A currency carry trade is a popular type of forex trade, whereby an investor borrows in a low-interest currency in order to invest in a currency with a higher rate.
Putting on a carry trade is one way to take advantage of discrepancies between the interest rates of different currencies, particularly if the investor uses leverage.
This strategy can be risky, however, owing to the fact that interest rates, and currency values, can fluctuate at any time. The use of leverage adds additional risk, if the trade moves in the wrong direction.
Key Points
• A currency carry trade involves borrowing funds in a low-rate currency and investing in assets in a higher-yielding currency.
• Thus, a currency carry trade is a way to profit from differences in interest rates.
• This is a popular forex strategy, owing to its relative simplicity: An investor just needs to find the appropriate currency pair to execute the carry trade.
• Because interest rate differentials may be small, some investors use leverage to maximize potential gains.
• The risk of loss is high, however, if interest rates suddenly change.
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What Is a Currency Carry Trade?
In a carry trade, forex traders borrow money at a low interest rate in order to invest in a currency where they can buy an asset with a higher rate of return. In the forex markets, a carry trade is a bet that one foreign currency will hold or increase its value relative to another currency, and that interest rates will also remain steady.
Of course, this active investing strategy hinges on whether or not interest rates and exchange rates are in the investor’s favor. The wider the interest rate spread between two currencies, the better the potential returns for the investor.
Even in cases with a relatively small rate differential, though, investors who use this strategy often employ leverage to maximize potential profits.
How Do You Execute a Carry Trade?
A carry trade strategy can be a relatively simple way to increase an investor’s returns, assuming they can find a currency with a higher rate and one with a lower rate, and that exchange rates between the two currencies remain relatively stable. In that way, it’s similar to understanding “spread trading” as it relates to stocks.
Currency Carry Trade Basics
Imagine that U.S. interest rates are at 5%, but the interest rate in Japan is 1% — a 4% spread. The yen would be considered the funding currency for the carry trade because the rate is lower, and the dollar is the asset currency (which typically has a higher rate).
A trader could borrow 1 million yen at 1%, and buy an asset such as a U.S. bond that has a 4% yield. When the bond matures, the investor could collect the bond yield, repay the yen they borrowed at 1%, and pocket the difference.
There is a wild card here, though, which is that both interest rates and currency values can change — sometimes suddenly — which can cause the trade to move in the wrong direction.
Here is an example of how the exchange rate and interest rate come into play in a currency carry trade.
Carry Trade Example
In this example the investor will borrow 1 million yen at 1%, and an exchange rate of 145 yen to the dollar.
1 million yen / 145 = $6,896.55
The investor could take the $6,896.55 and invest in a U.S. security that pays 4%, and collect that amount after a year.
$6,896.55 x $0.04 = $275.86
Total = $7,172.41
Now the investor has to repay the 1 million yen they borrowed at 1%, for a total of 1,000,100 yen, or $6,897.24
They subtract the principal from the ending balance in dollars:
$7,172.41 – $6,897.24 = $275.17
The resulting profit of $275.17 is 4% of the original spread between the interest rate spread of the two currencies.
The concept of a carry trade is simple, but in practice, it can involve investment risk.
In the above example, neither the exchange rate nor the interest rates moved — which in real life is highly unlikely.
Most notably, there’s the risk that the currency or asset a trader is investing in (the British pounds in our previous example) could lose value. That could put a damper on a trader’s expected returns, as it would eat away at the gains the difference in interest rates could provide.
Currency prices tend to be very volatile, and something as mundane as a monthly jobs report released by a government can cause big price changes.
Given the risks, carry trades in the currency markets may not be the most appropriate strategy for investors with a low tolerance for risk.
The Takeaway
Using a currency carry trade strategy is a popular one in the forex markets because it’s relatively easy to find currency pairs with an interest rate difference that can be exploited for a potential gain. The risk, though, lies in the potential for currency rates to shift, as well as interest rates.
FAQ
How does a carry trade work?
A currency carry trade works when two currencies are relatively stable, but one offers a much lower rate than the other. This makes it possible to borrow the funding currency to invest in a higher-yield security in the asset currency, and pocket the difference, minus the interest rate owed on the principal borrowed.
What happens when a carry trade moves in the wrong direction?
