KYC in the new era of DIY investing

Interest in do-it-yourself (DIY) investing has exploded in popularity in recent years. For example, Robinhood, the popular free trading app in the U.S., reached a peak of over 21 million users (average age 30-32) within six years of its 2015 launch. Canadians opened an unprecedented 2.3 million DIY accounts during 2020 alone. Memes, social media, and momentum investing have fostered an environment where many of these retail traders give little regard to the importance of the investment suitability or the financial fundamentals of the stocks they trade. 

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This has created new challenges for platform operators - how to open millions of accounts for tech-savy DIY traders while adhering to KYC standards. 

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Know-your-client (KYC) is an essential process in the financial industry that seeks to understand a client’s identification, background, needs, and expectations. This information is essential for companies to provide personalized services for their clients, meet regulatory compliance standards, and to help guard against money laundering and other financial crimes. The process has been legally mandated in Canada since 1991 (and is also in effect in the US). 

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KYC: The suitability rule.

KYC is also used to evaluate a client’s financial circumstances, investment knowledge, and risk tolerance in order to assess the potential risks and objectives associated with their investments. This is referred to as the suitability rule. 

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The suitability rule is used to ensure that investments are appropriate and well-suited to the needs of the investor. Investing generally requires some level of risk—which could be lower-risk investments such as bonds and treasury bills, or higher-risk investments such as stocks and derivatives. Suitable investments help the investor reduce their chance of unexpected losses. 

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Once the client’s risk appetite is established, financial advisors (or robo advisors) may then suggest investment strategies that are appropriate for the client’s needs. The suitability mandate also requires an ongoing monitoring process to ensure investments remain appropriately matched to the client’s objectives over time.

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But, how effective is the suitability rule on DIY trading platforms? Might regulators require these stock trading platform operators to implement client suitability guardrails on the stocks a client wishes to trade?

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KYC’s fintech disruption.

Traditional methods of KYC compliance in the capital markets are being disrupted. The old process of face-to-face meetings and paper-based account forms has evolved to virtual meetings, electronic signatures, and two-factor identification. With new technology, a client can take a selfie that facial recognition technology can compare with the photo on the authenticated ID. These new fintech tools are enabling platform operators to quickly perform background checks and open accounts with speed and scale.

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The suitability rule is poised to become one of fintech’s next KYC disruption opportunities. Is the stock suitable for the client’s risk profile? Is the company dividend as safe as the client thinks it might be? How will the ongoing monitoring process be achieved for DIY investors?  Artificial intelligence and machine learning technologies are likely to play a key role in the future of trading-enabled guardrails for DIY investors, including personalized suitability warnings when buying stocks. 

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Conclusion.

KYC is here to stay. The emergence of the DIY investors has created a new set of KYC compliance and suitability challenges, with millions of new tech-savvy traders rapidly opening trading accounts. The fintech industry has responded with new technologies to streamline the account opening and KYC process. And, with new AI and biometrics tools emerging, there will be more to come.  

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Now, the suitability rule for DIY investors is gaining regulatory focus and stands to become fintech’s next big disruption opportunity. Stay tuned for upcoming articles on how suitability analysis can be performed using AI for all publicly-traded stocks.