Module 14: AML/CTF Capital Markets

Transcription

1 Module 14: AML/CTF Capital Markets N.B. The content of this module is non examinable, but provides useful background in terms of the industry sector within which delegates may work. Learning objectives The purpose of this module is to: have an understanding of the capital markets and the mechanics of how they work have an understanding of wholesale verses retail participants and the level of money laundering risk associated have an understanding of the various traded products, their AML/CFT risk, vulnerabilities and considerations recognize the various access points in the markets and delivery channels and their associated risks recognize red flags pertinent to the capital markets industry AML/CTF Capital Markets Malaysia The prevention of Money Laundering and Terrorist Financing in Malaysia is a high priority under the Anti Money Laundering and Terrorist Financing Act (AMLATFA). The Securities Commission of Malaysia (SCA) has laid down Guidelines on the prevention of Money Laundering and Terrorist Financing for Capital Market Intermediaries (15 December 2008) as industry best practice to achieve the objectives of the legislation ( 1. Introduction 1.1. Money laundering and terrorism financing The regulatory framework for anti-money laundering (AML) has been adapted to counter terrorism financing (CTF). This adaptation intensified after the September 11, 2001 bombings in New York and the subsequent London, Bali and Madrid bombings. This module will focus on money laundering and money laundering risk although some of these vulnerabilities are directly translatable to terrorism financing. It is difficult to distinguish terrorist funds from other funds (see section 9 of the Wolfsberg Guidance on the Risk-based Approach). This presents the counterpoint; that it is possible to distinguish proceeds of crime from other funds which is a controversy in itself. The module will refer to AML/CFT and ML/TF but will not specifically address terrorism financing risks or controls in capital markets. The common element between ML and TF is that money is on the move. Illicit funds are used for TF. Licit funds are used for TF. All ML is illicit funds, by definition. 1.2 What is a Capital Market? A capital market is a financial market whereby companies, financial institutions and other entities such as governments can raise long term funding via equity and debt instruments. Funds are raised typically: 313

2 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism on a stock exchange for equity instruments, i.e. issuing shares in a company to raise funds, or over the counter ( OTC ) for example, through the issue of long term debt in the bond markets directly to counterparties and customers. The reference OTC is a reference to the trading desks operated by certain banks and wholesale financial institutions where traders are the connecting point for willing buyers and willing sellers of assets outside the operation of an exchange. These transactions are conducted by telephone not face to face. The choice between an entity raising capital to meet funding requirements via an equity issue or a debt issue is driven by a number of factors including the particular stage of the economic cycle, the current interest rates applicable, the appetite of investors for the type of instrument issued by that type of entity and the credit risk of that entity. Whilst capital markets traditionally incorporated equity and debt instruments, they have evolved to encompass other products such as: derivatives to hedge the risks associated with long term funding. money market instruments to address short term funding requirements. foreign exchange transactions to hedge currency exposures. Apart from being used to access sources of long term funding, many of the products in the capital markets are easily accessible and readily used for investment and trading purposes by both the wholesale and the retail markets i.e. the general public. In the past, capital markets tended to be thought of as wholesale in nature i.e. participants being financial institutions, professional investors and large corporations. Nowadays many of the products are easily accessible to and consequently more accessible to money launderers. The markets are global in nature and with the increasing developments in technology, payment systems, and other direct gateways into the markets, the speed and the relative anonymity that these avenues provide make them an option for money launderers. The securities sector within the capital markets has an additional distinguishing money laundering risk factor in that not only can it can be used to launder illicit funds that result from illegal activity outside of the financial markets but it can also be used to generate illicit funds from the market itself (for example insider trading). 314 In Saudi Arabia, Saudi joint stock companies had their beginnings in the mid 1930 s, when the Arab Automobile company was established as the first joint stock company. By 1975 there were about 14 public companies. The rapid economic expansion, besides the Saudisation of part of the foreign banks capital in the 1970 s led to the establishment of a number of large corporations and joint stock banks. The market remained informal, until the early 1980 s when the government embarked on forming a regulated market for trading together with the required systems. In 1984, a Ministerial Committee composed of the Ministry of Finance and National Economy, Ministry of Commerce and Saudi Arabian Monetary Agency (SAMA) was formed to regulate and develop the market. SAMA was the government body charged with regulating and monitoring market activities until the Capital Market Authority (CMA) was established in July 2003 under the Capital Market Law (CML) by Royal Decree No. (M/30). The CMA is the sole regulator and supervisor of the Saudi capital markets, it issues the required rules and regulations to protect investors and ensure fairness and efficiency in the market, including Anti Money Laundering rules and regulations, which are being covered in more detail in other areas of this Workbook.

3 Module 14: AML/CTF Capital Markets 1.3 Primary and secondary markets The capital markets are divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets provide the opportunity for investors to buy and sell securities subsequent to an IPO 130. The transactions in primary markets are between issuers and investors, while secondary market transactions are traded between investors. Investors in secondary market transactions include financial institutions, professional investors, large corporations, wholesale and retail investors. The products and services traded in the capital markets are commonly called traded products and therefore this term will be used throughout this material to refer to the various capital markets and associated products in general. Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold with a ready flow of demand and supply without having a significant impact on price movements. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount if they need to sell at a particular point in time. Money launderers may tend to transact in liquid securities for the primary reason that volumes are high and therefore ease of detection is much less than illiquid securities where volumes are lower and therefore irregularities (including the need to trade at all) are easier to detect. Making a profit or a loss on a liquid security may be of little concern or secondary to a money launderer as their primary purpose is to legitimize their illicit funds. 1.4 Over the counter (OTC transactions) OTC transactions are financial transactions contracted directly between two counterparties although there can be an intermediary agent such as a broker who arranges the trade. They are also sometimes referred to as off exchange transactions because they are not conducted through a regulated exchange. Typically they are transactions between wholesale participants (discussed below) however this is not always the case in some markets e.g. the foreign exchange market or CFD market which can also be accessible to retail customers. 1.5 Exchange traded (ET transactions) Exchange traded transactions are exactly that they take place on regulated stock, futures and commodity exchanges around the world and the underlying characteristics of the transactions and contracts are pre-established in contrast to OTC transactions which can be tailored between the counterparties. 1.6 Wholesale participants Wholesale markets commonly involve banking institutions and other large corporations providing financial services to other banks and large institutions. Typically a wholesale customer can be defined by a number of factors. This can include the customer s size i.e. its total assets, whether it is licensed and subject to direct regulatory oversight, its level of sophistication in transacting in certain products, the value of the transactions that the customer enters into. Wholesale customers can also be individuals who have a large personal income or wealth and who are considered professional investors An Initial Public Offering (IPO) is the first offering of the sale of shares or other securities in a company to the general public. 315

4 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Many countries have regulations that define or categorise a wholesale customer and/or a professional investor. Often this will include that transactions must be over a certain amount to qualify. This differentiation can be important to financial institutions licensed to provide financial services as depending on the particular regulations of a country, a customer being wholesale versus retail can mean that institutions may need to do less in terms of compliance obligations e.g. disclosures and product suitability. In some countries, if the customer is subject to regulatory oversight e.g. a regulated institution in the E.U, a lesser degree or simplified due diligence maybe required in terms of KYC identification and verification i.e. Know Your Customer rules and regulations. This is because the AML/CFT laws apply equally and directly to the customer who is the regulated institution and they themselves would be required to directly adhere to the AML/CF laws and program requirements of the country. Therefore arguably customers who are regulated institutions could be considered less likely to be a direct money laundering risk as they should have control systems in place to mitigate money laundering risks under their own country laws. While a regulated institution might present a lower level of money laundering risk in a capacity where a transaction is taking place directly between the institution and another wholesale participant, e.g. an OTC interest rate swap, if the regulated institution is acting as an intermediary and there is an underlying customer involved, e.g. brokering a foreign exchange transaction, there could still be potential for money laundering and therefore a greater level of risk. Wholesale customers in the capital markets tend to be thought of as posing less of a money laundering risk, this is a misnomer. Other factors need to be taken into consideration including the type of product and the intrinsic level of AML risk associated with that product; including whether there is an underlying customer and knowledge of that underlying customer, the jurisdiction where the underlying customer is based and the level of ML/TF risk associated with that jurisdiction. These factors at a minimum should form part of a risk assessment that is performed within a capital markets business prior or as part of the process of onboarding a new customer or entering into a new line of business or product with an existing customer. The approach to risk assessments should be built into a regulated organization s AML/CFT program. 1.7 Retail participants Retail customers are customers who are not wholesale. They tend to be individuals, small to medium sized businesses, trusts or partnership type entities. Generally retail participants are not directly regulated by AML/CFT regulations however they may be indirectly subject to AML/CFT account opening requirements for the accounts they use to transact and fund their dealings in capital markets depending on the jurisdiction. Some categories of retail participants however could be directly subject to regulatory requirements depending on the jurisdiction. E.g. Foreign exchange dealers and money service business in many countries are directly subject to AML/CFT laws and regulations of that country and must have AML/CFT programs even though they may not be considered as a wholesale participant under the relevant securities laws of the country in which they are regulated. 316

5 Module 14: AML/CTF Capital Markets Retail participants tend to have a greater level of money laundering risk associated to them in contrast to wholesale customers who usually will have a regulatory status and an established business. Money launderers will avoid licensing obligations and regulatory scrutiny preferring the opacity of private corporations and trusts. 2. Money Laundering and the Capital Markets In the past money launderers typically targeted banks to launder their illicit funds utilising traditional banking products such as wire transfers, cash deposits, cheques and other negotiable instruments to move their funds around and disguise the proceeds of crime. However, the global and highly liquid nature of the capital markets have made traded products an attractive means to launder funds and further disguise the trail and their movement. In addition, due to the high global volume of activity that takes place in the capital markets (both exchange traded and OTC) it becomes far more difficult for irregularities to be detected. Capital markets themselves can also be used to generate illicit funds. 2.1 Stages of money laundering and their characteristics in the capital markets Generically, there are three stages of money laundering, placement, layering and integration as outlined below. These three stages are increasingly difficult to align with modern financial markets and fund movements and have become less useful as an analytical tool in recent times. Proceeds of crime which are generated within the financial system never go through the first stage of placement. Funds laundered via the use of traded products in the capital markets tend to be considered as part of the layering and integration stages. In the placement stage of money laundering, a money launderer has proceeds of cash held in the form of cash which he or she wishes to move into the financial system where the cash is replaced by data. The tainted cash loses its association with the money launderer and therefore its association with the predicate crime that generated the cash. Capital markets do not deal in cash therefore placement risk is not usually associated with the capital markets. In the layering phase, funds are mixed with other funds and asset classes to create confusion and to break the connection with the original proceeds of crime and the original predicate crime. The capital markets are an option for money launderers to use in layering because it involves the acquisition and disposition of traded products within the financial system. The features of the capital markets that are particularly attractive to the criminal fraternity are the ability to move large amounts quickly around the globe to layer the funds/assets and the often liquid nature of the product. Frequent trading activity across country borders in different markets and asset classes is not regarded as unusual within capital markets allowing money launderers to pass undetected. In the integration phase proceeds of crime are integrated back into the activities of the criminals either through re-investment in further criminal enterprises or in assets outside the financial system such as real estate, cars, businesses, leisure and transportation assets. In this third stage, money launderers are easily able to realize their profits or losses made through trading products especially those that are exchange traded. Their illicit funds are finally regarded as clean and then they are integrated back into the money launderer s criminal enterprise and lifestyle via traditional methods. There are now criminal organisations that specialise in offering money laundering services to their criminal peers. For a fee they will undertake any placement work required, and then move funds to nominated destinations to achieve adequate levels of layering. Finally they will assist in the repatriation 317

6 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism of laundered funds for integration. Enforcement issues between criminals raise interesting questions were proceeds of crime to be lost or misappropriated or frozen by a regulator mid-flight. The investment characteristics of the capital markets and traded products allow for rapid and often blurred transfer of ownership. Organizations who offer or broker traded products must maintain robust AML/CFT programs and apply the same level of due diligence and monitoring as that applied to customers engaged in banking and other more traditional financial products. Erroneously capital markets are perceived to be lower risk from a money laundering perspective due to them predominantly being associated with wholesale markets and customers. This is not the case and organizations in capital markets businesses should not apply a lesser standard or think that they are immune from funds being laundered through them. Nothing stops money launderers from being poor investors choosing stocks which they then re-sell because they do not perform to expectation, generating losses in the process but effectively layering funds. Equally nothing stops money launderers from being astute investors and making profits in the process of trading securities or other traded products or from engaging others to make astute investments on their behalf. This is an example of the paradox of money laundering, for every perceived pattern of money laundering behaviour; the opposite is also usually true. The attractiveness of the capital markets is that they present a large number of trading opportunities that get lost among the millions of trades that take place on a daily basis in the world s financial markets. Brokers and other agents trading securities on behalf of money launderers offer a perfect blind to a money launderer. Stock markets can be engaged from overseas countries. Trading is discretionary and easily explainable in most circumstances. Some brokers and agents will facilitate third-party transactions, which are of great value in the layering phase. As transactions move around the globe and into different markets, sectors, jurisdictions, the sheer rapidity and changing asset structures creates a lack of transparency that facilitates layering. The constant question that must be asked at all times is whether the transaction makes sense and whether the transaction makes sense for the customers and counterparties involved. The answer to these two questions may be difficult to ascertain as an organisation may only operate in one specific financial area and consequently only be exposed to one leg or part of a transaction, but that still requires sensible questions to be asked to understand the overall picture of the activity. 3. Different traded products and assessment of ML/TF risk Traded products come in many different forms equities, bonds, derivatives, futures, options, currencies, funds, notes and so on. They are typically divided into markets as follows: Bond Markets (refer section 5) Stock Markets Money Markets Derivatives Markets Foreign Exchange Markets Commodities Markets 318

