Anti-Money Laundering in Capital Markets: Relatively Uncharted Territory
18 Jun 2019

The use of capital markets to launder money via investment banks is a topic seldom raised. There are the headline-grabbing cases, to be sure, such as Deutsche Bank’s trouble with mirror trades or Goldman Sachs’ connection to the 1MDB bonds, but these are rarities that fall short of driving industry efforts.

Yet it would be naive to assume that money laundering doesn’t occur through capital markets simply because participants are typically regulated and traded financial instruments fall under the purview of companies listed on stock exchanges. If one were to take the UK as an example, anti-money laundering (AML) risk management related to capital markets is in its relative infancy.

The lack of understanding about such risks also extends to some AML staff, even those with significant experience. This was a lesson I learned firsthand at two globally recognised investment banks.

“There’s no need for transaction monitoring for capital markets products here as the money is ring-fenced,” said one seasoned AML staffer when I asked how transactions were monitored at an investment bank some years ago.

A deputy money laundering officer at another investment bank, also some years ago, once asked in an interview, “could an institution onboard a new client wanting to trade bonds in 15 minutes?” After I responded that it wouldn’t be a sufficient timeframe to assess the clients’ AML risks, it was shocking to hear, “no, of course you can, just pick up the phone to their legal counsel and get them to confirm the client has no financial crime issues”.

For a less anecdotal take, one need only look at the latest UK National Crime Agency Suspicious Activity Reports (SARs) Annual Report to see that the sector appears to be underreporting potential criminality. Of the 463,983 SARs filed in 2018 by UK financial institutions, only 107 related to capital markets.

It’s not just investment banks. The historic lack of focus on the sector includes both regualtors and law enforcement officials. While the 2015 UK National Risk Assessment of Money Laundering and Terrorist Financing Report made no mention of vulnerabilities associated with capital markets, the 2017 assessment acknowledged that “capital markets (raising and trading equity and debt and trading derivatives, currency and commodities) are assessed as to be exposed to high risks” of money laundering, in part due to a “relative lack of controls”.

The inclusion of capital markets in the 2017 assessment doesn’t appear to be a coincidence, but rather a response to two monetary penalties imposed in January of that year against Deutsche Bank for failing to prevent suspicious mirror trades allegedly linked to a Moscow money laundering scheme.

Deutsche Bank’s AML failures were serious enough to merit penalties of £163 million by the UK Financial Conduct Authority (FCA) and $425 million by the New York State Department of Financial Services.

A new path

Change is afoot, however. In a July 2018 speech, FCA Director of Enforcement and Market Oversight Mark Steward confirmed that financial supervisors and law enforcement officials had launched multiple investigations within the capital markets space, both in the UK and overseas.

Then, in October 2018, the Financial Action Task Force (FATF) published guidance on risk-based AML compliance for the securities sector. The guidance characterised securities-related risks as complex, international in reach, with high volumes, speed and anonymity on offer.

More recently, the National Crime Agency’s 2019 National Strategic Assessment of Serious and Organised Crime also acknowledged the vulnerability of capital markets to money laundering and notes that detecting it remains challenging due to the sophistication and complexity of methods and techniques used by criminals.

The FCA’s 2019/2020 Business Plan cites wholesale markets (capital markets) as a key priority where “cross-sector” work includes financial crime. The FCA followed up on the topic again earlier this month, when it published a thematic review dedicated to money laundering in capital markets.

The thematic review should be mandatory reading in its entirety for both frontline and compliance staff in investment banks, as well as other participants in the sector. It outlines money laundering risks specific to the trading of financial instruments and includes examples of good and bad compliance practices. Importantly, it also provides case studies and typologies. The FCA concluded the following:

  • Firms are generally in the early stages of their thinking about money laundering-related risks and need to do more to understand their exposure.
  • Given the nature of transactions in capital markets, effective customer risk assessments and customer due diligence (CDD) are fundamental to AML compliance. Because transactions often involve a number of firms in a transaction chain, it is important that each part of the chain meets its CDD obligations.
  • Effective transaction monitoring is a challenge in the space but needs to be in place so that firms are not relying on others to flag suspicious activity.
  • Firms have historically focused on identifying market abuse, such as insider dealing and market manipulation, often to the detriment of their money laundering risks. Many firms had not considered that potential market abuse could also be indicative of money laundering.
  • Many companies involved in the sector were not clear on their obligations to file SARs.
  • More accountability is needed in the first line of defence, as opposed to viewing compliance as a back-office responsibility.
  • Whilst some firms had developed tailored training using a mixture of delivery methods, others relied almost exclusively on basic online compliance modules.

Spokespersons for the FCA did not respond to requests for comment on whether the authority intended to conduct follow-up visits to participants in the thematic review.

Lessons to be learned

Those interested in actual cases of money laundering may be interested to learn that, although the reporting of the Danske Bank scandal focussed on correspondent banking, there was a capital markets angle that went relatively unreported.

A September 2018 report on Danske Bank’s non-resident portfolio in Estonia found that a memorandum circulated by the Estonian unit’s executive committee in 2013 included a recommendation that select clients use bonds as a faster, cheaper means to transfer funds overseas rather than attempt to make the payments through a domestic Russian bank.

The memorandum cited two main risks: first, that “we do not have full knowledge about the end-clients of the Intermediary” and, secondly, that there is “potential reputational risk in being seen to be assisting ‘capital flight’ from Russia”. An earlier draft of the memorandum noted that the bank’s ignorance of end-clients meant that “this solution could be used for money-laundering.” References to AML risks were not included in the final memo, however.

The Petrobras bribery case also involves capital markets. A June 2019 Reuters story details how the oil giant identified suspicious activity by Seaview Shipbroking Ltd, a relatively obscure brokerage that consistently sold oil and derivatives above market price. Commodities trading firms Vitol, Trafigura, Glencore and Mercuria purportedly used Seaview or other intermediaries to move at least $31 million in bribes to Petrobras employees.

“In return, prosecutors say, these insiders would buy oil and derivatives at inflated prices or sell at discounted prices, thus delivering outsized profits to the parties on the other end of those trades,” Reuters said in the report. “Prosecutors allege such transactions were routine between at least 2011 and 2014 among some employees in the Petrobras trading unit, which has offices stretching across the globe.”

Despite such examples, money laundering risks within capital markets have yet to be fully appreciated. The FCA alludes to this in its thematic review, which opens by stating that “many participants told us they had used the FCA’s Final Notice for Deutsche Bank in 2017 to build their understanding of money-laundering risks in their sector”.

With the realisation for many that they may not have sufficiently understood their compliance obligations, now would be a good time for investment banks and other participants to review their AML programmes to ensure they understand the risks and can manage them accordingly.

Dev Odedra is an independent anti-money laundering and financial crime expert.  He has over a decade of experience in managing financial crime risk in the retail, corporate and investment banking sectors.  His expertise covers investigations, advisory and controls implementation and improvement.

This article is expressing personal opinions and is meant for information purposes only. The article does not intend to replace professional or legal advice. It is recommended that readers seek independent professional or legal advice, or speak to authorised persons/organisations.

Read more:

FCA Outlines Risks of Money Laundering to Capital Markets

Mirror trading

FCA launches money laundering investigations into capital market firms

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