What is Anti Money Laundering?
Money Laundering (ML) is the act of converting illegitimate and ill gotten money like those sourced from smuggling, extortion, drugs and terrorism into legitimate money that evades suspicion and scrutiny. Money laundering typically involves three stages –
- Placement – introducing ill gotten money into banking/ securities system
- Layering – merging ill gotten money with legitimate money for all money to look legitimate &
- Integration – process of integrating both legitimate and illegitimate money into regular flow of money making the whole stream to look legitimate.
Anti Money Laundering (AML) is described as activities taken actively by financial institutions to detect money laundering and to prevent it.
AML in banks and financial institutions is quite some time old and enjoys very sophisticated practices for detection and prevention. However, AML in securities domain is pretty new and is still challenging.
Why is Anti Money Laundering Important?
AML is important to curb financing of illegal activities discussed earlier. It is necessary that ill gotten money be checked, forfeited and should not enter the main stream money flow disguised as legitimate money.
Who lays the guidelines for AML in India?
The legislative framework for AML was laid by the Prevention of Money Laundering Act, 2002, after which substantial progress has been made in increasing awareness and robustness of Anti Money Laundering guidelines. The Financial Action Task Force (FATF) which is an independent and inter-governmental body is responsible for setting standards in this area. In 2010, after a tough evaluation, India was admitted as the 34th member to the FATF. FEMA has spelt out clear AML obligations to be complied with. Both RBI and SEBI have issued necessary guidelines on the monitoring mechanism and obligations of institutions on Suspicious Transaction Reporting. It is now incumbent upon institutions and service providers to follow these guidelines in true letter and spirit.
Whose responsibility is it to monitor for AML activities?
Every financial organization is expected to study their clients and their transactions and file a ‘Suspicious Transaction Report’ (STR) to the country’s Financial Intelligence Unit (FIU). The FIU itself studies the transactions reported and if it finds anything suspicious, it reports the transaction and client to country’s law enforcement agencies.
How does AML in securities stack up with AML in banking or finance?
AML in securities industry is tricky because most jurisdictions and markets don’t accept cash for securities transactions, which is normally used traditionally in ML and terrorism funding activities. ML in securities is also very lucrative for launderers because not only does securities markets helps them launder money, it also helps them generate money. Systems and processes have to be robust and intelligent enough to capture such ML activities in securities space.
What is the scope of AML in securities? Is insurance also covered?
Generally AML in securities refers to AML in Wholesale Markets, Wealth Management, Investments funds and
processing, unregulated funds like Hedge Funds, Bearer Securities, Bills of Exchange etc. Depending on jurisdiction, trading in securities is not limited to securities dealers and brokers but also touches upon banking and insurance. Insurance may thus be covered under securities and an AML guideline covers it as well.
How does ML take place in Insurance?
Money launders use insurance policy and industry to convert their black money or cash into legitimate money. Popular methods in not so advanced countries include buying long term single premium plans using cash and then surrendering the policy in free lookup period. The insurance company refunds the premium money in full and in cheque and when the money launderer deposits this cheque in his bank account, no suspicion is raised because the source of money is legitimate (coming from an insurance company). Additional indicators could be customer canceling a policy and asks the refund to be sent to a third party or a customer interested in products early surrender value or a customer purchasing an insurance policy using different instruments like traveler’s cheques or bearers cheques and cash.
What are the common patterns of laundering seen in securities industry that a market participant should be careful about? How can it be detected by use of technology?
Several common patterns are seen in securities markets in money laundering and AML strategies should be formulated accordingly.
Some patterns pertain to converting illegitimate money into legitimate and some pertain to generating more money.
For converting illegitimate money to legitimate, money launderers may involve simple tricks like –
- providing misleading information to intermediaries while opening accounts
- making many small cash deposits and buying securities when the amount becomes large
- Using brokerage accounts to hold funds for long term and similarly using broker’s pool accounts or broker’s beneficiary’s account to hold shares for long term
- transactions where one party is seen to be deliberately taking loss thereby transferring money to another
- purchase of long term investments followed by a sudden liquidation regardless of fees and penalties
- customer engages in extremely complex transactions where his profile may be otherwise
- Engaging in boiler room operations etc.Sometimes money laundering clients may bring cheques from another reputed financial institution to open an account or for transactions making the intermediary lower their KYC standard because they get biased into believing that the originating financial institution has already conducted its own KYC investigation and hence issued a cheque which may not be the case.
Sophisticated tricks may involve selling deep in the money options at a throw away price or generally at inferior terms allowing the counterparty to exercise the option and get money (so that payment looks legitimate),
Generation of more money involves tricks such as manipulating low priced securities, use of shell companies for reverse merger, insider trading and other kinds of frauds.
Technology plays a very crucial role in detecting AML activities. For example, all client lists must be daily scrubbed against debarred entities list. It may so happen that when a client is registered he may be acceptable but later he gets blacklisted hence daily check is needed. The case of undervalued options can be checked by having a good options pricing tool in place and software having validation that disallows in the money options to be sold cheap or at no cost. Similarly, trading systems must continuously scan for clients whose trading positions and strategies are not consistent with their risk profiles.
Do employees also play a role in money laundering? Should they also be monitored?
Certainly. Participants think AML is only about screen people like Politically Exposed Persons or drug/ terrorism and suspicious transactions but it is also about intermediaries, distribution channels, products, payment methods and most importantly employees of the organization who may be in collusion with the money laundering client.
In fact each organization must look for vital clues within the organization to check any such activity. Some indicators of employee involvement could be –
- employee reluctant to take leave
- employee’s lifestyle is lavish and inconsistent with his earnings
- employees job demands and goals are intense making him compromise on KYC guidelines
- employee is located in a different country than his supervisor
- a management culture that rewards numbers more than compliance with requirements
- employees bringing supporting documentation for clients which is inadequateThe AML monitoring department must constantly draw up policies to monitor its employees against this list. Software products must also have necessary checks in place. For example, it has been seen that employees delete transactions or amend the terms of transactions which may benefit clients in an undesirable way. Software should not allow any deletes. Any changes that employees may want to make should be through passing of necessary journal entries or reversing journal entries and never by deleting because auditors may not go through deleted transactions in normal course of time.
What basic care should a brokerage take to make sure it doesn’t become an agent for money laundering?
Some basic steps are
- strictly adhering to KYC guidelines
- disallowing cash withdrawals and use of cash for purchase of securities
- not allowing withdrawal or sale proceeds to be paid to a 3rd party
- not allowing changes to a financial product after the transaction that enables payments to be received from or paid to third parties
What are the main challenges that institutions and regulators are facing in AML compliance in the securities sector?
There are several challenges in this area starting from inconsistency in definition of ‘securities’ itself. Reporting requirement for securities has only been introduced very recently in many jurisdictions. Many institutions find it difficult to file STRs on time because transactions in securities market are very fast paced. Some institutions may not understand STR requirements itself. Institutions should also train employees rigorously on AML and the implications of ML as institutions that don’t comply will attract heavy penalties and will lead to reputation loss and even imprisonment of directors or those responsible.