There are various risk factors when using a carry trade strategy. One is that the lower-rate currency could strengthen against the asset currency, and the investor would effectively repay a larger amount than they borrowed, thus cutting into any profit.
What is the forex market?
The forex market is where financial institutions, as well as individual investors, trade foreign currencies. The forex market is the largest in the world, and it’s possible to trade 24/7 — which is different from most markets, which have open and close hours.
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SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
When an investor places an order with their brokerage to buy or sell an asset, there’s a certain set of steps that take place behind the scenes to fulfill it. That’s referred to as an order flow, and that involves some payments between market makers and brokerages in order to keep orders moving through the pipeline. With that in mind, payment for order flow (PFOF) involves market makers paying brokers for their clients’ order flow.
It can be beneficial for investors to know about the order flow process and payments involved, as it is a variable in how much they ultimately end up paying for trading, if anything. And it’s also been a somewhat controversial practice, despite the fact that it’s become commonplace in today’s market.[1]
Key Points
Payment for order flow (PFOF) involves brokerages routing customer orders to market makers for a fee, enabling commission-free trading.
PFOF allows brokerages to offer commission-free trading, enhanced liquidity, and potential price improvements to retail investors.
Market makers provide liquidity in the options market, executing trades and offering price improvements to retail investors, and PFOF involves brokers routing their trades to specific market makers.
PFOF has faced controversy, with critics citing a conflict of interest for brokerages, which may prioritize revenue over the best prices for customers.
Regulatory scrutiny has been applied to PFOF, with the DOJ investigating potential market maker profiteering at the expense of retail investors; brokers today must adhere to specific regulatory requirements.[2]
What Is Payment for Order Flow (PFOF)?
Payment for order flow (PFOF) refers to the practice of retail brokerages routing customer orders to market makers, usually for a small fee that’s less than a penny. Market makers, who are required to deliver the “best execution,” carry out the retail orders, profiting off small differences between what shares were bought and sold for. Retail brokerages, in turn, use the rebates they collect to offer customers lower trading fees.
What Are Market Makers?
Market makers — also known as electronic trading firms — are regulated firms that buy and sell shares all day, collecting profits from bid-ask spreads. The market maker can execute trades from their own inventory or in the market. Offering quotes and bidding on both sides of the market helps keep it liquid.
Market makers that execute retail orders are also called wholesalers. The money that market makers collect from PFOF is usually fractions of a cent on each share, but these are reliable profits that can turn into hundreds of millions in revenue a year. In recent years, a number of firms have exited or sold their wholesaling businesses, leaving just a handful of electronic trading firms that handle PFOF.
In addition to profits from stock spreads, the orders from brokerage firms give market makers valuable market data on retail trading flows. When it comes to using institutional or retail investors, market makers also prefer trading with the latter because larger market players like hedge funds can trade many shares at once. This can cause big shifts in prices, hitting market makers with losses.
How Does Payment for Order Flow Work?
Here’s a step-by-step guide to how payment for order flow generally works:
A retail investor puts in a buy or sell order through their brokerage account.
The brokerage firm routes the order to a market maker.
The broker collects a small fee or rebate – the “payment” for sending the “order flow” or PFOF.
The market maker is required to find the “best execution,” which could mean the best price, swiftest trade, or the trade most likely to get the order done.
The rebates allow companies offering brokerage accounts to subsidize low-cost or zero-commission trading for customers. It also frees them to outsource the task of executing millions of customer orders.
Usually the amount in rebates a brokerage receives is tied to the size of the trades. Smaller orders are less likely to have an impact on market prices, motivating market makers to pay more for them. The type of stocks traded can also affect how much they get paid for in rebates, since volatile stocks have wider spreads and market makers profit more from them.
Why Is PFOF Controversial?
While widespread and legal, payment for order flow is controversial. Critics argue it poses a conflict of interest by incentivizing brokerages to boost their revenue rather than ensure good prices for customers. The requirement of best execution by the Securities and Exchange Commission (SEC) doesn’t necessarily mean “best price” since price, speed, and liquidity are among several factors considered when it comes to execution quality.[3]
Defenders of PFOF say that retail investors benefit from the practice through enhanced liquidity, the ability to get trades done. They also point to data that shows customers enjoy better prices than they would have on public stock exchanges. But perhaps the biggest gain for retail investors is the commission-free trading that is now a mainstay in today’s equity markets.
