Since criminal enterprises began to scale during Prohibition, the challenge has always been hiding the source of money — particularly cash — from authorities so it could be spent freely.
The most common solution: "laundering" the money. The idea is to make "dirty" money collected from crimes such as smuggling, arms trafficking, drug trafficking, insider trading, bribery, and computer fraud look clean by passing it through some kind of legitimate enterprise, preferably one that does a lot of cash business. During Prohibition, for example, Al Capone used to launder some of his $100 million a year in dirty money through, ironically, launderettes.
Ever since, governments and law enforcement agencies have taken steps to make it harder for criminals to launder their illegal funds. Importantly, this included passing anti-money laundering laws and regulations that would eventually come to impact wide swaths of the economy.
Below, we take a closer look at how money laundering works. We then explain what anti-money laundering (AML) is, explore the history of AML regulations, and outline the AML requirements companies must implement in order to comply with AML law and effectively combat money laundering.
What does the money laundering process look like?
The details of laundering schemes can vary, but they all typically share three common stages. Here’s how money laundering works.
Stages of money laundering
- Placement: The first step a launderer takes is funneling their dirty money into the financial system, typically through a bank account or business. For example, funds can be blended with clean money, such as income generated by a business, or be used to pay debt, buy real estate, or buy stock from shady brokers.
- Layering: Once the dirty money is placed, the next step is to hide its source through a series of obscure and complicated bookkeeping maneuvers. The process often involves international transfers, especially to countries with laws that strongly protect account-holder privacy. According to the Basel Institue on Governance in Switzerland, in 2022, the top five countries with financial systems extremely vulnerable to money laundering were The Democratic Republic of the Congo, Haiti, Myanmar, Mozambique, and Madagascar. Typically, the dirty money is divvied up multiple times until it becomes almost impossible to track back to its source.
- Integration: Once the dirty money has been laundered, it can be integrated into a clean bank account where it can be used for any purpose.
Dangers of money laundering and financial crime
Money laundering harms both society and the world economy.
Society is harmed because laundering enables profitable activities such as drug trafficking, tax evasion, smuggling, human trafficking, and terrorism, and gives criminals the wherewithal they need to expand their illegal activities.
Meanwhile, the world economy is hurt by the enormous volume of laundered money entering it. According to the United Nations Office on Drugs and Crime, 2% to 5% of the world's Gross Domestic Product — or $800 billion to $2 trillion — enters the global banking system through money laundering. This means the world GDP could be higher if that laundered money entered the world's economy through legitimate means, where it could be used to stimulate business activity or fund government services, instead of being used to corrupt business people and government officials.
A classic example of how laundered money can threaten the financial system is the case of HSBC, a financial institution hit with a $1.9 billion fine in 2012 for its money laundering activities — but wasn't indicted because law enforcement authorities felt that doing so could endanger the global financial system.
Money laundering can also hurt citizens and financial markets. Laundering is often tied to tax evasion, and those taxes could be used to reduce government debt and taxes paid by taxpayers, as well as fund programs that benefit a nation's citizens. In addition, laundering gives criminal organizations the resources they need to thrive by corrupting police and politicians, thereby undermining faith in government. For example, in 2017 the Guardian reported that Azerbaijan’s ruling elite used laundered money as part of a $3 billion scheme to pay politicians and journalists to deflect criticism of Azerbaijan’s president and promote a positive image of the country.
Laundering can also undermine investor confidence in financial markets, especially when large sums of laundered money move in or out of a market. For example, in a typical equity placement scam, a small-cap company with an offshore company as a majority shareholder will sell convertible bonds to someone who needs their money laundered. The sale is undisclosed. The bond-holder then converts the bonds to stock — often at a share price greater than the price of the bonds. Then the stock is sold to investors and the clean money is deposited into a bank account
What is anti-money laundering (AML)?
Anti-money laundering (AML) is a set of procedures, laws, processes, and regulations financial companies must follow and implement to stop criminals from disguising illegally obtained funds as legitimate income.
