There are significant gaps in anti-money laundering (AML) defences within capital markets, according to a recent UK Financial Conduct Authority (FCA) thematic review, ‘Understanding the Money Laundering Risks in the Capital Markets’. Many of the issues raised by the regulator either relate to the way financial crime technology is deployed within capital markets, or how financial crime could be solved by the evolution of RegTech solutions.
Understanding a global trend
Around the world, there is more focus on the issue of AML within capital markets operations. In December 2018, the Netherlands Authority for the Financial Markets (AFM) completed its own review of AML controls in capital markets operations. The resulting document said capital markets operations were not doing nearly enough, particularly when it came to client checks and ongoing client monitoring.
In the US, broker-dealer regulator Finra issued ‘New Anti-Money Laundering Red Flag Guidance For Broker-Dealers’ at the beginning of May this year, after fining Morgan Stanley $10 million at the end of 2018 for multiple AML failings. In the UK, the 2018 National Risk Assessment – the Financial Action Task Force’s (FATF’s) review of the UK’s overall AML regime – specifically called out weakness within capital markets.
There are no statistics on the potential size of the money laundering problem within capital markets, but experts are beginning to think that sizeable amounts of laundering may be going on, undetected. Within the UK, an indicator of just how significant the problem is, is the number of suspicious activity reports (SARs) filed by individuals self-identifying as being within capital markets – just 107 in the fiscal year 2017-2018. This compares with 662 for asset management and a whopping 371,552 for banks. “If you can imagine the volume of transactions going on in the primary and the secondary [capital] markets, it must go into the hundreds of millions, even billions, I would suspect,” says Martin Cheek, managing director at SmartSearch, a provider of online AML services. Capital markets SARs, he adds, “are a tiny, tiny proportion of the overall volume.” Another indicator is the size of the Deutsche Bank ‘mirror trade’ scheme, which was referred to in the FCA’s report at $10 billion.
Overall, the problem with AML within capital markets has quite a lot to do with how activities are structured. The FCA report specifically calls out the fact that within a transaction, most firms have a lack of visibility as to who the underlying customer is – financial firms trade with other financial firms, and they are allowed to rely on the AML checks of their counterparties. “Most participants had no visibility of their customer’s customer or, for example, the ultimate beneficial owner (UBO) of the asset being traded,” states the report.
“I think there is a certain amount of complacency in the industry,” says Trevor Barritt, principal, AML solutions, EMEA & Asia Pacific, at Nice Actimize, a provider of financial crime solutions. “This is because with most transactions, financial firms are dealing with other regulated financial firms. Perhaps subconsciously, some capital markets teams may take the view ‘We are not really the gatekeepers in this industry. Others have looked at money laundering risk when they’ve opened accounts and relationships with these people before us, so the risk for us is relatively low.’”
As well, the complexity of structured transactions, for example, can also obscure who the UBO is. “Sometimes the UBO can be really difficult to find,” says Cheek. “If someone wants to obscure the true ownership of a company and they have cash, international connections and professional facilitators, the trail can be almost impossible to find.”
Another problem area is transaction monitoring. The FCA found ‘little evidence’ that AML monitoring was joined up with other areas of financial crime transaction monitoring, such as market abuse. The regulator also found that the effectiveness of automated transaction monitoring systems varied considerably between firms, with a lack of correct calibration being an issue. The regulator also said that such systems were not enough if a transaction was of a complex nature. Input from both the front line and analysts was essential in such cases.
Looking to the future
Enforcement actions against financial firms’ capital markets operations will probably increase over the next couple of years. “This an area of priority for the FCA,” says Barritt. “It’s going to be focused on money laundering in capital markets, and this paper is just the start of a series of communications coming from the FCA that will make it clear to the industry that this is something it has prioritised. Anticipating an increase in enforcement, the FCA included a suggestion that there could also be an increase in the number of cases that are actually put forward for criminal prosecution.”
It’s also likely that the regulator will continue its engagement with AML oriented RegTech. The FCA comments in the report that new RegTech approaches to AML transaction monitoring, such as artificial intelligence, behavioural analysis, and the adoption of wider contextual and networking approaches to automated monitoring might help solve some of the challenges that capital markets face.
For example, network monitoring can help firms identify complex networks or links between suspicious parties, or UBOs behind a transaction. The regulator said firms using this approach have seen a significant reduction in the number of false positives they received, compared with traditional rules-based transaction monitoring.
However, capital markets firms will also need to raise their game when it comes to more bread-and-butter tasks such as continuous monitoring of customers, and determining the UBO. Says Cheek: “There hasn’t been a single case of identify fraud that’s been perpetrated where the identity was checked electronically.” In response to the FCA report, SmartSearch has called for mandatory electronic identity checks within AML Know Your Customer (KYC) processes.
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