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Special report by ACFCS Affiliate member ManchesterCF Analytics – Trading on Misery

Thursday, October 1, 2015  
Posted by: Brian Kindle
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"I certainly wouldn’t invest in the stock market. I never believed in it.

Most people lose money because of the emotional difficulty involved."

Bernie Madoff, convicted fraudster, (1938 - )[i]

By Kim R. Manchester, 
Managing Director, ManchesterCF

Convincing capital markets traders and salespeople that significant money laundering risk exists on the dealing room floor is often met with laughter and dismissal.  As there is no physical cash involved with capital markets products, goes the standard reply, how can there be money laundering?

Throughout the world's financial centres, this ignorance or wilful blindness is exposing large international banks, asset managers and broker/dealers to near existential risks.  Since being burned by their lackadaisical oversight of The Great Recession in 2008/09[ii], financial sector supervisors and banking regulators will no longer tolerate egregious compliance failures on the dealing room floor.  For a capital markets firm or sub-division of an international financial institution, a weak compliance function could cost the firm hundreds of millions of dollars, if not billions.

The failures of compliance regimes within capital markets businesses have grabbed headlines since the onset of The Great Recession.  A multitude of investment banks paid billions in fines for "banging the close" in global foreign exchange markets[iii].  The rigging of a fundamental foundation for world interest rates, the London Interbank Offered Rate (LIBOR), by the interest rate derivatives desks at a handful of investment banks caused outrage from borrowers around the planet[iv].

Ponzi schemes, such as Madoff[v], "Sir" Allen Stanford[vi] and Scott Rothstein[vii] (aka, Mini-Madoff), wreaked havoc on the investment portfolios of retirees and innocent investors.  Fraud within mortgage-backed securities markets caused a bond market collapse that precipitated The Great Recession, the largest economic contraction since the The Great Depression.

Most of these financial crimes involved fraud, market manipulation and conspiracy. Outright money laundering in capital markets is relatively rare, however when it becomes exposed, it is often spectacular.  Laundering the proceeds of crime for the layering and integration stages requires careful planning, yet when successful, can create financial mechanisms that will wash billions of dollars without interruption.

In London, New York and Moscow, financial sector regulators are examining securities transactions that caused $6 billion to flow out of Russia and into London.  The underlying transactions that laundered this Russian money and caused such enormous outflows of capital into London were identified as "mirror" trades.

According to the Financial Times[viii], Deutsche Bank is facing an investigation for these mirror trades by the United Kingdom's Financial Conduct Authority, the New York State Department of Financial Services and BaFin, the German financial regulator. Deutsche Bank had reported to regulators that it had identified the mirror trades and was implementing remedies to stop the practice and improve its compliance regime.

The securities transactions, which took place over a four-year period ending in 2015, involved the purchase of Russian shares on the Moscow Exchange by Russians seeking to transmit value out of Russia and into a safe financial haven, out of reach from the perils of the Russian economy and most likely the prying eyes of Russian tax officials.

At the same time the shares were purchased in Moscow, Deutsche Bank allegedly purchased the same shares in London but with hard currencies, such as USD and EUR, not roubles (RUB).  As Euroclear and Clearstream have direct access to Russia's National Settlement Depository, foreign banks can purchase the shares of Russian companies directly from the Moscow Exchange.

With a bit of transaction settlement manipulation, a bank in London could purchase Russian shares in Moscow from local investors and then pay them with hard currencies into the offshore bank accounts held by those same investors in London.

In other words, what looks to be a patriotic investment in Russia's publicly-traded companies by investors based in Moscow then becomes a money laundering transaction that finds rouble purchases of local equities being re-purchased for hard currencies by Deutsche Bank in London.

Once the transaction arranging bank in London has acquired the Russian company shares from the Moscow investors in exchange for hard currency, the shares are then re-sold via Euroclear or Clearstream on the Moscow Exchange.  Deutsche Bank would absorb the transaction costs of the stock purchase and sale most likely in exchange for special fees for offering the laundering service to the Russian investors.

By conducting these mirror trades, the Moscow investors are able to transmit billions out of Moscow and into London without alerting Russian anti-money laundering officials.  These billions left the country not via SWIFT MT103 person-to-person payments, the less expensive route but the more susceptible to detection by Russia's financial intelligence unit, the Federal Financial Monitoring Service[ix] (Rosfinmonitoring).

