Introduction to AML, CFT and Proliferation Financing

What this chapter is for

Chapter 1 carries 6 marks out of 50 — 12% of the paper.

Learning Objective- After studying this chapter, you should know about: Detailed definition of Money Laundering and Combating the Financing of Terrorism · All probable sources of illegally gained money (for e.g. arms sales, narcotics, human trafficking, contraband smuggling, embezzlement, insider trading, bribery, and fraud schemes).

1.1 What money laundering is

A large number of criminal acts aim to generate a profit for the individual or group that carries out the act. Money laundering is the process of these criminal proceeds to disguise their illegal origin.

This process is of critical importance, as it enables the criminal to enjoy these profits without jeopardizing their source.

That last sentence is the whole point of the offence — the crime is not making the money, it is making the money usable.

Where the money comes from: illegal arms sales, smuggling, and the activities of organised crime, including drug trafficking and prostitution rings, can generate huge amounts of proceeds. Embezzlement, insider trading, bribery and computer fraud schemes can also produce large profits and create the incentive to "legitimize" the ill-gotten gains through money laundering.

Note that insider trading is on that list — securities market offences generate launderable proceeds just as drug trafficking does, which is why this examination exists for securities market intermediaries.

How the laundering is done: when a criminal activity generates substantial profits, the individual or group involved must find a way to control the funds without attracting attention to the underlying activity or the persons involved. Criminals do this by disguising the sources, changing the form, or moving the funds to a place where they are less likely to attract attention.

Practice of or engagement in any of such activities is known as Money Laundering.

Three techniques, then — disguise the source, change the form, or move the money.

Why it matters

Money Laundering has devastating social consequences. For one thing, money laundering provides the fuel for un-ethical persons such as drug dealers, terrorists, arms dealers, and other criminals to operate and expand their criminal enterprises.

And laundering is itself an industry: in addition to organized criminal groups, professional money launderers perform money laundering services on behalf of others as their core business.

If, left unchecked, money laundering can erode the integrity of our nation's financial institutions. Hence, financial institutions employ anti-money laundering (AML) policies to detect and prevent such activities.

1.1.1 Why AML laws exist

Anti-money laundering (AML) laws are important and much required because they help preventing criminals from hiding illegally obtained money and the financial impact of money laundering on a country, thus safeguarding the financial system from crimes.

Put simply, AML laws make it hard to hide dirty money. That protects the financial system.

The workbook's own sample question asks why AML laws matter, and this is the answer — they help prevent criminals from hiding illegally obtained money.

How the global framework grew. Two things drove it: FATF was formed, and it issued common standards. In the workbook's words, anti-money laundering guidelines came into prominence globally as a result of the formation of the Financial Action Task Force (FATF) and the promulgation of an international framework of anti-money laundering standards.

The turning point came later. These standards began to have more relevance in 2000 and 2001, after FATF began a process to publicly identify countries that were deficient in their anti-money laundering laws and international cooperation. Being named in public put pressure on weak countries to act.

And India's response: the Prevention of Money Laundering Act, 2002 (PMLA) forms the core of the legal framework put in place by India to combat money laundering. The provisions of PMLA came into force on July 1, 2005.

The objective of PMLA is, "to prevent money-laundering and to provide for confiscation of property derived from, or involved in, money-laundering and for matters connected therewith or incidental thereto."

1.2 The three stages

There are typically three stages of the money laundering process to release laundered funds into the legal financial system. These three stages of money laundering are:

• Placement.
• Layering.
• Integration/extraction.

Stage 1 — Placement

The placement stage in money laundering is when the illegally obtained funds are introduced in the financial system.

This is often done by breaking up large amounts of cash into less conspicuous smaller sums to deposit directly into a bank account or by purchasing monetary instruments such as checks or money orders that are collected and deposited into accounts at other locations.

And it is the riskiest step for the criminal: the placement stage of money laundering is full of challenges for the criminals as it involves placing money into the legal system without causing any suspicion.

The placement methods listed:

Adding illicit cash: Adding illicit cash from a crime to the legitimate takings of a business, particularly those with little or no variable costs.

Smurfing: Smurfing is where small amounts of money below the AML reporting threshold are inserted into bank accounts or credit cards and used to pay expenses, etc.

