Financial institutions play a crucial role in the fight against various financial crimes, such as money laundering, terrorist financing, bribery and corruption, the proliferation of weapons of mass destruction, and violations of economic, financial, and trade sanctions. They face risks associated with legal liability, regulatory penalties, financial losses, and reputational damage for failing to comply with the current laws and regulations related to detecting and preventing financial crimes.
Compliance with all requirements regarding financial crimes can be seen by financial service providers as an additional complication, with little to no reward for compliance efforts, as well as severe penalties for any violations of those requirements. However, the motivation to combat financial crimes should extend beyond risk and profit considerations for financial institutions. The integrity of the financial system is vital for maintaining the legality of financial flows and is a responsibility shared by all involved parties.
This article is devoted to the topic of “trade-based money laundering” (TBML), which the Financial Action Task Force (FATF) defines as “the process of disguising proceeds of crime through the movement of valuables using trade transactions in an attempt to legitimize their illicit origin or finance criminal activity.” According to the FATF, TBML is distinct from other trade-related crimes (such as smuggling) in that its goal is to move money, not goods. The primary aim of any TBML scheme is to launder money through trade transactions.
Financial institutions serve as the main conduit for the flow of illicit funds under the guise of financing or paying for a trade deal. TBML can be carried out by misrepresenting the price, quantity, or quality of imports or exports, as well as through fictitious trade activities. Common tactics include over- or under-invoicing, issuing multiple invoices, reducing or increasing shipment volumes, misrepresenting (shipping goods not specified on the invoice), or failing to ship altogether. For these reasons, establishing the existence of a genuine trade transaction is critical for trade finance — it helps prevent money launderers from exploiting trade finance operations, financial institutions, and the financial system.
For those who consider the risk of TBML negligible, it is worth noting the grim fact that organized crime groups, professional money launderers, and terrorist financing networks (collectively referred to hereinafter as “syndicates”) are behind TBML. They seek to hide proceeds from crimes such as the illegal drug trade through the financial system. Trade finance bankers may turn a blind eye to TBML, especially when the revenues derived from these operations yield substantial profits, given that syndicates are not overly concerned with the cost of services when it comes to paying financial institutions to launder money.
According to the United Nations Office on Drugs and Crime, the amount of money laundered worldwide annually ranges from $800 billion to $2 trillion, or 2-5% of global GDP. The Global Financial Integrity (GFI) research center analyzed official government data presented in the UN Comtrade database to estimate the scale of “trade mismatches,” which it considers one of the largest measurable components of illicit financial flows. For example: if Ecuador reported exporting bananas to the United States worth $20 million in 2016, but the US reported importing bananas from Ecuador worth only $15 million in the same year, this reflects a discrepancy, or gap, of $5 million in the recorded trade value of this commodity between the two partners for that year. A trade mismatch occurs when importers and exporters deliberately falsify the prices stated on invoices for imported or exported goods with the aim of illegally moving value across international borders, evading taxes and/or customs duties, laundering proceeds from criminal activities, circumventing currency controls, and hiding profits in offshore accounts. According to GFI, between 2008 and 2017, the value gap among 135 developing and 36 developed economies amounted to $8.7 trillion.
Assessing the fairness of the prices for goods that a financial institution finances or pays for is a way for financial institutions to detect TBML. The question of how to effectively verify prices is crucial for banks, but it is difficult to answer.
Trade Finance and TBML Control
According to the World Trade Organization, 80-90% of global trade is conducted using trade finance. International trade is a key driver of economic growth, reduces poverty, and facilitates private financial flows between countries. Access to affordable trade finance is one of the prerequisites for successful international trade. Trade finance involves funding the real sector of the economy, and financial institutions can view providing trade finance to legitimate borrowers or applicants as serving the public good. Combating TBML is necessary to protect the financial system and its providers from being tainted by involvement in supporting criminal activities.
Most bank TBML control mechanisms focus on documentary trade, where banks work with documents containing information about the trade transaction. Some argue that the sheer volume of transaction information is extremely burdensome for banks, as they must sift through vast amounts of data to detect incorrectly issued invoices and/or other red flags. When banks make payments against an invoice, they typically require fewer documents/data than with letters of credit — invoices supported by a copy of transport documents may be the only requirement, and in some cases, only invoice data is needed.
