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The High Risk Ghost in Trade Finance
It is a fact that there is a perception that the Trade Finance Area is High Risk for the purpose of AML.
Auditors, regulators and compliance officers often make reference to external reports when arguing that the AML risk of Trade Finance is High. In my experience they make reference to the following:
* The Financial Action Task Force (FATF)
Report: Trade-Based Money Laundering. Published 2006
* The Wolfsberg Group
Report: The Wolfsberg Trade Finance Principles. Published 2011
* The Joint Money Laundering Steering Group (JMLSG)
Report: Prevention of money laundering/combating terrorist financing. Published 2011 (amended 2012)
* Financial Conduct Authority (FCA)
Report: Thematic Review 13/3 (TR13), Banks’ control of financial crime risks in trade finance (published July 2013)
As can be seen from the above; the latest of the referenced external reports have been published in 2013. However, within the latest 5-10 years the area of regulatory compliance has matured a lot – not least within the Trade Finance area.
Recently (2017) international bodies have published new reports. These reports are setting the international standards in respect of regulatory compliance within the Trade Finance area. These reports offer a more nuanced and mature risk approach, then is the case for the previous.
The reports in question are:
* The Wolfsberg Group, ICC and BAFT Trade Finance Principles
Published January 2017
Combating Trade Based Money Laundering: Rethinking the Approach
Published by BAFT (Bankers Association for Finance and Trade. https://www.baft.org/) August 2017
The below is a walk through some of the key findings in respect of the risk picture for Trade Finance – based on the tow above reports.
The Wolfsberg Group, ICC and BAFT Trade Finance Principles
“The Wolfsberg Group, ICC and BAFT Trade Finance Principles” is an update of the “The Wolfsberg Trade Finance Principles” from 2011. In reality the 2017 version is a totally different – and much more comprehensive – document that the 2011 version. In addition the 2017 version is not only drafted by the Wolfsberg Group – but drafted together with the International Chamber of Commerce and BAFT – two organisations recognised for setting the standards for international practice within the Trade Finance industry.
For starters the report makes reference to the FATF report – which can be referenced as the “Mother” of the other reports mentioned above. The following is stated:
This paper does not cover Trade Based Money Laundering as defined in the FATF report on TBML, which covers multiple areas outside of the scope of Trade Finance. The FATF Report on Trade Based Money Laundering highlights that problems are not limited to the Trade Finance activities in which FIs are directly involved, but that any process to move money through the banking system by simple payment may be manipulated as a means of financing trade in order to disguise the true underlying (and potentially illegal) activity.
In other words, when the FATF report addresses the issue of Trade Based Money Laundering, this is not limited to Trade Finance, but also covers (for example) open account payments covering international trade (which represents approximately 80% of all international trade). This is further elaborated upon in Chapter 1.4:
Trade Based Money Laundering (“TBML”) has become a widely used term. It covers a broad spectrum of financial and other services, including those financial services referred to as Trade Finance, but also transactional activities across current and deposit accounts and payments for example, which are not in the purview of Trade Finance operations of FIs.
Following the above the report makes a clear distinction between trade based money laundering that relates to open account trade – and trade based money laundering that relates to the use of Trade Finance products. Chapter 1.5 address this issue and states that:
The majority of world trade is carried out under “Open Account” terms, whereby the buyer and seller agree to the terms of the contract and goods are delivered to the buyer followed by a clean or netting payment through the banking system. Under such Open Account terms, unless the FI is providing credit facilities, the FI’s involvement will be limited to the clean payment and it will not generally be aware of the underlying reason for the payment. As the FI has no visibility of the transaction, it is not able to carry out anything other than the standard anti-money laundering (AML) and sanctions screening on the clean or netting payment.
In other words, when a trade is settled via open account payment (which is the majority) the bank is not aware of the underlying transaction, and has no visibility of the transactions. For Trade Finance the opposite applies: The bank is aware of the underlying transaction (commodity, counterparties etc.), and the documentation is visible to the bank, meaning that the bank is capable of making a comprehensive compliance check.
In respect of the risk rating the report states that:
There is a perception that Trade Finance is a “higher risk” area of business from a financial crime perspective, therefore, all FIs involved in Trade Finance should have risk policies and controls which are appropriate for their business.
The report does not indicate that Trade Finance is high risk per se; but rather that it is perceived as higher risk. The point made is that this perception should result in risk policies and controls that are appropriate for the individual bank. I.e. risk policies and controls that cover the actual risks for the individual bank. This is further elaborated upon in Chapter 3,b – Risk Assessment. This chapter caters for a risk based approach, so that the actual risks are addressed, for example taking into account the counterpart country.
The point of addressing the risk level of Trade Finance in this manner clearly is to nuance the picture: One cannot not reasonably label Trade Finance with a certain risk per se, as it depends on how the products are being used.
