From KYC, AML to KYT: The Compliance Path and Technological Breakthroughs in Stablecoin Regulation

Written by: Zhu Weisha

After the introduction of the "Stablecoin Regulation" in Hong Kong, I have conducted relevant analyses in five articles, including "Concept Confusion and Clarification Triggered by Hong Kong's Stablecoin Regulation" (details can be found on the No Chain website). This article continues the idea of "clarification" and focuses on the core challenge of stablecoin regulation: balancing compliance requirements with technical characteristics.

Some viewpoints (such as those expressed by Hui Sheng Huang Li Chong in "Hong Kong is only 'Web2.5' and not Web3") believe that the Hong Kong Monetary Authority (HKMA) has overly stringent requirements for KYC (Know Your Customer) and AML (Anti-Money Laundering). For example, requiring "real-name penetration + data retention + T+1 redemption." We will specifically discuss its necessity later. It must be clearly recognized that when stablecoins are anchored to real assets and integrated into the traditional financial system, regulatory upgrades are an inevitable and necessary choice. This article will argue the irreplaceability of KYC/AML from three aspects: credit foundation, the dilemma of non-bank institutions, and the advantages of on-chain technology, and explore a regulatory optimization path based on transparency — that is, fully leveraging the role of KYT (Know Your Transaction).

1. Clarifying misconceptions: Privacy rights, anonymity, and the necessity of regulation

Privacy is not secrecy, anonymity is not the goal.

Eric Hughes pointed out incisively in the 1993 "A Cypherpunk's Manifesto": "Privacy is necessary for an open society in the electronic age. Privacy is not secrecy. Privacy is the power to selectively reveal oneself to the world. Secrecy is the power to keep things confidential from everyone." Anonymity is a means of protecting privacy, not an ultimate goal.

Satoshi Nakamoto's design (using public key addresses instead of real identities for public transactions) aims to avoid directly exposing the identities of traders to the public ledger, in line with Eric Hughes' philosophy. The core of this philosophy is: privacy is a personal right, and individuals should have the right to choose under what conditions and to whom they disclose information. Users can choose whether to exchange necessary information (such as complying with KYC requirements) for services, and service providers have the obligation to protect user privacy and prevent information leakage to third parties.

The practical rationality of "real-name penetration"

It is crucial to handle the relationship between real-name authentication and transparency properly. The requirement for "real-name penetration" (i.e., tracking to the ultimate beneficiary) is not unacceptable under the financial regulatory framework; it is a basic rule that has long operated in the real world (Web2). Numerous successful Web2 projects have proven that reasonable real-name registration has not led to user loss, and the key lies in the regulation and protection of information usage.

The limitations and paradoxes of existing privacy protection

The current privacy protection mechanisms in cryptocurrency have structural defects: during an on-chain transfer, both parties to the transaction can see each other's entire asset balance. If the counterparty is an acquaintance, personal financial status is fully exposed. The risk of asset information being exposed to acquaintances is much higher than that of disclosing it to banks bound by strict confidentiality agreements. Banks have internal regulations prohibiting the disclosure of customer asset information, while acquaintances have no such restrictions. If the Web3 ecosystem hopes to achieve large-scale applications ("scale up Web3") but refuses to cede some privacy rights when necessary, it will fall into an irreconcilable practical paradox.

2. KYC and AML: The Cornerstone of Modern Financial Order

Definition and Core Values

KYC (Know Your Customer): The core process for financial institutions to verify customer identity and assess risk status, it is the starting point for establishing trustworthy business relationships and preventing identity fraud.

AML (Anti-Money Laundering): A defense system that blocks the use of illegal funds to "cleanse" through the financial system, which is key to maintaining the safety, integrity, and judicial justice of the financial system.

KYC: Building the Anchor Point of Financial Trust

The credit of Bitcoin comes from the traceability of transactions brought by its "public ledger". Similarly, the cornerstone of any financial activity is trust. In the traditional financial system:

1. Identity verification is a trustworthy starting point: Customers opening an account must provide identification issued by government or authoritative institutions (such as passport, ID card, etc.) and undergo "face-to-face verification" and strict validation (address proof verification, form filling) to ensure the authenticity of the documents and the match of the holder. This forms the most basic trust anchor.

2. Credit transmission relies on verified identities: banks base their trustworthy identities on this to collect information, assess risks, and themselves become trusted nodes in the financial network. Subsequent credit assessments and transaction monitoring are built upon this. Meeting KYC standards is a prerequisite for effectively implementing AML.

In the era of online banking, technologies such as facial recognition have partially replaced face-to-face verification, but challenges still exist regarding the integrity and security of credit transmission (such as the risk of forgery), often requiring supplementary measures like binding to bank accounts (utilizing the high-intensity KYC already completed by banks). This reaffirms the core position of a robust KYC mechanism.

3. The KYC/AML Compliance Dilemma of Non-Bank Institutions

Hong Kong's "Stablecoin Regulation" allows eligible non-bank institutions to issue stablecoins, but they face significant structural challenges when meeting KYC/AML requirements that are on par with those of traditional banks:

1. Lack of infrastructure and experience: Banks have mature customer authentication systems, risk assessment models, professional compliance teams, and mechanisms for regulatory engagement. Non-bank institutions (especially startup tech companies) face high costs and long timeframes to establish systems of equivalent efficacy.

