In the 1930s, one of the most wanted men for the US treasury agents was Al Capone. It was the time when the US was witnessing the Prohibition era. But this didn’t stop Al Capone from running his successful liquor business.
Knowing that he can’t carry out his business openly, he knew how to run it behind the curtains. In those days, households in the US didn’t have running water and therefore keeping a washing machine made no sense. Sensing this need, entrepreneurs started setting up commercial launderers. These places were very common and, to date, can be seen sprawled across the US.
But, back in those days, one of these places was helping Al Capone mask their ill-gotten money. Hiding behind the lawful operations of launderers In Chicago, Al Capone and his mob showed their profits from liquor businesses as the money generated through hundreds of launderers in and out of Chicago. This notorious activity is behind the term ‘money laundering’.
The idea behind money laundering is simple. Anyone who has ill-gotten wealth will have to use the fund in such a manner which doesn’t raise doubts among people with regard to the origin of those funds. The criminals create legitimate businesses to mask the source of illegal cash. Casinos, bars and fast food restaurants, newspapers sales, launderettes, insurance, and real-estate are just a few businesses that are often used by criminals as a cover for their illicit business.
Money laundering is a process through which criminals transfer money to wash, legitimise, or launder their illicit funds. They usually keep dirty money in a financial institution in ways that don’t raise any suspicions and pass the financial transparency reporting requirements.
They also ‘layer’ the money by moving it between different accounts or wiring it through multiple jurisdictions. The laundered money is then injected back into the economy through real-estate businesses or investment in the stock market.
The Magnitude of Money Laundering
Due to the illegal nature of the transactions, it is virtually impossible to come up with a definitive amount of money that is laundered annually across the world. However, it is true that money laundering has become a serious concern for almost all governments. Back in 1996, an IMF spokesperson expressed that around two to five percent of the global economy comprise laundered money.
The recent estimates, carried out by Finextra, shows that $200 billion-worth laundering transaction occur in the US in 2017 alone of which sale worth $6 billion involved illicit services or goods. These transactions were carried out by almost 335,000 unregistered merchants.
And what about Trade-Based Money Laundering?
The trade-based money laundering is very common these days. Criminals use a variety of techniques to legitimise funds in ways that don’t come under the watchful eyes of the authorities. What makes these things even more complex to detect is the fact that these activities easily pass financial reporting requirements. Hence, through trade, criminals integrate their money in the global economy without getting caught. Some of the ways through which trade can be used as a tool to launder the money obtained through illicit sources are described below:
Over- and under-invoicing of Goods and Services: Deliberately over or under invoicing, or charging, for goods and services is one of the most classic, but still commonly used methods for laundering money across international borders. In theory, it is really quite simple. The exporter delivers goods to the importer worth a certain amount, say $10 million, but only charges them $7 million. If unnoticed by customs, the scheme successfully transfers $3 million worth of value to the importer. Alternatively, the scheme can be run in reverse where the exporter over-invoices the importer thereby transferring value to the exporter. The Financial Action Task Force highlights three important points in these scenarios. First, the exporter and importer must be colluding. Second, they may be completely unrelated but there is also nothing preventing the exporter and importer from being the same entity. Third, this scheme also has major tax ramifications, specifically export tax credits and import duties invoicing.
Multiple Invoicing of Goods and Services: As opposed to over or under invoicing, money launderers may instead invoice the same shipment of goods more than once. In order to obscure the true nature of this scheme, organisations will employ multiple financial institutions to assist in financing. Unlike over and under invoicing, the price specified for the goods or services does not have to be manipulated, making it harder to detect, not to mention that it is not uncommon to issue multiple payments in legitimate transactions due to amendments and corrections.
Over- and Under-Shipments of Goods and Services: The over or under shipment of goods is similar to over and under invoicing in that value is transferred to either the buyer or seller. However, rather than misrepresent the cost, the parties misrepresent the quantity. The seller charges the buyer $7 million, which reflects the true cost of the goods being sold, at least on paper. The seller then proceeds to ship $10 million worth of product, so again the buyer ends up with an additional $3 million. In extreme cases of under shipment, sellers will ship nothing at all — just an empty container and full documentation that appears to be in order.
Falsely Described Goods and Services: exporters can falsely describe the goods or services being transferred — either inflating or deflating their true value in order to pay off or get paid off. In essence, they are trying to disguise the true market value of the transaction for their benefit. False description is the TBML scheme that is sometimes service-based rather than good-based. It can entail things like financial advice, consulting work, or market analysis.
The Black Market Peso Exchange (BMPE)
One of America’s largest money laundering methodologies, Colombia’s Black Market Peso Exchange (BMPE) is a regional black market financial system supported on the misuse of international trade.
When it was established, the market’s main aim was to collect restricted US dollars. This was done to facilitate Colombian businessmen to import goods (from the US, mainly) and sold them in their country at competitive prices. However, over the years, this scheme contributed with disastrous consequences to the economy.
While on one hand, the BMPE became a place where Colombian-based drug cartels laundered the money, on the other hand, the black market deeply hurt Colombian businessmen who were carrying out their businesses in a legal manner. It is important to clarify that the BMPE is not one of its kind. Several financial institutions operating on the module of the BMPE exist across the world, facilitating launderers to whiten their money received through illicit ways.
How Does it Work?
Drug business in the US generates a lot of cash. However, if the head of a drug cartel is in Colombia, he’d want a way to turn the dollars generated through drug sales into pesos and then, have them transferred back to Colombia. For this purpose, the BMPE is used widely.