7 Module 14: AML/CTF Capital Markets Some features of traded products might prove more attractive to money launderers e.g. a tradable equity verses a long term bond and they may use a combination of traded products to launder funds. The likelihood of going undetected will be a major influence on trading decisions made by money launderers. Equally, having succeeded with prior transactions will also be a factor as criminals are creatures of habit, just like people engaging in legitimate transactions. Money launderers will often consider other factors e.g. utilizing a broker who is known to have weak AML controls, using online facilities to provide a level of anonymity, selecting highly liquid products which are traded constantly and can be without apparent reason, transacting in jurisdictions with a weak AML/ CFT regulatory environment. Money launderers will also establish close relationships with brokers and other client relationship managers who benefit from their business, in order to smooth the pathways for their laundering activities. 4. Risk based approach To adequately mitigate money laundering risk in capital markets an organisation must adopt a risk based approach and a methodology to determine a holistic view of the level of risk posed. Organisations should avoid a silo approach through assessing the relationship between risks. For example, does a product considered low risk present a higher risk if traded with a customer in a high risk jurisdiction? Does a high ML/TF risk product traded by a Fortune 500 company present an overall lower level of risk? The following risks are examples of the ML/TF risks that should be considered: The type of traded product understanding the intrinsic risk factors associated with a certain product type, e.g. its level of liquidity and volume, is it a product typically restricted to the wholesale market verses retail? Is the product one that is easily tradable or one that would lock a money launderer in for a longer period of time e.g. a 10 year bond? Are the financial risks that the product addresses relevant to the client? The type of client. This doesn t mean just determining whether the client is wholesale or retail, but going a further step and understanding what type of wholesale client a client is e.g. a fortune 500 company or a sophisticated high net worth individual; or if the client is retail are they a private trust with little known information about the beneficiaries or are they a regular investor well known to the organization with a transparent structure. The jurisdiction of the client e.g. whether the client is domiciled or incorporated in a country where there are AML/CFT requirements that have been independently assessed as meeting international standards or is the client registered in a jurisdiction that is known to have an inadequate AML/ CFT environment e.g. the British Virgin Islands or Panama. Similar questions might arise regarding the reputation of certain countries for associations with terrorism or handling funds from countries with associations with terrorism. The delivery channel/market access point e.g.is the transaction occurring through an omnibus account where the underlying client maybe anonymous or is the transaction an OTC transaction occurring directly with a counterparty being settled on a recognized exchange. Has the transaction been presented through some form of intermediary which acts as a blind for the client? 319

8 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism All of these factors in conjunction must be taken into account in order for appropriate controls to be established to mitigate the likelihood of an organisation being used as a conduit for money laundering. It is a challenge to be able to combine all these factors into a coherent single view of ML/TF risk by customer or by transaction. Product functionality will also work for and against the utility of the product for money laundering or terrorism financing. Each of the capital markets, the various traded products and their specific money laundering (ML/TF) risks and vulnerabilities are discussed in further detail throughout the following sections. The regulations of the Capital Markets Authority and the Saudi Arabian Companies laws do not allow the issue of bearer shares by companies incorporated and operating in Saudi Arabia. Certainly, any company shares traded on Tadawul, the Saudi Stock Market, must be registered with the Central Depository System of the stock exchange, as are the names of each person(s) holding the shares. 5. Bond Markets Issuers of bonds primarily use decentralised OTC markets to raise funds to finance their capital needs. This can include funds to finance the entity to fund acquisitions, construction of property, infrastructure (bridges, dams, etc.) or other working assets needed e.g. aeroplanes, trains, ships, telephone etc. Bonds are issued by an issuer which may be a government, a corporate entity, a financial institution, a municipality or local authority and various other vehicles that are used as debt raising entities. Bonds issued by governments are known as sovereign bonds or sovereign debt. Bonds issued by corporates, financial institutions and other non-government entities are known as corporate bonds. While the bond markets are primarily OTC, some bonds are listed and traded on exchanges. Due to the nature of the bond markets, the ML/TF risk of bonds could be considered lower in comparison with other markets such as the equity markets. Bond offerings tend to be transparent, participants are predominantly wholesale, transactions tend to have long tenures in terms of years and the markets are less liquid in comparison with other traded products e.g. equities and foreign exchange. 5.1 Role of the Bond Market The bond market is not a formally regulated exchange, but is governed via associations, for example, the Bond Market Association (BMA), the Association of International Bond Dealers (AIBD), and the ISDA (International Swap Dealers Association). The bond market is also subject to regulatory oversight of the specific jurisdictions. An entity can access the bond markets via a bond issue and it can return to the market as many times as it likes with further issues. While some electronic bond trading is available to retail investors, the bond market remains very much an OTC market, on the basis that there is seldom a continuous two way market and so therefore lacks price transparency 131 and liquidity What is a bond A bond is a security that represents an issue of debt by a company, a government, a local council/authority/municipality etc. This issue of debt will often have an interest Price transparency is the availability of all the bid and ask prices for a traded product at any point in time In the context of a security a high level of trading activity allowing buying and selling with relative ease.

9 Module 14: AML/CTF Capital Markets rate of return built into the security, as well as a defined return on maturity. The interest element is referred to as the coupon and is paid by the issuer at pre-determined intervals. The rate of interest is known to the holder of the bond which is agreed upfront. This is why bonds are often called fixed income instruments. Bonds may be issued in either registered or bearer forms Registered bonds Registered bonds are recorded with the issuer, so interest and principal payments can be disbursed automatically. Most bonds issued in recent years are registered and ownership is tracked electronically via registers held by the appointed clearing house Bearer bonds Bearer bonds are issued as paper and are payable to the bearer/holder of the instrument consequently its ownership is not recorded with the issuer. For the holder of a bearer bond to receive the interest (or at repayment time, the principal payment), a paper coupon attached to the bond for that interest payment date must be removed from the bond and submitted to the issuer for payment. Bonds used to be issued as beautifully illustrated certificates (to stop forgery) with coupons attached that were torn off upon collection of the interest payable (almost like a receipt). The issue of bearer bonds by governments, corporations and other entities has dramatically reduced in the last 30 years. ML/TF risks consideration and vulnerabilities Bearer bonds carry a significant risk in respect to theft, fraud and money laundering and are of greater risk for financial crime. They were very much a method of choice for money launderers and were valuable documents as ownership could be passed from hand to hand with little control or knowledge of who the owner was. However they are extremely uncommon in the wholesale capital markets these days and with the advent of clearing houses and electronic tracking few bonds these days are issued in bearer form. 5.3 How is a bond issued? Bonds are issued to investors by originators who will specialise in ensuring that the issuer obtains the level of funding they require at the interest rate they are willing to pay (what the market will bear). Originators are typically larger banks who provide the structure for the bond to be issued and arrange for the bonds to be initially purchased in the primary market. They are also responsible for the pricing of the issue. This originator may syndicate (share) the issue with other large financial institutions to underwrite and assist in the distribution and sale of the shares directly to investors. The initial participation by syndicated financial institutions comes with risk as the price at which they agree to underwrite may not reflect the risk that the markets as a whole perceives of the issuer and therefore the issue may appear mispriced. An example of this was seen in the Eurozone in 2011 when Greek bonds (debt) could not be sold, as investor s appetite to purchase them at the rate of return offered was not commensurate with the investor s perceived risk of default by the issuers, leaving the underwriters with the debt to manage on their balance sheet. 5.4 Bond Ratings Whilst not necessarily relevant from an AML/CFT perspective it is worth providing some background in regards to bond ratings and the underlying credit risk of the performance of a bond instrument and the returns it generates Refer section 14 for more information on clearing houses 321

10 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Bonds are often rated by ratings agencies (i.e. Moody s, Standard & Poor s, and Fitch). A bond rating is based on the agency s opinion of the risk and likelihood of default of that particular bond, be it issued by a government, a corporate or any other issuer. The rating opinion is generated by the rating agency which takes into account and considers as many risks as possible that might affect the issuer including but not limited to: the economic global risk, the government policy upon that particular issuer s industry in its main operating jurisdictions, the products it offers, its financial stability now and projected forward, any security offered, the ability of the issuer s management. ML/TF risk is not considered by the rating agencies. The ratings scale used by different agencies is broadly the same. For example, using Standard & Poor s rating system: AAA and AA: High credit-quality investment grade AA and BBB: Medium credit-quality investment grade BB, B, CCC, CC, C: Low credit-quality (non-investment grade), or junk bonds D: Bonds in default for non-payment of principal and/or interest The ratings discussed above relate to the credit risk of an organisation and the debt they may issue. It does NOT relate to the ML/TF risk of that organisation. There are NO standard market ML/TF risk ratings. The determination of ML/TF risk via a risk assessment methodology and/ or risk rating of a customer or issuer must be performed by the organisation conducting business with that customer. Organisations adopting a risk based approach may choose to take into account credit risk ratings as a factor relevant to its ML/TF risks, however that is entirely down to the risk appetite and risk methodology approach of the organisation. Bonds rated BBB- or less are known as junk bonds. Junk bonds were once a popular method for launderers to clean illicit funds although probably less so in more recent times as other traded products are more readily accessible. Junk bonds tend to be illiquid and loss making and therefore organisations should be alert to customers wishing to invest in illiquid bonds with a poor investment grade and make enquiries to understand their business rationale. 5.5 Secondary trading in the bond market Once an issue has been floated, the bonds can be traded on the secondary market. In secondary markets, existing securities are bought and sold among investors or traders usually on an OTC basis. There are new exchanges being launched that provide exchange quoted bonds, but these are still in their infancy and do not yet have any significant market share. They will work in a similar fashion to the equity exchanges. 322 The US is currently the largest market for bond sales and the volume of issues dwarfs that of the US stock market (in terms of face value) by a ratio of almost five to one in the primary market. However it should be noted that the secondary stock market volume by face value is much greater than that of the secondary bond market volume (in other words, the frequency of trading stocks is much greater than for bonds).

11 Module 14: AML/CTF Capital Markets Generally, at the start of secondary trading, the participants (notably the sellers) are professional participants (i.e. investment banks) selling to professional investors, and therefore ML/TF risks are generally low. It is likely that significant parts of the secondary sales will be held by long term investors (pension funds etc.) leaving only a smaller participation available for continued secondary sales. As the secondary trades start to get broken into smaller saleable amounts, smaller brokers, investors and traders become involved occasionally from outside the mainstream investment fraternity. This is typically when the money launderer can become involved, as the rapid movement of the asset across the global financial sector is a useful means of changing between assets classes, thereby allowing the regulated brokers, investment houses (either as buyers or sellers) to become unknowingly used for money laundering purposes. Transactions may also be part of a multiple transaction with different brokers used in order to further hide the origin of funds and the total sums being laundered. The Capital Markets Authority (CMA) in Saudi regulates the issue and trading of various different types of stock market instruments, including shares, sukuk and bonds, EFT s (Exchange Traded Funds) and Mutual Funds, and the main exchange for the trading of these instruments in Tadawul, the official Saudi Stock Market. Tadawul, as part of its role in facilitating the introduction of new services and products, has developed a new electronic market for trading Sukuk and Bonds. The Sukuk and Bonds Market is a market where participants (investors & issuers) are able to trade investment securities that have a periodic returns and lower risk than equity investment. Sukuk and Bonds are considered important channel for governments, companies, and institutions to provide the necessary liquidity to finance its projects at relatively low cost. In addition, the Sukuk and Bonds market will enable investors to diversify their investments and provide financial protection for their portfolios with lower risk tools which ensure a safe and periodic return for the investor. 6. Stock markets 6.1 What is a stock exchange? Most countries in the world have a primary stock exchange (or main market) that lists various local and/or international companies and facilitates the trading of their shares on. The larger economies, (economies with a significant financial sector) and other countries have additional exchanges (or markets) that cater for special or specific needs for example, technology stocks, and the small capitalisation exchanges for companies that are not large enough to meet the full listing requirements on the primary exchange. Examples of these are NASDAQ in the US, and the Alternative Investment Market (AIM) in the UK. All stock exchanges are regulated and participants including those that list their shares and members who transact on the exchange are subject to rules and regulations of the exchanges. Separately AML/CFT laws, rules and regulations are also applied where they have been enacted in a country s legislation. 323

12 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism 6.2 Equities/Stocks/Shares The terms equities, stocks and shares can be used interchangeable but basically are all one and the same. We will use the term shares to refer to equities, stocks and shares. An equity investment generally refers to the buying and holding of shares of a company on a stock market in anticipation of income from dividends and capital gains as the value of the investors shares rise. As with bonds, computer based registers record ownership of shares traded on a stock market and therefore they do not physically change hands in any form. There are major registers in most countries for both bonds and shares. The most common type of share is the ordinary share which essentially means that each share issued carries one vote at the time of any shareholder voting. Although the different categories or types of shares issued by an entity may be traded upon an Exchange (ordinary or preference shares, for example), there is one type of share that is never traded on exchanges and that is the bearer share Bearer shares A bearer share is an OTC security represented by a physical certificate that describes the ownership of a part of an entity, which can be passed from hand to hand and not recorded anywhere (including within the issuing organisation s own share register). By its nature it is not traded on a regulated stock market. Instead bearer shares will only relate to non-listed companies and only where the country incorporating the company permits the issue of bearer shares. 134 Historically bearer shares were the main form of corporate ownership where the owner did not have to rely on any other paper records to verify ownership other than being in possession (the bearer) of the physical share certificate. They were considered an efficient means to evidence a share in a company given that prior to the advent of technology and the internet, record keeping of corporate ownership was very challenging. Bearer shares were also easily transferable being high liquid and almost treated like cash. Nowadays however, with the advent of technology and more importantly the pressures brought to bear by regulators due to ML/TF concerns, bearer shares are much less prevalent. Some regulators have cracked down on issuance altogether e.g. the U.S. have banned the issuance of bearer shares and require that all stock ownership and changes be recorded. AML/CTF risks and vulnerabilities It is rare for bearer shares to appear within the capital markets sector. The appearance of bearer shares is an immediate flag calling for further due diligence While there are legitimate uses for bearer shares, the high level of anonymity of such shares provides opportunities for misuse. Bearer shares can be used to hide ownership of assets to avoid financial responsibilities, such as court judgments in favour of creditors, spousal or child support payments, or to hide ownership of assets from tax authorities. Bearer shares are also extremely attractive to money launderers as they present total anonymity and can be used both to finance illegal activity and to use as a means to launder funds. They can be used in all 3 stages of money laundering i.e. Placement, Layering and Integration, in contrast to exchange traded shares which typically money launderers use in the Layering process Bearer shares are seen by the FATF as an obstacle to transparency see Interpretative Note 24 section D paragraph 14.

