Three years since the US declared its intention to get tough on money laundering, a raft of new regulations has been introduced requiring everyone to put in place stringent know your customer measures. John Piccitto reports on how this has extended to the world of securities finance and discovers that the problems may be at the margins.
ANTI-MONEY laundering regulations evolved out of attempts to prevent criminals from enjoying the spoils of drug sales and other illegal activities. Gradually these techniques have been applied to cases of tax evasion as well. Although resistance from the private banking industry stalled the effort, the events of September11, 2001 allowed regulators to overcome these protests. Money laundering was now associated with financing terrorism and terrorism had a political impact that other criminal activity did not. The reluctance in some sections of the financial industry to become part of a policing effort evaporated.
The bad old days when smudged driving licences or silhouette photos might just be enough to identify a really promising client - had gone for ever. The epic battles between prime brokers wanting to wave as much stock as possible in front of their hedge fund clients, and their credit and legal departments, were over. Equity finance operations now had to routinely conduct extensive know your customer inquiries and scrutinise trading patterns, quickly identifying those that required suspicious transaction reports.
Procedural changes have also produced a transformation in attitude. Walls have been built to keep dirty money out of the global financial system. Yet money laundering allegations still feature in the news. Terrorists, tax evaders, fraudsters and dictators of hapless, impoverished countries seem to find new entry points as quickly as the old ones are stopped up. The expansion of the finance industry into previously unregulated markets poses a new challenge can established anti-money laundering procedures be transferred to new cultures, effectively blocking potential new entry points?
The evidence suggests that entry points for dirty money havent been entirely closed up in the existing system. Sometimes, the activities of a few employees can affect the reputation of an entire company, as when UBS was fined US$100 million this year by US and Swiss authorities after it was found to have traded banknotes with Cuba, Iran, Libya and Yugoslavia, in breach of an agreement with the NY Fed.
THE BAD OLD DAYS - WHEN SMUDGED DRIVING LICENCES OR SILHOUETTE PHOTOS MIGHT JUST BE ENOUGH TO IDENTIFY A REALLY PROMISING CLIENT - ARE GONE FOREVER.
Citibank Japan has also been in the news recently for a number of improprieties, including a violation of laws in connection with its duty to identify customers and to report suspicious transactions. The private banking division was deemed to have allowed trans-actions that could be suspected of being associated with money laundering by permitting an account to be opened without proper procedures. As a result, the division had to suspend all new transactions with customers, three senior managers lost their jobs, and a number of other employees were disciplined.
Unusual patterns
Securities finance professionals are held to the same know your customer requirements as deposit banks, and must also look for unusual patterns of trade and the transfer of funds through settlement. Besides the individual traders intuition, the line of defence here is the kind of software programme that specialises in anomaly detection and predictive modelling.
Additionally, the application of anti-money laundering detection techniques is expanding to proximate legal issues, so that front running (see box) for example, is isolated and reported as well. The Proceeds of Crime Act 2002 and the 2003 money laundering regulations have brought EU practices into UK law and increased the number of Suspicious Activity Reports (SAR) submitted to the National Criminal Intelligence Service (NCIS) considerably.
In the equity finance industry, the anti-money laundering effort takes up considerable staff time and energy. It is the subject of the usual sarcastic jokes and horsing around, but it works - according to all estimates, it is now much more difficult to wash money through the financial system than was the case five years ago.
Equity finance personnel from two global custodians, two US broker/dealers and a UK fund management company were all forthcoming and enthusiastic about their respective in-house anti-money laundering programmes. While it is interesting that the sources interviewed spoke only on condition of anonymity, it is surely significant that none suggested that the laws against money laundering were unnecessary. For everyone interviewed, an anti-money laundering exam is a yearly competency requirement. You must take it and you must pass it.
The capital markets division of one of the global custodian banks annually monitors traders and back-office staff by means of an online anti-money laundering study programme and examination. Subjects include the application of the Know Your Customer rule and spotting suspicious transactions. Each test is different, so peeking at the next PC doesn't help. A passing grade (75%) is mandatory and trading privileges are suspended until it is achieved. A password produces a study module that cannot be downloaded or copied, and after that is completed, a second password produces an exam. The second pass-word invalidates the first password, so there is no looking back.
Two traders found that this applies system-wide when one sat at a PC reading the study guide and the other sat at the PC next to him and logged on to take the test generated by that study guide, hoping to follow the open study guide on the machine next to him. As soon as the system recognised the beginning of the test, the study guide on the machine next to it faded from view. The traders, not having read the study guide through, failed the test.
The London office of a US broker dealer uses the same process - study material on the PC, but then its off to an exam room for the written test. A UK fund management company confirmed that its method is much like this, except that online examinations are taken in a different room from the trading area, so there can be no coaching from colleagues. And this test changes questions every 72 hours, so that questions answered incorrectly cannot be mechanically revised for the next test session.
