U.S. Department of State
1996 International Narcotics Control Strategy Report, March 1997

United States Department of State

Bureau for International Narcotics and Law Enforcement Affairs

FINANCIAL CRIMES AND MONEY LAUNDERING

MONEY LAUNDERING: A CHANGING SCENARIO

International banking continues to evolve, both in terms of the worldwide connections among banks, as well as the increasing sophistication of banking methods. The constant challenge is to ensure that every bank can account for its customers, that every government has laws which ensure the prosecution of financial crimes, and that every society sets a moral and ethical standard for the conduct of commerce.

Many important financial centers have now adopted legislation to curb drug-related money laundering, and the number of governments which have ratified the 1988 UN Convention continued to increase in 1996. But, the race between criminals seeking new venues and oversight bodies seeking more widespread compliance still goes to the crooks.

In 1987, when the first INCSR money laundering chapter was published, the priority concern was with twelve leading financial centers including the United States, United Kingdom, France, Germany, Italy, Switzerland, Hong Kong, Singapore, Panama, the Bahamas, the Cayman Islands, and Colombia. When FATF was founded in September 1989, the belief was that major relief could be achieved through a congruence of laws and policies among 15 major industrialized countries: the US, UK, Germany, France, Italy, Canada, Japan, Netherlands, Australia, Switzerland, Luxembourg, Spain, Sweden, Belgium and Austria. By 1991, FATF had expanded to include all 24 members of the Organization for Economic Cooperation and Development, as well as Hong Kong and Singapore.

The 1988 INCSR noted that Cyprus, for example, was not a priority, while Mexico was treated marginally, Russia was still the heartland of the Soviet empire, and Israel, Turkey, Aruba, the Netherlands Antilles, Antigua and others did not appear on most money laundering maps. Yet, Russia, Turkey and the Netherlands Antilles were raised to High Priority in 1996, where Mexico and Aruba remain continuing concerns; Israel and Antigua are Medium-High priority and Cyprus has been raised to High Priority in 1997.

Now, new trafficking routes in Africa and in the lower regions of the old Soviet regime pose the concern whether traffickers will soon take advantage of the minimally regulated banking systems along these routes. An ever-lengthening list of Low Priority governments include several which were of no concern as recently as two years ago.

Moreover, too many priority financial centers have still not adopted needed legislation or ratified the Convention (the latter include Aruba, Colombia, Mexico, Netherlands Antilles, Nigeria, Singapore, Thailand, Turkey and Venezuela). There is also a substantial question whether the drug trafficking-oriented money laundering laws which many governments adopted in the earlier part of this decade are adequate, given recent developments in money laundering practices, the upswing in non-drug financial crimes, and the need to adapt to new technologies used in banking, as well as extending laws to include non-bank financial institutions.

Organized crime groups are increasingly a factor in major money laundering schemes -- and the multiple sources of their proceeds compounds the difficulty of linking the monetary transaction to a unique predicate offense like drug trafficking. Moreover, criminal organizations have distinct patterns of operation which vary from one part of the globe to the next. Russian "mafiya" groups have enlarged their presence in the Western Hemisphere, and are becoming as much a concern as the traditional Italian/Sicilian "mafia", Colombian cartels or the Asian triads and yakuza.

In its 1997 public report on typologies, the FATF noted that organized crime continues to be responsible for a large proportion of the illegal funds entering financial systems. FATF said organized crime groups in Italy, Japan, Colombia, Russia and Eastern Europe, Nigeria and the Far East (among others) were involved in a wide range of criminal activities, including drug trafficking, loan sharking, illegal gambling, fraud, embezzlement, extortion, prostitution, corruption, illegal trafficking in arms and human beings, organized motor car theft and other crimes. FATF also cited a trend in some countries where criminals who were once only engaged in drug trafficking were either broadening their activities to include other proceeds-generating criminal activities or had switched to other financial crimes carrying lower penalties.

However, FATF analysts concluded that drug trafficking and financial crimes (bank fraud, credit card fraud, investment fraud, advance fee fraud, bankruptcy fraud, embezzlement etc) remain the most frequently cited sources of illegal proceeds, with drug trafficking continuing to be the principal generator of illegal funds.

That scenario changes by regions and by countries within regions. Scandinavian experts believe their greater problem is financial crime. Contraband smuggling tends to dominate in some areas; cigarette smuggling, for example, is considered the primary generator of illegal funds in Albania.

Meanwhile, an increasing number of drug traffickers do not directly manage the laundering or conversion of their proceeds, but rely predominantly on professional money brokers. Such brokers are increasingly crafting effective schemes to evade normal monitoring, detection and reporting devices.

We are seeing a proliferation of financial crimes, not limited to drug money laundering. These include the more common types of financial frauds, but, they also include new variations, particularly the use of prime bank guarantees, phony or fictitious letters of credit, counterfeit and/or stolen bonds and other monetary instruments offered as surety for loans, and other scams.