2. Access to identity verification is restricted: Although strong identity verification infrastructure has been established in places like China (such as the Ministry of Public Security interface), access rights are usually limited to authorized institutions (mainly banks) and are not fully open to the public or all types of enterprises. Non-bank institutions find it difficult to obtain high assurance level identity verification services conveniently and at low cost. Decentralized Identity (DID) technology has broad prospects, but its current development is unbalanced and costly, and large-scale application will take time.

3. The defense logic of "penetration, retention, T+1": These requirements are precisely aimed at the core defenses against the specific risks associated with stablecoins:

Real-name penetration: Ensure transparency of ultimate beneficiaries and prevent anonymous transfers of large illegal funds.

Data retention: to meet the needs of post-audit and judicial investigation.

T+1 Redemption: Provides risk buffer and verification time to cope with potential withdrawal risks.

These measures aim to ensure the robust operation of the system, rather than imposing arbitrary restrictions. Therefore, under the current identity verification system and technological conditions, requiring non-bank institutions to independently undertake KYC/AML obligations that are equally stringent as those of banks presents significant practical challenges. The related complaints reflect the real operational dilemmas.

There is a reason why the U.S. only allows banks to issue stablecoins.

Historical experience shows that the early radical "crypto-anarchist" creed has been corrected in practice. However, the balance between privacy and regulation remains an issue. We need a trustworthy (whether centralized or decentralized) and transparent public service platform. Users need to cede some of their privacy rights to this platform, just as they cede some rights to the government in exchange for order and security.

4. KYT: Regulatory Innovation Driven by On-Chain Transparency

On-chain transparency: from challenge to advantage

Traditional fiat currency trading: opaque → reliant on post-audit.

Cryptocurrency trading: On-chain public verification → Supports real-time risk monitoring.

KYT (Know Your Transaction) utilizes the inherent transparency of blockchain data to track the flow of funds in real-time by analyzing public ledgers.

Core Functionality: Utilize big data analysis and artificial intelligence to monitor on-chain transaction activities in real-time, identify abnormal patterns (such as interactions with high-risk addresses, use of mixers, and unusually rapid large transfers), and assess transaction risks.

Regulatory Value:

Meet compliance requirements: Assist exchanges, wallet service providers, etc. to comply with AML regulations, efficiently identify and report suspicious activities, and reduce legal risks.

Enhancing regulatory effectiveness: Providing regulatory agencies with a more comprehensive and real-time panoramic view of the market, empowering precise regulation and proactive policy making.

Strengthening Risk Management: Helping institutions analyze and assess counterparty credit risk based on historical trading data, effectively preventing money laundering and illegal trading.

Business Value:

Automated monitoring significantly improves operational efficiency.

Show compliance commitments to enhance customer trust.

Optimize products and services based on data analysis.

The unique value of KYT: Bridging the gaps of non-bank institutions.

The core advantage of KYT lies in its ability to fully leverage the transparency of on-chain data, which can significantly compensate for the relative disadvantages that non-bank institutions face during the initial stage of customer identity due diligence (KYC). This leads to more efficient subsequent transaction monitoring and risk analysis. In certain scenarios, tracking transparent on-chain transactions can even be more feasible than tracking opaque traditional fiat currency transactions.

5. Conclusion and Recommendations: Embrace Transparency, Optimize Regulatory Details

6. Reaffirming the Cornerstone: KYC/AML is irreplaceable. KYC and AML are the cornerstones of maintaining the integrity, stability, and security of the financial system. In the uniquely risky realm of stablecoins, their importance should not only not be diminished, but rather emphasized.

7. Acknowledge differences and explore pragmatic paths: It is essential to face the structural difficulties faced by non-bank institutions in implementing high-intensity KYC/AML. The design of regulatory details should:

Exploring diversified identity verification solutions: researching how to safely and compliantly broaden non-bank institutions' access to authoritative identity verification services, or recognize new high-assurance verification technologies (such as mature and reliable DID solutions).

Implement risk-based differentiated regulation: establish practical and graduated compliance standards based on institution type, business scale, and risk level.

3. Leverage the native advantages of cryptocurrency: KYT should be the core tool: The core innovation of Hong Kong's stablecoin regulatory guidelines should lie in fully understanding and utilizing the transparency characteristics of blockchain transactions, avoiding the simple application of regulatory models designed for opaque fiat systems:

Clarify the core position of KYT: The regulations should clearly encourage and require issuers to adopt a robust KYT system for real-time transaction monitoring and risk management, and explicitly incorporate it as a core requirement for AML compliance.

4. Build a regulatory framework "based on transparency": The design of regulatory requirements (such as suspicious transaction reporting standards and audit scope) should fully consider the availability of on-chain data and its analytical potential. The "principled" approach of relevant U.S. legislation (though perhaps appearing "broad") reserves space for innovation, while also formulating more refined and forward-looking rules in conjunction with the realities of Hong Kong, leveraging the advantages of transparency.

In summary:

The strict requirements of KYC and AML are the cornerstone of financial stability and cannot be compromised. Only Web3 applications that support controllable anonymity (i.e., allowing for moderate anonymity at the transaction level after meeting regulatory thresholds such as KYC) can potentially integrate closely with the Web2 ecosystem, achieving true mass adoption.

The core challenge faced by the Hong Kong Monetary Authority in the regulation of stablecoins lies in designing a practical path for non-bank institutions that adheres to compliance standards (KYC/AML) while fully leveraging the transparency characteristics of crypto assets by incorporating KYT into compliance requirements. Future regulatory guidelines should aim to establish an "innovation framework based on transparency" that effectively manages risks while vigorously promoting the prosperity and healthy development of Hong Kong's Web3 ecosystem.