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There are banking regulations in place that are known as KYC. The definition of KYC is “know your customer,” and these rules provide guidelines for financial institutions to know more about their customers.

This isn’t just a matter of curiosity but of national security and crime prevention. Banks need to protect themselves from unwittingly participating in illicit activities.

For example, if a criminal uses a bank for illicit purposes, such as money laundering, the financial institution could be held accountable. It’s the bank’s responsibility to always know who their customers are. That way, they can help avoid being involved in criminal activity.

KYC plays an important role in financial institutions maintaining accurate information about their clients. KYC procedures and anti-money laundering (AML) laws can work together to minimize risk. Read on to learn more about know your customer regulations.

3 Components of KYC

There are three main parts of a KYC compliance framework, which were instituted under the USA Patriot Act in 2001: customer identification, customer due diligence, and enhanced due diligence. Each phase of the process of this kind of financial regulation gets more intensive according to the estimated risk that the potential client might pose.

Customer Identification Program (CIP)

The first of the three main KYC requirements is to identify a customer. (Incidentally, some people refer to KYC as know your client vs. know your customer.)

Organizations must verify that a potential customer’s ID is valid and doesn’t contain any inconsistencies. The person must also not be on any Office of Foreign Assets Control (OFAC) sanctions lists.

An organization also needs to know if their prospective customer is “politically exposed.” A politically exposed person (PEP), such as a public figure, is thought to be more susceptible to corruption than the average individual, and is therefore considered high-risk, requiring special attention.

As part of their AML/KYC compliance program, all financial institutions are required to keep records of their Customer Identification Program (CIP) as mandated by the Financial Crimes Enforcement Network (FinCEN).

FinCEN works under the guidance of the department of Treasury and is charged with guarding the financial system against illicit activity and money laundering.

The following information will satisfy the minimum KYC requirements for a Customer Identification Program:

•   Customer name (or name of business)

•   Address

•   Date of birth (not required for businesses)

•   Identification number

For individuals, the customer’s residential address must be validated. US Postal Office boxes are not accepted. Individuals with no physical residential address can use an Army Post Office box (APO), Fleet Post Office Box (FPO), or the residential or business street address of their next of kin.

For business banking customers, the address provided for know your customer laws can be the principal place of business, a local office, or another physical location utilized by the business.

The ID number for most individuals will be their social security number or Taxpayer Identification Number (TIN).

For business entities, the number will usually be their Employer Identification number (EIN). Foreign businesses without ID numbers can be verified by alternative government-issued documents.

Recommended: Opening a Bank Account While Living in a Foreign Country

Customer Due Diligence (CDD)

Due diligence includes:

•   Collecting all relevant information on a customer from trusted sources

•   Determining what the customer will be using financial services for

•   Maintaining ongoing surveillance of the situation to further verify that customer activity remains in line with recorded customer information.

The goal of this phase of the know your customer process is to assess the risks a potential customer might pose and assign them to one of three categories — low-, medium-, or high-risk.

Several variables — including the customer’s expected cash transactions, the type of business, source of income, and location — will help determine the customer’s risk level.

Other categories for assessing risk include the customer’s business industry, whether they use a foreign or domestic account, and their past financial history. The customer is also screened against politically exposed persons (PEP) and the Office of Foreign Assets Control’s (OFAC) sanctions lists.

Enhanced Due Diligence (EDD)

Enhanced due diligence (EDD) involves increased monitoring of customers deemed to be high-risk. This may include customers from high-risk third countries, those with political exposure, or those that have existing relationships with financial competitors.

Conducting enhanced due diligence on high-risk business entities requires identifying all beneficiaries of those entities when they open an account. Customers that are legal entities are those that have had legal documentation filed with a Secretary of State or other state office, and include:

•   Limited liability companies (LLC)

•   Corporations

•   Business trusts

•   General partnerships

•   Limited partnerships

•   Any other entity created via filing with a state office or formed under the laws of a jurisdiction outside of the US

On May 11, 2018, a new AML/KYC requirement came into effect. This change to KYC laws states that all banking and non-banking firms subject to the Bank Secrecy Act (BSA) must verify the identity of beneficiaries of legal entity customers when they open an account.

Firms must also develop risk profiles and continually monitor these customers. This must be done regardless of what risk category the customer falls into.

Due diligence is an ongoing process and requires financial institutions to constantly update customer profiles and monitor account activity.

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5 Key Steps Involved in Know Your Customer?

There are five main steps of complying with the know your customer rule, which is part of how banks are regulated. These include:

1. Customer Identification Program (CIP)

As mentioned above, the first step is to ensure that a prospective client’s ID is valid, real, and consistent. The address and other details must be checked. The applicant must be screened to be sure they are not on any OFAC sanctions list and their PEP status must be investigated.