PFOF in the Options Market
Payment for order flow is more prevalent in options trading because of the many different types of contracts. Options give purchasers the right, but not the obligation, to buy or sell an underlying asset. Every stock option has a strike price, the price at which the investor can exercise the contract, and an expiration date, which is the day on which the contract expires.
Market makers play a key role in providing liquidity for the thousands of contracts with varying strike prices and expiration dates.
The options market also tends to be more lucrative for the brokerage firm and market maker. That’s because options contracts trading is more illiquid, potentially resulting in larger spreads for the market maker.
Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
Criticism of Payment for Order Flow
Payment for order flow was pioneered in the 1980s by Bernie Madoff, who later pleaded guilty to running one of the largest Ponzi schemes in U.S. history.
Critics argue retail investors can get a poor deal from PFOF. Since market makers and brokerages are only required to provide “best execution” and not necessarily the “best possible price,” firms can make trades that are profitable for themselves but not necessarily in the best interest of individual investors.
As such, regulators have proposed reforms to PFOF, and in 2024, the SEC did adopt some amendments that updated required disclosures.[4]
Defenders of Payment For Order Flow
Proponents of payment for order flow argue that both sides — the retail investors and the market makers — win from the arrangement. Here are the ways retail customers can benefit from PFOF, according to its defenders:
No Commissions: In recent years, the price of trading has collapsed and is now zero at some of the biggest online brokerage firms. While competition has been a big part of that shift, PFOF has helped bring about low trading transactions for mom-and-pop investors. For context, online trading commissions were $40 or so per trade in the 1990s.
Liquidity: Particularly in the options market, where there can be thousands of contracts with different strike prices and expiration dates, market makers help provide trading liquidity, ensuring that retail customer orders get executed in a timely manner.
Price Improvement: Brokerages can provide “price improvement,” when customers get a better price than they would on a public stock exchange.
Transparency: SEC Rules 605[5] and 606[6] require brokers to disclose statistics on execution quality for customer orders and general overview of routing practices. Customers are also allowed to request information on which venues their orders were sent to. Starting in 2020, brokers also had to give figures on net payments received each month from market makers.
The Takeaway
Payment for order flow (PFOF) refers to the practice of retail brokerages routing customer orders to market makers, usually for a small fee. Payment for order flow has been controversial, but it’s become a key part of financial markets when it comes to stock and options trading today.
Industry observers have said that for retail investors weighing the trade-off between low trading costs versus good prices, it may come down to the size of their trades. For smaller trades, the benefits of saving money on commissions may surpass any gains from price improvement. For investors trading hundreds or thousands of shares at a time, getting better prices may be a bigger priority.
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FAQ
What is payment for order flow (PFOF)?
Payment for order flow, or PFOF, refers to the practice of retail brokers routing their customers’ orders to specific market makers in exchange for a fee.
Why is PFOF controversial?
The crux of the criticism surrounding PFOF involves brokers putting their own financial interests ahead of their clients. Specifically, brokers may be more concerned with generating PFOF-related fees than ensuring their clients receive the best order flow treatment possible.
What are common defenses of PFOF?
Defenders of PFOF say that retail investors benefit from the practice through enhanced liquidity, the ability to get trades done, and low-cost or commission-free trading.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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A market-on-open order (MOO) is an order to be executed at the day’s opening price. Investors typically have until two minutes before the stock market opens at 9:30am ET to submit a market-on-open order. MOO orders are used in the opening auction of a stock exchange.
While investors who subscribe to a more passive type of investing strategy may not incorporate MOO orders into their daily lives, they can be important to know about. You never know, after all, when you may want to place an order before trading commences.
Key Points
• Market-on-open orders execute at market opening, without price guarantees.
• MOOs have a higher likelihood of execution compared to limit orders.
• MOOs are useful for capturing immediate price movements.
• Risks involve volatility and potential liquidity issues.
• Limit-on-open orders may provide price protection.
What Is a Market-on-Open (MOO) Order?