13 Module 14: AML/CTF Capital Markets Despite bearer shares being less prevalent in recent years, some countries continue to offer bearer share ownership e.g. Panama, British Virgin Islands, Switzerland. These countries can be attractive to money launderers as it is very easy to establish multiple entity structures such as a series of trust companies with ownership evidenced by the issuance of bearer shares (or bond certificates). These structures in effect layer and/or provide anonymity of ownership and provide for an ideal means for a money launderer to conduct their business. Given the difficulty in identifying the persons who own or control bearer share companies, organizations should have policies and procedures in place to determine the course of action when a prospective customer is identified as one who may partly or in entirety have a bearer share-holding structure. This is typically identifiable and documented in a customer s constitution or articles of incorporation, which are usually examined as part of the customer due diligence process. These policies and procedures may include subjecting the customer to enhanced due diligence and understanding the relevance of why the customer issues bearer shares, ensuring appropriate senior management focus and customer approval or declining to do business with the bearer share company. 6.3 What is the basis for the issuances of equities/stocks/shares? A company wishing to raise funds for its business can offer its own shares for sale via an Initial Public Offering (IPO) (also known as going public ). The company will list itself on a stock exchange by complying with its listing rules. This is also known as the flotation (or float). The legal or originating entity (i.e. the company) is called the issuer or the listed company. Once a company is listed, it is able to issue additional common shares via a secondary offering or rights issue, whereby existing shareholders are offered the opportunity to buy additional shares, thereby again providing itself with capital for expansion without incurring any debt. This ability to raise large amounts of capital quickly from the market is a key reason many companies seek to go public. Global companies are now not only listed on their own domestic market exchange but may also be listed on other overseas exchanges. This is mainly driven by the desire to increase liquidity and to meet the increasing global demand for their shares. When a company issues shares, the investor funds are paid directly to the company. Subsequently the shares of that company can be traded in the secondary market via the stock exchange whereby funds move between the investors as they buy and sell the shares. The secondary market, i.e. the stock market is probably the most attractive of all of the capital markets to money launderers and terrorism financiers. It has a global reach. The global volume of transactions conducted daily on exchanges is significant. Money launderers and terrorism financiers can rapidly enter and exit the markets layering their transactions to avoid detection of the movement of illicit funds. 6.4 Listing methods A company can freely elect its own issue method and such an issue can be made in a number of ways to enable the shares to be listed, such as: An offer for subscription An offer for sale, or A placing/selective marketing. 325

14 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism The method used is usually determined by the country of issue and what is most efficient for that market e.g. the UK government used offers for subscription when certain state owned entities were privatised, but since then the most common issue is via an IPO by the company itself An offer of subscription This occurs when a company issues new shares directly to the public for shares that will be listed on an exchange. To be listed on an exchange an offer may require the support of one or more financial institutions in order to ensure that the shares are listed at a specific price a price at which the company is willing to accept for the sale all or part of its share capital. These financial institutions may use their own balance sheet to buy the shares on issue for the date of listing (first day of trading of the Initial Public Offering) and this process is called underwriting or placement. The underwriters (often a syndicate) are paid a commission for this role and for the risk that they take. If the shares are mispriced they can be left holding a significant number of shares at less than they paid for them and they will need to wait until the share price rises sufficiently upon that market before they can sell and therefore recoup their costs. For the underwriters to participate in these types of transactions they require significant capital funds on their balance sheet to cover the risk that a failure to sell all of the issue to clients means that they will need to purchase any unsold shares. Hence large issues require large balance sheets. As a result the typical underwriter is an investment bank, a commercial bank or a specialist underwriting firm. Each of these will need to take a credit risk on the issuer. Those who acquire shares in new issues of shares may be using proceeds of crime to fund the acquisition or may be creating an asset to be used for the financing of terrorism. All of the standard AML/CFT controls should be applied to those who acquire shares from regulated financial institutions on regulated markets. An offer of shares in a company which is based on fraud regarding its business, profits, expected revenues, market forecasts etc. is a way that criminals might generate proceeds of crime from within capital markets, and then need to launder the resulting proceeds. Underwriters expose themselves to reputation risk as they put at stake their own reputation that the issuer is not involved in any illicit activity associated with a mispriced float. So in addition and often as part of the credit due diligence process, the underwriter should carry out detailed and in depth AML/CFT due diligence on the principals behind the company. The type of industry of the issuer should be a factor in the level of due diligence performed e.g. a float of a company associated with a higher risk industry such as a gaming institution or the float of a company located in a higher risk jurisdiction could pose a greater level of reputation risk if the company has been involved or associated with any illicit activity An offer for sale This is when a company appoints an issuing house (or an investment bank) to deal with the public on its behalf. The issuing house advertises the security, obtains acceptance from the public, processes and allots shares and then sends the money to the company after the deduction of a fee. 326

15 Module 14: AML/CTF Capital Markets An offer for sale need not revolve around the issue of new securities; it can equally be used by a large shareholder selling a significant stake in the issuer onto the market place (bearing in mind that these shares are listed). The same ML/TF risks and reputation risks apply as for an issuing house as for an underwriter and the appropriate level of customer due diligence on the principals behind the company should be undertaken Placing or selective marketing This can often be the cheapest route open to a company which wants to raise cash via a sale of shares in itself. Under a placing, the company arranges for a particular broker to sell the shareholding to the market or to its own client base at the best prices it can achieve. The same reputation risks apply as in an offer for an IPO subscription and the appropriate level of due diligence on the principals behind the company should be undertaken. 6.5 Post listing Once listed shares are freely tradable (subject to the relevant stock exchanges rules and regulations) the trading that occurs after the IPO is known as trading on the secondary market. From this point on, the value of the shares in a company that are offered on the stock exchange is driven by the success of the company and also by market sentiment. Consequently the value of the shares can rise and fall rapidly depending on that sentiment. To facilitate the process of secondary buying and selling, there are stockbrokers or broker/dealers who are licensed to access the stock exchange and buy and sell shares to or on behalf of others. The clients of stockbrokers/broker dealers can include other market participants (members of the same stock exchange), traders (those organisations that will trade such shares with a view to short or long term profit such as proprietary traders, hedge funds, day traders, algorithmic traders etc.) or other investors (such as individuals, pension funds etc.). At the start of secondary trading for a newly issued share and then ongoing, there can be a mix of wholesale and retail participants including money launderers and terrorism financiers. The initial volume of turnover can be particular high once the float has been launched especially if the IPO has attracted significant publicity and market attention and therefore money launderers and terrorism financiers buying and selling as part of the general public are more likely to avoid detection in contrast to normal trading activity. The price movement of the stock on a float can be erratic as investors and traders wanting make a quick profit jump in and out of the market. Money launderers not concerned with making a profit or a loss so much as legitimizing funds through rapid transactions completing the layering process. They are less likely to be detected by market surveillance mechanisms where there is less stability in price movements. Money launderers can easily place orders for multiple transactions using different brokers and different corporate entities and trusts in order to further hide the origin and total sums being laundered. 327

16 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism 6.6 Who regulates the trading? The equity markets are, in most jurisdictions, heavily regulated by that country s financial regulator(s). This regulatory oversight usually covers both exchange activities and any secondary activities in those listed shares whether they are traded on exchange or OTC. The regulations are designed for a number of purposes, including but not limited to: ensuring the integrity of the exchange, maintaining the integrity of the financial sector in that country, protecting market participants (especially retail investors) and managing systemic risks. The exchange traded markets have surveillance systems and mechanisms that use a combination of technology and surveillance teams to look for and detect anomalies in transactions conducted on the exchange. Whilst not specifically designed to detect money laundering, they are designed to detect activities that might be a result of market manipulation or insider trading which are predicate offences to money laundering. They are useful tools but on their own, insufficient to detect indicators of money laundering. Predicate offences in the securities markets are discussed in further detail below. 7. Additional AML risks and vulnerabilities in the bond and stock markets The exchanges upon which equities are traded are regulated and the members are regulated entities, however customers upon whose behalf they transact are often not regulated. It is easy for criminal organisations to hide in plain sight with other nonregulated customers. Trading in listed equities is rapid in execution and this speed of transfer of ownership of shares together with the ease of access to global exchanges increases overall money laundering and terrorism financing risks. Arguably most exchanges are well regulated and suitably transparent. Organisations contemplating becoming a member of an exchange should consider conducting a risk assessment and/or due diligence to ensure that the exchange (particularly if located in a higher risk jurisdiction) is able to be relied upon to assess and identify any beneficial owners prior to the listing of a company on that exchange; and to ensure that any significant shareholders in a listed company that is not fully floated are properly identified and known. Exchanges generally impose limits and rules regarding large transfers of securities between counterparties and this often has the effect of reducing the risk of largescale money laundering as it invites greater scrutiny from the regulators where large transfers occur. It is usually fairly straightforward to ascertain the client relationship between two direct counterparties to an OTC bond trade. This can be less straightforward where there is an underlying customer e.g. where there is a broker or other organisation acting as an intermediary. The factors that are relevant for organisations to consider and identify in assessing money laundering risk include: 328

17 Module 14: AML/CTF Capital Markets the differing parties to each transaction the part that they play, (i.e. seller, intermediary, purchaser?) how the money or assets pass between the entities, the rationale for such trades to take place and the source of funds. The inherent risk of accepting orders and payments from a different jurisdiction may be reduced by the understanding of the reason for the trades. An example being that a client in a high risk jurisdiction could be legitimately trading a commodity derivative purely to hedge their own production of that commodity. An organisation acting on behalf of a customer in capital markets should, amongst other things, understand the customer s profile which could include understanding the customer s investment strategy and the rationale for that strategy, or at the very least understanding the customer s source of funds or wealth e.g. what do they do to produce their income or wealth. Absent this information, an organisation cannot know enough about their customer to understand the money laundering risk they represent. Usually, transactions are settled in the wholesale market without the involvement of cash or the intervention of any third parties, which has the potential to reduce certain money laundering risks. Consequently, organisations participating in activities on-exchange are not exposed directly to the initial placement element of money laundering. The greater money laundering risk is that of the ability to change assets rapidly and in different jurisdictions all within a short timeframe. In addition, with many brokers vying for business and potentially being used in any part of the laundering process, the ability to disguise the ultimate origin of the funds is made easy. For a broker, they will need to carry out the requisite checks upon both their client and the market participant to whom they will settle the trade. It is likely that the latter will be regulated from which they can take some level of assurance that the market participant is legitimate and compliant with regulatory requirements. Given the sheer volume of trades occurring daily around the globe, money launderers trading in volumes which are insignificant against daily totals within any one organisation can operate safely in plain sight. 8. Stock markets and bond markets predicate offences to money laundering The stock market i.e. the securities industry has a distinguishing factor from a money laundering perspective compared to the bond markets. Not only can it be used to launder illicit funds that result from illegal activity outside of the financial markets but it can also be used to generate illicit funds from the market itself. The following fraudulent activities are illegal in most countries and are can be considered predicate offences 135 to money laundering: 8.1 Insider trading Insider trading is an activity where an individual buys or sells securities of an issuer based on information that is material but also not public i.e. the information is not known to the general public and if it were known it would have an impact on the price of the security The definition of a predicate offence varies by jurisdiction. In summary it is a criminal offence that leads to another criminal offence. 329

18 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism An example of insider trading could be where an executive of ABC Ltd has insider knowledge of a pending merger that is not known to the general public and decides to buy shares of ABC Ltd on a stock exchange knowing that when the information is made public the share price will raise and therefore on selling the stock the executive will make a profit. The proceeds of insider trading are considered proceeds of crime and therefore individuals engaged in insider trading are liable to be prosecuted not only for the illegal insider trading act (the predicate offence) but also for committing a money laundering offence with the profits that they make. 8.2 Market manipulation Market manipulation is a deliberate attempt or act to interfere with the free and fair operation of a market to artificially change the price of a security, bond, commodity or currency, or to artificially influence movement in a market in order to make a profit. In most countries this is an illegal activity whereby any profits made as a result are considered proceeds of crime and therefore dealing in those profits is money laundering. An example could be wash selling, in which an investor both sells then quickly re-buys the same security, hoping to create the impression of increased trading volume, and therefore raise the price. 8.3 Churning Churning is where a broker executes buy and sell trades for a client account in order to generate commission from the account; or where the broker funnels investment funds into products which may be unsuitable to the client. Churning is in violation of securities laws in many countries as it is unethical and a malpractice that is unlikely to be in the customer s best interest. It can also have the effect of manipulating the market and artificially changing the price of a security or other financial instrument. Dealing in any money made from churning is money laundering. 8.4 Pump and dump schemes Pump and dump schemes are another form of market manipulation whereby the price of a security is artificially raised ( pumped ) by publicly promoting a company s stock with false or misleading information about that company. Often this is in parallel with engaging in purchasing stocks of that company along with convincing unwitting investors to buy the stocks. The end result is to influence the market and raise the price of the securities. The stocks held by those artificially raising the stock value are then sold ( dumped ) at a profit. Whilst the term scheme is used, it should not be considered as an activity that is conducted in isolation by shady characters. This activity is thought to be pervasive in the global financial markets and conducted alongside legitimate business activities. It is an activity that can be hard to detect. Regulators are clamping down on this activity in many countries and increasing investigation and surveillance efforts especially where they can see trends where the underlying security was low priced, illiquid, and trading with little volume and a sudden spike in activity occurs thus leading to a suspicion of market manipulation. Market manipulation is a criminal offence as well as a predicate offence to money laundering. 330

