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Regulatory intelligence

Flying Persian carpets test money laundering controls

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

Iranian rugs started flying into the United States almost as soon as Implementation Day on January 16 allowed Americans to buy the country’s most storied luxury goods after a five­-year ban. For U.S. banks, the opening of the Iran market for carpets and a wide range of goods will put new pressure on compliance departments to start putting in place tighter money laundering controls needed for Iran and other sensitive trading partners.

“There is a steep learning curve for banks to recognize and respond to trade-­based AML,” said Henry Balani, head of innovation at consulting firm Accuity. “Things are not going to change that quickly. It will probably take at least five years to get to normal trade relations with Iran. Now is the time to get compliance in place and up to the standards of the rest of the world.”

Other countries stepped up their direct investment and trade relations with Iran immediately after the International Atomic Energy Agency ruled that Iran met the requirements of the Joint Comprehensive Plan of Action in its nuclear program. But the United States has made relatively small steps in restoring economic ties and still operates under restrictions that have been in place for decades, and there is strong political opposition to further moves.

The deal has paved the way for banks to begin building direct trade relationships with Iranian merchants. The U.S. Treasury Office of Foreign Assets Control rules stipulate that “United States depository institutions are authorized to issue, advise, negotiate, or confirm letters of credit to pay for transactions” for rug purchases. The U.S. rules still prohibit any direct contacts with the government of Iran and the country’s financial institutions.

Testing compliance with rug trade

Persian rugs could provide a test of banks’ trade finance departments’ capability to manage the special risk factors involved in trading with a country still operating under heavy trade sanctions. Other countries have gone further than the United States in building compliance practices to meet new demands of regulators in managing trade-­related money laundering, Balani said.

For U.S. banks, updating trade finance “will mean some changes for the banking structure,” he said. The process “is all about understanding the value of the goods being traded.” That does not pose such a major challenge for commodities such as oil that are clearly priced on world markets. “You can price a public commodity like oil and it is pretty clean and easy to understand. But items like Persian rugs are more of a challenge. Sometimes you have no clue how much they cost.”

The U.S. State Department’s International Narcotics Control Strategy Report has estimated that hundreds of billions of dollars are laundered each year through trade­-based schemes.

Trade­-based money laundering is harder to detect and potentially larger in scope than bank­-deposit money laundering schemes, say AML experts. But the need to develop risk controls is essential. The international trade consortium, the Financial Action Task Force, warned in a report that trade is “the most logical next step” for money launderers who have been blocked at the “front door” as AML restrictions curbed bank deposit manipulation.

While there are few cases of trade finance departments becoming embroiled in enforcement actions, regulators have issued repeated warnings that banks must learn to detect money laundering in trade channels.

The $1 billion Iranian rug market is relatively small on the scale of global trade. But as the first wave of business from Iran, the carpet business will be a proving ground for banks’ ability to manage trading in big ticket articles like replacement parts for the country’s outmoded industrial infrastructure, especially its accident ­prone airline fleet that uses among the world’s most ­outmoded carriers.

During the past five years of its international trade sanctions Iran has gone to the black market to find spare parts to run its vital industries such as oil and steel production using financing outside legal banking channels. Those transactions can now be routed through legal banking channels outside the United States, which still enforces its ban on direct contact with Iranian banks. American banks are allowed to issue letters of credit and documentation services for their clients doing legal business with Iran.

“When you look at trade financing you have to fundamentally change processes to detect money laundering. It’s not just know­-your-­customer, it involves fundamentally changing how you do business. Trade finance is about identifying the value of goods and that is not a structure that banks are set up to do,” said Balani.

The Financial Action Task Force said that the red flags to watch for include over­-invoicing and under­-invoicing of goods and services, multiple invoicing of goods and services and falsified records on shipments of goods and services.

Anticipate AML­-trade enforcement

While few enforcement cases involving trade finance laundering have been reported, the U.S. Financial Crimes Enforcement Network has become more sophisticated in targeting trade-related AML schemes and has pushed banks to institute new controls. Some are reluctant to take the step of reporting suspicious activity for trade finance because reports can cause costly shipment delays.

FinCEN has shown it will push banks to help. In a case last year, a coordinated FinCen investigation uncovered a Florida money laundering operation in which the drug cartels were using electronic goods “as part of sophisticated trade–based money laundering schemes in which drug proceeds in the United States are converted into goods that are shipped to South America and sold for local currency.”