Again, market-on-open orders are trades that are executed as soon as the stock market begins trading for the day. They may hit the order book before then, but do not actually go through the trading process until the market is opened. Note, too, that MOO orders are only to be executed when the market opens — they are the opposite of market-on-close, or MOC orders.
These orders are executed at the opening price during the trading day, or immediately (or soon after) the bell rings opening the market on a given day.
How Market-on-Open Orders Work
There may be different rules for different stock exchanges, but generally, the stock market operates between 9:30am ET and 4pm ET, Monday through Friday. Trades placed outside of the hours are often called after-hours trades, and those trades may be placed as market-on-open orders, which means they will execute as soon as the market opens for the next trading day.
An investor might place a market-on-open order if they anticipate big price changes occurring during the next trading day, among other reasons.
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Different Order Types
To fully understand how an MOO order works, it may help to first understand both stock exchanges and the different ways that trades can be executed. The latter is generally referred to as an “order type.”
Stock exchanges are marketplaces where securities such as stocks and ETFs are bought and sold. In the U.S., there are more than a dozen stock exchanges registered with the Securities and Exchange Commission (SEC), including the New York Stock Exchange and Nasdaq Stock Exchange.
Next, market order types. Order types can be put into one of two broad categories: market orders and limit orders.
Market Order
A market order is an order to buy or sell at the best available price at the time. Generally, a market order focuses on speed and will be executed as close to immediately as possible.
But securities that trade on an exchange experience market fluctuations throughout the day, so the investor may end up with a price that is higher or lower than the last-quoted price. Therefore, a market-on-open order is a specific version of a market order.
Because it is a market order, it will happen as close to immediately as possible and at the open of the market. The order will be filled no matter the opening price of investment. There is no guarantee on the price level.
With each order type, the investor is providing specific information on how, and under what circumstances, they would like the order filled. In the world of order types, these are semi-customizable orders with modifications.
Limit Order
A limit order is an order to buy or sell a stock at a specific price. A limit order is triggered at the limit price or within $0.25 of it. At the next price, the buy or sell will be executed.
Therefore, limit orders can be made at a designated price, or very close to it. While limit orders do not guarantee execution, they may help ensure that an investor does not pay more than they can (or want to) afford for a particular security.
For example, an investor can indicate that they only want to buy a stock if it hits or drops below $50. If the stock’s price doesn’t reach $50, the order is not filled.
After-Hours Trading
An MOO order is not to be confused with after-hours trading and early-hours trading. Some brokerage firms are able to execute trades for investors during the hours immediately following the market closing or prior to the market’s open.
3 Reasons to Use a Market-On-Open Orders
There are several reasons to use a market-on-open order, including the following.
Trading Outside of Operating Hours
Stock exchanges aren’t always open. The New York Stock Exchange (NYSE) and the Nasdaq Stock Exchange are both open between 9:30 am and 4:00 pm EST.
Anticipating Changes in Value
Traders and investors may use a market-on-open order when they foresee a good buying or selling opportunity at the open of the market. For example, traders may expect price movement in a stock if significant news is released about a company after the market closes. They may want to cash out stocks, and do so using a market-on-open order.
The News Cycle
Good news, such as a company exceeding their earnings expectations, may lead to an increase in the price of that stock. Bad news, such as missing earnings estimates, may lead to a decline in the stock price. Some traders and investors may also watch the after-hours market and decide to place an MOO order in response to what they see.
It’s also important to know that stock exchanges tend to experience the most volume or trades at the open and right before the close. Even though the stock market is open from 9:30am to 4:00pm, many investors concentrate their trading at the beginning and near the end of the trading day in order to take advantage of all the liquidity, or ease of trading.
Examples of MOO Trade
Let’s look at some hypothetical examples of why an MOO order might be useful:
Example 1
Say that news breaks late in the evening regarding a large scandal within a company. The company’s stock has been trading lower in the after-hours market. An investor could look at this scenario and believe that the stock is going to continue to fall throughout the next trading day and into the foreseeable future. They enter an MOO order to sell their holding as soon as the market is open for trading.
Example 2
Or maybe a company quarterly earnings at 7am on a trading day. The report is positive and the investor believes the stock will rise rapidly once the market opens. With an MOO order, the investor can buy shares at whatever the price may be at the open.