19 Module 14: AML/CTF Capital Markets 8.5 Boiler rooms 136 Boiler room scams or boiler houses are operations whose objectives are to sell nonexistent shares or bonds directly to members of the public on the basis that the value of the shares or bonds will rise rapidly and those holding the real shares and bonds (including the criminals operating the boiler rooms) would achieve significant returns. They often enlist illicit actors and prey on the greedy but vulnerable, via telephone calls. They are often domiciled in a different jurisdiction to that of the purchaser therefore making investigation and prosecution of the offenders challenging. Since the regulators in certain jurisdictions have much broader powers, boiler rooms are now rarely located in the US or UK but are known to operate from Spain, Argentina, South Africa and Nigeria and other jurisdictions. They are fraudulent and the scams often use trading names similar to recognised and properly regulated brokers or other organizations and they obtain funds from investors by deception and lies. 8.6 Ponzi schemes Ponzi schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. They entice investors by offering high returns on their money and the schemes rely on the ongoing flow of investment funds from new investors to pay previous investors the returns promised on their money. Ponzi schemes rarely last indefinitely and collapse either because funds have dried up or the scheme has come to the attention of authorities. They are fraudulent schemes and therefore profits made from the operation of the schemes are considered proceeds of crime and therefore a predicate offence to money laundering. Probably the most notable modern day Ponzi scheme was that run by Bernard Madoff, the former NASDAQ chairman. Madoff founded a Wall Street firm that ran a 20 year US$50 million dollar Ponzi scheme. He was arrested and in 2009 was sentenced to 150 years imprisonment. Case Example: Case Study The Capital Market Authority, or CMA (Saudi Arabia) The market regulator, said Sunday it fined the chief executive of Saudi Dairy and Foodstuff Co or Sadafco, 50,000 Saudi riyals ($13,333) for violating the bourse rules. The CMA said in a statement posted on the Saudi bourse website that Sadafo s CEO revealed insider information about the rise of the firm s net profit in the first quarter last year. Over the past six months, the oil-rich kingdom s market regulator has asserted more control over the stock market, the Persian Gulf s best performer this year so far, in an effort to stamp out manipulative and speculative trading so to attract more stable institutional and foreign investors. The CMA issued its first prison sentence in August, locking up the former chairman of Bishah Agricultural Development Co for three months, and fined Prince Ahmed bin Khaled Al Saud, the chairman of Saudi Chemical Co, for disclosure violations in October. The Tadawul, as Riyadh s stock exchange is known, has long been closed off to the rest of the world through stringent foreign investment rules and has remained dominated by local investors who account for almost 90% of trading volumes. Listed companies in Saudi are worth about $319 billion, almost as much as the rest of the Gulf markets combined Boiler rooms are so called as scammers would often hire a cheap space within premises often located alongside an actual room that house the boilers for the premises. This often enabled them to obtain a prestigious address at a lower cost) 331

20 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism 9. Money Markets 9.1 Money Market Instruments What is a money market instrument? The normal definition of a money market instrument is that of any debt instrument with a maturity term of less than one year. However, as the financial sector has grown in complexity and globally, longer dated instruments can also be considered under certain circumstances as money market instruments. Typical money market instruments are usually offered at a discount to their face value rather than carrying a coupon. However, some securities with a maturity term of over one year pay annual coupons. The difference between a money market instrument and a bond is that bonds have longer terms and tend to be used to raise funds to finance an organisation s long term financial needs, for example to raise funds for building projects or a major business restructure. Money market instruments are normally used to meet short term funding needs e.g. funds needed to pay suppliers or meet payroll needs. They are also often used for investment purposes to get a short term return on money where a number of the money market instruments may offer a better rate of interest than a typical bank deposit rate. They are also attractive because they are liquid and investors can take their money out quickly. Additionally they provide a good place to park excess cash that might be needed in the shorter term for other things but can be earning a better rate of interest in the interim rather than leaving the funds in the bank How does the money market trade? One of the main differences between the money market and the stock market is that most money market instruments trade in very high denominations. This generally limits access for the individual investor and therefore for many money launderers. Furthermore, the money market is a dealer market, which means that organisations buy and sell instruments for their own accounts and at their own risk. They do not represent clients when trading in the money market and all transactions are on their own account. Participants tend to be financial institutions and corporate treasuries who are either managing their short term funding needs, hedging interest rate risk or are proprietary trading, buying and selling instruments to take advantage of price movements in a liquid market. Money markets lack a central trading floor or exchange. Deals are transacted over the telephone or through electronic systems often using intermediaries (brokers). Instruments issued in the money markets tend to be of a primary nature. That is they are bought directly from the issuer. There is limited liquidity and so secondary trading is relatively uncommon in comparison to other traded products What are the different types of money market instruments? Money market deposits: the simplest of all money market instruments is deposits themselves. In the deposit market (outside the money market) banks receive deposits either from retail clients, from their corporate clients or from other banks. These deposits are then used to on-lend to other clients or other banks (the latter being called the interbank market) in the money market. The market is global in nature and is also very liquid with funds being place on deposit with maturity terms from overnight out to one year. Hence the term the short term money market. 332

21 Module 14: AML/CTF Capital Markets Treasury bills ( T-Bills ) are issued by governments and are a promise to repay (a promissory note) a specific sum of money at a specified date in the future. The term of these T Bills is decided by the issuing government and is driven by their own debt requirements or as an instrument of monetary policy. The difference between T-Bills and government bonds are that treasury bills are a short term instrument with maturities usually less than 1 year. They are issued at a discount to the face value and they do not pay interest prior to maturity. Bonds are longer dated instruments that pay interest ( coupon ) at predetermine intervals throughout the tenure of the bond. They are issued by governments into the primary market and can be traded in the secondary market. however due to their short term nature it is more common for holders to retain them to maturity. T-bills as with Government bonds are considered to be a safer investment option as they are securitised by sovereign governments. Bank Bills have the same characteristics as T-bill however they are issued by banks Their degree of security and credit rating will vary depending on the issuing banks creditworthiness however they are typically considered a safer investment than CD s or CP. Certificates of deposit ( CDs ) have the same characteristics to T- bills and bank bills however they usually issued by financial institutions other than banks and are afforded a lower credit rating and degree of security in comparison. Commercial paper ( CP ) has the same characteristics as T-Bills, bank bills and CD s however they are issued by a commercial entity e.g. a large corporate, in general they have a similar degree of security to that of a CD however their credit worthiness will also depend on the issuer. Bills of exchange are instruments that are drawn and issued by the seller of goods to the buyer, specifying an amount to be paid, either immediately, or at some particular date in the future. Once the bill has been accepted by the buyer (by stamping and signing the reverse), the bearer of the bill is entitled to the proceeds at maturity. The accepted bill may then be discounted in the money market provided the purchaser is willing to take on the credit risk of the bill s acceptor, which is the promise of repayment. A bank may add its acceptance to a bill. This service to their clients is effectively a guarantee of the repayment. In certain countries, a condition imposed on such a trade bill is that it must have an underlying commercial substance which does reduce money laundering risk. Money market repurchase agreements ( repos ) are a form of overnight borrowing against securities and are very common for government securities. A holder of securities sells the securities to a lender in the money market and agrees to repurchase them at an agreed future date (usually between overnight and 30 days) at an agreed price. Reverse repo is a term used to describe the opposite side of a repo transaction. The party who sells and later repurchases a security is said to perform a repo (repossession). The other party who purchases and later resells the security is said to perform a reverse repo. While a repo is legally the sale and subsequent repurchase of a security, its economic effect is that of a secured loan. Money market funds are short term mutual funds that invest in deposits and other short term interest related products such as cash and near 333

22 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism cash 137 ). They were created in the U.S. to circumvent a regulation 138 that prohibited interest being paid on demand deposit accounts, therefore providing an alternate to a bank deposit account. Money market funds typically provide a higher yield than deposit accounts. The money markets are not considered a high risk for money laundering as they tend to be wholesale in nature with transactions taking place between known wholesale participants limiting access to individual investors. Nonetheless, organizations must still perform the appropriate level of customer due diligence to meet regulatory requirements and expectations not only to mitigate money laundering risks, but also reputation and regulatory risk. Sufficient information must be gathered about counterparties to be satisfied as to their regulatory status, source of funds and purpose of transactions. Participants are usually well known banks, large financial institutions, corporate entities and government entities who use these instruments to manage their short term funding needs. The instruments tend to be purchased directly from an issuer and held to maturity and therefore liquidity and secondary trading is not commonplace. This means that the level of money laundering risk is very low as money launderers would face difficulties in making investments in such instruments sold directly from an issuer and any attempt at trading by money launderers in a secondary market would not go unnoticed. 10. Derivatives markets 10.1 What is a derivative? Financial derivatives can be both exchange traded and OTC products. Derivatives are contracts where the value of that contract is derived from the price of something else, for example an equity, bond, interest rate or a commodity. Recent developments in this sector have seen various other derivatives structured and offered including for weather, emissions, carbon, longevity, credit default swaps. (Yes it is possible to gamble on the weather on the derivatives market! It is well known that a weather derivative was developed for ice cream sellers regarding the risk of a cool summer. Derivatives usually settle on a financial rather than physical basis. For example if a futures contract on a commodity is left to its maturity date the purchaser would have to pay for the physical underlying asset upon maturity, and the seller would have to deliver the physical commodity to the buyer. However typically this does not happen for derivatives and the contract is sold prior to the maturity date and settled on a cash basis for the differential in the purchase and sale price of the futures contract. A typical structure for an equity or share derivative is based on a purchaser having the right to buy a particular share at a stated price up to a given date. This then enables the value of that right to be directly related to the price of the share from which it is derived. If a share s price moves up, then the right to buy at that earlier agreed fixed price becomes more valuable; if it moves down, the right to buy at a fixed price becomes less valuable reducing the value of the derivative Near cash is a term used to describe non-cash assets that can be readily exchange for cash e.g. money market instruments such as short date CDs or T-Bills United States Federal Reserve Bank (FRB) Regulation Q

23 Module 14: AML/CTF Capital Markets These are two examples of a derivative contract. The close relationship between the value of a derivative contract and the value of the underlying asset is the common feature of all derivatives What is the origin of derivatives? The more recent origin of modern derivatives came from the agricultural industry in the US in the 19 th century 139 when farmers wished to hedge against production risks and fix the future price of their commodity (wheat, orange juice etc.) whilst it was still growing/ being produced. Based on the delivery of those commodities being of a common standard (weight, quality, delivery warehouse etc.), then the purchaser was able to trade that future to other users in the food chain generating cash flow against the value of current and future production. Since then the derivatives market has evolved in complexity and underlying asset coverage and is still developing and growing Use of derivatives The use of derivatives has essentially remained the same i.e. hedging risk and trading for a profit. Derivatives can be split into predominantly three broad categories futures, options and swaps and can also be divided between exchange traded and OTC. Derivatives can be based on many different underlying financial instruments and/or their attendant risks; such as share prices, foreign exchange, interest rates, the difference between two different asset prices, or even derivatives of derivatives. The possible combinations of derivative instruments are almost limitless What are some of the more common types of derivative instruments? Swaps are mainly OTC transactions in which the parties agree to exchange cash flows at specific time intervals throughout the tenure of the swap, based on the interest rate or exchange rate at the end of each interval (.e.g. in an interest rate swap one party agrees with the other party that it will exchange a fixed rate for a floating rate on a specified notional amount of principal at the end of each interval usually set to a quarterly or semi-annually basis. Swaps are primarily used to manage risk exposures to changes in interest rates and foreign exchange rates although they can be used for trading and arbitrage purposes. Money laundering risk in swaps can be considered to be very low. Swaps are generally restricted to the wholesale OTC primary markets, periods of tenure are usually in excess of 12 months and they serve the purpose primarily as that of a hedging instrument to manage risks as opposed to an instrument used for the purpose of trading to generate profits. Forwards are OTC transactions in which a contract exists between two parties where payment takes place at a specific time in the future at today s predetermined price. Similar to swaps, forward contracts are restricted to the wholesale OTC primary markets and again money laundering risks are considered to be low as counterparties are almost always large wholesale participants. Options can be either OTC or exchange traded. An option is a contract that gives the owner (the buyer) of the contract the right but not the obligation to purchase (in the case of a Call Option) or sell (in the case of a Put Option) an asset at a future date at an agreed price (known as the exercise price or the strike price). The buyer of an option pays a premium for the right Derivative style contracts can be traced back to the 6th Century BC to a renowned philosopher of Greece, Thalus, who is thought to be the first person to formulate an agreement, which is very similar to that of the option derivatives of today, for making profit. (source: 335

24 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Options in the OTC markets are generally considered lower risk for money laundering as they are typically executed between wholesale participants either for hedging or trading purposes. The greater risk lies in options contracts executed via an exchange due to the relative ease of access by money launderers via brokers, the global nature of exchanges, the volume of transactions conducted on an exchange which present monitoring challenges and the ability to rapidly enter and exit the markets. All these features allow a money launder to layer transactions to avoid detection of the movement of illicit funds and the mixing of illicit funds with licit funds. Contracts for Difference (CFDS) are primarily OTC although can be traded on some global exchanges e.g. the Australian Securities Exchange. A CFD is an agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price of that contract, with reference to the change in value of the underlying asset. Trades are conducted on a margined basis 140 enabling a trader to leverage their initial stake and increase their ability to profit although it also increases their risks of loss. This business has seen substantial growth in Europe and Asia in the past 10 years. CFD s however are not permitted in the U.S. CFDs are traded between individual traders and CFD providers. There are no standard contract terms and no expiry dates rather it is left to each CFD provider to determine terms with the customer. The customer opens a position and the position is not closed until a reverse trade is executed. Because CFDs are traded on margin calculated against profit and loss on the trade, the customer can be called upon regularly to increase the amount of money on deposit with the CFD provider. The following factors intrinsic to CFD s make them a very attractive proposition to money launderers: CFDs are an OTC and exchange traded product currently attracting less regulation and therefore less regulatory scrutiny than traditional exchange traded products which are subject to exchange surveillance mechanisms. There is no restriction on the entry or exit price of a CFD, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first making it easy to enter or exit at different times and values. This facilitates the movement of value between two parties that appear unconnected but who may be involved in the same criminal enterprise. CFDs are traded on leverage and can give money launderers more trading power, flexibility and opportunities and a disguise for their layering activities. Many CFD providers offer electronic trading platforms via the internet and mobile applications for smartphones and tablets making the access to the CFD markets very simple and convenient and once established easily used as a vehicle for money laundering without direct contact with the CFD provider. Financial Futures are always traded on a futures exchange. They are a standard contract between two parties based on an underlying asset. This could be a commodity such as wheat, grain, electricity, an intangible financial asset including currencies, securities or based on a referenced product e.g. stock Trading on a margined basis means that the liability is for the difference, not for the entire value of the underlying asset.