2. Customer Due Diligence (CDD)

The next step of due diligence involves researching and vetting the customer’s intentions regarding the financial services they are seeking.

3. Enhanced Due Diligence (EDD)

Further scrutiny may determine that some applicants are considered risky. If the customer is deemed high-risk, additional ongoing screening is required to make sure activity doesn’t cross any lines.

4. Account Opening

If verification is successful and a client is eligible, the customer can open a bank account, with some clients requiring closer monitoring than others.

5. Annual Review

Once an account is opened, the institution will conduct an annual review of their activity. The higher the risk category a customer falls into, the more often their activities will be reviewed.

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4 Key Elements of a KYC Policy?

KYC compliance involves four key elements. When gathering KYC information, organizations must:

1. Identify Their Customers

In this step, the financial institution will gather information about the customer’s identity.

2. Verify That the Customer’s ID Is True and Valid

The identification documents will be checked against independent sources to make sure identity theft isn’t occurring

3. Understand Their Customer’s Source of Funding and Activities

In this step, a review of the customer’s activities and background can shed light on how likely it is that the client would do reputational damage or could commit crimes that involve money laundering or the financing of terrorism.

4. Monitor the Activities of Their Customers

Monitoring of customer activities is an ongoing process, particularly for high-risk clients. Most firms review clients based on their level of risk.

Low-risk clients might only be reviewed once every two or three years, moderate-risk clients every one to two years, while high-risk clients tend to be reviewed once a year or even once every six months.

Recommended: Guide to Keeping Your Bank Account Safe Online

Why Does KYC Matter?

KYC procedures matter because they are an important screening step. Their implementation can help verify customers and assess and minimize risk.

The KYC process provides guardrails and can help protect against such crimes as money laundering, terrorism funding, and other illegal activities.

Is KYC Successful?

KYC programs are seen as improving a financial institution’s reputation and integrity, though it can add a layer to a prospective client’s application process and banking life.

As the banking landscape evolves quickly with technological advances, banks are finding new ways to track customers and comply with protective KYC and other guidelines. For instance, the use of artificial intelligence (AI) in banking may be able to perform some of these functions.

AML vs KYC

KYC and AML are both ways that financial institutions comply with regulations designed to inhibit terrorism financing and money laundering.

•   AML is the more general practice of an institution seeking to identify and stop such activity.

•   KYC is one aspect of AML, focusing on customer identification and verification.

The Takeaway

KYC, or know your customer, is a regulation that helps financial institutions prevent fraud by their customers. KYC involves constant check-ups and ongoing measures to ensure customer information and account profiles are kept up-to-date.

Wherever you decide to bank, know that teams are likely to be at work, ensuring compliance with KYC regulations.

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FAQ

What is a KYC procedure in banking?

KYC procedures in banking are regulations that involve a financial institution verifying potential clients’ identities and backgrounds and monitoring their activity if they become customers. This can be one of the ways a bank ensures that it’s not being used in criminal activity such as money laundering.

Do all banks require KYC?

Yes. FinCen, or the US Financial Crimes Enforcement Network, requires financial institutions and their customers to adhere to KYC regulations.

Why is KYC mandatory in banks?

KYC is an important measure as banks work to know their customers and make sure accounts are not being used for illegal purposes. KYC regulations are one way that the government seeks to prevent money laundering and terrorism financing.

Photo credit: iStock/Andrii Yalanskyi

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SOBNK-Q325-001

A covered call ETF is an exchange-traded fund that generates potential income by writing call options on the securities the ETF holds. These actively-managed ETFs give investors the opportunity to benefit from covered call writing without having to participate in the options market directly.

Covered call ETFs allow investors to earn income in the form of options contract premiums, in addition to any other dividends, and potentially reduce portfolio volatility. One trade-off is that upside potential may be limited if call options are exercised — typically when the underlying security reaches the strike price — which could result in shares being called away from the fund.

Basics of the Covered Call Strategy

Covered calls involve buying shares of a stock and then writing call options contracts on some of those shares. A covered call is also a type of “call writing” or “writing a call option” on a security.

Other investors can then purchase the call option contract. They pay a set fee to the call writer, known as the option’s premium, for doing so. The contract gives a buyer of the option the right, but not the obligation, to buy shares at a specific price on or before a specified date (known as the expiration date).

In the case of call options, when the share price of the underlying security rises above the strike price, an option holder can choose to exercise the option, at which point the stock may be called away from the shareholder who wrote the call option.

The option holder receives shares at a cost lower than the market value. Their profits may equal the difference between the option strike price and where the stock is currently trading minus the premium paid. The higher the stock price rises before the expiry date, the greater the potential profit for the person holding the call option.