In just the last six months, we have detected a number of offers involving such schemes in this hemisphere. However, some of the more flagrant examples are occurring in Asia. In one instance, financial "fraudsters" obtained the secret telex codes which banks use for bank-to-bank transactions and were able to take $42 million in cash out of Hong Kong and Shanghai Bank in Jakarta. A number of other alleged scams have also involved the principals of Dragon Bank, which is chartered in Vanuatu but operates in Manila and elsewhere. It has now lost its license in Jakarta.

In the wake of the Dragon Bank incident, Embassy officials in Jakarta, Hong Kong and other cities met with US banks, and learned that foreign and national banks in many Asian countries are being confronted on virtually a continuous basis by what are perceived to be financial frauds.

One attempted transfer confirms that the world of banking is truly a world without horizons. We learned that one group proposed to transfer $1.3 billion from a bank in the Caribbean to Indonesia, which heightens the concern to us. These and other attempts are notable, not only for their variation, but because of their higher probability of success.

The "fraudsters" use fake certificates of deposit drawn on other branches of an international bank, which can range from $10 million to $25 million. The "fraudsters" also use fund transfers, which involve real dollars, opening up small accounts into which they then pour millions of dollars. "Fraudsters" will also use counterfeit letters of agreement, drawn on bank letterheads, seemingly vouching for a client from another branch of that bank, or confirming a deal is been approved, etc.

Many of these proposed frauds are easily detected. A request for a loan on a US bank for $36 billion was easily refused, as were telexes which omitted the needed secret codes or had the wrong codes. But all banks in every region have to be concerned that not all of these deals are illegitimate just because they are to be made in currency or the details are thinly documented.

The problem, which creates a temptation to approve such transactions, is that these banks may be turning away legitimate business. Thus, there is concern that US banks operating overseas may be at a competitive disadvantage because they adhere to US standards for knowing your customer, identifying beneficial owners of transactions, refusing suspicious or unusual transactions etc. US banks have been advised informally that the answer is not to lower US standards, here or abroad, but to intensify efforts to ensure that all major financial centers operate within the limits of an international consensus on countermeasures.

This problem is somewhat analogous to the dilemma challenging bankers in Western Europe. As FATF noted in its 1997 report on typologies of money laundering, many European countries report that significant amounts of cash and monetary instruments were being transferred from the former Soviet Union and Eastern European countries. Two difficulties were cited: determining whether the money was capital flight or stemmed from criminal activities, and, if the latter, determining the predicate offense.

How Money Is Laundered. To understand money laundering as it is practiced today on a global basis, one has to appreciate money as a commodity. Professional money launderers differ little in this respect from corporate money managers. A corporate money manager enters the money markets of various countries where the corporation will need national currencies during the next year and buys/sells currencies in a constant effort to improve the manager's average position at the time of payment. Similarly money launderers use a bidding system to buy/sell drug proceeds, especially US dollars. Just as a sound investment portfolio will contain stocks, bonds and other monetary instruments, the money brokers vary their holdings.

Like institutional investors who put a percentage of their money into hedge funds, money brokers and the drug traffickers and other criminals who employ them collaborate to minimize risk. The Cali Cartel, for example, minimizes risk by selling a substantial portion of the drug proceeds it earns from the sale of cocaine in the United States. Mexican traffickers in heroin, cocaine and marijuana do the same, often selling to the same money brokers on behalf of Cali or for their own account. These brokers will convert proceeds for a fee, or, they will buy the proceeds at a discount. Given the high profit margins of the drug trade, discounts of 7-10 percent or even higher, depending upon risk, are common. At the end of the day, Cali and other trafficking groups may own or control 50 per cent or less of the initial drug proceeds.

The following hypothetical example illustrates the options available. Assume that the Cali Cartel is moving $100 million over the rather porous border from the United States to Mexico and operating on a 75 per cent profit margin (earnings minus costs). Just $25 million must reach Colombia to replenish the operating budget. Cali wants to net $60-65 million from the bulk of the cash, or $85-90 million in total. Brokers have a bid or discount range of 10-15 per cent. Cali agents will attempt to sell $25 million on the gray market -- supported by Latin and even US businessmen who want to convert pesos or other currencies into dollars -- and go into the gray market to avoid exchange rates, or avoid taxes, or, when profit margins are narrow on US goods which can be sold in their countries, to realize higher profits. These currencies, especially pesos, can be readily returned to Colombia. The amounts over which Cali or Mexican traffickers retain actual control will be influenced by prevailing discount rates, investment opportunities, current risk dynamics, and gray market demand, more than it will by the presence or absence of laws. At the same time, the need for fluidity and convertibility, influenced by the strength/weakness of the Mexican peso and the status of US investor confidence, among other factors, will leverage the rate at which Mexican banks will do business with brokers.

