Financial advisors are required to meet certain standards when adding new clients to their book of business or selling regulated products to existing clients. Under Know Your Client (KYC) rules, advisors must confirm clients’ identities while assessing suitability and risk. These rules fall under the umbrella of anti-money laundering (AML) practices that banks and other financial institutions must follow.
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What Is the Know Your Client Rule?
Know Your Client or know your customer refers to a set of processes that banks and other financial institutions are expected to follow when establishing business relationships with new customers and maintaining relationships with existing ones. The purpose of the rule is to ensure that advisors and other financial professionals know who they’re working with and are adequately assessing the risks of the relationship.
Specifically, the aim is to prevent the occurrence of financial crimes, such as money laundering, fraud, and embezzlement as well as the financing of terrorist activities, drug trafficking or human trafficking operations. In terms of who is subject to Know Your Client rules, the list includes:
- Banks and credit unions
- Private lenders or lending platforms
- Wealth management firms
- Broker-dealers
Fintech companies that don’t operate under these types of structures may also be subject to KYC rules depending on the nature of the activities they engage in.
Financial advisors and other entities that are subject to KYC rules must take steps to ensure compliance with anti-money laundering laws and can face penalties for failing to do so. Penalties can include civil fines and sanctions, but advisors may also suffer reputational damage as regulatory violations must be disclosed to current and prospective clients.
The Financial Industry Regulatory Authority (FINRA) and the Financial Crimes Enforcement Network (FinCEN) oversee compliance in the U.S. There are two specific FINRA rules advisors should be aware of:
- Under FINRA Rule 2090, broker-dealers are required to exercise reasonable diligence when establishing and maintaining client accounts.
- FINRA Rule 2111 imposes a suitability requirement on broker-dealers to ensure that investment recommendations are suitable for a client’s financial situation and needs.
How Know Your Client Rules Work
Know Your Client rules work by establishing a framework for onboarding new clients and managing existing client accounts. In implementing KYC standards, advisors must determine and verify the client’s identity, establish the client’s risk profile to assess the suitability of investments and monitor transactions on an ongoing basis.
The KYC process can be broken down into three core elements.
Customer Identification Program (CIP)
The Customer Identification Program is a Patriot Act provision that was introduced to prevent the funding of terrorism as well as other financial crimes. Under CIP rules, there are a minimum of four pieces of information advisors must collect from clients when establishing new accounts:
- Name
- Date of birth
- Address
- Customer identification number
All of this information is required for identity verification and advisors are expected to collect it within a reasonable time when establishing new client accounts.
For U.S. clients, the customer identification number refers to their tax ID number, which is typically a Social Security number. Non-U.S. citizens may offer a passport number, alien identification card number or an identification number present on government-issued documents from their home country instead.
Customer Due Diligence (CDD)
The second phase of KYC is designed to help advisors understand who they’re working with, in terms of where the client is located and the types of business activities or financial transactions they engage in. Here, the goal is to determine the suitability of working with a particular client and assess any potential risks they may pose.
For example, if a client routinely moves substantial amounts of money into international bank accounts, you’d likely want to investigate further to ensure that it’s not related to any illegal activity. There’s also a second dimension to assessing risk for advisors under FINRA Rule 2111.
Again, broker-dealers are expected to adhere to a suitability standard in making investment recommendations. That means they must consider the client’s goals, needs and risk tolerance to select investments that meet the standard. This is different from the best interest standard that fiduciaries are obligated to uphold.
Enhanced Due Diligence (EDD)
Once you’ve onboarded a new client, continued monitoring is required under KYC rules. The level of monitoring required for client accounts can depend largely on what you learn during the initial due diligence phase.
Enhanced due diligence is most often associated with clients who pose an elevated risk. That risk may be tied to where they’re located, the type of work they engage in or their financial transaction history. For example, a sudden uptick in cross-border transactions or a pattern of unusually large deposits could be indicators of illicit activity.
Tips for Staying Compliant With KYC Rules
Advisors can ensure compliance with Know Your Client rules by creating a uniform process that checks off all three of the boxes listed above. Reviewing your current onboarding process can help you identify areas where you may be lacking or need to adjust.
At a minimum, advisors should be taking steps to:
- Collect and organize the required documents to establish the client’s identity.
- Make a concerted effort to verify the client’s identity, based on the submitted documentation.
- Verify the client’s residency and citizenship status.
- Confirm the details of the client’s financial situation, including their assets and liabilities.
- Apply the suitability standard when recommending investments, if required to do so as a broker-dealer.
- Monitor client transactions on an ongoing basis and flag any activities that seem suspicious or outside the ordinary pattern of behavior.
- Investigate any flagged transactions to determine whether any illegal activity is occurring.
These are all tasks that a compliance officer may be tasked with handling. Advisors may also consider the use of digital tools to ensure compliance.
Electronic or eKYC processes can prove more efficient for advisors while also improving accuracy and reducing some of the financial costs of ensuring compliance. Relying on digital tools to conduct KYC tasks can also improve the client experience during onboarding and beyond.
Frequently Asked Questions
What Are Anti-Money Laundering Regulations?
Anti-money laundering rules are outlined in the Bank Secrecy Act and are designed to prevent illegal activities. That includes money laundering as it occurs in connection with other types of crimes, including transactions related to drug smuggling, terrorism and human trafficking. Know Your Client rules operate and apply within the framework of AML regulations.
What Documents Are Required Under Know Your Client Rules?
Advisors are required to verify a client’s identity and residence during the onboarding process. The types of documents they may accept for identity verification can include:
- Social Security card
- Government-issued driver’s license or ID card
- Passport
- Birth certificate
The type of documentation that’s considered acceptable can depend on whether the client in question is a U.S. citizen. Proof of residence can be established using the same documents, but advisors may also ask to see bank statements, proof of employment or copies of a mortgage to determine residency.
What Is a KYC Questionnaire?
A Know Your Client questionnaire is a form that advisors can provide to new clients or existing ones to verify their identity, assess risk and better understand their needs. A questionnaire may ask clients about their investment objectives and goals, the types of investments they feel most comfortable with and assets that are held away.
Bottom Line
Know Your Client rules are an important compliance requirement for wealth management firms, broker-dealers and other financial services institutions. For advisors, understanding these rules and when they apply is essential for staying on the right side of regulatory guidelines while serving your client base.
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- When seeking new clients, it’s important to clarify what standard you use when offering investment advice. If you’re a fiduciary, for example, you’re obligated to select investments based on the best interest of the clients. Financial professionals who are held to a suitability standard, on the other hand, only have to choose investments that are deemed suitable based on the client’s needs and situation. A registered investment advisor is an example of a fiduciary, while broker-dealers are held to a suitability standard under federal law.
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