Because the writer of the covered call option receives income on the deal in the form of a premium, they typically want the stock price to stay flat, fall, or rise only slightly. If the stock rises beyond the strike price of the option, then they’ll receive the premium, but their shares may be called away. The option writer could have a gain or loss depending on the difference between the option’s exercise price and the purchase price of the stock and the premium received.

On the other hand, if the stock doesn’t reach the strike price of the option, then the writer keeps both the premium and the shares. They’re then able to repeat the process depending on market conditions.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is a Covered Call ETF?

A covered call ETF is an actively-managed exchange-traded fund (ETF) that buys a set of stocks and writes call options on them — engaging in the call-writing process with the goal of generating income through option premiums.

By investing in a covered call ETF, investors have the opportunity to gain exposure to covered calls without directly participating in options trading on their own. The fund takes care of the covered calls for them.

The ETF covered call strategy usually involves writing short-term (under two-month expiry) calls that are out-of-the-money (OTM), meaning the security’s price is below a call option’s strike price. Using shorter-term options enables the strategy to try to benefit from rapid time decay.

Options like these also serve to create a balance between earning relatively high premium payments while increasing the odds that the contracts will expire OTM (which, for covered call writers, is a positive outcome).

Writing options OTM serves to help ensure that investors may retain exposure to some amount of the upward price potential of the underlying securities.

When to Buy a Covered Call ETF

It may be a good time to consider buying a covered call ETF when most of the securities held by the ETF are expected to trade sideways or go down slightly for some time. Some investors may find covered call ETFs appealing if they are comfortable trading off potential outsized gains during rallies for near-term income.

Covered call ETFs might also be attractive to those with lower risk tolerance looking to add some potential additional income to their portfolio without having to learn how to write and trade options.

It’s important to know, however, that the focus and performance may vary significantly between different covered call ETFs. Many track index funds, such as the S&P 500, while others may track individual stocks and different funds may employ different call trading strategies. It’s important to research performance and identify funds that align with your risk tolerance.

When Not to Buy a Covered Call ETF

A time when it’s generally not advisable to buy a covered call ETF may be when stocks are rising and making new record highs on a regular basis. This is a scenario where covered call ETFs may underperform the rest of the market.

If the underlying securities rise only slightly, and do not exceed the strike prices set for the covered calls, then these ETFs may also perform well. It’s when stocks rise to the point that the shares get called away from the fund that the fund may underperform compared to holding shares directly.

Pros and Cons of a Covered Call ETF

The main benefits that come from using an ETF covered call strategy are the potential for reduced risk and increased income.

Pros of a Covered Call ETF

Covered call ETFs may appeal to investors seeking enhanced yield, reduced volatility, and more stable long-term returns, though returns may lag during strong bull markets.

Some investors view these ETFs as a way to pursue income while smoothing returns in choppy or rangebound markets. While writing covered calls may help buffer some downside, these ETFs do not eliminate loss risk, particularly during sharp drawdowns or rallies that force shares to be called away.

Cons of a Covered Call ETF

Covered call ETFs are actively managed, which means they tend to have higher expense ratios than passively managed ETFs that track an index. These ETFs may also come with opportunity cost, since writing covered calls can cap upside potential in a bull market when market prices are spiking.

Covered call ETFs also carry both market and options risk. However, the income from options premiums may help offset those costs.

The Takeaway

A covered call ETF is an actively managed exchange-traded fund that provides exposure to the possible benefits of writing call options on stocks, without investors having to participate directly in the options market. For investors looking for a simpler approach, this may be a way to see income without managing options directly. Covered call ETFs have two primary features in the potential for reduced volatility and increased income.

That’s not to say that they don’t have downsides, too. Notably, they tend to be actively-managed, which generally means they have higher associated fees. Again, all of this should be taken into consideration before integrating any type of security into an investment strategy.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

FAQ

Is a covered call ETF a good investment?

It depends on the investor’s goals. Covered call ETFs may be attractive to those seeking income and lower volatility, especially in flat or slightly rising markets. However, they typically underperform in strong bull markets due to capped upside.

Why would someone buy a covered call ETF?

Investors may consider covered call ETFs to generate income from option premiums without managing options themselves. These funds can also reduce volatility, making them appealing to more conservative or income-focused investors.

What is the risk of a covered call?

The main risks include limited upside if the underlying stock rises sharply and potential losses if the stock declines. While the option premium can help provide limited downside protection or partially offset losses, covered calls still carry downside risk and may underperform in bull markets.

How often do covered call ETFs pay income?

Most covered call ETFs distribute income monthly, though payment schedules vary by fund. The income comes from the premiums collected by selling call options, which may fluctuate based on market conditions and the fund’s strategy, and may come from regular dividends as well.