Perhaps $25 million more will be "consigned" to allegedly licit importers who use various invoice schemes, at a discount, to legitimize the return of dollars to their countries. The textile trade is a typical cover. For example, a South American clothing manufacturer working with Cali will obtain a permit to export $20 million worth of suits to New York. The manufacturer actually ships $6 million worth of suits to the Aruba Free Zone, where they are repackaged and sent back to Colombia, and sold at discount. Meanwhile, the manufacturer's agent picks up $20 million in drug proceeds in New York and returns it to Colombia, covered by an export license.

The bulk of the $100M will be deposited in Mexican banks, after which a number of schemes can be used. Commonly, the money will be wire-transferred to accounts in the United States. The Mexican banks will then issue checks drawn on its US accounts, payable to individuals or corporations. These checks can be batched for resale in Latin America, or deposited into foreign bank accounts. Enforcement officials believe that as much as $10 billion in Mexican bank drafts is laundered through such schemes each year in Panama alone. While some of the trade is in contraband goods, these checks, certificates of deposit, and other financial instruments have also been used to pay for legitimate shipments. Gold trade in the Aruba Free Zone amounts to more than $200 million a year. The Mexican banks will also issue their own dollar-denominated checks, up to a level which they think will not cause inquiries.

Such brokers offer as much as $500 million to a bank or another broker at a point or two below the official exchange rate. The offer is probably not for a single transaction, but reflects the amount of money this broker has at his disposal. However, transactions are increasing in size. One recent transfer reportedly involved $78 million which went through a US bank in a single transaction.

Why then don't US reports and economic indicators reflect this volume of money transfer? The answer is that these kinds of transactions are designed to fall outside the scope of Treasury and other reporting. For example, US banking law does not require reports on bank to bank transfers (nor are we suggesting it should), let alone transfers from one branch to another of the same bank. Transactions in bulk conducted outside traditional foreign exchange venues are probably escaping conventional monitoring systems.

However, there is also a reverse flow of physical currency back to the US. Flows from Latin America, especially Panama, Paraguay and Mexico, to commercial banks in the US as well as dollars returned to Federal Reserve Banks are in fact in excess of the levels which can be explained by traditional commerce. Research is ongoing as to whether surplus currency at Federal Reserve Banks can be associated with illegal activities, such as money laundering. Currency surpluses in the US are not, in and of themselves, necessarily indicative of money laundering. However, currency does not have to leave a placement site physically. Banks are at least one generation or more beyond the period in which physical money was moved to settle accounts. Dollar settlements are accomplished through reciprocal balances. For example, a Mexican bank wires $50 million to a bank in New York, which gives the Mexican bank instant credit on the latter's New York account because the Mexican bank has simultaneously given the New York bank credit for $50 million at the latter's Mexican facility. Rather than moving physical cash to New York, the Mexican outlet is more likely to transfer physical cash south, as individual checks wind their way through various payment schemes. However, some cash does move back to the US in bulk, carried by Mexican transfer agents who are not required to declare currency when crossing the US border north.

The US economy is one unintended beneficiary of the kinds of swaps and schemes carried out in Mexico. The gray market enables Latin businessmen to buy US goods and services here, or in a free zone like Colon, and pay for it in dollars (or dollars converted to checks and other monetary instruments) which originated in the US drug market.

The use of non-bank financial institutions is not confined to the Western Hemisphere. The 1997 FATF report cited a continuing trend of money launderers moving away from banks to non-banks in many sections of the world. Yet, there has not yet been a parallel effort in many countries to subject these non-bank financial institutions to the same kinds of regulations as banks. In effect, when the money "hits" a bank, the money broker has already achieved first-stage placement, and is now in the process of layering his funds through banks and ultimately integrating his funds into legitimate businesses.

Are the Laws Being Implemented? In the seven years since the 1988 UN Convention was adopted, and particularly since FATF issued its 40 money laundering recommendations in April 1990, dozens of governments have statutorily enacted various countermeasures, as indicated by the charts in this chapter.

The pace of implementation of these laws, and the scope of their application varies. A review of results reported by key financial centers relative to the generation of suspicious transaction reports indicates that several such centers have reporting ratios which are disproportionately small, given the volume of financial activity and diversity of enterprises in their systems. Such minimal results could be an accurate reflection of a low level of suspicious activity, but, such results could also indicate a law which is drawn too narrowly or a banking system which is not giving a good faith compliance.

In addition, it has been difficult to assess the degree to which newer electronic banking practices may render banks more or less vulnerable to money laundering. Few governments have control mechanisms adequate to identifying and tracing such transactions should they occur.

Apart from financial institutions in which officials are complicit in the money laundering transaction, financial institutions are rendered most vulnerable by the combination of correspondent banking relations and electronic transfers. In 1995 the twin problems of regulating wire transfers and tracing wire transfers in pursuit of an investigation were on the threshold of some containment because FATF had reached agreement with the dominant system (SWIFT) and its key members on including in each message critical information needed to identify transmitters and receivers and especially beneficial owners of transactions. Recordkeeping may have improved, however, over the past year there has not appeared to be any diminution of electronic transfers of illicit proceeds. Control efforts are being sorely challenged by the creation of new, independent wire transfer services, some which service small clusters of banks.