The local Moscow stockbroker's account could be funded very easily prior to the purchase of shares.  As it was a domestic transfer of funds (assuming no cash), it would not raise suspicious flags for capital flight.  The purchase of the equities by the London branch from the Moscow branch of the same bank could be reconciled as an internal transfer of assets, an internal accounting entry that would only require notification to the National Settlement Depository of the Moscow Exchange, leaving Russian anti-money laundering detection mechanisms completely oblivious to the transaction.

Arranging such transactions to assist in capital flight and the evasion of money laundering safeguards takes careful coordination by traders, salespeople, the back office and AML compliance functions in Moscow and London.

To construct such a conduit for money to flee Moscow and seek refuge in London, a financial institution would undoubtedly charge hefty premiums and fees.  With $6 billion at stake over a four-year period, it is likely that the associated revenues from such a conduit were substantial, to say the least.  This could easily become another case of the AML compliance function submitting to the overwhelming demands of business line management.

Compliance professionals seeking to erect defences against money laundering within a capital markets division face a daunting task. Preventing the establishment of this type of money laundering conduit from Moscow to London requires careful management and preparation by the compliance division, and should probably incorporate the following:

a. Product knowledge

The compliance function can establish robust AML/ATF defences only if it understands the true foundations of the business, including product knowledge, geographic footprint and customer base.  Capital markets products, especially their derivatives, can be quite complex, however that same complexity is often used to camouflage money laundering activity from exposure to compliance officers and investigators. By piercing the veil on capital markets products, compliance professionals will be better prepared to identify their weaknesses to money laundering.

Despite the somewhat intimidating environment of a dealing room floor, the compliance function will need to spend hours in the trenches, watching and learning how a modern capital markets business functions. Instruction by PowerPoint slide is useless. There is no substitute for experience.

A solid network of internal experts within the firm can advise the compliance function of changing market circumstances and "black swan" events that may impact the firm's AML/ATF defences in the capital markets division.  These internal experts must be briefed by the compliance function on the latest developments on AML/ATF in capital markets, along with ancillary businesses such as private banking and correspondent banking.

b. High margin red flags

In overseeing transactions, the compliance function will have a transaction monitoring system in place.  One of the most crucial alerts within this system must be a form of alert notifying AML/ATF analysts where unusually high product margins have been recorded in a product or business line's profit and loss statement.

In order to convince traders and salespeople to be "flexible" in their identification of suspicious activity, money launderers will entice their conspirators, if necessary, with fat margins and ridiculously wide bid/offer spreads.  Incidents which record very high margins for no apparent reason must be queried by the compliance function for possible linkages to money laundering activity.  If the suspicions of the investigator are piqued, then further enquiries must be made.

c. Support

Those who spend their careers on dealing room floors understand that employee loyalty to the firm can be fleeting, however loyalty to a tribal leader can take on near mythical properties.  Charismatic leaders in equities, fixed income, currencies and commodities markets inspire their peers and junior staff to work superhuman hours and endure near fatal pressures.  When markets implode, teams are flung apart throughout the industry, yet can reform in bull markets to once again generate bumper profits.

A charismatic leader's tribe of traders, salespeople and back-office staff will place the interests of the tribe ahead of shareholders.  Loyalty will motivate some to engage in bizarre antics, perhaps even the structuring or approval of a transaction that makes little business sense to an observer but perfect sense to a money launderer.  To break tribal bonds, the compliance function will require the unequivocal support from the board of directors and head of the capital markets division.  To blur this support or to belittle the role of compliance will undermine those enforcing AML/ATF defences and policies and create gaping holes within the firm's regulatory and legal structure.

d. Vacation

When conspirators are forced to take a minimum of two weeks' vacation within one calendar year, they run the risk of their conspiracy being uncovered by those who replace them.  Enforcing the two week rule will produce tremendous results for the compliance function, as internal conspiracies are difficult to manage at the best of times, let alone when key staff in the conspiracy are replaced by others for an uninterrupted two weeks or more.

By combining product knowledge, red flags and senior management support, a compliance professional overseeing the capital markets business can have a chance against the wolves of Wall Street, The City, Central, Raffles Place and Bay Street, to name just a few dens.  Without either of these four components firmly in place, compliance officers should consider safer and more tranquil careers, such as rodeo cowboy, urban paramedic or hairstylist to certain Neanderthal candidates for President of the United States.

To implement the risk-based approach within a capital markets business, consider investing in ManchesterCF's Financial Crime Training (Capital Markets) program.











This story originally appeared in the ManchesterCF Analytics September newsletter. It is kindly reprinted here. For more information on the company, please visit:

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