In order to comply with various AML laws and regulations, financial institutions must meet certain requirements. This includes implementing Know Your Customer and customer due diligence programs, reporting suspicious customer activity, and monitoring customer transactions in an ongoing manner.
Know Your Customer (KYC)
A Know Your Customer program involves various processes designed to determine whether a person is who they say they are. This typically includes identity verification as well as other AML screenings. In many ways, KYC can be thought of as a type of mini background check that a customer must pass before they are allowed to open an account with a financial institution.
Financial institutions working with other businesses — for example, third-party contractors — are also required to verify key details about those companies. When the KYC process is applied to businesses instead of individuals, it’s known as Know Your Business (KYB).
Customer due diligence (CDD)
Customer due diligence refers to the steps a financial institution must take to assess and mitigate a customer’s risk of money laundering. To comply with the CDD rule, financial institutions must:
- Identify and verify the identity or customers
- Identify and verify the identity of beneficial owners of companies opening an account
- Understand the nature and purpose of customer relationships to develop customer risk profiles
- Conduct ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information
Because money laundering risk varies from customer to customer and from transaction to transaction, financial institutions are free to apply different levels of due diligence depending on how much risk they assess during the account opening process. These levels include:
- Standard due diligence, for customers who exhibit the standard level of risk
- Simplified due diligence (SDD), for customers who exhibit less than standard risk
- Enhanced due diligence (EDD), for customers who exhibit greater than standard risk
Financial institutions are required to monitor customer transactions in an ongoing manner. The goal of transaction monitoring is to identify suspicious activity that may be indicative of money laundering or other financial crimes. Transaction monitoring typically occurs automatically — only moving to manual processes when suspicious activity has been identified.
A number of factors are considered during transaction monitoring, including where the money originated and where it is being sent, how large of a transaction it is, the account’s transaction velocity, and the recipient of the funds.
Suspicious activity reporting (SAR)
When suspicious activity is identified, organizations are required to submit a suspicious activity report (SAR) within 30 days of the suspicious transaction having occurred. Some examples of suspicious activity may include:
- Large cash transactions
- International wire transfers
- Suspected insider trading
- Increased activity in dormant accounts
- Transactions that don’t correspond with the type of business listed as the recipient
- Transactions that appear structured to avoid record-keeping and reporting requirements
History of anti-money laundering (AML) regulations
AML laws vary from country to country, but many of them incorporate recommendations made by the Financial Action Task Force (FATF), an international authority on money laundering and territorial financing. Some of the key measures aimed at money laundering include:
The Bank Secrecy Act (BSA) was passed in the United States in 1970. It was one of the first laws aimed at preventing and punishing money laundering activity. Under the measure, banks and financial institutions cooperate with the government to fight illegal activity by helping regulators "follow the money." A well-known provision of the law requires banks to fill out a currency transaction report for cash transactions greater than $10,000. Other provisions include keeping records of cash purchases of negotiable instruments and reporting suspicious activity that may signify money laundering, tax evasion, or other criminal activities.
Currency transaction report requirements were modified by the Money Laundering Control Act in 1986 to include any transaction greater than $10,000, not just cash. The act also made money laundering a federal crime. Primarily aimed at drug cartels, the law contains controversial provisions allowing the federal government to seize assets without charging anyone with a crime.
The federal government ratcheted up regulation of banks in 1992 with the Annunzio-Wylie Anti-Money Laundering Act. It required banks to implement anti-money laundering prevention practices and penalizes them if criminals use them to launder money. Additional reporting requirements were introduced by the law, namely the Suspicious Activity Report (SAR), which must be filed if a customer or transaction raises certain money laundering flags.
Following the attack on New York City’s World Trade Center in 2001, money laundered by terrorists became a target of regulators through the USA Patriot Act. The measure beefed up cooperation between banks and anti-terrorism fighters within the federal government and boosted fines and penalties for money laundering. The act also requires financial institutions to implement Customer Identification Programs (CIP), which forces banks and broker-dealers to more carefully scrutinize their clients.
