pmla project

8/11/2019 PMLA Project

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CHAPTER 1: INTRODUCTION TO MONEY LAUNDERING

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Background

The term "money laundering" is said to originate from Mafia ownership of Laundromats

in the United States. Gangsters were earning huge sums in cash from extortion,

prostitution, gambling and bootleg liquor. The major headache that gangsters faced was that

the money was in cash, often in small denomination coins. If the coins were put into the

bank, the questions would be asked. But the storage of large amounts of money in low value

coins is a storage nightmare.They needed to show a legitimate source for these monies.

Ironically, one of the methods of concealing the source of the money was legal gambling. So

they created businesses, one of which was slot machines, and another of which was laundries

- so, it is said, that the term "money laundry" was born.

One of the ways in which they were able to do this was by purchasing outwardly

legitimate businesses and to mix their illicit earnings with the legitimate earnings they

received from these businesses. Laundromats were chosen by these gangsters because

they were cash businesses and this was an undoubted advantage to people like Al Capone

who purchased them.

Al Capone, however, was prosecuted and convicted in October, 1931 for tax evasion. It

was this that he was sent to prison for rather than the predicate crimes which generated

his illicit income. It would seem, however, that the conviction of Al Capone for tax

evasion may have been the trigger for getting the money laundering business off the

ground.

Meyer Lansky (affectionately called the Mobs Accountant) was particularly influenced

by the conviction of Capone for something as obvious as tax evasion. Determined that the

same fate would not befall him he set about searching for ways to hide money. Before the

year was out he had discovered the benefits of numbered Swiss Bank Accounts. This is


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where money laundering would seem to have started and was one of the most influential

money launderers ever. The use of the Swiss facilities gave Lansky the means to

incorporate one of the first real laundering techniques, the use of the loan-back concept,

which meant that hitherto illegal money could now be disguised by loans provided by

compliant foreign banks, which could be declared to the revenue ifnecessary, and a tax-

deduction obtained into the bargain.

Money laundering as an expression is one of fairly recent origin. The original sighting

was in newspapers reporting the Watergate scandal in the United States in 1973. The

expression first appeared in a judicial or legal context in 1982 in America in the case US

v $4,255,625.39 (1982) 551 F Supp.314. Since then, the term Money Laundering has

been widely accepted and is in popular usage throughout the world.

But whilst the term "money laundering" was invented in the 20th Century, the principles of

money laundering have been around for far longer. Sterling Seagrave in his book "Lords of

the Rim" conducts a roundup of the history of the Overseas Chinese. He explains how the

abuse of merchants and others by rulers led them to find ways to hide their wealth, including

ways of moving it around without it being identified and confiscated. Money laundering in

this sense was prevalent 4000 years before Christ.

"Money laundering is called what it is because that perfectly describes what takes place -

illegal, or dirty, money is put through a cycle of transactions, or washed, so that it comes

out the other end as legal, or clean, money. In other words, the source of illegally

obtained funds is obscured through a succession of transfers and deals in order that those

same funds can eventually be made to appear as legitimate income".

Money laundering as a crime only attracted interest in the 1980s, essentially within a

drug trafficking context. It was from an increasing awareness of the huge profitsgenerated from this criminal activity and a concern at the massive drug abuse problem in

western society which created the impetus for governments to act against the drug dealers

by creating legislation that would deprive them of their illicit gains.


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Money laundering today is a truly global phenomenon, helped by the International

financial community which is a 24hrs a day business. When one financial centre closes

business for the day, another one is opening or open for business.

1.2IMPORTANCE AND RELEVANCE OF THE STUDY

Money laundering has become the buzzword for a developing country like India. India

has been witnessing huge capital inflows in the recent past and such flows are getting

channeled into various investment avenues such as stock markets and other related

investment vehicles. With India witnessing such huge flows it has become very important

that India does not attract such black money to its financial hubs merely as a tool to

convert black money to white.