FinCEN issued geographic targeting orders, or GTOs, in Florida and California calling on banks and businesses to take special measures to detect such scams.

Those special FinCEN orders provide clues on how to operate in a sensitive AML environment. Those operating in FinCEN’s GTO zones were required to use unique identification numbers for the parties in any transaction, and to disclose third parties that are sometimes shell corporations set up for the sole purpose of receiving payouts. Special reports were mandated for any covered transaction of $3,000 or more and the data must be held for five years. FinCEN said firms could be assessed civil and criminal penalties for non­compliance.

How to build AML trade compliance

The Financial Action Task Force recommends steps that banks might take to update trade based money laundering compliance. These include:

  • “Assessing the adequacy of a bank’s systems for managing the risks associated with trade finance activities, including whether the bank effectively identifies and monitors its trade finance portfolio for suspicious or unusual activities, particularly those that pose a higher risk for money laundering.
  • “Determining whether a bank’s system for monitoring trade finance activities for suspicious activities, and for reporting suspicious activities, is adequate, given the bank’s size, complexity, location, and types of customer relationships.
  • “Sample testing trade finance accounts with a view to verifying whether the bank is meeting its customer due diligence, record keeping, monitoring and reporting obligations.
  • “Providing AML training to financial institutions’ global trade services departments and personnel.”

The FATF report said, “The vast number of trade transactions produces a high level of ‘noise’ about the level of legitimate trade and increased flexibility of the processes masks the criminal money laundering activity.” The use of corporate shells by money launderers adds a detection layer that is hard to notice, and with non­standard parts any automated monitoring process “becomes relatively ineffective.”

Banks should create enterprise plan

Major banks have a clear incentive to get it right in Iran and other countries where AML risks are high. Issuing letters of credit and documentation for trade finance is a large, profitable business for the top ­tier global banks that dominate trade finance. Iran represents one of the biggest new trade markets to emerge in recent history.

American banks are still prohibited from dealing directly with Iran, but foreign subsidiaries will be allowed to do so. The potential risks of managing those units were seen in the problems Citigroup group faced with its Banamex AML unit. Citi last year closed the U.S. Banamex unit after it paid a $140 million fine for money laundering violations.

Banks will need to take a closer look at integrating AML processes across their entire enterprise to avoid the problem of a subsidiary operating in a less­ regulated geography undermining a firm’s overall compliance effort, banking expert say. That effort needs to support front­line representatives in building relationships with customers in specific import-export verticals whose knowledge of their sector will be critical. Banks need to work with clients to produce trade credits and documentation that meet regulatory demands for accurate and consistent data and, when necessary, managing Suspicious Activity Reports on their own clients’ trade activities.

Sampling AML trade with “rug test”

The rug market might be a way for banks to begin the “sample testing” that FATF recommends and provide clues on the culture of Iran. Valuation may not pose such a problem, according to a leading rug merchant and appraiser in New York. Techniques for appraising the value of rugs have been used in insurance claims and property disputes and claims involving valuable rugs for years. Persian rugs can be priced at anywhere from $100 to $250,000 for newly woven pieces, and as much as $35 million for fine antiques.

“You look at the city where it came from and check the knot count, That will give you the comparables,” said Nader Balour, owner of Doris Leslie Blau Gallery in New York.

No museum showpieces in ship containers

Antique rugs are much more difficult and appraisals vary widely, as they do with any other antique, Balour said. The prices of antique rugs depend on auctions and other open market transactions that can be subjective.

“One day a piece like an eighteenth century French armoire will be $50,000 and the next day you will have two people fighting over it for $150,000,” he said. “It’s the same with rugs.”

The value of antique Persian rugs has soared in recent years, hitting a record of $34 million at a Sotheby’s auction in 2013 for a much-prized eighteenth century carpet. The sanctions on Iranian rugs are being lifted on much­-coveted historic rugs that fetch far higher prices – but Balour said he would be suspicious of any prize works coming out of the country.

There are still many quality rugs being produced. But not the priceless variety that would confound a trade finance department. The kind of rugs Sotheby’s auctions are handled like works of art and are not coming over in ship containers. The silk rugs of Iran’s master weavers that hang on museum walls and drawing room floors of wealthy buyers have always commanded a premium.

“The best antique rugs left Iran a long time ago.”

About Thomson Reuters Regulatory Intelligence

This article was produced by Thomson Reuters Regulatory Intelligence, and initially posted on February 12, 2016.

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