In 2020, Congress passed the Anti-Money Laundering Act of 2020 (AMLA) to build upon previous laws. The law has many provisions. It made art and antiquities dealers subject to AML law; required FinCEN to establish a new beneficial ownership database for US businesses; increased information sharing with foreign branches and subsidiaries; streamlined the filing process for non-complex SARs, and established new AML and CFT priorities at the national level, amongst other provisions.
Need for AML compliance
Know Your Customer programs seek to discourage money laundering by verifying customers' identities and ensuring transactions are traceable.
Customers can be screened against global watchlists, sanctions lists, and Politically Exposed Person (PEP) lists. People on PEP lists include current or former senior officials in the executive, legislative, administrative, military, or judicial branches of a government; senior officials of a major political party; senior executives of a government-owned commercial enterprise; or immediate family members or close personal/professional associates of such individuals.
In addition to checking lists, financial institutions need to query customers when an activity or transaction requires greater due diligence. For example, a large deposit of cash into an account could prompt a bank to ask the depositor to verify the source of the money. While this may annoy customers who aren't doing anything wrong, the process is necessary to identify those who are up to mischief.
KYC is a cornerstone of any AML compliance program. Designating an AML compliance officer, creating internal policies and anti money laundering procedures, and continuously training employees are other elements of a good compliance program, as well as hiring an outside source to independently evaluate the program from time to time.
Compliance with industry best practices and government regulations is not only important for preventing and stopping money laundering, but also for avoiding stiff penalties (and potentially prison time) for failing to do so. For example, Nasdaq Stockholm AB fined Swedbank more than $5.1 million in May 2021 for "shortcomings in the bank's anti-money laundering controls between December 2016 and February 2019."
And that wasn't the first time the bank was fined for AML shortcomings. In March 2020, the institution was hit with a $386 million fine by a Swedish financial regulator for serious deficiencies in its anti-money-laundering work and withholding information from authorities.
More recently, in December 2021, financial regulators in the United Kingdom fined HSBC $85.1 million for lack of efficiency in its transaction monitoring systems and anti-money laundering processes over a period of eight years.
AML compliance made easy
While it used to be difficult to keep up with constantly evolving regulations, there’s no excuse with today’s wide array of intelligent, flexible, and easy-to-use AML and automated identity verification solutions that can help:
- Monitor transactions and flag suspicious transaction patterns
- Identify large cash transactions, such as those greater than $10,000, as specified by U.S. law
- Generate alerts when sanctioned individuals and organizations are added to watchlists and other reports
- Collect and verify information about users
AML software can be comprehensive, adaptable, and still easy to implement and use. For example, Persona's identity infrastructure can securely collect and verify information about customers, such as passports and driver’s licenses, as well as augment that data with information from third parties, such as records from the Social Security Administration. These pieces of data can be used to screen new users and monitor customers over their lifecycle. What's more, all this can be done through a single dashboard, making it easier for AML teams to identify suspicious activity.
By automating the collection, verification, and storage of customer information with Persona, companies can reduce the time spent on manual processes. Decision processes can be created without writing a single line of code, and an audit trail can be created automatically without the need to store personal identifying information.
The use of artificial intelligence and robotic process automation in AML solutions can greatly enhance companies’ abilities to identify criminal behavior. For example, used in tandem, the technologies can run statistical analysis of unstructured data to find high-risk cases and eliminate "false positives" caused by redundant data. AI, through the use of flexible Natural Language Processing models, can detect changes in user behavior and, combined with contextual information, improve financial institutions’ ability to know their customers.
With today's AML solutions, financial institutions can efficiently track transactions, effectively monitor questionable ones, and intelligently monitor client behavior so suspicious activity can be discovered early and the organization can stay in compliance and not run afoul of regulators.
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