• Mules or cash smugglers: Cash is smuggled across borders and deposited into foreign accounts.
• Hiding Identity: Hiding the beneficial owner's identity through trusts and offshore companies.
• Investing in commodities: Using gems and gold that can be moved easily to other jurisdictions.
• Buying and Selling: Using cash for quick turnaround investment in assets such as real estate, cars, and boats.
• Gambling: Using casino transactions to launder money.
• Shell companies: Establishing inactive companies or corporations that exist only on paper.

The workbook defines a mule account by reference to SEBI's own rules. As per SEBI PFUTP Regulations, "mule account" includes a trading account maintained with a stock broker or a dematerialised account or bank account linked with such trading account in the name(s) of a person, where the account is effectively controlled by another person, whether or not the consideration for transactions in the account are paid by such other person.

Note the last clause — it does not matter who funds the account; what matters is who effectively controls it.

Stage 2 — Layering

The layering stage is when the launderer moves the money through a series of financial transactions with the goal of making it difficult to trace the original source.

The funds could be channeled through the purchase and sales of investments, a holding company, or simply moved through a series of accounts at banks around the globe.

And the geography is chosen deliberately: widely scattered accounts are most likely to be found in jurisdictions that do not cooperate with AML investigations.

In some instances, the launderer could disguise the transfers as payments for goods or services or as a private loan to another company, giving them a legitimate appearance.

Three layering tactics, all drawn from digital assets:

• Chain-hopping — converting one digital currency into another and moving from one blockchain to another.
• Mixing or tumbling — the blending of various transactions across several exchanges, making transactions harder to trace back to a specific exchange, account, or owner.
• Cycling — making deposits of fiat currency from one bank, purchasing and selling digital currency, and then depositing the proceeds into a different bank or account.

Stage 3 — Integration

The integration stage of money laundering is the final step in the laundering process. This is when the launderer attempts to integrate illicitly obtained funds into the legitimate financial system.

To use the funds to buy goods and services without attracting attention from law enforcement or the tax authorities, the criminal may invest in real estate, luxury assets, or business ventures.

And the launderer will pay for the appearance of legitimacy: they are often content to use payroll and other taxes to make the "washing" more legitimate, accepting a 50% "shrinkage" in the wash as the cost of doing business.

Half the money is an acceptable price for the other half being clean.

Common integration tactics include:

• Fake employees – a way of getting the money back out. Usually paid in cash and collected.
• Loans – to directors or shareholders, which will never be repaid.
• Dividends – paid to shareholders of companies controlled by criminals.

A caution on the model

While not all money laundering cases will use all the three-stage process – they could be combined or stages repeated several times, thus the rule of three stages of money laundering frames the thinking of many compliance teams.

The three stages are a way of thinking, not a fixed sequence.

1.3 Global initiatives

Anti-money laundering Laws are an international web of laws, activities, regulations, and procedures, aimed at uncovering money that has been disguised as legitimate income.

For decades, governments and law enforcement agencies have tried to fight crime by following the money, thus aiming to achieve the purpose of the AML Laws which is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, securities fraud and market manipulation.

The idea is simple. Crime leaves a money trail. AML laws exist to spot that trail and report it.

1.3.1 Bank Secrecy Act of 1970

The United States was one of the first nations to enact anti-money laundering legislation when it enacted the Bank Secrecy Act (BSA) in 1970.

The Bank Secrecy Act of 1970 (BSA), also known as the Currency and Foreign Transactions Reporting Act, requires financial institutions in the United States to assist U.S. government agencies in detecting and preventing money laundering.

Three specific requirements:

Financial institutions to keep records of cash purchases of negotiable instruments.

File reports if the daily aggregate exceeds $10,000, and

Report suspicious activity that may signify money laundering, tax evasion, or other criminal activities.

The history: the BSA was originally passed by the U.S. Congress in 1970 and signed by President Richard Nixon into law on October 26, 1970. Until the 1980s, there was a prolonged period of inaction on it, but eventually financial institutions complied with its reporting requirements.

The BSA is sometimes referred to as an anti-money laundering law (AML) or jointly as BSA/AML. An early effort to detect and prevent money laundering, the BSA has since been amended and strengthened by additional anti-money laundering laws.

Who administers it now: the Financial Crimes Enforcement Network is now the designated administrator of the BSA – with a mission to "safeguard the financial system from the abuses of financial crime, including terrorist financing, money laundering and other illicit activities."

1.3.2 FATF (1989)

The Financial Action Task Force (on Money Laundering)- FATF, also known by its French name, "Grouped'action financière" (GAFI), is an intergovernmental organization founded in 1989 with the initiative of the 1989 G7 Summit in Paris.