Invoice-based trade occupies a significant market share in international trade. By many estimates, at least 80% of global trade is conducted on an invoice basis, and less than 20% through documentary letters of credit and their derivatives. This is in stark contrast to four decades ago, when the share of invoice-based trade was 20% and documentary trade was 80%. Although many claim that the use of letters of credit in international trade is declining (and the volume of global trade without letters of credit and documentary collections seems to confirm this viewpoint), understanding the reasons behind the growth of invoice-based trade must take into account widespread globalization and the growth of transnational corporations over the past few decades, which has led to the widespread relocation of manufacturing and extraction from developed to less developed countries. Shipments of goods produced offshore by subsidiaries of giants are accounted for as exports and imports between countries — from a commercial perspective. Such transactions between de facto monopolists (parent and subsidiary companies) do not require letters of credit and have significantly contributed to the growth of invoice-based trade.
Non-bank organizations, including fintech companies and funds, are increasingly providing trade finance. Such organizations often do not fall under the same regulatory levels as banks, resulting in less TBML compliance scrutiny. Nevertheless, they must exercise the same vigilance to avoid unwitting use by syndicates in TBML schemes, especially when financing invoice-based trade.
A Sectoral Approach Needed to Combat TBML
The Bankers Association for Finance and Trade (BAFT) made an interesting calculation: of all types of payments made in the world, only 0.52% are trade settlements. Since at least 80% of trade is conducted via invoices, a mere 0.1% of all payments worldwide represent documentary transactions.
Most banks’ AML monitoring efforts focus on documentary trade (simply because banks are provided with documents to verify). But this is a highly inefficient use of resources, given that such measures are taken to detect and intercept illicit funds in flows that account for only 0.1% of total global fund flows. BAFT’s findings show that combating TBML cannot be left solely to banks — law enforcement, government agencies, and regulators must adopt an ecosystem approach to the problem, bringing together stakeholders such as financial institutions, customs authorities, and shipping companies, who perform specific functions and have access to different information. Individual institutions and sectors have their limitations, but an ecosystem approach is more comprehensive and effective for detecting and proactively preventing financial crimes.
The Asia-Pacific Financial Forum’s (APFF) Digital Trade Finance Lab has leveraged BAFT’s findings and recommendations in its recent project, analyzing the role that technology can play in more effectively countering TBML. According to a forthcoming paper, innovative technologies such as blockchain, artificial intelligence, and privacy-enhancing techniques can be used to share information among entities. These technologies can alleviate compliance challenges related to the private exchange of information between individuals and legal entities, which is standard for cross-industry and multi-industry responses to TBML. A series of recommendations and prescribed measures have been identified, which will be presented to the finance ministers of APEC member economies. They include standardization, security, and transparency of data for financial institutions and enterprises. Such data include prices, volumes, origin and destination of goods, HS codes, quality/grade of goods, and models/brands. The exchange of data should involve financial institutions, governments (e.g., customs), logistics providers, traders, inspectors, and technology providers.
Acknowledging that AML is carried out by entities including syndicates, an effective “Know Your Customer” (KYC) system serves as the first (but not the only) line of defense for a financial institution. KYC is a labor-intensive and costly process for financial institutions. The Legal Entity Identifier (LEI) is a relatively new initiative that is gaining momentum, providing a uniform global identification for businesses worldwide. The LEI uniquely and unambiguously identifies legal entities involved in financial transactions, providing information about the ownership structure of an organization, thereby answering the questions “who is who” and “who owns whom.” By increasing business transparency, the LEI is considered transformative for creating greater certainty in client onboarding and credit approval processes. The Asian Development Bank outlines the benefits of the LEI as follows: enabling trade finance organizations to verify the identity of potential clients, foreign counterparties, and service providers; reducing fraud; enhancing the efficiency of AML and CFT practices by reducing instances of “defensive compliance”; reducing “false positives” in compliance activities; improving the ability to detect patterns in AML and CFT issues in trade finance. The use of the LEI can become best practice, if not mandatory, for organizations financing global trade, as a means of increasing transparency in the identification of parties appearing in transaction documents and data.
