Money Laundering Risks in Capital Markets

On 10 June, the Financial Conduct Authority (FCA) published findings from its latest thematic review, “Understanding the Money Laundering Risks in the Capital Markets” TR19/4 (the report). As part of its review the FCA visited 19 market sector operators, including investment banks, recognised investment exchanges, clearing and settlement houses, trade bodies, inter-dealer brokers and trading firms. The FCA states that the visits were only “diagnostic”, so the systems and controls of each of the participants were not assessed. This report follows closely on a recent Dear CEO Letter for wholesale market broking firms, which highlighted a lack of understanding and complacency about their responsibilities in relation to financial-crime risk.

The report noted that while the nature of some of the products and markets may be considered less attractive to launderers, due to entry barriers, levels of scrutiny and complexity of products (e.g. most firms in the sector are regulated institutions), there are several capital market-specific money laundering risks of which the firms need to be more aware. Effective customer risk assessment and customer due diligence (CDD) are key to reducing the opportunities for money laundering. It is important that each firm in the chain correctly fulfil its obligations in relation to CDD for its own customer, specifically because trading chains often have multiple layers, involving complex products and players who are often cross-border.

The FCA indicates that some participants rely too heavily on their customers being regulated financial institutions, with little consideration of other risk factors associated with the customer. Whilst firms are allowed under certain circumstances to apply simplified due diligence (SDD) – for example, if the firm determines that a relationship or transaction presents a low degree of money-laundering risk – they should take a risk-based approach rather than simply defaulting to SDD. Firms should also document the rationale for any decision to apply SDD.

The FCA noted that firms who provide Direct Electronic Access (DEA) and delegate their system access to a sub-user (which might create a lack of visibility) should consider taking measures such as detailed questionnaires and on-site visits for DEA customers, or gathering detailed information on risk-management controls, in order to achieve an in-depth understanding of the type of trading taking place.

Generally, the FCA found that the firms they visited are at the early stages of their thinking in relation to money-laundering risk and need to do more to fully understand their exposure. It noted that focus is about detecting market abuse, without fulling considering that potential market-abuse suspicions could also be indicative of money-laundering suspicions. The FCA also found limited reporting by capital markets firms on suspicions of money laundering, as some participants were not clear on their obligations to submit Suspicious Activity Reports (SARs). The FCA believes that the low level of markets-related SARs is to be attributable to the following factors:

• Believing suspicious activity to be market abuse related and, therefore, only reporting market abuse to the FCA.
• Not having sufficient knowledge or capability to detect suspicions of money laundering through the capital markets.
• Having very few case studies and precedents.
• Thinking that money laundering may be occurring elsewhere in the market or trading chain, and therefore believing that a submission of their own SAR is unnecessary.

Some participants said they perceive the money-laundering risk to be lower when transactions are conducted on exchange, as they thought exchanges may have better visibility of the overall transaction chain. The FCA noted that this might not always be the case as some exchanges can see details of the members but not of the underlying trader.

Here a few consideration points, which are easily applicable to other sectors too:

• The first line of defence needs to take greater ownership and accountability of money laundering risks, rather than viewing it as an exclusive responsibility of compliance (or back office in general).
• Training tends to be high level and not tailored enough to inform staff regarding the specific money laundering risks in capital markets (e.g. basic online anti-money laundering training module with little else to support it). This is mostly seen as a necessary annual exercise to avoid a possible disciplinary process. Firms, instead, should ensure that staff performing relevant roles receive tailored training on how money laundering could manifest itself.
• Firms must have an effective surveillance system for transactions in place, rather than leaving it to others to monitor transactions.
• Firms must consider that potential market-abuse suspicions could also be indicative of money-laundering suspicions.
• Work is still needed to change behaviours within firms operating in the capital markets. Poor behaviour across firms can undermine market integrity, creating harm and damaging confidence in the market.

The report includes a useful Annex with a set of sector-specific typologies built from a variety of intelligence sources which can be used to inform risk assessments, transaction monitoring and training. The list is not exhaustive and firms are responsible for determining how certain risks and factors are relevant to their own business model.

Potential red-flags include:

• Remote booking of trades between group entities
• Pre-arranged trading and non-standard settlement instructions, including involvement from third parties
• Free of payment’ asset transfers
• Uneconomic or irrational trading strategies of a customer;
• Unusual trading patterns, such as:

• • counterparty concentration
  • unusual win/loss rates or flat/neutralising activity
  • no trading on an account

The Annex also includes questions for firms to consider in their approach to identifying and assessing the money laundering risks.

Why is this report important to you?

The FCA expressly states in this report that it is considering taking a supervisory approach in response to this work (e.g. no longer a diagnostic effort). It is likely, therefore, that the failings identified may prompt the FCA to actively seeking to initiate enforcement actions in capital markets. Firms operating in this area should anticipate increased regulatory attention.

Senior managers in other sectors should also consider the results of this thematic review and how the FCA concerns could be addressed in their own firm. Keeping in mind the continuous improvements in technology, firms should ensure that their anti-money laundering prevention systems and controls comply with the latest standards and expectations.

If you require any assistance in understanding how the points raised in the report might apply to your business, please do not hesitate to contact us.