The mission of FATF is:

• To devise and promote international standards to prevent the growing problem of money laundering.
• Study money laundering trends.
• Monitor legislative, financial and law enforcement activities taken at the national and international level.

Reporting on compliance, and

Issuing recommendations and standards to combat money laundering.

Its growth: at the time of its formation, FATF had 16 members, which by 2023 had grown to 40.

Its output: in its first year, FATF issued a report containing forty recommendations to more effectively fight money laundering. These standards were revised in 2023 to reflect evolving patterns and techniques in money laundering.

Forty recommendations, and forty members by 2023 — two different forties, easily confused.

And 9/11 widened its remit: shortly after the 9/11 attacks on the US, FATF expanded its mandate to include AML and combating terrorist financing.

India's position: India became a member of FATF in 2010. India is also a member of two FATF Style Regional Bodies (FSRBs)- Asia Pacific Group (APG) and Eurasian Group of Combating Money Laundering and Financing of Terrorism (EAG).

What FATF actually does day to day: the core work of FATF is to conduct Mutual Evaluation of its Members and to guide and assist SRBs to conduct Mutual evaluation of their respective member jurisdictions.

1.3.3 The International Monetary Fund

The International Monetary Fund (IMF) is another important organization. With 189 Member countries, its primary purpose is to ensure stability of the international monetary system.

The IMF is concerned about the consequences of money laundering and related crimes affecting the integrity and stability of the financial sector and the broader economy.

The IMF has decades of experience in these areas. It has helped shape policies on anti-money laundering (AML) combatting the financing of terrorism (CFT) and counter-proliferation financing internationally and within its members' national frameworks.

The dates: the IMF expanded its AML efforts in 2000 and extended them to CFT after the terrorist attacks on September 11, 2001. In 2004, the IMF Executive Board agreed to make AML/CFT assessments and capacity development a regular part of IMF work.

1.3.4 Bank for International Settlements (1930)

The Bank for International Settlements (BIS) is an international financial institution which is owned by member central banks. Its primary goal is to foster international monetary and financial cooperation while serving as a bank for central banks.

With its establishment in 1930, it is the oldest international financial institution. Its initial purpose was to oversee the settlement of World War-I war reparations.

Its AML contributions:

• Providing a forum for cooperation - The BIS provides a platform for central banks and financial supervisory authorities to exchange information and collaborate.
• Supporting research and policy analysis - The BIS conducts research and policy analysis on issues related to monetary and financial stability.

Acting as a bank for central banks — the BIS acts as a prime counterparty for central banks in their financial transactions

• Issuing guidelines - The BIS has issued guidelines on sound management of risks related to money laundering.
• Providing online learning tools - The BIS offers online learning tools, such as FSI Connect, on AML and CFT in banking.

1.3.5 The Vienna Convention (1988)

Money laundering has been addressed in the UN Vienna 1988 Convention Article 3.1, describing Money Laundering as: "the conversion or transfer of property, knowing that such property is derived from any offense(s), for the purpose of concealing or disguising the illicit origin of the property or of assisting any person who is involved in such offense(s) to evade the legal consequences of his actions".

This is the classic international definition — conversion or transfer, with knowledge, for the purpose of concealing origin or helping an offender escape consequences.

The Vienna Convention, adopted in December 1988, lays the groundwork for efforts to combat money laundering by creating an obligation for signatory states to criminalize the laundering of money from drug trafficking.

It promotes:

• International cooperation in investigations.
• Extradition between signatory states for money laundering.

And its most consequential principle: it establishes the principle that domestic bank secrecy provisions should not interfere with international criminal investigations.

Bank secrecy is no longer a shield against a criminal investigation abroad.

1.4 Indian initiatives

Anti-money laundering laws in India are a critical aspect of the country's financial and economic framework. They are designed to prevent the illegal flow of funds through the banking and financial system and to promote transparency and accountability in financial transactions.

India has implemented a comprehensive set of anti-money laundering laws, which have been updated periodically to keep pace with global best practices.

1.4.1 PMLA, 2002

In India, Prevention of Money Laundering Act, 2002 (PMLA) was enacted to fight against the criminal offence of legalizing the income/profits from an illegal source.

The act provides for the prevention, detection, and prosecution of money laundering activities. It requires financial institutions to maintain records of all transactions and report any suspicious activity to the authorities.