25 Module 14: AML/CTF Capital Markets indexes or interest rates. The two parties agree to exchange a specified asset for a price agreed today at a specified future date (expiry date). The buyer of the contract hopes that the underlying asset price will rise as there is a direct correlation between this and the futures price and therefore he will make a profit. Conversely the seller will hope that prices fall. Typically on expiry the differential is settled in cash as opposed to any delivery of the underlying asset. Futures are traded by wholesale and retail customers and can be an attractive proposition for money launderers. Money launderers can readily buy or sell futures via brokers layering transactions on many exchanges, they can take large positions by providing illicit funds to cover margin calls, they can realize profits or losses at any time as exiting the market is as simple as entering into the reverse transaction thus recouping outstanding margin deposits and bringing the funds back into the broader financial system with seeming legitimacy. Exchange-Traded funds (ETFs) are quoted and traded on stock exchanges but are open-ended collective investments vehicles effectively a hybrid of a Unit Trust and an Investment Trust. It is a unit within these investment vehicles which is traded. EFTs are structured to track a stock exchange index or a part of an index with greater efficiency (in terms of cost and performance) than individually holding the constituent parts of that index. The units trade and settle like shares so are considered as if they are shares. There are variations upon these plain vanilla index trackers, such as the leveraged or structured ETF. These have been designed to enable investors to access a return driven by a specific section of index, for example, when the underlying asset is comprised of different asset classes. ETF s can be considered similar to equities and therefore the ML/TF risks are similar to those instruments. 11. Foreign Exchange Markets Daily turnover in global foreign exchange (FX) markets likely reached US$4.7 trillion on average in October The global foreign exchange market is considered the largest financial market in the world with huge volumes divided between transactions entered into to meet a commercial business need and investment and speculative trading to make a profit. The FX markets are predominantly wholesale with banks, corporations, hedge funds and other financial institutions being the primary participants trading as principal or on behalf of other wholesale clients. Governments are also major participants in this market, often as support mechanisms for their own currencies. Virtually all trading is now conducted via electronic platforms. Automated FX trading is increasing the number of market participants in the same way that the Electronic Communication Networks 142 did for the equity markets. As there is no central market for FX, there tends to be certain jurisdictions that act as centres for trading in their regional currencies, for example, Singapore/HK/Tokyo for Asian currencies, New York and London have a global market, Frankfurt/Paris for, Geneva for Swiss Francs As cited in the Bank for International Settlements Quarterly Report March Refer to the section on Internet and Electronic Market Access for further information on ECN s. 337

26 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism There are also much smaller retail FX markets (estimated in 2007 to represent about 5% of the total market) which still amounts to approximately US$ billion 143 in daily trading turnover globally. Brokers provide intermediary services between the retail market and FX participants in much the same way as the brokerage services for equities, CFDs and other retail traded products. As the amounts traded in the wholesale markets are significant they are generally restricted to regulated financial institutions, governments and large corporates and therefore the AML risks are generally considered lower. The retail markets however pose a significant risk for money laundering. Individuals and other retail participants are able to readily trade in most currencies. With the increasing use of technology and the software development in trading platforms and tools, including smart phone and tablet applications, after being accepted as a customer by a retail FX broker, the customer or the customer s account can be used to transact from anywhere to anywhere 24 hours a day. This presents an ideal environment for money launderers for laundering funds to make them seem legitimate. It also assists trans-border criminals to move funds between jurisdictions to fund their crimes and front operations. For example a Russian card skimming gang will wish to repatriate the proceeds of their card skimming operations from the country where the skimming has occurred through safe corridors back to place where they can safely access and use the funds. This may involve multiple currency conversions to perfect the layering process and at the same time separate the funds from their connection to the original crime. 12. Commodity Markets The physical commodity markets can be split into two distinct sectors the direct trading of the physical commodity and physical commodity derivatives. Physical commodities can be traded for spot (delivery and settlement two days from transacting), or forward contracts for delivery at a future point in time; or the derivative of these where futures and options contracts can be bought and sold. There are also other derivative products including swaps and other more sophisticated products. There are currently 48 large global exchanges trading across these sectors offering approximately 100 different commodity categories. The main commodity markets are predominantly located in global financial sector hubs, e.g. the London Metal exchange, the New York Mercantile Exchange (NYMEX), the Tokyo Commodity Exchange (TOCOM) however often an exchange serving a specific commodity industry is located near its point of production (or its historical place of first production) for example rubber for which the main exchange is the Singapore Commodity Exchange Commodities The physical commodities market includes five basic categories of goods that are sold on this market; grains and oilseeds, (e.g. corn, wheat and soybeans); energy products (e.g. crude oil, heating oil, gasoline and natural gas); metals, (e.g. gold, silver, platinum and copper); soft commodities (includes food and manufacturing products e.g. as cotton, lumbar, orange juice and coffee); and meats (e.g. live cattle, feeder cattle, lean hogs, pork bellies) As cited in the Triennial Central Bank Survey, 2007 BIS

27 Module 14: AML/CTF Capital Markets Commodity market exchanges generally operate in a similar fashion to the stock market exchanges. Access to the exchange is via a broker who must be a member of that exchange. Settlement is often carried out via a specified central clearing counterparty (CCP) although there are some exchanges that self-clear without the involvement of a third party. The commodity market is made up of two primary types of participants; those with a commercial need to purchase/sell the physical commodity (e.g. food processors, manufacturers, producers) and those who are trading to make a profit. Commodities can either be traded directly or indirectly through derivatives. Most commodity products are now sold through futures contracts which guarantee that a certain quantity of a physical commodity will be sold at a future date for a predetermined price. However investors will often speculate in the commodity market by buying and selling futures contracts with no intention of ever taking possession of the underlying physical product. Participants on the exchange are regulated and clearing is conducted through formal clearing arrangements. There is also an OTC trading market which operates similarly to OTC equity and bond markets Commodity derivatives As mentioned above, traditional commodity derivatives include futures, options and swaps based on the underlying physical commodities. These include derivatives for all of the commodities in the five categories outlined above. As the markets have developed and there is increased recognition (and concerns) regarding our planet s environment, it is relevant to recognised the advent of new derivatives relevant to physical commodities but generally not based on underlying physical commodities. These include the following derivatives: Weather derivatives are financial instruments that can be used by organisations as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. For example, farmers can use weather derivatives to hedge against poor harvests caused by drought or frost; an ice cream manufacturer can hedge against a cold summer. The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct asset value to price the weather derivative. In 1996 the first (OTC) weather derivative trade took place and a new industry was born which has developed into an $ billion weather-derivatives industry in Weather derivatives became exchange traded in 1999 when the Chicago Mercantile Exchange (CME) launched exchange-traded futures and options on weather derivative futures. Emissions trading is focused on the trading of emission credits designed to control and ultimately reduce pollutants produced from business activities. The central driver for emissions trading is the impact on the global climate and the degradation of the environment and environmental resources from emissions of various gases and pollutants. Exchange-traded emissions derivative instruments are traded on certain exchanges such as Intercontinental Exchange (ICE). Carbon trading is a more specific and global example of emissions trading often grouped with Energy. Large companies or organisations are assigned (initially allocated for free by governments, but now they also use partial auctions as well to as a means of allocation) a quota of carbon dioxide or equivalent gases (greenhouse gases), that they are allowed to emit from their operations. If a company s emissions are less than its quota then it can sell credits whereas if 144. Weather Risk Management Association

28 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism emissions are more, then it will need to buy carbon credits. The carbon credits are sold via an exchange in Europe the major exchange is ICE. ML/TF Risks and Vulnerabilities The physical commodity market (i.e. the delivery of the underlying product) is outside the regulated financial sector however, certain parts of its trading activity and also the participants within the market are within the financial sector. Therefore an organisation needs to ensure that it knows exactly who its counterparty is and the rationale for that counterparty to be a participant in that market. The main participants at the user end of the market includes:- Producers those entities that mine, prospect, grow or produce the commodity (oil firms, farmers, mines etc.) Users those entities that turn the raw material into a saleable state (refiners, smelters, food manufactures) Wholesalers who sit between the producers, users and other market participants (utility firms) Commercial merchants who are typically smaller than the wholesalers but are involved in the distribution of the commodity (agents, traders etc.), and Financial organizations that finance or actively participate in the speculative trading of the commodity. An organization may only see one or more of these participants as its counterparty and so the underlying commercial rationale for transactions may not be clear. Furthermore, it is also recognized that the physical commodity i.e. the raw materials, are often produced in jurisdictions with a higher risk of criminal activity and influence. This has been further exacerbated in recent years by the higher than average returns available to participants as commodity prices have risen significantly. Higher potential returns attracts new market entrants where due diligence is perhaps not what it should be as they target increasing market share. The physical commodity market is attractive to large scale money launderers as it can be easier to hide the illicit funds with illicit trades attached to legitimate primary production businesses where there is price volatility, cross border movements of production as well as funds, global exchanges and certain complexities in the trading. 13. Market access and delivery channels 13.1 Brokers A broker is an individual or a party that arranges a transaction between a buyer and a seller. This includes any entity dealing as an agent or intermediary in a financial product (broker, dealer agency traders, capital markets advisers, name passing broker). In most countries, the activity of being a broker in stocks and shares is a licensed or regulated activity to ensure that the integrity of the market is maintained. Brokers receive and communicate their orders via a variety of ways voice brokers (where orders are placed via telephone very common in the OTC and derivatives market), electronic messaging (i.e. Bloomberg), dedicated electronic trading platforms directly connected to exchanges and some web-based trade execution platforms and interfaces. Minimal transactions take place face to face if at all. A request to perform a transaction face to face would itself raise concern. A broker can act as the buyer or the seller in a transaction becoming the principal counterparty to the deal. In this arrangement the broker is acting on their own account. 340

29 Module 14: AML/CTF Capital Markets When acting for a buyer or a seller, the broker is not the counterparty to the trade in an agency or brokered transaction the trade is between the client and the exchange member or OTC entity. When dealing with a broker, an organization may know the broker and have conducted the appropriate customer due diligence on the broker; however they will not have knowledge of the broker s customer base. Regulated brokers should have AML/CFT policies and programs designed to identify and mitigate ML/TF risks and therefore an organization should conduct the type of due diligence that satisfies itself as to the AML/CTF regulations that apply to the broker and its level of compliance. Seeking access to copies of AML/CFT programs and procedures is risky because then the organisation is on notice of gaps and weaknesses that increases its own ML/TF risks even if it has not detected them. Adapting the questions that the Wolfsberg Group pose as questions in correspondent banking is one way to secure assurances that the right AML/CFT controls are in place without assuming an excess of knowledge. Huge reliance is made on the fact Electronic trading With technology and the enablement of the internet and electronic trading, virtual market places e.g. NASDAQ and Globex have developed in direct competition to the traditional stock exchanges. Electronic access to the markets originated in the US in the early 1990 s. In the US they are called Electronic Communications Networks (ECN s), in Europe they were called Alternative Trading Systems (ATS) but since 2007 have been known as Multi-Lateral Trading Facilities (MTF s). Investment organisations, financial institutions and brokers all have electronic platforms and web based solutions directly accessing the virtual markets providing themselves and customers the ability to trade without the need for any human interface between the client and the broker or the market. I.e. they are an electronic route from the investor (client) via the broker to wherever the network connects. The network can connect to the main exchange and to various other pools such as fellow networks, other exchanges, the major investors (or traders) in the instruments types (notably these will be investment banks and hedge funds) and to dark pools. A dark pool is a market that is not openly available to the general public where large volumes of securities are traded. They are predominantly open to large financial institutions and other institutional investors for buying or selling large parcels of securities without showing their hand to others and therefore do not impact the market as the quantity and price are not revealed until the transaction is completed. This can have the advantage for the investor to gain an improved price as to that which he might trade at on the open stock market. Dark pools therefore provide for a level of anonymity to trades they effect as it is not on- exchange. The largest dark pools are operated by the major investment banks (Credit Suisse, Goldman Sachs etc.). All participants in these dark pools must be suitably regulated to ensure the integrity of the market. Their influence can be seen by the significant reduction in on-exchange trading on the main exchanges that display prices (e.g. NASDAQ and NYSE have experienced up to 70% reduction in trading volume since 2006 as trades that would have traditionally be traded upon these exchanges have been executed over ECN s and dark pools). 341

30 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Brokers now offer direct electronic trading to access markets via applications on mobile devices including smartphones and tablet computers. Trading in the markets has probably never been easier and hence provides a money launderer with not only the ability to operate in any market from any jurisdiction but provides a significant level of anonymity in that other than satisfying initial client account opening requirements of a broker, mobile technology access alleviates the need to have any further direct contact with the brokerage firm or to even remain in the same country as the broker. Accounts may be set up for criminals in overseas countries who control the account activity using the identification of a pawn who made the initial application. Dark pools may provide initial concerns due to the level of anonymity however they are currently wholesale in nature and therefore could be considered a lower ML/TF risk Give Up Brokers A give up broker is an executing broker who places a trade on behalf of someone else (often another broker) as if that person actually executed the trade. Once the trade is executed, the executing broker gives up that trade to the clearing broker for settlement and the trade becomes a bilateral settlement arrangement between the clearing broker and the other party. There are various parties to the Give Up agreements. These include: Client: The party to whose account the positions ultimately will be given up for clearing. Trader: The party to whom the Client has given authority to place orders on its behalf with Executing Brokers of the Trader s choice for give-up to its account maintained by the Clearing Broker. Executing Broker: The party that executes trades on an exchange pursuant to orders received from the Client or trader Clearing Broker: The party that maintains a clearing account for the Client and to which the positions resulting from orders executed by an Executing Broker pursuant to the Agreement ultimately are given up. Order Passing Broker: This term is used for a party that has been authorised, usually by the Trader, to pass Trader s orders for the Client s account to the Executing Broker. It might not be a party to the Give Up agreement. Both the executing broker and the clearing broker have an agency relationship with the customer, albeit they have differing roles. Both will need to conduct appropriate due diligence upon the customer to ensure that they understand enough about the client to assess the ML/TF risks (including source of funds and wealth). Depending upon the local rules and regulations, an executing broker and clearing broker may be able to rely upon the customer due diligence information received by one or the other as long as they have assured themselves that the information and minimum standards required for obtaining and verifying such information is sufficient to meet their own standard and made the necessary agency appointments Introducing Brokers (IB) and Introducing Agents (IA) The definition of introducing broker and introducing agent can vary across jurisdictions and markets.

