What is “Money laundering”: cases on financial markets
Money laundering is the legalization of the possession, use or disposal of money or other property obtained as a result of a crime, which is the transfer of such funds from the shadow economy to legal area. Today, the problem of money laundering is very acute — with the advent of cryptocurrency and the expansion of tools on the financial markets. Anna Voevodina, Сhief Legal Counsel of Kuna.io cryptocurrency exchange platform, told how “money laundering” happens and what are the ways to combat it.
How regulators deal with money laundering: European directives, FATF and FATCA
Sanctions of the UN and other sanctions applied at the local level have to be supported by monitoring from financial institutions that will allow to freeze clients ’ assets. But the latter are not only banks, but also payment organizations, brokerage and insurance companies, credit unions, other smaller market participants like holders of cryptocurrency licenses in Estonia (crypto-fiat exchange service and cryptocurrency wallets providers).
There are various international and regional bodies setting standards for AML, such as the FATF and the Basel Committee for banks, however, local laws and regulations must comply with the rules of supranational bodies — for example, the 4th EU directive today and 5th when it comes into force.
Foreign Account Tax Compliance Act, better known by the abbreviation FATCA, was adopted by the United States in 2010 and is directed against the evasion of American citizens and residents from paying taxes. The adoption of FATCA had major foreign economic implications, since it obliges foreign financial institutions to report to the US Internal Revenue Service on the movement of funds from American taxpayers. Otherwise, financial institutions expected sanctions in the form of 30 percent fines on the movement of funds from their correspondent accounts in US banks and even the closure of such accounts.
After the adoption of this law, the US State Department began negotiations on concluding intergovernmental agreements regulating cross-border reporting, a number of agreements were concluded with other countries based on one of two “models”: according to the 1st model, financial organizations submit reports to the tax authorities of their countries, and they send it to the US Internal Revenue Service; according to the 2nd model, organizations submit reports directly to the US tax administration.
Full agreements were not signed with some countries, instead — the agreements in substance were concluded, stating future intentions, so that starting from July 1, 2014, when the law extended to foreign organizations, the companies of these countries would avoid punishment. On March 2017, agreements were concluded with 113 states.
In Russia, where the law prohibited organizations from reporting to foreign countries, financial organizations found themselves in a difficult situation when the Ukrainian conflict caused a deterioration in relations with the United States.
In May 2014, the US Treasury Department refused to continue negotiations on FATCA with the Russian authority, and the consequences of this could have hit the Russian economy more than the “Ukrainian” sanctions. However, a few days before July 1, the State Duma passed a law allowing Russian banks to report to foreign tax authorities.
Algorithms of actions
Money laundering occurs in three stages. At the first stage, funds are placed from an illegal to a “legal field” — for example, cash in a country where anti-money laundering procedures are not as strict as, for example, in Switzerland or the United States, is brought into a local bank to the subsequent transfer of these funds to the country’s bank “more civilized and decent”, like the EU, and the same Switzerland or the United States. Then comes the construction and creation of a set of complex transactions in order to conceal traces of criminal activity, for example, dividing financial flows from your bank account into different accounts in different banks and jurisdictions. Then, the erosion and mixing of illegal operations with formally legal ones occurs.
Thus, the process of money laundering cannot continue without the placement of funds in a financial institution. This is where the whole process of money laundering begins, where it continues and where it may come to an end.
The Fourth EU Directive requires all suspicious transactions, including attempted transactions, to be reported by the financial institution to the regulatory authorities regardless of their amount. In the USA, they additionally require a CTR (currency transaction report) for any operations in or out of the Bank for amounts which exceeds 10,000 USD.
A suspicious operation is any operation that does not corresponding to the usual behavior of the client, and which cannot be clarified by the usual personnel servicing the daily operations.
Any information on a suspicious transaction, including any that ordinary personnel cannot clarify, should be submitted to the Compliance Officer for review, who investigates and submits a suspicious transaction report to the supervising authorities, if he deems it necessary.
The authorities also should not disclose to the client that he is taken under supervision. Client notification about an investigation being underway and a report being submitted is considered a violation.
Risks for banking
In retail banking, there are large volumes of low-cost transactions requiring automated systems for effective monitoring, and rather fragmented client-bank relationships that prevent monitoring and investigating suspicious transactions. Most operations are carried out without the ability to identify the client face to face since modern banking provides for the possibility of remote service and digital services.
