A thematic review into the money laundering risks across capital markets by the UK Financial Conduct Authority (FCA) identified a catalog of concerns, which industry experts say market participants would be foolish to ignore.
“Senior managers who have anti-money laundering (AML) and financial crime responsibility on their docket need to be reading this, as their personal ‘to-do list’ of items to work through, because it is now their neck on the line as well as the firm’s, if the firm is not up-to-scratch on tackling money laundering risks,” said Lucy Kerr, senior associate for financial regulation at law firm RPC in London.
Kerr said the thematic review was clearly intended to fire a warning shot across the bows of capital markets firms, which would end in enforcement down the line for those that did not act now to reduce money laundering risks.
The thematic review looked at 19 firms involved across the full array of capital market activity from investment banks, recognized investment exchanges, trade bodies, custodian banks, clearing and settlement houses and inter-dealer brokers to trading firms.
Despite the £163 million penalty notice issued to Deutsche Bank in January 2017, for failing to establish and maintain an effective AML framework, and the Upper Tribunal decision in April 2019 with regard to Linear Investments Ltd, the FCA found the 19 participants it looked at “were generally at the early stages” of their thinking in relation to money laundering risk and needed to do more to understand their exposure.
“It was very surprising to see that some firms were found to be at an early stage in developing their understanding of their exposure. Money laundering is nothing new. It has been at the top of the FCA’s agenda in its business plan for several years in a row, so I think that there will be concern at the 19 firms that the FCA visited, who are still at an early stage,” Kerr said.
The FCA said firms had been focusing on identifying market abuse at the expense of spotting money laundering, and that many firms had failed to appreciate that market abuse could also be indicative of money laundering.
“We found little evidence that participants had considered whether parallels may exist between their market abuse surveillance and AML transaction monitoring,” the FCA said in the review, adding that it expected to see much more coordinated thinking about the inter-connectedness in trade surveillance at firms.
Samantha Sheen, director at Ex Ante Advisory Ltd, a financial crime prevention consultancy, said firms could deploy the surveillance technology they already use to monitor their staff for market abuse for AML.
“The end goal here that the regulator has given is that we should better understand how clients are going to behave. I would be thinking creatively and go, ‘right, we already have technology looking at how employees behave, so we need to leverage some of that and flip it around for our customers, so we can anticipate what would be expected behavior, where there might be anomalies, and spot patterns’,” Sheen said.
The FCA singled out the front office as being of particular concern.
“The FCA flagged that generally there is insufficient understanding of firms’ exposure to money laundering risks in capital markets. In particular, the first line of defense needs to take greater ownership and accountability of ML risks, rather than viewing it as an exclusive responsibility of the second line (i.e., compliance). Dedicated AML training is too high-level and not tailored enough to inform staff regarding the specific money laundering risks in capital markets,” law firm Norton Rose said in an update to clients last week.
It will not necessarily be traders sitting in the front office who will pick up that something is amiss, though, according to Sheen. Financial crime will not always present itself by means of the trading activity, she said.
“The problem is the transfer of ownership to third parties. The people who would matter the most to pick that up would be your share register team. They would be the ones going, ‘Okay, we have to change the names on this, who is this?’ So not your customer, because your customer has sold some shares to someone you know absolutely nothing about. That has absolutely nothing to do with trading activity, it won’t be a spike, or an anomaly, it will look like any other secondary activity,” Sheen said.
Customer not product
The FCA identified that the money laundering risk centered on customers, and not products. It further found that many firms relied on others in the trading chain, such as custodians and exchanges, or assumed that they were more responsible for carrying out customer due diligence.
This is not what the regulations say. Each firm is required to know who their customer is and what their trading strategy is.
“I always explain to firms that it is crucial to gain an understanding of their clients’ overall trading strategy when they are on-boarding them, in order to understand what as a client they are looking to achieve. If you don’t have that information at the outset then you are much less likely to be able to identify unusual trading patterns down the road,” Kerr said.
The FCA also warned that when firms decide simplified due diligence (SDD) is sufficient for a customer, it expects the reasons for awarding SDD to be documented and justified. The regulations also require firms review a customer’s status if they become aware of any changes, such as orders being placed by unconnected third parties.
The FCA has reminded firms that they cannot outsource regulatory responsibility for customer due diligence, even if they choose to use a third-party provider to perform such checks.
“Reliance is not about relinquishing responsibility; rather, the relying firm retains responsibility but may benefit from efficiencies in both time and resources by avoiding duplication of SDD that another firm has already carried out,” the FCA said in the report.
The thematic review concluded that firms were more successful in identifying suspicious activity when human and automated oversight were deployed in tandem.
“The FCA’s view here is that they will expect some human oversight of these issues as well, to try to pick up issues,” Kerr said.
Regular readers of FCA thematic reviews will have been surprised not to have found any mention of the worst-offending firms being passed to enforcement, according to Kerr.
This is because the FCA did not test the systems and controls of any of the participating firms, but instead based its conclusions on “information and examples” it amassed from its 19-strong firm sample.
The report’s annex contains a list of questions the FCA expects market participants to ask themselves when deciding if their AML procedures are up-to-scratch. The regulator has also provided examples drawn from real life which firms can incorporate into their training and testing.
The FCA said it was updating its supervisory practices on the back of the thematic review’s findings.
Sheen, however, called for a more fundamental review of what capital markets are being asked to put in place.
“The findings aren’t that surprising given the criticism of the [Fifth Anti-Money Laundering Directive] by the investment sector. These are criticisms that have been going for years that have continually fallen on deaf ears. AML regimes are designed for banks. They are not designed for this sector, they don’t fit nicely for this sector: this sector does not walk and talk like a bank, nor do its customers or the other parties involved,” Sheen said.
Sheen said there needed to be a review looking at what AML controls would be appropriate given the reality of how financial crime takes place in capital markets.