What is Front Running?
Front Running, also called forward trading, is the practice of trading an equity or security issue based on information obtained from either an in-house source or a rumour source, before the public at large has access to the same or similar information. It also occurs when a trader takes a position in a security (equity or fixed income) in advance of an action that they know their firm will take that will move the security’s price in a predictable way prior to that action being made public via the stock exchange. Borrowing securities on rumour, on-lending it at usurious rates, or creating a feeding frenzy among borrowers, are all types of front running. This may be compared to a practice from the 1990s of paying a fee to hold securities or pre-borrowing issues so as to create a false sense of importance towards a particular issue in the market. While this is not precisely a money laundering issue, two of the people interviewed from securities lending desks mentioned it as a closely related issue, covered in their money laundering programmes.
Getting to know you
The Know Your Customer rule is perhaps the most frequent concern for securities lending desks, but trading patterns are relevant, as well (see box). And although patterns of trading may seem to have a greater day-to-day impact on prime broker operations, the Know Your Customer rule is of equal concern, especially in dealing with unregulated hedge fund clients. Hand-books distributed throughout companies make penalties for non-compliance clear: discipline -including summary dismissal - looms for those who fail to scrutinise new clients, to report suspicious transactions, or for those who tip off clients whose identity or activities are under investigation. Criminal penalties are specified, as well.
The specifics of the Know Your Customer rule are exhaustive - not only is identification required, but should the country of origin be one where drug trafficking or production are known to be a problem very great scrutiny of the individual is required before an account can be considered. Similarly, the litany of dubious trading problems is comprehensive using cash or bearer securities, distributing proceeds across a number of jurisdictions, seemingly random trades executed at the account holders request (without concern for trading losses), and so on all these will prompt an SAR.
Shortly after fining the Bank of Scotland 1.25 mil-lion and the Bank of Ireland 375,000 for transgressions against Know Your Customer rules, the FSA issued a progress report ID Defusing the Issue (14 October, 2004) to inform the industry and other stakeholders of current thinking and activity on ID. An FSA working group had decided to make one piece of client identification acceptable in more cases, to rely on electronic verification of identification (voter registration databases, credit checks from other firms, etc). ID may attract an undue proportion of spend on anti-money laundering without commensurate benefit, the executive summary stated, adding that how ID is done may be unduly influenced by perceptions of FSA supervisory and enforcement policies.
Case study: Laxey & British Land
IN Q1 OF 2002, a shareholder of British Land, Laxey Partners (UK), a subsidiary of Laxey Partners Ltd (Isle of Man), began borrowing shares of British Land. Most of the major broker/dealers were contacted, as well as one or two of the bigger, well-known fund managers in London.The purpose of the borrow was not to cover short sales of shares, but to win a voice at the up coming British Land AGM.
Corporate Action
By May of 2002, Laxey had accumulated some 2% of the outstanding shares of British Land, and was looking to have the chairman and CEO, who founded the company, removed in favour of the chairman’s son. A proponent of corporate governance, Laxey said that it wanted the board to be more accountable to the shareholders and that only a professional board of property managers could do this. Such an unusual reason for borrowing shares met with some resistance. British Land asked the Department of Trade and Industry to investigate how Laxey had borrowed securities from Hermes, Scottish Widows and Barclays Global Investors. A spokesman for British Land scoffed at Laxey’s claims to be interested in corporate governance “when they borrowed stock in away that was designed to obfuscate, and severely embarrass some important institutions”. The institutions in turn suggested that borrowing securities to affect boardroom make-up and AGM proposals should be recognised as market abuse. It was further suggested that the government should block borrowed shares from being voted in the future.
The situation of prime brokers is somewhat more complex than banks, because they also scrutinise a constant stream of changing trading patterns for underlying features. All five of the prime broker heads interviewed for this article praised the thoroughness of their anti-money laundering programmes, pointing out that things had been beefed up considerably over the last few years. Scandinavian financial institutions have recently come into even closer compliance with FATF recommendations regarding money laundering and reporting suspicious trading activity, as have the newer members of the EU.
The tight account-opening procedures (including details of sources of funds) of one North American equity services operation entail a detailed description of the trading strategy a prime broker client will follow. The prime broker unit manager undertakes an annual full account review to renew the accounts credit and trading line. Anything out of the ordinary is brought to the attention of the money laundering officer. Some of the trading patterns these traders are trained to look for include random buy and sell orders without regard to trading losses; requests for settlement funds to be paid to another account third party payment especially those located in a tax haven, or indeed anything that deviates from the original strategy. The list continues at other prime brokers: offering bearer securities from dubious jurisdictions, transfer-ring title of investments to unrelated third parties, and churning ordered by the client, or transactions that settle in unusual cities or territories.