The overall ‘flow’ of activities are simple: the cartels-owned dollars are exchanged for pesos that are already in Colombia. This is done through a broker and the movement of goods from one country to the other. In simple words, this is the process:
1. A Colombian cartel contacts a BMPE broker to buy US dollars that are generated through the sale of drugs in the US.
2. The broker then sells the dollars to a local Colombian importer who needs the currency to pay for goods to a US supplier who is yet to export the goods to Colombia from the US.
3. Now, the broker gets the US representative to collect the dollars from the cartel.
4. The dollars so received are used to pay the US supplier for the exports. This can be done in a variety of ways. The broker can pay the supplier in cash or through forwarding funds via wire transfer.
5. The supplier in the US sends the goods to the Colombian importer.
6. Once the goods are received, the Colombian importer pays the broker in pesos.
7. The broker, after deducting his commission, has the money to pay the Colombian cartel the required pesos.
The Consequences of Money Laundering
Money laundering has negative effects on the overall economic policy of the countries where these schemes are the norm. These financial crimes are also one of the reasons for imbalance in money demand and the increased volatility of exchange rates, international capital flows, and interest. This makes it all the more difficult for the governments to implement their sound economic policies. Some of the consequences of money laundering are listed below:
Undermining the Legitimate Private Sector: One of the most serious microeconomic effects of money laundering is felt in the private sector. Money launderers often use front companies, which co-mingle the proceeds of illicit activity with legitimate funds, to hide the ill-gotten gains. In the United States, for example, organised crime has used pizza parlours to mask proceeds from heroin trafficking. These front companies have access to substantial illicit funds, allowing them to subsidise front company products and services at levels well below market rates. In some cases, front companies are able to offer products at prices below what it costs the manufacturer to produce. Thus, front companies have a competitive advantage over legitimate firms that draw capital funds from financial markets. This makes it difficult, if not impossible, for legitimate business to compete against front companies with subsidised funding, a situation that can result in the crowding out of private sector business by criminal organisations.
Undermining the Integrity of Financial Markets: Financial institutions that rely on the proceeds of crime have additional challenges in adequately managing their assets, liabilities, and operations. For example, large sums of laundered money may arrive at a financial institution but then disappear suddenly, without notice, through wire transfers in response to non-market factors, such as law enforcement operations. This can result in liquidity problems and runs on banks. Indeed, criminal activity has been associated with a number of bank failures around the globe, including the failure of the first Internet bank, the European Union Bank.
Loss of Control of Economic Policy: In some developing economies, illicit proceeds may dwarf government budgets, resulting in a loss of control of economic policy by governments. Indeed, in some cases, the sheer magnitude of the accumulated asset base of laundered proceeds can be used to corner markets — or even small economies. Money laundering can also adversely affect currencies and interest rates as launderers reinvest funds where their schemes are less likely to be detected, rather than where rates of return are higher. And money laundering can increase the threat of monetary instability due to the misallocation of resources from artificial distortions in asset and commodity prices. In short, money laundering and financial crime may result in inexplicable changes in money demand and increased volatility of international capital flows, interest and exchange rates.
Economic Distortion and Instability: Money launderers are not interested in profit generation from their investments but rather in protecting their proceeds. Thus they “invest” their funds in activities that are not necessarily economically beneficial to the country where the funds are located. Furthermore, to the extent that money laundering and financial crime redirect funds from sound investments to low-quality investments that hide their proceeds, economic growth can suffer. In some countries, for example, entire industries, such as construction and hotels, have been financed not because of actual demand, but because of the short-term interests of money launderers. When these industries no longer suit the money launderers, they abandon them, causing a collapse of these sectors and immense damage to economies.
Risks to Privatisation Efforts: Money laundering threatens the efforts of many states to introduce reforms into their economies through privatization. Criminal organisations have the financial wherewithal to outbid legitimate purchasers for formerly state-owned enterprises. Furthermore, while privatisation initiatives are often economically beneficial, they can also serve as a vehicle to launder funds. In the past, criminals have been able to purchase marinas, resorts, casinos, and banks to hide their illicit proceeds and further their criminal activities.
Reputation Risk: Nations cannot afford to have their reputations and financial institutions tarnished by an association with money laundering, especially in today’s global economy. Confidence in markets and in the signalling role of profits is eroded by money laundering and financial crimes such as the laundering of criminal proceeds, widespread financial fraud, insider trading of securities, and embezzlement. The negative reputation that results from these activities diminishes legitimate global opportunities and sustainable growth while attracting international criminal organization with undesirable reputations and short-term goals. This can result in diminished development and economic growth. Furthermore, once a country’s financial reputation is damaged, reviving it is very difficult and requires significant government resources to rectify a problem that could be prevented with proper anti-money-laundering controls.
Social costs: Money laundering is a process vital to making crime worthwhile. It allows drug traffickers, smugglers, and other criminals to expand their operations. This drives up the cost of government due to the need for increased law enforcement and health care expenditures (for example, for treatment of drug addicts) to combat the serious consequences that result. Among its other negative socioeconomic effects, money laundering transfers economic power from the market, government, and citizens to criminals. In extreme cases, it can lead to the virtual take-over of legitimate government.
The magnitude and the consequences of money laundering show that it is a complex problem that must be dealt with in an effective and cooperative manner.
It’s effect are destabilising and devastating for local economies, but the issue is global. To address the issue, global standards and international cooperation are needed if we are to reduce the ability of criminals to launder their proceeds and carry out their criminal activities.
In future posts I will cover which solutions are currently in place to prevent Money Laundering and where are the improvement areas.