And it reaches the property itself: the Prevention of Money Laundering Act, 2002 enables the government or the public authority to confiscate the property earned from the illegally gained proceeds.

1.4.2 Unlawful Activities Prevention Act, 1967

This Act provides more effective prevention of certain unlawful activities of individuals and associations, and for dealing with terrorist activities, and for matters connected therewith.

The act empowers the government to ban organizations involved in terrorist activities and freeze their assets. It also provides for severe punishment for those involved in such activities.

UAPA is the terrorism statute; PMLA is the money statute.

1.4.3 Foreign Exchange Management Act, 1999

This Act consolidates and amends the laws relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India.

The act regulates foreign exchange transactions and prohibits money laundering and financing of terrorism through such transactions.

1.4.4 The SEBI AML/CFT guidelines

Two instruments set the duties of securities market firms. They are the PMLA and the PML Rules. In the workbook's words:

The Prevention of Money Laundering Act, 2002 ("PMLA") and the Prevention of Money-Laundering (Maintenance of Records) Rules, 2005 (PML Rules), as amended from time to time and notified by the Government of India, mandate every reporting entity which includes intermediaries registered under section 12 of the Securities and Exchange Board of India Act, 1992 (SEBI Act) and stock exchanges, to adhere to client account opening procedures, maintain records and report such transactions as prescribed therein to the relevant authorities.

Three obligations, then — account opening procedures, record maintenance, and reporting.

Where SEBI's power comes from: the PML Rules, inter alia, empower SEBI to specify the information required to be maintained by the intermediaries and the procedure, manner and the form in which such information is to be maintained.

It also mandates the reporting entities to evolve an internal mechanism having regard to any guidelines issued by regulator for detecting the transactions specified in the PML Rules and for furnishing information thereof, in such form as may be directed by the regulator.

The aforesaid guidelines stipulate the essential principles for combating Money Laundering (ML) and Terrorist Financing (TF) and provide detailed procedures and obligations to be followed and complied with by all the registered intermediaries.

1.4.5 Financial Intelligence Unit – India

Financial Intelligence Unit – India (FIU-IND) was set by the Government of India vide O.M. dated 18th November 2004 as the central national agency responsible for receiving, processing, analyzing and disseminating information relating to suspected financial transactions.

FIU-IND is also responsible for coordinating and strengthening efforts of national and international intelligence, investigation and enforcement agencies in pursuing the global efforts against money laundering and financing of terrorism.

Who it reports to: FIU-IND is an independent body reporting directly to the Economic Intelligence Council (EIC) headed by the Finance Minister.

Independent, and reporting to the EIC under the Finance Minister — not to SEBI or the RBI.

The main function of FIU-IND is to receive cash/suspicious transaction reports, analyse them and, as appropriate, disseminate valuable financial information to intelligence/enforcement agencies and regulatory authorities.

In plain terms, FIU-IND does three things. It receives reports. It studies them. It passes on what it finds. It does not itself investigate or prosecute.

The workbook's sample question asks which organisation does this — the answer is FIU-IND, not the RBI, SEBI or IRDAI.

The six functions:

• Collection of Information: Act as the central reception point for receiving Cash Transaction reports (CTRs), Non-Profit Organisation Transaction Report (NTRs), Cross Border Wire Transfer Reports (CBWTRs), Reports on Purchase or Sale of Immovable Property (IPRs) and Suspicious Transaction Reports (STRs) from various reporting entities.
• Analysis of Information: Analyze received information in order to uncover patterns of transactions suggesting suspicion of money laundering and related crimes.
• Sharing of Information: Share information with national intelligence/law enforcement agencies, national regulatory authorities and foreign Financial Intelligence Units.
• Act as Central Repository: Establish and maintain national data base on the basis of reports received from reporting entities.
• Coordination: Coordinate and strengthen collection and sharing of financial intelligence through an effective national, regional and global network to combat money laundering and related crimes.
• Research and Analysis: Monitor and identify strategic key areas on money laundering trends, typologies and developments.

Five report types to remember: CTRs, NTRs, CBWTRs, IPRs and STRs.

Why all of this matters together

The prevention of money laundering is essential to combat financial terrorism effectively.

The workbook names three tools for this:

• Robust regulations and guidelines.
• Improved collaboration between financial institutions and governments.
• The use of technology-driven solutions.

All three are considered crucial to prevent the financing of terrorism. No single law or body can do the job alone.

Collective action approach of the institutions aims to combat financial terrorism and ensure global financial stability and security.