As a result of the training, its constant updating and the atmosphere of awareness it engenders, patterns of suspicious activity may pop up unbidden, but they do not go unrecognised. Should a UK trader be pressed by a lender (Buy the rumour! Theres an IPO coming up and everybody is borrowing the stockif you want some, tell me now!), they go to the head of the desk. Typically the desk head decides whether or not to take the matter up to the director of equity finance, who then decides whether or not to go to the money laundering officer, usually a member of the compliance department. A suspicious activity report (SAR) maybe filed, and sent along to the NCIS. Since it is a crime not to report suspicious activities, an initial flurry of SARs threatened to bury the very regulators who required them to be submitted. Getting control of the storm of submitted reports was a problem that required great effort.
Red flags
This spring, a witness told the US Senate Committee on Banking, Housing and Urban Affairs that our government does not currently have the appropriate resources to process and make full use of information that is flowing to it from financial institutions. Earlier, another witness had complained that the information that was sent to the Financial Crimes Enforcement Network (FinCen) of the US Treasury is merely lodged like a book on a library shelf without a card cataloguethe information remains unexploited. Surely we ought to have an artificial intelligence programme that red flags patterns and concerns for investigation.
Ukraine's opposition leader Viktor Yushchenko addresses supporters during a rally in central Kiev on
December 5, 2004 following the widely contested election. Ukraine was only taken off the FATF list
of non-cooperating countries or territories in February 2004.
Discussion of the same problem in the UK began with a BBC report in early March of 2004 that NCIS, already in undated with SARs, was likely to receive double the number this year, up from58,000 (a figure that itself represented a 60%increase over the previous year) to more than100,000. But Nigel Coles, NCIS assistant director, insisted to the Financial Times that the back log had been cleared and a system had been developed to cope with the increased reports. In a speech to an anti-money laundering conference in late April 2004, the FSAs Philip Robinson noted that input into the reform of the SAR regime was highly placed among the FSAs many other activities. He suggested that a risk-based approach (in contrast to a prescriptive approach) would involve financial firms as well as those dealing with SARs in focusing and organising efforts to identify money launderers and laundered money.
In September 2004, the NCIS web site dealt with the SAR mountain in fairly specific terms. Recognising a60% increase in reports from 2002 to 2003, it stated that: NCIS prioritises disclosures on the basis of risk for development and direct dissemination to partner agencies. As a result of its operations, the Inland Revenue had been involved in new cases, information had been disseminated to the National Terrorist Financial Investigation Unit, frauds had been identified and referred to appropriate authorities, drug proceeds had been identified, drugs seized and drug traffickers arrested, and money laundering cases had been initiated, in one case against a previously suspected individual.
Despite this progress, two things are worrying. Firstly, problems still seem to occur in implementation, particularly in the area of building databases and massaging data. A recent complaint by an NCIS officer to an annual Law Society conference that lawyers were submitting too many SARs to protect themselves suggests an over-supply of data, among other things.
Secondly, if there are problems applying the rules against money laundering in countries like the US and the UK, what can be expected of countries that have recently joined the EU? What about those countries that have just been taken off the FATF list of Non-Co-operating Countries and Territories and are only newly signed up to some agreement that commits them to fighting money laundering?
Shadowy forces
For example, Ukraine was only taken off the FATF list of Non-Co-operating Countries or Territories in February 2004. In October The Baltic Times noted that Vilnius Bank as has acquired 90% of Ukranias Agio Bank as part of its strategic plans to expand in the Eastern market, and elsewhere in the same edition that the integrity of Latvias banking system came under question againwith reports that a major US bank has shut down its correspondent accounts with local financial institutions and that a high ranking US official had expressed concerns about the possibility of Latvias banks being used by the shadowy forces that finance global terrorism.
As the industry expands into Eastern Europe and other uncharted waters, this sort of question will increasingly arise. As of July 2004, only the Cook Islands, Indonesia, Burma, Nauru, Nigeria and the Philippines remained on the FATF list of Non-Co-operating Countries and Territories. That seems to leave a lot of clean banks and other institutions in places that have only very recently learned what the FATF regulations are all about.
Finally, what of other unregulated groups, those not yet quite under the rules and regulations of FinCen, NCIS, FATF or their functionaries? Will regulation inG8 countries go beyond antique auctions and jewellery stores? A veteran of hedge funds and prime brokers looked sceptical when asked whether current terrorist threats and concern over money laundering might bounce hedge funds into being regulated, just as September 11 had shunted retail banks into acquiescence with long-resisted anti-money laundering legislation. Hedge funds are going to be regulated whether they want to be or not, he said. Theyll still make money.
A younger colleague agreed. Regulation of hedge funds is necessary, he said. But he added that regulation would mean more paperwork and segregated reports will be necessary to send information to the regulators. And presumably, this means new jobs for staff trainers, money laundering officers and those who write online anti-money laundering packages.