31 Module 14: AML/CTF Capital Markets In the US the term Introducing Broker is used to define an entity that can perform all the functions of a broker except for the ability to accept money or securities from a client. In Europe, the term IB is used to refer to an entity that introduces clients to a broker (principal broker) for which it is paid a commission or a part share of the trade commission. The introduced client can become a client of the principal (but may also remain a client of the IB. The IB may sit between the two parties and provide certain services on behalf of the broker, but is not generally allowed to participate in the execution of any trade. It is a requirement in certain jurisdictions that the IB is regulated. Introducing Agents typically introduce a client to a principal broker and then steps away from the relationship and the relationship then becomes one between the client and the principal broker. The Introducing Agent receives a fee for doing so. Whilst this is the typical functionality of an IA, again it can vary by jurisdiction and market. In an IB/IA relationship the underlying client can be a client of both the IB/IA and the principal therefore both organizations need to carry out suitable due diligence as will give up brokers. Perhaps the biggest risk is that of legality, in certain jurisdictions, the role of an IB/IA is ill defined yet often reliance is placed by organizations upon such entities as if they are defined and regulated. Organizations must ensure therefore that they understand the activity and the legality of such arrangements before conducting business. This issue is further complicated when an IB/IA is in one jurisdiction and is introducing clients from another (for example, an IB/IA is Hong Kong based, but introducing clients from China). It is in the interest of the IB/IA to push as much business through the arrangement as possible as they will be paid for the flow. This has potential for various regulatory issues (fraud such as ID theft, churning, market abuse etc.) to take place which needs to be monitored. Additionally the IB/IA can change the nature of its business activity without the principal being aware especially if there is a language difference. The IB/IA may start acting as an executing broker on behalf of the underlying clients and/or as a discretionary manager in both these cases, the principal may be completely unaware of the change. The ability to make such changes and the pressure to maintain or increase profitability in the broking sector may also tempt the IB/IA to cut corners and allow criminals to become its customers and thus enter the financial sector by this potentially weak link. Where the IB/IA relationship stands between a principal and retail clients, there are significant risks that need to be considered as this type of relationship can often be an easy potential route for fraud and money laundering. From the principal s point of view, the risks arise in a number of ways:- Initially, they will carry out their identity checks upon the underlying client although this can prove difficult in communicating with them if there is no common language (i.e. the retail client is not being able to speak the language of the principal, yet the IB/IA does). Significant care needs to be taken over the risk of ID theft especially as the principal may be relying upon to the IB/ IA to an extent (as allowed under their AML/CFT policy and relevant AML/CFT regulations) to translate documents, arrange for them to be certified, send them to the principal etc.); 343

32 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism The intermediary IB/IA is representing the principal and therefore needs to be suitably controlled by the principal. It has been common for the IB/ IA in certain jurisdictions to offer principals with access to underlying retail clients promising significant returns. Then, the IB/IA accesses the retail clients accounts via the PoA established to transact through the principal and their money is lost either via outright theft (IB/IA withdraws the cash from their accounts); or via the IB/IA being paid a volume based revenue share that encourages them to churn the account. There have been a series of cases whereby the IB/IA runs a fraud across the accounts. This comes about when they arrange retail clients to open direct accounts with the principal and thereafter takes a Power of Attorney (POA) over the accounts without advising the principal that they have taken control of the accounts. From the principal s point of view, they have not identified the person holding the POA as they continue to only see the underlying client as trading, whereas that client has given the account access information to the POA holder. In essence therefore, the principal is now having accounts traded and accessed by an unknown person about whom they have no knowledge. These issues are not restricted to those countries with different languages to the principal; there are a number of these frauds in Europe and the US. This can arise simply by duplicity of the POA holder or by cultural differences; families pooling their investments and allowing one senior member of the family to trade their account without the principal being aware of the arrangement. This can also be illegal in Europe and the US as that person can be deemed to be an investment manager and is therefore required to be regulated Market makers Market makers are wholesale participants who play a fundamental role in the capital markets ensuring liquidity by quoting two way prices i.e. the price they will buy and sell at. Market makers typically trade/deal in a principal (or proprietary) capacity i.e. on their own account. They enter into transactions (buying or selling) in traded products on a continuous basis and at prices they determine, making a profit on the spread of the transaction and at the same time ensuring continuous liquidity in those instruments. A market maker, sometimes known as a specialist often receives privileges in share dealing on an exchange in return for providing liquidity e.g. they are provided access to sensitive information on prices and trade executions..market makers are required to always quote firm bid and offer prices for at least a minimum quantity of each security they are a market maker in (the minimum varies from security to security). As these roles are conducted by members of the exchange who will be regulated by both the exchange and the regulators, they are very much industry known, large professional organizations whose business is based upon their reputation. Generally the money laundering risk of dealing with them in this capacity is low because of their regulatory status. They are not providing financial services to counterparties so they do not experience ML/TF risk in their transactions. They may however experience a range of other risks associated with the underlying value of the assets they buy and sell. 344

33 Module 14: AML/CTF Capital Markets 13.6 Omnibus accounts (also known as concentration accounts or pooled accounts) Omnibus account structures are commonly used to facilitate relationships between brokers where one broker (Broker A) is domiciled in a different jurisdiction and wants to access the markets in the jurisdiction of the other broker (Broker B). For example Broker A is domiciled in the U.S. and has customers who want to buy shares traded on the Hong Kong Stock Exchange ( SEHK ). Broker A opens an omnibus account with Broker B who is domiciled in Hong Kong and uses the account to facilitate and record the trades executed on the SEHK by Broker B on its behalf but ultimately for the benefit of Broker A s end customer. Broker B might not see the underlying customer(s) of Broker A only recognising the account and trading activity as belonging to Broker A. The trades in the account could be pooled and be those of Broker A trading as principal and also the trades of Broker A s customer(s). (In some countries this is not permitted). In order for Broker A to recognise ownership of the trades it may record the various interests of the underlying customer(s) as separate records in its own books. Alternatively Broker A may set up a series of unnamed sub accounts on its account held with Broker B. These accounts would not be in the name of Broker A s underlying customer(s) but would assume an identifying sub account number that Broker A would be able to recognise as belonging to his underlying customer(s). From Broker B s point of view, its relationship is with Broker A and it would need to satisfy the applicable customer due diligence requirements on Broker A. However not having a relationship with any of Broker A s underlying customers Broker B is exposed to the risk that Broker A s underlying customer(s) could be a money launderer and the monies flowing through the account could potentially be illicit funds. Omnibus account structures provide underlying customers with a level of anonymity. This could prove attractive to criminals who are aware of how these structures operate. By opening an account in their own jurisdiction and instructing their broker to trade on their behalf in another jurisdiction further layers their money laundering activity, obscures their identity behind the broker, moves assets to other jurisdictions and thus reduces the likelihood of detection. Omnibus structures can be very attractive to brokers opening accounts for other brokers because of the potential for increased volumes of trading that ensues leading to higher commission flows. This could influence a broker to perhaps perform a lesser degree of due diligence or perhaps not pursue the expected higher level of due diligence for accounts from offshore jurisdictions, in their eagerness to open and keep the account. An organization looking to open an omnibus account should ensure that they employ a significant level of customer due diligence on their client prior to entering into an omnibus arrangement. This should include having an appropriate understanding of their clients AML/CFT obligations and the standard of their AML/CFT program. The opening of an account should also have the appropriate level of senior management approval and oversight and omnibus accounts should be subject to ongoing enhance customer due diligence. 345

34 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Whilst not technically an omnibus structure it is worth giving an example of the risks presented regarding anonymous accounts. The prohibition against holding anonymous accounts is a key part of the FATF recommendations on customer due diligence and is what underpins the obligation to be reasonably satisfied as to the identity of customers. Probably the largest example of this was in Austria. Until the year 2002, Austria allowed its banks to hold anonymous passbook savings accounts (the value of which was approximated at US$100bn). There were approximately 27 million accounts in existence and with a population of just 8 million people this could be considered unusual. These passbooks were freely available on the internet and were a significant breach of the then applicable EU AML/ CFT requirements. A number of wholesale banks declined to transact with the anonymous account holding banks on the basis that the unidentified accounts were considered high risk for criminal money. Austria was on the verge of being suspended as a member of the FATF unless it passed suitable laws and removed the anonymous accounts which they did in 2000 and the passbooks were ultimately phased out in The implications of being suspended as a member by FATF would have damaged Austria s reputation and placed in the company of a number of lesser countries regarded as non-compliant countries and territories at the time Nominee Accounts A nominee account is similar to an omnibus account but can typically be distinguished from an omnibus account by two features. While a nominee may open an account for the purpose of holding several clients securities, this is not necessarily so. Often a nominee acts for a single client, for example an omnibus account provider (who acts for many clients). A nominee s duties and discretions will usually be much narrower than those of other account providers. An omnibus account provider will commonly be granted discretionary powers by its client, whereas a nominee is likely to be permitted only to do such acts as are strictly necessary to maintain the client s holding of securities Principal traders The term principal trading refers to any type of trading where someone is trading in their own capacity to make a profit for themselves. The term Principal trader generally refers to independent proprietary trading organisations that trade on their own account. They use their own capital to support this trading so that profits and losses are accrued to the organisation. Some organisations that trade for themselves and on behalf of customers, e.g. banks, hedge funds, can act in a principal trading capacity however generally are not referred to as Principal Traders. A principal trader can also be an individual who uses their own funds, judgement and skill to pick trades. Depending upon their jurisdiction a principal trader may or may not be regulated and this affects the level of ML/TF risk. 346

35 Module 14: AML/CTF Capital Markets Generally principal traders having direct access to an exchange will need to meet the eligibility and due diligence requirements of that exchange. This often includes being licensed and/or regulated in that jurisdiction. The ML/ TF risk would be lower as money launderers would be less attracted to the proposition of being directly subject to regulatory requirements. Principal traders operating through a broker would offer a more attractive proposition to a money launderer. Other than the need to meet the broker s customer due diligence requirements they would not be subject to direct regulatory oversight. Depending on the jurisdiction, principal traders in the OTC markets may or may not be licensed and/or regulated. Organisations trading with an unlicensed or unregulated principal trader should ensure that they conduct an appropriate level of CDD as the ML/TF risk is greater than dealing with a licensed and/or regulated principal trader. 14. Clearing houses In the capital markets, clearing (or settlement) means all activities between parties that must take place from the time a transaction is made until the security is delivered to the purchaser and the cash paid to the vendor. Some additional activities carried out by clearers include reporting to and monitoring on behalf of the exchanges and/or clients, risk margining, netting of identical trades to provide a single position, tax handling, and failure or error handling. Most on-exchange trading in Europe and the US is settled (or cleared) by a Central Counterparty Clearing (CCP) entity. The main such entities and their owners are noted in the table below. In most cases, these CCP s guarantee the trade will be settled on that market which therefore removes significant risk for any participant. CCPs are regulated and are generally required to have certain risk management practices. However in relation to jurisdictional AML/CTF obligations, generally the onus to conduct CDD and monitor for suspicious matters falls on the clearing member and any other party permitted to clear through the CCP. The CCP is not directly at risk of being a conduit or facilitator for money laundering, but is indirectly at risk due to the nature of its role to clear the trades of its members. The main clearing houses in the US and Europe Name Owner Products US CME Clearing CME Group Futures & options on interest rates, FX, equity indices, petroleum, natural gas, metals, agricultural products Options Clearing Eight stock Stock option Corporation option exchange ICE Trust Intercontinental exchange OTC credit default swaps ICE Clear US Intercontinental exchange Futures & options on soft commodities Canadian derivatives clearing TMC group Futures & options on bond, equities, energy National Securities Clearing Depository trust and clearing Cash equities 347

36 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Europe CC&G London Stock Exchange Cash equities, bonds, energy futures, equity derivatives Eurex clearing Deutsche Borse/SIX Cash equity, bonds, repo EuroCCP DTCC (user-owned) Cash Equities Iberclear Bolsas y Mercados Equity derivatives, repo Espanoles ICE clear Europe ICE Energy, futures & options, CDS LCH. Clearnet SA LCH. Clearnet Cash equities, CDS, energy, bonds, repo LCH. Clearnet Ltd (83% user-owned) Cash equities, commodities, energy, bonds &repo, freight, swaps 14.1 Clearing agreements Clearing agreements are two distinct and very different things Bilateral agreements are reciprocal trade agreements entered into between governments to exchange a specific amount of a commodity for another commodity e.g. wheat for oil, thereby avoiding the transfer of foreign exchange and minimising the use of cash to pay for a commodity. They were prevalent leading up to and during World War II however are not as common these days and have been condemned by the World Trade Organisation as they cause disruption to the free market economy. Clearing member trade agreements allow a broker to represent their client and choose other brokers that will be involved in their trading strategies. These agreements allow investors to employ different brokers who may specialise in different investment types or have access to different pools of liquidity, whilst consolidating trade orders through a single broker. Clearing member trade agreements can be divided into two models as discussed below What are Model A and Model B Clearing Agreements? Model A. The broker will outsource the clearing or settlement process of the trades it has executed to a clearing organisation. The clearer takes the administrative role in clearing and settling the trades on behalf of the broker. The client is a client of the broker not of the clearer consequently the positions remain on the balance sheet of the broker. Model B. The clearer becomes the counterparty to the trade and so the trades appear on the balance sheet of the clearer. In most cases the underlying client does not have contact with the clearer as the relationship is between the broker and that client. However, a tri-partite agreement is entered into between the clearer, the broker and the client; this is usually called a Give-Up Agreement as the broker agrees to give up the trade to another entity, in this case, the clearer The implications for a Model B arrangement are that the clearer may expect to have pre-approved, identified clients of the broker before it can allow trades to be cleared. Without this, the clearer would also need to be responsible for AML/ CFT and due diligence requirements as the counterparty to the trade. Certain jurisdictions will require both the broker and the clearer may be required to conduct due diligence on the underlying client regardless of the terms of the Give-up Agreements.