Combating Trade Based Money Laundering: Rethinking the Approach
The report “Combating Trade Based Money Laundering: Rethinking the Approach” by BAFT is a clear indication that the issue of regulatory compliance is maturing: Not least when it comes to Trade Finance. This is the report that – in the clearest and well documented manner – makes a distinction between TBML arising from transactions that are “non-documentary” and those that are “documentary”. For example it is stated that (Background, page 2):
To better understand TBML in a bank context, it is essential to first differentiate trade that is bank-intermediated from that which is not. Buyers and sellers agree to contract terms independent of any financing that may be required. In some instances, financing is not required. In other cases, financing is provided between the two parties (e.g., 30/60 day terms of sale), where the buyer pays the seller within a designated period of time from the invoice date. The only role for the bank is processing the payment to settle the transaction. The bank has no knowledge or visibility to the underlying trade transaction as it was not bank-intermediated, and therefore, has limited ability to identify illicit trade behavior.
In instances where trade is bank-intermediated, the bank may provide financing and/or risk mitigation. Financing occurs in a variety of forms including transaction types such as documentary (e.g., letters of credit, collections, guarantees) and non-documentary (e.g., trade loans, receivables/payables financing). Transactions that are non-documentary and those that are not bank-intermediated are broadly referred to as open account trade. In 2017, Wolfsberg estimated that approximately 80% of global trade was transacted using open account settlement.
In respect of the above Trade Finance falls under the “documentary” category – that covers approx. 20% of all global trade transactions. Although this is 20% of all transactions, it represents only roughly 0,1 % (or less) of the total global trade volume (Page 6).
The document is very clear that “The type of trade transaction used determines the opportunities a financial institution has to identify the suspicious activity.” Following that statement the document includes an example, where the following is stated:
In this case, the bank advising and/or negotiating the letter of credit has sufficient access to the transaction’s underlying information to review it for red flags before executing the payment. There is some potential to identify indicators of money laundering, especially given that documents generally undergo several stages of (often manual) review by experienced processing staff within a bank’s trade services department. (Example 1, page 3)
Basically the document argues that 1) there is a good possibility for banks to do compliance checks on documentary transactions – whereas there is only little information available in open account transactions, making the transaction much less transparent, and 2) The number of documentary trade transactions and the value of same is relatively low – compared to trade transactions where the payment instruction is open account.
As for the second part of item one above the document underlines that:
Generally, the only time a bank intervenes to obtain more details on a payment is if:
1: The payment instructions are unclear, requiring more information.
2: A sanctions filter automatically stops the transaction for further review by Operations and/or Compliance staff. The bank may ask for additional detailed information on the underlying transaction and purpose of the payment to determine if there is actually a true “hit” i.e., a sanctions violation.
(Monitoring Non-Documentary Trade Transactions, page 7)
This leads to the conclusion that:
There is limited data to indicate what percentage of actual TBML involves bank-intermediated, documentary and non-documentary trade. Nevertheless, for reasons outlined above, there appears to be a very low instance of documentary TBML relative to open account. Yet, an inordinate amount of emphasis is placed on the controls within the trade services department to mitigate TBML in documentary trade.
In other words: There is no evidence as to the actual volumes of trade based money laundering. However the volumes for documentary TBML is relatively lower then TBML relating to open account payments. The document even makes the conclusion that the emphasis on “Trade Finance based money laundering” does not match the value of the required controls:
All of the AML monitoring and controls put in place in a bank’s trade services department are there to identify and intercept roughly 0.1% (or less) of illicit funds flow. This is not a very efficient use of resources.
Basically the document concludes that there is no evidence – or for that matter reasonable arguments – that the AML risk within the Trade Finance area is high. On the contrary!
For that reason the document argues that the solutions to better combat trade based money laundering is not additional controls on the banks, but rather activities that are based on co-operations, training, information sharing, technology etc., all of which either at a higher level than the Trade Finance department – and in many cases based on a co-operation outside the banks.
On the basis of the above, the following can be concluded:
1: The referenced external reports have been published between 2006 and 2013. Within the latest 5-10 years the area of regulatory compliance has matured a lot – not least within the Trade Finance area, therefore updated information should be sought in more recent reports like “The Wolfsberg Group, ICC and BAFT Trade Finance Principles” (Published January 2017) and “Combating Trade Based Money Laundering: Rethinking the Approach” (Published by BAFT August 2017). It is even concluded that the key report – i.e. the FATF report - covers multiple areas outside of the scope of Trade Finance.
2: There is no evidence as to the actual volumes of trade based money laundering.
3: When addressing the issue of TBML one must makes a distinction between TBML arising from transactions that are “non-documentary” (e.g. based on open account payments) and those that are “documentary” (e.g. based on the Trade Finance products such as documentary credits, collections and guarantees).
4: When a trade is settled via open account payment (which is the majority) the bank is not aware of the underlying transaction, and has no visibility of the transactions. For Trade Finance the opposite applies: The bank is aware of the underlying transaction (commodity, counterparties etc.), and the documentation is visible to the bank, meaning that the bank is capable of making a comprehensive compliance check.
5: At least 80% of the trade transactions are open account, only about 0.1% of the value of the payments made reflect settlement of documentary trade.
I truly hope that the above - and the "new" reports for once and for all will kill the High Risk Ghost in Trade Finance.
Take care of each other and the LC.