The capital markets are also exposed to money laundering

The capital markets are one of the most powerful instruments in promoting economic growth and wealth creation as they facilitate the movement of vast amounts of capital from different geographical regions with relative ease. Capital market participants range from trading venues which provide the infrastructure for the capital markets to operate, to investment firms offering brokerage, portfolio management and financial advisory services. In view of this, the capital markets are exposed to various risks arising from the array of services and products offered by market participants, which amongst others, relate to money laundering and other forms of financial crime.

Money laundering typologies and practices in the capital markets

There are various types of capital market transactions and typologies that in practice are deemed as predicate securities offences and linked with money laundering. Unlike other financial sectors, money laundering risks in the securities and investment area are more evident at the layering and integration phase, rather than the placement stage.

In October 2009 the Financial Action Task Force published a typology report entitled Money Laundering and Terrorist Financing in the Securities Sector^[1], which provided thorough insight on how criminals and perpetrators may launder money and/or fund terrorist activities through securities firms, and how illicit funds can be generated following illegal activities conducted through investment firms.

Predominantly, capital markets-based money laundering usually involves transactions which are not in line with an investor’s business and risk profile, and anticipated investment activity. Typical examples of these transactions include frequent, short-term, investment activity involving large amounts of transactions in financial instruments, which is inconsistent with the normal practice of the client, requests for services which involve amounts which are outside of the norm taking into account the circumstances of the client and unexpected, sudden increases in the frequency or value of investment activity without reasonable explanations.

Illicit funds can be also laundered via irrational investing activity involving different investment positions which do not yield returns on investments, including movements of investment positions within various financial instruments that give rise to a loss or lower rate of return without any investment benefits or economic sense.

Best practices for market participants

To ensure that all anti-money laundering regulatory obligations are met and that market participants are safeguarded from being misused by criminals for any illicit activities, it is of utmost importance for senior management to instil and promote a strong culture of compliance within their firms. These are some of our recommended best practices to foster a culture of compliance:

1. Thorough risk assessments. In order to effectively combat money laundering and financing of terrorism, market participants should understand all the risks that they are exposed to, understand how such risks can manifest themselves in their operations, and apply a thorough risk-based approach to use the available resources at hand in an efficient manner and focus on business activities that expose the entity to higher risks, than others.
2. Sophisticated systems and controls. Market participants should have in place all the necessary systems and controls commensurate with the nature, size and complexity of the business offered to investors, to ensure that they can efficiently mitigate the risks arising from money laundering and financing of terrorism. Proper governance arrangements are fundamental to clearly assign regulatory responsibilities and leadership roles to the senior management that in turn will assess the development and implementation of the compliance and AML monitoring plan.
3. Robust monitoring systems. A robust transaction monitoring system is one of the most essential tools that market participants require to perform thorough scrutinization of clients’ transactions passed through their systems. The monitoring system should include different alerts, calibrated in line with the products and services offered by the entity, to be able to flag any suspicious transaction patterns relating to the various money laundering typologies which the firm may be subject to. For best practice, information obtained on the purpose of the business relationship and the anticipated level of business for the purposes of compliance with anti-money laundering obligations should be utilised in order to inform the transaction monitoring system from a money laundering perspective. Customer data should be used in such a way as to satisfy regulatory requirements arising from different legislations.
4. Regular training. Needless to say, training and having the right people to analyse and assess the relevant alerts is key in order to ensure full compliance with the relevant regulatory regimes. Training should be well-structured and self-development programs should be designed to provide staff with thorough insight not only on the latest regulatory obligations and internal policies and procedures, but also on the latest trends and typologies, thereby ensuring that the firm remains up to speed with new threats.
5. Meaningful internal audits and reviews. In addition, assessing your internal controls, policies and procedures in order to ensure that they are effective is key. Any shortcomings in the internal control framework of the firm could bear significant damage to the firm, not only from a regulatory perspective but also from a reputational perspective.

Moving forward

Over the years new and updated regulatory frameworks designed to combat money laundering and the financing of terrorism have been implemented and enforced, yet, market-based money laundering is still pervasive, not least due to the accessibility of the capital markets.

Although the Maltese capital markets are far less liquid than their foreign counterparts, there can be no guarantee that local markets aren’t used for money laundering purposes. It is therefore fundamental for local market participants to keep abreast of developments in this area in order to ensure that they are well-equipped to meet their ever-evolving regulatory obligations.

[1] https://www.fatf-gafi.org/en/publications/Methodsandtrends/Moneylaunderingandterroristfinancinginthesecuritiessector.html

This article was written by Dr Beppe Degiorgio (Associate, Capital Markets) & Jonathan Camilleri (Regulatory Advisor, Capital Markets, AML & ISF).