37 Module 14: AML/CTF Capital Markets 14.3 Clearing and non-clearing members Clearing members are exchange members permitted to clear trades directly with a clearing house. A clearing member typically sits between the broker and the exchange. A non-clearing member can trade on the market but cannot clear its trades or those of its clients; whereas a clearing member can trade, clear its own trades and clear the trades of others including non-clearing members. Non-clearing members can be banks, brokerage firms or other financial institutions. A non-clearing member may maintain one or several accounts with a clearing member. Where a non-clearing member acts as a broker or an agent for its clients, this may be through an omnibus account held with the clearing member on behalf of all of the non-clearing member s underlying customers. This poses the risk that the clearing member is reliant upon the non-clearing member to have undertaken and met AML/CFT due diligence requirements on its customers. This does not prevent the clearing member from monitoring the activity of those accounts for unusual patterns however it would prevent the clearing member from being able to identify the underlying customer in the case of unusual patterns. Therefore they would need to liaise with the nonclearing member to access this information. Care would need to be taken to ensure that any liaison with the non-clearing member does not infringe on any local regulatory requirements in regards to confidentiality obligations, privacy and tipping off provisions. 145 If not trading via an omnibus account, the non-clearing member will give up the trade to the clearing member and so these clients will become clients of the clearing member for bilateral settlement of the transaction and will remain clients of the broker in relation to servicing, advice etc. This transfer obliges the clearing member to perform due diligence on each such client. 15. Corporate Finance Corporate finance can mean many things. At its broadest it refers to the various financial dealings of an organisation. In the context of the financial services sector, it covers the activities and various methods of advising clients regarding their dealing, financing and valuations in relation to their own balance sheet or when they are potentially looking to acquire other organisations or divest all or part of themselves. The term corporate finance has varying interpretations across different jurisdictions. For example, in the US it broadly describes activities, decisions and techniques that deal with many aspects of an entity s finances (including cash flow) as well as capital, whereas in Europe it tends to revolve around the advisory and mechanics of raising capital to enable an organisation to create, develop, grow or acquire businesses. The organisations that provide these services include the larger banks (investment banks particularly) and specialist boutique organisations that concentrate solely on this activity. These organisations act as on behalf of companies, for the raising of funds (debt capital raising or equity capital raisings), mergers and acquisitions and corporate lending. It is usually the advisory function of these corporate finance organisations that will advise a company in regards to:- Restructure of their balance sheet to ensure it is as efficient as possible; Listing (an Initial Public Offering or Flotation) on a stock exchange (i.e. issuing shares in the company to the public); Cross listing (i.e. a company lists its equity shares on an exchange in a foreign jurisdiction as well as listing on the exchange in its home country It is usually an offence under AML/CFT regulations for the reporter of suspicious activity to inform the subject of their report that a report has been made, known as tipping-off provisions. 349

38 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Issuing a private placement (the offering of shares or bonds for sale directly to professional investors); Raising debt via bonds, syndicated loans, bank debt etc.; and The financial implications of acquiring, merging, divesting, and closing operating activities. An additional service that can be provided by the corporate finance organisations and banks is that of underwriting (or placing). This is where an organisation has guaranteed that they will raise the necessary funds; the corporate financiers will arrange for other institutions to buy the equities/bonds at issue date if the public or other investors fail wholly or partially to invest. When certain IPOs/flotation s and bond issues are of a significant size, often no one institution would want to (or may be allowed to due to its own capital constraints) underwrite the whole transaction, consequently an underwriting group or syndicate is put together to underwrite the transaction. Naturally the activities of a corporate finance organisation will have the ability to directly influence the market price of a listed organisation s share price, the value of its bonds and also the price of any derivative that is based upon the company (equity futures and options, equity CFD s etc.) consequently there can be a significant risk of insider trading leading to a predicate offence to money laundering. All corporate finance organizations should have controls in place to manage and avoid potential conflicts and mitigate the likelihood of insider trading. As previously discussed, insider trading is a predicate offence to money laundering. Mitigating controls would normally be overseen by a Control Room, a department responsible for overseeing and ensuring compliance to the organisations Information Wall and Personal Trading policies. These controls enable employees engaged in an organization s dealing and trading activities ( public side employees) to safely transact in the securities of an issuer without being inadvertently exposed to material non-public information (inside information) on an issuer organization that the corporate finance employees ( private side employees) may be advising on. In many jurisdictions laws recognize that the presence of an Information Wall or Chinese Wall i.e. policies and procedures to manage potential conflicts, is a legal defence in cases of insider trading if proven to be in effect. A corporate finance firm will need to ensure that it carries out suitable due diligence upon its clients as it may well be listing a firm on a stock exchange where AML/CFT regulations permit other investors to rely upon the exchange for its simplified money laundering requirements. Such due diligence is reviewed and checked by the stock exchange as it can be a significant risk to the stock exchange if it lists an entity with a criminal reputation or involved in criminal activity. As an example, Glencore PLC was listed on the London Stock Exchange in May 2011 and there were significant questions regarding its reputation prior to that listing. For other corporate finance activities, a corporate finance organization is an ideal entity for any criminal enterprise to influence as it is often the primary gatekeeper for entry to the financial sector. That being said, it is very unusual for such an entity to be involved in the placement of illicit funds, but much more in the layering and ultimately the integration aspects. This is of course done, via the transfer of assets between the relevant parties including ownership. 350

39 Module 14: AML/CTF Capital Markets As the fees for carrying out corporate finance work are generally very large (based upon a percentage success fee) and the transactions can be high profile and lengthy in execution, corporate finance organizations will often need to conduct very detailed and specific due diligence upon their client, its controllers, beneficial owners, agents, directors and senior management and also upon the target entity. In the latter case, if they did not carry out the due diligence on the target, a respected organization could acquire a criminal entity inadvertently or pass funds to a criminal organisation for a legitimate operation that was originally acquired through the proceeds of crime. The depth of the due diligence will depend upon the jurisdiction, the entity itself and the nature of its business either locally or on a global scale. Where a corporate finance organisation may also be selling their client s assets (shares, ownership, other assets) to another party, as with the example above, they should carry out suitable customer due diligence upon the acquirer to ensure that the funds they receive are not the proceeds of crime. 16. Syndicated lending Many large institutions have a need to borrow money. As has been outlined previously, two ways of accessing such funds is via a share or a bond issue. The choice is complicated but is generally also an economic decision for example which is the most efficient (cheapest) form of accessing that cash and how quickly can it be raised. A third way of raising those funds is via bilateral borrowing i.e. from one lender, or via a syndicated loan from a group of lenders. These syndicated loan arrangements are usually structured, arranged and administered by one party, usually a bank. As organizations have become ever larger and more complex in their operations spanning numerous countries of the globe, a single bank simply would not want to take the credit risk of such a large amount (assuming the bank was actually large enough to do so) and it also may not be able to due to the rules governing its exposures and capital requirements. Therefore loans can be syndicated between a number of lenders so that they all contribute to the debt requirements of the borrower. The total global, annual volume of syndicated loan issuance had increased to more than a US$1 trillion although the credit crunch in recent years has restricted the capacity and willingness of banks to lend. The businesses that are choosing this option to finance their growth have expanded beyond the major international companies that were its first users to both mid-sized companies and smaller companies that are on the cusp of moving into mid-sized status. Syndicated loans in the US are now available for as little as US$10 million. In many ways, a syndicated loan operates like an ordinary loan; there is an interest rate (fixed or floating) and a defined repayment schedule (albeit a revolving loan allows for the re-borrowing of repaid amounts). Typically there is a lead bank or underwriter of the loan, known as the arranger, agent, or lead manager or bookrunner. In certain situations the role of the agent and the lead manager may be split between banks. This lender may or may not be lending within the main loan but they will become the agent between the syndicate of banks and the borrower. They carry out the due diligence upon the borrower and all of its associated parties on behalf of the syndicate and they also carry out all the administrative duties for the running of that loan (drawdown s, repayment distributions, etc.). They make the due diligence available to each member of the syndicate. Syndicated loans are also used in the leveraged buyout community to fund large corporate takeovers where there is a requirement for debt funding. Terms such as 351

40 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism mezzanine debt, subordinated debt, senior/junior debt etc. are all to do with the ranking of the lenders (creditors) in the case of the insolvency of the borrower and of course, the higher risk for the lender, the greater the interest rate they tend to receive. Syndicated loans are governed by specific loan agreements that can include all of security elements offered by the borrower. This agreement will also define the different roles and ranking of the lenders and their ability to sell sub participations or their entire participation. Guarantors may also be included in the structure and these entities are usually part of the operating group of the borrower. The cash flows between the parties in these arrangements are between the lenders to the agent and thereafter to the borrower. Repayments are a simple reversal of these flows. The use for criminal purposes is limited due to the professional nature of the market and the size of the loans that are provided. Potentially layering and integration could be an issue but is considered low risk depending upon where the borrower is located due to the depth of the due diligence conducted on the borrower, associated parties, the business and the guarantors. Care should be taken during the life of the loan as to any changes requested to the loan agreements, changes to ownership and/or control or corporate structures; these should be considered in their context for their economic purpose and context. Such changes may alter the ML/TF risk significantly. Typically, the arranger will conduct suitable due diligence on behalf of the syndicated lenders upon the borrower(s) and the lenders will generally rely upon the evidence provided. The lenders will of course have to carry out suitable due diligence upon the arranger and the arranger upon the lenders. All borrowers in the lending market will be legal entities of some type, companies, incorporated partnerships, banks, authorities etc. The initial due diligence is carried out by the agent bank and the syndicate will usually rely upon this. For the agent bank, it will also consider its requirements for due diligence upon the other lending institutions. As most syndicate members tend to be large financial institutions, the ML/TF risk is low for them as they are highly regulated and often publicly listed. Therefore, money flowing to a borrower in a syndicated loan is unlikely to be the proceeds of crime because of the size and regulatory status of the initial lenders. The risk can increase if the borrower defaults and the guarantor (if there is one) is called upon to repay the outstanding debt. In this scenario an organisation should consider conducting the appropriate due diligence on the guarantor as ultimately the ML/TF risk of the guarantor may cause problems for the lenders. Serious questions of constructive trust might arise if the lenders acquire knowledge that the source of funds may be the proceeds of crime as they will be balancing credit risk against ML/TF risks Secondary markets for syndicated loans. Under the loan agreement, it is usually possible for any lender to sell all or part of its participation to another entity and there is a significant market for such loans. It may not be that a traditional credit institution (bank) will purchase that participation, but any numbers of investors are now actively pursuing such assets, including pension funds, hedge funds and other investors. 352

41 Module 14: AML/CTF Capital Markets The flow of cash in any secondary sale is between the new lender and the selling lender. Each needs to conduct due diligence on the other to be aware of the ML/TF risks. The purchaser will of course be acquiring obligations from the borrower so will need to carry out their due diligence upon that entity too. Often, but not always, the agent is actively involved in the transfer. The agent will need to conduct due diligence upon the new lender as they will, in time, may be required to make payments of principal and interest to the borrower under the terms of the loan syndication. As the monies are distributed from the banking group (syndicate) to the borrower, there is a very low likelihood of money laundering in terms of movement of money to the borrower. However, as the loan agreement may be for a significant period (over 5 years is common) the desire of the members of the syndicate to continue to lend can change for a variety of reasons. In these cases, a syndicate member can often sell a part of their lending commitment to another lender or can sell its entire commitment. The arranging bank is at that time obliged to carry out due diligence on that new lender coming in. Recent developments in the market have seen non-traditional lenders participate in the syndicate market these typically being hedge funds. This has the potential to raise the risk as hedge funds may or may not be regulated depending upon the jurisdiction from where they operate. Similarly hedge funds often take a shorter term view than a bank does and so would wish to on-sell their participation to other funds. The agent bank will need to control these changes carefully (it may have an assignment mechanism written into the loan agreement that can require their approval). The same serious questions of constructive trust might arise if new syndicate members acquire knowledge that the source of funds may be the proceeds of crime as they will be balancing credit risk against ML/TF risks. 17. Hedge funds Hedge funds are structures that are unregistered collective or pooled investment vehicles. Typically they are offered to private investors through use of disclosure documents that set out the investment objectives, strategies, risk factors, conflicts of interest, tax treatment, management fees, redemption rights and other relevant terms. Some hedge funds are corporations, some are trusts. They rarely have employees and rely on the Investment Manager to perform all the functions required. They have complex structures which could involve all or some of the following: A controller who might be a general partner or a managing member under the control of the Investment Manager. The Investment Manager will operate under an investment management agreement which relates to the hedge fund. In return it receives a fixed asset fee or a performance based fee or allocation. A fund administrator may also handle accounting, customer due diligence and any applicable AML/CFT obligations. Sub-advisers who is involved in executing trades on behalf of the hedge fund. Introducers or managers who broker relationships between the hedge fund (and its investment manager) and a financial institution (see Omnibus relationship where the financial institution may not even be aware that the underlying client is a hedge fund). Some funds might have a board of directors. 353

