CIP) if they suspect fraudulent activity on any customer’s account. They may also verify the customer’s account activity before every transaction in order to prevent loss arising from impersonation.

KYC vs. CDD: What You Need to Know

It’s usually tempting to use the terms “Know Your Customer” and “Customer Due Diligence” interchangeably. However, they refer to entirely different concepts, even if they appear to be similar.

The primary difference between Know Your Customer and Customer Due Diligence is that KYC enables businesses to develop a customer’s risk profile from its database before they begin a business relationship.

CDD, on the other hand, verifies the correctness of the information. It basically involves background testing and ultimate utility ownership testing.

KYC and CDD are critical to anti-money laundering (AML) compliance. What’s more, firms under regulation are required to verify those they work with. The purpose is to ensure they’re not entangled in a web of criminal activity or sanctions.

Understanding Customer Due Diligence

Regulation has transformed many Know Your Customer initiatives into Customer Due Diligence programs. However, one major way to pick them apart is that while Customer Due Diligence emphasizes financing, its controls take place as part of a process. Meanwhile, communication with the customer continues.

Moreover, CDD provides a framework for continuous assurance, especially where organizations oversee multiple day-to-day transactions, as is the case with banks and real estate concerns. Due diligence is crucial in verifying the identity of clients and assessing their risk profiles to prevent business relationships with illicit actors. At the same time, a transaction monitoring framework is essential for detecting and reporting suspicious activities in real-time, thereby safeguarding the financial system against abuse for money laundering or terrorist financing. Both are fundamental components of an effective anti-money laundering strategy, ensuring regulatory compliance and mitigating financial and reputational risks for institutions.

Organizations employ advanced computer software to monitor movements and detect suspicious scenarios. In a way, CDD continues the work of control that KYC began. Basically, it continues throughout the life cycle of the customer relationship and stakeholder activity. It assures organizations that someone is not exploiting its systems to conceal criminal proceeds.

Once you’ve placed it, could you send over the PayPal invoice link so I can take care of the payment?

Again, CDD happens after the initial onboarding of the customer. It includes checking for screenings or sanctions on politically exposed persons (PEP), and also continuously assessing the potential risk level of a customer to a business.

Conducting Know Your Customer

In running Know Your Customer checks, the financial institution conducts background checks as a component of its risk-based approach. It goes beyond customer identity verification using documents including a photo ID and proofs of date of birth and address.

Know Your Customer programs are usually manual procedures involving physical documentation. However, faster electronic procedures with an online data component are fast becoming the norm.

Banks and other financial institutions need to know their customers, especially as identity theft has grown to more than 3 million cases per year. A good KYC policy makes it easy to create a risk profile. There are several elements of a good KYC policy:

1. Customer Acceptance Policy

Banks should clarify their requirements for admitting a customer. They should outlaw anonymous account opening or account opening by proxy. Furthermore, banks should be clear concerning all the documents required for account opening.

2. Account Activity Monitoring

Financial institutions should be on the alert for suspicious activity. They should also verify transactions to ensure their legitimacy. Banks should require important documentation, including the recipient/sender information and source of funds. Meanwhile, they should also perform routine regular checks to ensure that a customer’s risk profile has not changed.

3. Risk Management

A sound KYC policy should give the bank the ability to assess the specific risk profile of a customer. It’s the way to decide the appropriate risk management procedure to apply.

Ensuring conformance to KYC policies requires a continuous internal audit process.

Electronic KYC Verification

Electronic KYC or E-KYC enables banks to query an identification system for customer verification. However, banks are fully aware of the existing hacker threat and prepare for it.

The reasons why Know Your Customer is effective include:

It’s a fast system for inputting data and rapid onboarding of new customers.
It automatically checks for and fixes errors and improves accuracy.
E-KYC systems enable easy auditing of the CIP and report generation.
E-KYC systems track customer needs in real time.

The Future of Know Your Customer and Customer Due Diligence

Electronic KYC and CDD processes are gaining wider adoption among financial and non-financial institutions. Organizations are increasingly investing in digital infrastructure to meet the requirements of government curfews and lockdowns while continuing to do business.

Remote banking is the modern reality, but it’s essential to incorporate digital customer identification systems that follow government guidelines. These systems need to be replete with authentication controls to prevent unauthorized access and robust enough to withstand hacker attacks.

Electronic CIP adoption gives financial institutions the advantage to perform in an increasingly digital world.