In the fast-evolving world of Web3, decentralization is more than just a buzzword—it’s a paradigm shift. Traditional Know Your Customer (KYC) and Know Your Transaction (KYT) processes, long the cornerstone of compliance in finance, are being reimagined through decentralized technologies. But how do decentralized KYC and KYT differ from their centralized counterparts, and why are they critical for the Web3 ecosystem?
The Problem with Centralized Systems
Centralized KYC and KYT systems rely on siloed databases controlled by banks, exchanges, or regulatory bodies. While effective in many respects, they often suffer from inefficiencies, security vulnerabilities, and privacy concerns. Even companies that promote decentralization are not immune to security risks. For instance, in July 2024, Fractal ID, used by Web3 projects such as Polygon ID, Ripple, XRP Ledger, and Avalanche, suffered a data breach exposing sensitive user information, including KYC documents. The breach, affecting approximately 50,000 users, occurred due to unauthorized access via an API. Despite Fractal's claims of enabling decentralized data ownership, this incident underscores the vulnerabilities of centralized systems. The breach also impacted Fractal’s token (FCL), which dropped 2.9% in value, with a 43% decline year-to-date, highlighting the risks for Web3 projects relying on centralized identity solutions.
Unlike traditional systems, which are slow and repetitive, requiring users to submit the same documents across multiple platforms and institutions to bear high compliance costs, decentralized KYC and KYT systems empower individuals with control over their data. Users can share only the necessary information while ensuring compliance, and verified credentials are reusable across platforms, eliminating the need for redundant processes. Privacy is enhanced through cryptographic tools like zero-knowledge proofs, while security is bolstered by decentralized data storage. These systems also reduce costs by automating compliance and minimizing reliance on intermediaries.
Real-World Examples
Projects like Civic and Dock are revolutionizing the KYC process by giving users full control over their identities through blockchain wallets, enabling them to securely manage and share their personal information with only the necessary parties. This decentralization shifts the power away from centralized institutions, ensuring greater privacy and user sovereignty.
A recent case of $2M laundered on YouTube highlights how KYT gaps can allow fraudulent activities to slip through. A $2 million account, suspected to be the endpoint for ill-gotten funds from a scam, funneled money primarily to ByBit and Stake.com wallets. The likely laundering method? Off-chain betting. Interestingly, if platforms like Stake.com and ByBit accept transfers from such an account, it implies the account appears reputable, at least on the surface. One would expect KYT—or even KYC—systems in place to flag suspicious transactions. So, how was this missed? The explanation lies in timing and detection. If the scam is recent and has yet to be flagged in KYT databases, the account might not yet appear risky to automated systems. This underscores a critical limitation: KYT tools rely on existing data, which means emerging schemes can evade detection until they’re identified and reported. For now, vigilance and rapid updates to KYT systems are crucial to closing these gaps.
At NOMINIS, we are advancing the fight against financial crimes by using decentralized analytics to monitor blockchain transactions for suspicious activity in real-time and allowing our clients to act in a rapid way.
For Web3 applications, decentralized KYC and KYT represent a leap forward, aligning compliance with the core principles of decentralization. Platforms that adopt these solutions benefit from increased user trust, streamlined operations, and enhanced regulatory compliance—all without sacrificing privacy.
As the Web3 space grows, the integration of decentralized compliance tools will be key to building a safer, more secure digital ecosystem.
What are KYC and KYT?
KYC (know Your Customer) - a process that identifies users by collecting their personal information, such as ID
KYT (Know Your Transaction) - a process that tracks the movement of funds through transactions to detect or follow suspicious activity, like money laundering.
Both of these processes are components of Anti-money laundering programs and other compliance frameworks in the crypto space, promoted by regulatory authorities to ensure those trading in crypto have access to relevant information that is important to track suspicious activity.
What is an API, and how can it be used to gain unauthorised access?
An application programming interface (API) allows different software applications to communicate with each other, via endpoints. Imagine each endpoint serves as a mailbox between each application, where requests to retrieve data from the server can be sent.
Unauthorized access via an API usually occurs when a malicious actor exploits a weakness in the API’s authentication, authorisation or input validation mechanism, so they can gain access to data even though they shouldn’t be able to. For example, if an API endpoint does not require proper authentication, anyone could send a request to this endpoint, without any credentials, and still receive sensitive data or perform typically restricted activity.
What are zero–knowledge proofs (ZKPs) ?
ZKPs allow users to prove their identity, and confirm that financial activity was their own, but without revealing sensitive details of information. ZKP functions as a compromise to the eternal difficulty within the crypto community, balancing security and anonymity.