The Economics of Identity Verification: When KYC Becomes Infrastructure

KYC, or Know Your Customer, is a popular term for identity verification requirements that are now widely used across the financing, tech, business, education, and medical sectors.  Due to the increasing ease of conducting online fraud and scams, it is of great importance for companies in these sectors to verify the identity of those logging in as customers and clients.  Whereas fraudsters of previous generations often had to conduct their schemes in person, risking immediate arrest, today’s hackers and other digital ne’er-do-wells can steal money, documents, or sensitive information from thousands of miles away.  They can also conduct online operations at any time of day, especially when legitimate customers and employees are unaware.  

Because hackers, scammers, and fraudsters are online at all times, searching for easy ways to manipulate websites and accounts, customers want peace of mind that their identities, information, and money are being protected.  As one might expect, there is a financial incentive for companies to assure customers and clients that they are receiving this protection.  Businesses that are seen as protective of customers’ digital assets are more likely to attract new customers.

The Economics of Network Effects and Demand Enhancement

We want our goods and services to synchronize smoothly together in terms of compatibility.  This is the goal behind network effects, where something becomes more valuable as more people use it.  For example, as more people use electric cars, having an electric car becomes more desirable due to the expanding network of infrastructure that supports electric cars.  When only a few people own an electric car, little infrastructure exists to support them and can make use of them expensive and risky.  

Our demand for goods and services increase when we see that they are widely trusted; we assume that we can trust them as well.  Trust is a component of the demand determinant of consumer tastes and preferences - we desire things we trust to be reliable and of high quality.  Brands and companies that are proficient in KYC are more effective at building trust with consumers.  If consumers feel safe with a brand, they are likely to seek out additional products and services offered by that same brand or in connection with that brand.

Trusted Companies Get to Join Desirable Networks

Companies often form networks with other companies to provide communication, financial, transportation, and data management services.  For example, sellers create networks with financial institutions to accept payment transactions or transportation companies to ship their products.  They can then advertise these networks to customers, offering a greater range of products and services.  

Some companies offer a greater range of services through bundling, with two brands offering their services together in a package.  Therefore, engaging in KYC and being seen as a trustworthy company makes it more likely that a firm will have opportunities to bundle their goods and services with complements that increase consumer demand.  If a company’s KYC method is popular and user-friendly, other firms may use it to allow access to all of their products.  For example, users who log in to one website may be allowed to access other websites whose services are bundled without logging in additional times.  

The Economics of Trust

Perceived Insurance Against Loss

With so much of our lives online today, ranging from our finances to our health records, there is tremendous risk of loss from being hacked or scammed.  To avoid catastrophic loss, customers may be willing to pay extra to be protected by a company’s trusted KYC system.  This additional cost can be rationalized as akin to purchasing an insurance policy.  The up-front cost of using a KYC-focused firm is higher, but may be cost-effective when compared to using a non-KYC firm and having a separate insurance policy.

Perceived Superior Quality

Consumers will pay for peace of mind, and firms that engage in comprehensive KYC policies are likely to be seen as higher quality.  It is often assumed that having to go through security means there is something inside worth stealing, so consumers may view online companies with robust KYC policies as having more value.  Although the customer’s digital assets will not have inherently different value based on the online firm, feeling that one firm is of greater value than another may make customers feel that their own digital assets are of similar greater value.  Customers transfer the prestige of the brand onto their own assets being managed by that brand.

Economics of Distrust and Misinformation

What is the economic rationale for governments to require many types of firms to implement KYC protections, ranging from identity verification to data and communication monitoring to fraud detection?  After all, these are often expensive to implement with fidelity and can be considered burdensome by some customers.  

Consumer Confidence and Aggregate Demand

A positive externality of government mandates for KYC policies is increased consumer confidence, which results in increased aggregate demand.  Therefore, the costs incurred by businesses in implementing KYC can theoretically be made up, especially in the long run, by more consumers being willing to spend in those markets.  For example, consumers feeling that credit cards, online payment systems, online medical records, and online education are secure will make them more likely to put their money in them.  Consumers who feel that online systems are not secure are more likely to save their money rather than spend it, leading to less economic stimulus.

Market Failures and Government Bailouts

An extreme effect of public distrust of online systems due to lack of KYC (and resulting rampant hacking and fraud) would be market failure.  After long periods of consumers avoiding certain types of businesses, they would collapse.  People would stop sending payments online, engaging in telemedicine services, or attending online classes.  When these businesses collapsed, resulting in unemployment and lost consumer services, many citizens would demand government intervention.  This could result in expensive bailouts at taxpayer expense.  KYC regulations can be seen as an investment, therefore, in preventing future bailouts.

Information Verification as a Public Good

Of course, firms may not want to pay the entire costs for KYC on an individual basis.  Therefore, there is business demand for governments to assist with identity and information verification.  If the government uses public funds to verify the identities of consumers and data being used by businesses, this would theoretically benefit all firms in the market (aside from those who create KYC services).  The universal benefit of information verification, even for those who do not pay for KYC services, makes a strong argument that it should be public good.  WIthout government provision of information verification, too many consumers and firms would be free riders and simply hope that the KYC services of others would reduce fraud to a tolerable level, resulting in an unacceptably high level of fraud.