Despite the fact that private banking services are characterized by operations with sometimes are of low cost of financial assets that are easier to track, the latter can also be problematic due to the requirement of observing bank secrecy standards and banks’ loyalty policies to customers in a fairly competitive market. The risk of reduced vigilance in the context of confidence in one or another long-standing client, the habit of working with it according to the old rules, despite the cases of non-standard operations in the history of the client.
Correspondent banks have other risks — associated with remoteness from the primary client, sometimes because of the different regulation of certain cases in different jurisdictions, sometimes lack of internal control rules.
Example. One of the American correspondent banks blocked the transfer of funds from the UK to Ukraine for absolutely legal software deliveries because the client who initiated the payment from a bank in London indicated the abbreviation SS in the payment purpose, which was the name of the product that was paid. The correspondent bank, a recently fined for connection with payments for the supply of arms to South Sudan, decided to double-check the operation for communication with the country — South Sudan. In a different situation, earlier, when it was really about supplying weapons to the country from the blacklist, bankers did not reveal an illegal operation, for which they were fined billions of US dollars.
In loans and borrowings, illegal funds or assets can be used as collateral or to repay obligations in fact to a third party who does not participate in the initial transaction. This third party may be from a low tax jurisdiction or be associated with a person because loans in international payments are often subject to special control and transfer pricing. Therefore, the bank must carefully ascertain the real sources of funds and the links between the parties involved in the transactions.
Investment banking services have similar characteristics with retail banking services since they are aimed at private banking, but with a smaller number of operations, the latter usually have a higher cost, becoming the object of money laundering at later stages.
Investment loans were often used in international tax structuring until they became the subject of close attention to financial and tax control.
A vivid example of how money is laundered through a loan is a “Luxembourgish” loan. In this jurisdiction, payments to holders of shares of investment funds and holdings, as well as payments of profits under joint activity agreements, if the latter are foreign legal entities are equal to the return of interest on the loan, which is not a subject to withholding tax. As a result, holders of preferred shares of the holding company SOPARFI (Société de Participations Financières “company of financial participation”) can receive payments of such interest without paying taxes in offshore jurisdiction. At the same time, when carrying out holding activities, the thin-capitalization rule requires SOPARFI to maintain the ratio of controlled debt to equity (capitalization) in the ratio of 85:15.
Non-banking “laundering”
Insurance is also a scope for money laundering. No matter how strange it may sound. Products such as bearer insurance policies (in the interests of a third party) are an attractive option for money laundering, since participants can easily transfer assets to another person who is not originally a party to the transaction and is not subject to “Know your customer” policy. There is much in common with bearer shares, and this institution is prohibited by the corporate legislation of many jurisdictions precisely because of the sophisticated control and revealing of the real final beneficiary of the transaction.
A particular vulnerability associated with the activities of brokers and dealers is their dependence on “Know Your Customer” procedures and the CDD (Customer due diligence) of another financial institution. Some brokers and exchanges often ignore the possible risks due to the assumption that their regulated predecessors have checked everything thoroughly and the money that came from the accounts of their clients should be completely “clean”. Such errors are made by various providers of chain analysis in systems of a distributed registry of transactions. Sometimes a transaction on entering a cryptocurrency from a reliable source by default refers to a low or medium risk operation, without taking into account the history of the funds and the client before they hit a particular crypto to currency exchange with high reputation.
Forex traders usually operate under investment company licenses, effectively occupying a special place in modern electronic trading in financial instruments. Their product, however, has its own characteristics, since it is characterized by a large number of small investors dealing with a very large number of low cost transactions. So in some ways, this is similar to retail banking. Since this business is digital, almost all clients do not pass “face-to-face” verification when being face to face with the broker.
In addition, since currency markets are rather volatile, it is quite normal for the client to encourage the broker to open an account for him as soon as possible and to execute one or another order. And such a risk can be considered normal, and the operation does not look suspicious, although it can be a tool for laundering illegally obtained funds.
Finally, one of the most common methods of money laundering in the cash remittance sector is structuring of transactions, which is called smurfing. This happens when a person performs several cash transactions in smaller amounts to avoid mandatory thresholds or KYC / CDD requirements. In most cases, such clients bypass bank accounts opened in their name, since the latter simply do not have those bank accounts.
Conclusion
Participants of financial markets should understand that financial service providers today are under the strict supervision of their regulators. Many suspicious transaction markers have already been automated, and the entire civilized world is struggling against money laundering. The latter is becoming increasingly impossible, and often even completely legal transactions fall under control. To avoid problems with compliance services and prevent freezing of operations and account blocking, one needs to carefully think through each transaction and study the rules for working with providers of banking, financial services, and cryptocurrency exchanges.