Effective TBML risk management through the adoption of industry initiatives and standards by providers should lead to reduced complexities for their clients and allow providers to offer more financing to a larger number of clients.
Potential Real-Life TBML Risks (Examples)
After sufficient time has passed, I believe I can share some stories from my own experience. I had a trading client from Singapore who claimed to be the largest supplier of a certain commodity to India, with a market share of over 50% and hundreds of buyers in India. Indian buyers financed their purchases using letters of credit, while the trader bought goods from suppliers in Southeast Asia using a demand draft letter of credit. The trader had credit lines with our bank, which issued letters of credit to his suppliers. It was assumed that settlements for these letters of credit would be made from receipts of discounted export letters of credit from the trader. Export letters of credit were discounted by other banks, as the trader had credit lines with these banks for pre-shipment discounting with recourse to the trader (recourse rights were removed after receiving acceptance from the issuing banks). The reason our bank did not provide the trader with letter of credit discounting was that the bank could not meet the trader’s request for discounting immediately upon presentation of documents without verification. The trader insisted on such an arrangement on the grounds that, based on his experience, he would never be able to present documents without discrepancies, and that any buyer in India wanting to receive the goods would have to accept discrepancies (given the trader’s dominant market position). Furthermore, there was always pressure to urgently forward documents to the issuing bank due to the imminent arrival of a chartered vessel.
Over time, our bank noticed a change in the source of payments for settling the letters of credit it had issued — payments began to come from banks in Hong Kong. When questioned, the trader explained that Indian buyers were using Hong Kong agents to make payments. Eventually, our bank decided to sever ties with the trader, considering his transactions too opaque and inexplicable. Recently, this trader was accused of fraud in financing operations related to his dealings with a major multinational commodity trader.
There was another incident when a client was presented to us, who requested that we, on behalf of his bank in Singapore, discount several letters of credit for large sums from North Asia. According to the client, the issuing banks would bear no risk, as the letters of credit would be fully backed by cash, and the beneficiary would not be sensitive to the fees of the nominated bank. Although our bank had sufficient approved limits for the prospective issuing banks, we decided to decline the request because the client was evasive in answering questions and insisted on disclosing information about what trade transactions the letters of credit would serve.
I share these stories to illustrate the practical difficulties banks face when trying to evaluate their clients’ transactions without complete information. Banks often have to assess risks based on the “plausibility” of clients’ responses to questions about their trade operations. Providers should be aware of the various risks they assume regarding their clients (credit, compliance, fraud risks, and others) and regularly conduct risk assessments.
On the Way to More Effective TBML Controls
Current recommended methods for reducing TBML risk include the following:
- Training and educating financial institution staff on compliance issues and instilling a culture of compliance based on regulatory guidelines or directives.
- Effective KYC practices to verify the client and their owners before onboarding (and periodic post-onboarding reviews) and client due diligence to assess the level of AML/CFT risk.
- Reviewing, analyzing, and monitoring transactions to ensure that the underlying trade operations are genuine and do not violate applicable laws.
Money laundering is essentially a problem for all types of settlements, as it is carried out by moving money. Therefore, TBML efforts should not only focus on documentary transactions but also on tightening AML guidelines for all types of settlements, since documentary transactions represent only a small fraction of total trade-related payments. TBML risks in invoice-based trade are significantly higher. Consequently, effective solutions must include industry-level measures such as expanding public-private cooperation, data sharing between the private and public sectors, the use of technology, and requiring financial institutions and enterprises to provide LEIs. Financial institution employees are on the front line of managing TBML risks for businesses and must recognize that combating TBML is the responsibility of various departments, including client services, operations, credit, risk, compliance, and internal audit. Money laundering is a problem that affects the entire financial system and is not limited to trade finance. Given the volume of data actually present in trade (currently in data warehouses), the ability to use this data while preserving confidentiality promises to make TBML controls more effective, thereby reducing the risk of money laundering in the field of trade finance.