Example 3
Though this won’t apply to the average individual investor, MOO orders may also be used by the brokerage firms to fix errors from the previous trading day. A MOO order may be used to rectify the error as early as possible on the following day.
Risks of Market-on-Open Orders
It is important to understand that if a MOO order is entered, the investor receives the opening price of the stock, which may be different from the price at the previous close.
Volatility at the Open
Considering the unpredictable and inherent volatility of the stock market, the price could be a little bit different — or it could be very different. Investors that use MOO orders to try and time the market may be sorely disappointed in their own ability to do so, but only because timing the market is exceedingly difficult.
Most investors will likely want to avoid trying to weave in and out of the market in the short-term and stick with a long-term plan. Some investors may use MOO orders with the intention of taking advantage of price swings, but the variability of the market could trip up a new investor.
Because the order could be filled at a price that is significantly different than anticipated, this may create the problem of not having enough cash available to cover a trade.
Using Limit-on-Open Orders
An alternative option is to use a limit-on-open order, which is like an MOO order, but it will only be filled at a predetermined price. Limit-on-market orders ensure that a transaction only goes through at a certain price point or “better.” As discussed, there are other types of limit orders out there, too, for given situations. For instance, there may be a context in which it’s best to use a stop loss order, rather than a limit-on-open or similar type of order.
The downside of doing a limit-on-market order is that there is a chance that the order doesn’t get filled.
Liquidity Issues
With an MOO order, there could also be a problem of limited liquidity. Liquidity describes the degree to which a security, like a stock or an ETF, can be quickly bought or sold.
As mentioned, there tends to be greater liquidity at the beginning of the day and at the end, and investors will generally not have a problem trading the stocks of large companies, because they have many active investors and are very liquid.
But smaller companies can be less liquid assets, making them slightly trickier to trade. In the event that there is not enough liquidity for a trade, the order may not be filled, or may be filled at a price that is very different than anticipated.
💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.
Creating a Market-on-Open Order
Creating a market-on-open order is fairly simple, but may vary from trading platform to trading platform. Generally speaking, though, a trader or investor would select an option to execute a MOO when filling out the details of a trade they wish to make.
For instance, if you wanted to sell 5 shares of Company A, you’d dictate the quantity of stock you’re trying to sell, and then choose an order type — at this point, you’d select a market-on-open order from what is likely a list of choices. Again, the specifics will depend on the individual platform you’re using, but this is generally how a MOO is created.
The Takeaway
Market-on-open orders are submitted by investors when they want their order executed at the opening price and be part of the morning auction. An investor may use this order if they want to capture a stock’s price move up or down as soon as the trading day starts.
However, MOO orders don’t guarantee any price levels, so it may be risky for an investor if shares don’t move in the direction they were expecting. Unlike limit orders though, they are more likely to get executed.
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FAQ
What is a market-on-open order?
Market-on-open (MOO) orders are stock trading orders made outside of normal market hours and fulfilled when the markets open. Trades execute as soon as the market opens.
What is a market-on-open limit on open?
A limit-on-open order, or LOO, is a specific form of limit order that executes a trade to either buy or sell securities when the market opens, given certain conditions are met. Usually, those conditions concern a security’s value.
What is the difference between market-on-close and market-on-open?
As the name implies, market-on-close orders are executed when the market closes at 4 pm ET, Monday through Friday (excluding holidays). Conversely, market-on-open orders are executed when the market opens at 9:30am ET, Monday through Friday.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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¹Claw Promotion: Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.
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.
Key Points
• Know Your Customer (KYC) law requires financial institutions to verify customer identities.
• The purpose of KYC is to help prevent money laundering, terrorism financing, and fraud.
• The KYC process includes the Customer Identification Program, Customer Due Diligence, and Enhanced Due Diligence.
• Under KYC, there is monitoring and annual reviews of customer activities.
• Compliance with KYC generally enhances a financial institution’s reputation and integrity.
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.
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.
• 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.
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.
AML and KYC Similarities
AML and KYC Differences
Designed to inhibit money laundering, including terrorism financing
FKYC focuses on customer identification, while AML has a wider scope
Both are implemented by financial institutions to comply with government guidelines
KYC represents one aspect of larger AML procedures
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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