Definition, Stages and Methods of Money Laundering

The September 11 attacks was the reason for the Patriot Act in the United States. This led to an emphasis on new set of rules to combat money laundering . The Group of Seven (G7) countries used Financial Action Task Force (FATF) to put pressure on governments. It required financial institutions to increase surveillance and monitoring of financial transactions.

India passed Prevention of Money Laundering Act in 2002. Today, AML KYC regulations have become a much larger burden for financial institutions. Money laundering activities in India witnessed substantial growth, especially when dirty money obtained from corruption was invested in real estate. Money obtained from the organized crime pushed it further.

What is money laundering ?

Money Laundering is the process of changing the colors of the money. Its very easy to define but involves multiple techniques.

Money Laundering is an act of act of disguising the illegal source of income. Basically, different money launderers gain money from illegal sources and try to convert it into legitimate by using different ways. These are called methods of laundering. Its a three phased process.

In the first phase, money enters the banking system. This phase is termed as placement. Second phase involves mixing the funds. It is important to mix the funds from illegal sources with legal. In the third stage money flows back to the beneficiary.

These phases are called placement, layering and integration.

Notable money laundering scandal

Money laundering became the concern for the banks when regulators imposed heavy fines on banks. Most notably, HSBC for violating the Bank Secrecy Act. It failed to monitor over $200 trillion in wire transfers between its Mexico and U.S. subsidiaries. Also, HSBC bank accounts were used in other crimes such as drug trafficking.

In this process tax evaded money starts appearing like income from legitimate sources. Money travels through the global financial system before it finds place in the account of ultimate beneficiary.

Methods of Money Laundering

There are different methods of money laundering through financial system. For example, a criminal could use a large number of complex wire transfers to disguise the illegal origin of the funds. The criminal could also go into a casino, exchange the funds for chips, gamble for some time, and cash-out.

1.Structuring

This is a method of placement whereby cash deposits are divided into smaller deposits of money. This method is used to avoid detection and anti-money laundering reporting requirements. A sub-component of this is to use smaller amounts of cash to purchase bearer instruments, such as demand drafts, and then ultimately deposit those, again in small amounts of money. Smurfing is another variation of Structuring.

2. Bulk cash smuggling

This involves physical transportation of cash to another jurisdiction and depositing it in a financial institution. Generally, the money is moved to jurisdiction with greater bank secrecy or less rigorous money laundering enforcement. A sub-component of this is to transport fake currency to enemies. Fake Currency destroys the economy of the enemy nation.

3. Cash-intensive businesses

Business expected to receive a large proportion of its revenue as cash is the target of launderers in this method. Criminal uses bank accounts of cash intensive business and deposit cash proceeds of crime.

Such enterprises often operate openly such as shop in a mall or a petrol station. Cash revenue from legitimate business is added to the illicit cash. In such cases the business will usually claim all cash received as legitimate earnings.

4. Trade-based money laundering

Illicit trade is becoming popular but it is far from a victimless crime. Governments lose tax revenue, public health risks increase and legitimate economy is in danger.

These methods involve under or over valuation of invoices to disguise the movement of funds. For example, the art market is an ideal vehicle for money laundering. There are several unique aspects of art such as the subjective value of artworks is difficult to ascertain.

Auction houses maintain complete secrecy about the identity of the buyer and seller. This is a trending tool of tax evasion.

5. Shell companies and trusts

Trusts and shell companies disguise the true owners of money. Trusts and corporate vehicles, depending on the jurisdiction, need not disclose their true owner. Sometimes referred to by the slang term rat-hole, though that term usually refers to a person acting as the fictitious owner rather than the business entity. There is a difference in Shell, Shelf and Front companies.

6. Round-tripping

Round tripping starts with deposits in in a controlled offshore foreign entity. Preferably, this entity is in a tax haven. In addition to laundering, tax heaven entities facilitate in tax evasion. And then shipped back as a foreign direct investment, exempt from taxation. A variant on this is to transfer funds to a law firm on account of fees, and then to cancel the retainer agreement. Beneficiary receives the money from law firm towards settlement of a dispute.

7. Bank capture

In this case, launderers or criminals buy a controlling interest in a bank, preferably in a jurisdiction with weak AML controls, and then move dirty proceeds through the bank without scrutiny. Nauru was an island nation which distributed offshore banking licenses when its phosphate reserves depleted and the country had no source of income.  This increased criminal activity in Nauru.

8. Casinos

In this method, an individual walks into a casino and buys chips with illicit cash. The individual will then play for a relatively short time. When the person cashes in the chips, the payment is made through cheque, or at least get a receipt so they can claim the proceeds as gambling winnings.

9. Gambling on Cricket

One way to minimize risk with this method is to bet on every possible outcome such as cricket match. In a cricket match, one can bet on outcome of the match as well as outcome of a single over. Gamblers chose cricket matches to place their bets. Cricket matches have many possible outcomes.

In an eventful manner India’s Chief of Cricket Premier Leagues laundered more than Rs. 425 crores. So no outcome have short odds. The bettor will lose only the small amounts and will have one or more winning bets. This gambling income is then declared as income.

These winnings can be shown as the source of money. The losing bets will remain hidden.  

10. Cash salaries

Un-organised sector in India is huge. Given that, it employs thousands of daily wage workers. Daily wage workers don’t need any government registrations. Businesses pay them in cash. They are not provided with the salary slips. There are no employment contracts.

Additionally, in certain cases, huge cash withdrawals from bank becomes false positive when cash is used to pay the contract labor.

11. Voluntary Disclosure Schemes

These are the tax amnesty schemes for the tax defaulters. If the defaulter declares his hidden wealth, government offers to take no action against the default. With this in mind, it is a limited-time opportunity for taxpayers to pay a taxes on evaded income, in exchange for forgiving liability. For example, those that legalize unreported assets and cash in tax havens.

12. Transaction based money laundering

When a merchant unknowingly processes illicit credit card transactions for another business. It is a growing global problem. It is distinct from traditional money laundering in using the payments ecosystem to hide that the transaction even occurred e.g. the use of fake front websites.

13. Agriculture Income

India is an agriculture based economy. In order to boost the agricultural activities there are no taxes on the agriculture income. Launderers mix their income from other sources in agriculture. They disclose the income, file the documents with government but under the wrong head.

Similarly, hospital and micro finance companies are the new vehicles of layering.

Summary of AML

As the Money Laundering regulations evolved financial institutions enhanced their review mechanism. Law enforcement became active in investigation of financial crimes. Banks started investing in training and the new profession was borne. In India this profession is Certified Anti Money Laundering Expert (CAME).