42 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Hedge funds are open to the non-retail sector only i.e. its participants are all wholesale in nature or must qualify as sophisticated investors. It is currently estimated to be a $2 trillion industry and growing, with approximately 10,000 active hedge funds in the world 146. Retail investors may have exposure to hedge funds through other investments they make in managed funds and pooled trusts. Hedge funds invest in a diverse range of assets but typically trade in liquid products predominantly securities on the public stock exchanges. Originally hedge funds would use hedging strategies and leverage techniques to reduce financial risks and amplify financial returns. Nowadays hedge funds use an infinite variety of strategies that may not have any hedging within them. Their strategies are based on both market prices rising and falling. A hedge fund can be aggressive in its trading or passive. The popular misconception is that all hedge funds are volatile and that they place large, one way, or hedged bets against global securities or commodities funding such trades with leverage. Most hedge funds use derivatives only for hedging or don t use derivatives at all, and many use no leverage. Investments made into hedge funds are illiquid as they often require investors keep their investment in the fund for a minimum period or a withdrawal can only be made on certain predefined dates. This in itself may reduce the attractiveness and the risk of money laundering. Hedge funds are private entities, until recently very lightly regulated if at all and have few public disclosure requirements including no obligations to disclose their activities to third parties i.e. regulators. Historically this lack of oversight and perhaps lack of transparency and secrecy surrounding them has made investing in hedge funds an attractive and viable proposition to money launderers. There are criminal organisations that provide money laundering services to others. Hedge funds make the perfect vehicle because of the ability to make the structure complex, superficially compliant with regulation and in substance focused on movement of proceeds of crime for other criminals. However as a result of the Global Financial Crisis and the concerns around the part played by hedge funds in exacerbating the events involved, many countries are now introducing regulations, particularly in the US and the EU where hedge funds are now required to report on certain information and are subject to AML/CFT regulation regarding their investors. Funds that have achieve significant profits are actively cultivated by financial sector participants wishing to access those profits. This may allow for simple questions to not be asked and appropriate levels of due diligence to not be conducted. The best recent example of this is of course was the Madoff Affair whereby the evidence was in front of the organizations participating, but the profits they were making tended to override the need for perhaps a greater level of due diligence and enquiry that might be treated as invasive and risk the opportunity of participation. 18. ML/TF risks and considerations The following bullet points provide a sample list of risks and considerations firms should consider as part of formulating and implementing their AML/CFT programs Source: Hedge Fund Association (

43 Module 14: AML/CTF Capital Markets when participating in capital markets. It is not an exhaustive list but rather a list to encourage a way of thinking about AML/CFT implications for program development and implementation Should, and if so how, could primary and secondary bond market trading risk be included and assessed in the firm s AML/CFT risk framework? What risk mitigation factors could be included in policies and procedures relating to primary and secondary market trading? Who needs to be aware of the ML/TF risks assessed and how to identify and quantify them for the primary and secondary market? What is the role of CDD in mitigating AML/CFT risk for the primary and secondary markets and does the firm s AML/CFT program optimise that role? How is monitoring relevant or important in the primary market and secondary markets and should the same level of monitoring be applied in both markets and if not why not? What might qualify as unusual secondary market transactions and/or activity? How should commodity product risk be included and assessed in the organisation s AML/CFT risk framework? Why is it important to understanding the various participants roles or rationale for transacting in the commodity markets? Under what circumstances might a firm perform enhanced customer due diligence in capital markets? What might qualify as unusual commodity transactions and/or activity? What jurisdictional implications might there be associated with identifying and managing ML/TF risk for different commodities traded? What factors should be considered regarding FX trading in an organization s AML/CFT risk framework? Who in the firm needs to be aware of FX AML/CFT risk factors and how to identify and mitigate against them? What might qualify as unusual in an FX transaction? How should ML/TF risks associated with the various listing methods be included and assessed in the firm s AML/CFT risk framework? Under what circumstances might a firm consider entering into a business relationship with a company who issues bearer shares? Should the nature and risk of predicate offences be included and assessed in an organization s AML/CFT risk framework? Should controls regarding predicate offences be included in an AML/CFT Program? Who in the firm needs to be aware that insider trading, market manipulation etc. are predicate offences to money laundering? Who in the firm is accountable for ensuring compliance with controls related to predicate offences? What risks do omnibus accounts present and how could they be managed? 19. Red Flags in the Capital Markets 147 Although by no means exhaustive, the following is a list of potential red flags relating to trading and investment related transactions that could give cause for concern as possible indicators for money laundering or terrorism financing in the capital markets. Face-to-Face transactions in capital markets very unusual to meet your customer/counterparty. Large or unusual settlements of transactions in cash or bearer form. Buying and selling of securities/futures with no discernible purpose or in circumstances which appear unusual Published by the Hong Kong Securities and Futures Commission 355

44 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism A number of transactions by the same counterparty in small amounts relating to the same security, each purchased for cash and then sold in one transaction, the proceeds being credited to an account different from the original account. Any transaction in which the counterparty to the transaction is unknown or where the nature, size or frequency appears unusual. Investor introduced by an overseas bank, affiliate or other investor both of which are based in countries where production of drugs or drug trafficking may be prevalent. The use by a customer of a licensed corporation or an associated entity to hold funds that are not being used to trade in securities, futures contracts or leveraged foreign exchange contracts. A customer who deals with a licensed corporation or an associated entity only in cash or cash equivalents rather than through banking channels. The entry of matching buys and sells in particular securities or futures or leveraged foreign exchange contracts ( wash trading ), creating the illusion of trading. Such wash trading does not result in a bona fide market position, and might provide cover for a money launderer. Wash trading through multiple accounts might be used to transfer funds between accounts by generating offsetting losses and profits in different accounts. Transfers of positions between accounts that do not appear to be commonly controlled also could be a warning sign. Frequent funds transfers or cheque payments to or from unverified or difficult to verify third parties. The involvement of offshore companies on whose accounts multiple transfers are made, especially when they are destined for a tax haven, and to accounts in the name of companies incorporated under foreign law of which the customer may be a shareholder. Non-resident account with very large movement with subsequent fund transfers to offshore financial centres. Red Flags Capital Markets Malaysia The Securities Commission of Malaysia has published a list of red flags of suspicion in Appendix 2, Guidelines on Prevention of Money Laundering and Terrorism Financing for Capital Market Intermediaries. Examples of suspicious transactions: Buying and selling of a security with no discernible purpose or in circumstances which appear unusual. 2. The intensity of transactions for an inactive trading account suddenly increases without plausible reason. 3. Larger or unusual settlements of securities transactions in cash form. 4. Requests by customers for investment management services (either foreign currency or securities) where the source of the funds is unclear or not consistent with the customer s apparent standing. 5. A client for whom verification of identity proves unusually difficult and who is reluctant to provide details. 6. Back to back deposit/loan transactions with subsidiaries of, or affiliates of, overseas financial institutions in known drug trafficking areas. 7. The entry of matching buys and sells in particular securities, creating an illusion of trading. Such trading does not result in a bona fide market position and might provide cover for a money launderer. 8. In a situation where multiple accounts are used to transfer funds between accounts by generating off-setting losses and profits in different accounts. 9. Abnormal settlement instructions, including payment, to apparently unconnected parties.

45 Module 14: AML/CTF Capital Markets 10. A client who suddenly starts making investments in large amounts when it is known to the reporting institution that the client does not have the capacity to do so. 11. The crediting of a customer s margin account using cash and by means of numerous credit slips by a customer such that the amount of each deposit is not substantial, but the total of which is substantial. 12. Funds credited into customer accounts from and to countries associated with (i) the production, processing or marketing of narcotics or other illegal drugs or (ii) other criminal conduct 13. Investors based in countries where production of drugs or drug trafficking may be prevalent. 14. Non-resident account with very large movement with subsequent fund transfers to offshore financial centres. 15. There may be circumstances where the money laundering may involve employees of reporting institutions. Hence, if there is a change in the employees characteristics, e.g. lavish lifestyles, unexpected increase in performance, etc. the reporting institution may want to monitor such situations. 16. Structuring transactions to evade substantial shareholding. 17. Unusually short period of holding securities. 18. Transactions that cannot be matched with investment and income levels. 357

46 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Case Study 1 A UK regulated firm ( ES ) acts as an Introducing Broker to Broker A and as ES is regulated it is allowed to trade CFD s via an omnibus account in the name of ES There are 400 underlying accounts within the omnibus account structure held with Broker A. Broker A manages the overall relationship via a master account but also provides the service of allocating trades and providing confirmations etc. for the 400 sub accounts (who are named for settlement purposes but Broker A does not recognise them as clients of theirs). One of the omnibus sub-account owners, JB refuses to pay their margin requirement which would cause an immediate loss to ES who cannot fund the margin from their own resources. ES borrows temporarily from another profitable sub account s position to fund the loss (bearing in mind that all 400 accounts are under the control of ES management). JB is actually a firm that is controlled by a fraudster not identified during ES original customer due diligence as they were a newly established firm desperate for business and therefore that motivated ES to cut corners. The fraudster then threatens the senior management of ES (who is really a one person Board and weak) the result being that JB becomes influential in the business of ES. The initial purpose for JB was to manipulate the market using both his account at ES and accounts elsewhere, however this changed as his lucky break in not paying the margin gave him greater influence over a regulated firm that held almost 30m of clients profitable trades in its books. JB then set about to remove the 30m as quickly as possible to jurisdictions outside of the EU. What lessons can be learned from the above case (which is a true case) if you were working for a. ES b. Broker A? What and when were the trigger points when suspicions should have arisen? 358

47 Module 14: AML/CTF Capital Markets Case Study 2 A public listed company was a shell company. An individual who was a sole owner of a private company used his private company to acquire a controlling interest in the listed shell company via various OTC transactions. Part of the acquisition price ($2.5m) that the acquired shell company received was returned to the private acquiring company. The private company then started to receive significant deposits from external accounts controlled by drug traffickers. In addition, some transactions were credited to the listed company from a known drug trafficker via a money service business before being transferred to the private company. New directors (including family members) were appointed to the listed company by the new controlling owners. Additional sums from the $2.5m received by the listed company were remitted back to the money services business (MSB) account; further sums sent to another company associated to the drug traffickers. The individual and his family were known to the authorities for having acquired shell companies previously and using them to launder money. It was also suspected that the process was used to manipulate the share prices of companies they owned, and fraudulently removing funds from companies. It transpired that the individual who made the initial acquisition was a student in his 20 s whose newly opened bank account was credited with $2.5m within a few days and that he used these funds to acquire the controlling interest. Discuss the specific issues in respect of money laundering by acquisition of a publicly traded shell company including: The use of a public shell company (traded on the stock exchange); The use of a front company/straw man to perform the acquisition; Transferring funds through several accounts; The use of a money services business (MSB) to transfer funds; Withdrawing the funds shortly after the acquisition by means of loans; and Transferring funds to the same MSB. Are there any other red flags present themselves? 359

48 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Case Study 3 An individual obtained a business card of someone senior in a large listed company. He successfully held himself out to a large brokerage organisation to be an authorized representative of the company and attempted to establish a large credit facility for trading purposes. He arranged for a series of fraudulent identification documents to be sent to a postal address near to the office of the listed company (same street name, different number). The account opening department of the broker sighted the documents and opened the account pending credit approval. Unfortunately for the fraudster, the credit department questioned why they had not met other senior managers of the company and attempted to arrange a visit resulting in the fraud being uncovered. The staff in the account opening department had not considered that anyone would try such a simple attempt to obtain circa 20million on the basis of one real business card and had not even considered such a fraud was likely. Often the failure of an organisation firm is not really knowing who their customer is. Are there any additional controls that the broker might consider implementing to strengthen their customer due diligence e and AML/CFT program? Would AML/CFT training have made a difference? 360

49 Module 14: AML/CTF Capital Markets Further Readings Money Laundering and Terrorist Financing in the Securities Sector, October fatf-gafi.org/dataoecd/32/31/ pdf MoneyVal, Use of Securities in Money Laundering Schemes, monitoring/moneyval/typologies/moneyval(2008)24reptyp_securities.pdf APG Typologies Workshop 2010, Money Laundering & Terrorist Financing: Methods and Trends in the Asia/Pacific Region, Regional Vulnerabilities in Securities/Capital Markets. Presentation by Rita O Sullivan, Principal Counsel, 28 October 2010 Dhaka, Bangladesh documents/others/ogc-toolkits/anti-money-laundering/documents/presentation-securities-capitalmarkets.pdf Finra Website Anti-Money Laundering Efforts in the Securities Industry, United States General Accounting Office, Report to the Chairman, Permanent Subcommittee on Investigations, Committee on Governmental Affairs, U.S. Senate, October AML/CFT Measures & Typologies, Rita O Sullivan, Senior Counsel, Asian Development Bank APEC-FRTI Securities Regulators Workshop, 4 April 2008, ADB Headquarters, Manila adb.org/documents/others/ogc-toolkits/anti-money-laundering/documents/aml-cft-measurestypologies.pdf Money Laundering Through Securities an Analysis of Canadian Police Cases by Stephen Schneider, Asper Review [2004] Vol. IV conferences/2003/papers/010%20money%20laundering%20through%20securities.pdf Dayanath Jayasuriya, (2003) Money laundering and terrorist financing: the role of capital market regulators, Journal of Financial Crime, Vol. 10 Iss: 1, pp emeraldinsight.com/journals.htm?articleid= &show=pdf PWC Broker-dealer and investment adviser compliance programs, Spring pwc.com/us/en/financial-services/regulatory-services/publications/pli-compliance-programs.jhtml Money Laundering in Securities Markets, Sgt. George Pemberton, Royal Canadian Mounted Police Vancouver Integrated Proceeds of Crime Section, originally published in the July/August, and September 2000, editions of The Money Laundering Bulletin, London, England. bcboman.com/english/articles/laundry.pdf Robert Vella-Baldacchino, (2006) Overview of a securities market strategy to prevent money laundering and terrorist financing: The Malta Stock Exchange s experience, Journal of Money Laundering Control, Vol. 9 Iss: 3, pp htm?articleid= & Good stock market governance in the context of anti-money laundering regimes by Dr Dayanath Jayasuriya Amicus Curiae Issue 65 May/June JayasuriyaIssue065.pdf 361

50 Advanced Certification in Anti Money Laundering and Counter Financing of Terrorism Identification and Supervision of Money Laundering on Securities and Futures Market Securities Firms Still Struggle with CIP, Resources, Says Former Finra Counsel, edited transcript featured by ComplianceAdvantage.com and MoneyLaundering.com, Tuesday, August 23, with_cip_resources_092211/ Arnett, G. W. (2011) Money Laundering, in Global Securities Markets: Navigating the World s Exchanges and OTC Markets, John Wiley & Sons, Inc., Hoboken, NJ, USA. doi: / ch