Further as the countries of the west enforce stringent anti-money laundering controls,

launderers are looking at developing countries as attractive destinations to launder their

funds. The impact of black money entering the developing countries can be severe. Thus

India must adhere to high anti-money laundering standards so as to check such black

money entering its economy.

1.3LITTERATURE REVIEW

Money laundering involves disguising financial assets so that they can be used without

detection of the illegal activity that produced them. Through money laundering, the

launderer transforms the monetary proceeds derived from criminal activity into funds

with an apparently legal source. Money laundering is regarded as the worlds third largest

industry after international oil trade and foreign exchange (Robinson, 1995). The

International Monetary Fund (IMF) estimated the size of money laundering worldwide to

be between US$600 million and US$1.5 trillion, which is about 2-5 per cent of the

worlds GDP (Camdessus, 1998).


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With the globalisation of economic activities and of financial markets, money can be now

laundered internationally. Money laundering allocates dirty money around the world not

so much on the basis of expected rates of return but on the basis of ease of avoiding

national controls. Dirty money tends to flow to countries with less stringent controls

(Tanzi, Vito. 1996).

Much of the research studies which have been carried out have focused on the areas on

money laundering through banks and financial institutions, with much attention being

paid to developed countries and offshore financial centres. (Baity 2000 & Hampton

1996)

Money laundering and measures to counter it have become the focus of an intense

international effort. The wide range of activities and financial instruments involved inmoney laundering are not directly observable and estimates are difficult to compile.

According to Baker (1999), the combination of criminal money laundering and illegal

flight capital constitutes the biggest loophole in the free-market system.

A number of studies have elaborated the numerous domestic, international and private

measures which have been established to fight money laundering, relevant legislation and

the activity of regulatory and professional bodies both domestically and internationally.

International efforts to combat money laundering have gained momentum in the past

decade. United Nations Convention and another planned convention, along with

numerous multilateral governmental initiatives and bilateral agreements, have contributed

to the development of a broad set of national and international legal standards. However,

this emergent regime has developed unevenly, the most significant advances occurring

in regions dominated by the United States and its allies (Castle and Bruce 1998)

The negative economic effects of money laundering on economic development are

difficult to quantify. Such activity damages the financial-sector institutions that are

critical to economic growth, reduces productivity in the economy's real sector by


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diverting resources and encouraging crime and corruption, which slow economic growth,

and can distort the economy's external sectorinternational trade and capital flowsto

the detriment of long-term economic development (Bartlett 2002). When the integrity of

the financial institutions is weak, it has a discouraging effect on foreign direct investment

due to lack of investor confidence. This in turn can distort the long-term growth of the

economy. Studies by Quirk (1997), Barrett (1997), Paradise (1998) and also

Masciandaro and Portolano (2003) have argued that money laundering threatens

economic and financial systems in countries.

Jurisdictions which offer high levels of secrecy, and a variety of financial mechanisms

and institutions providing anonymity for the beneficial owners are highly attractive to

criminals for a wide variety of reasons including the potential cover and protection they

offer for money laundering and various exercises in financial fraud (Blum 1998).Historically, it has been argued that offshore financial centres (OFCs) have facilitated

money laundering by providing a conduit for the proceeds of crime. Popular culture,

international bureaucracies, left-wing interest groups, and politicians from high tax

governments have all joined forces to consistently portray OFCs as havens for dirty

money where the authorities are either unwilling or unable to implement measures in

their islands to assist in the global fight against money laundering (Mitchell, 2002).

Money laundering through banking system is doubly difficult to identify as well as

control, mainly becauseKYC is difficult to implement, because there is no obvious end

point to the information that would be useful to a bank manager in seeking to prevent

money laundering, and it will be hard to deal with third-party introducers (where the

main beneficiaries wish to remain anonymous), and it can be hard to balance KYC with a

customers right to privacy (Jackson 2000).

No major research study has been carried out on money laundering through capital

markets as a tool. The present study tries to examine the problem of money laundering

through capital markets from the point of view of using capital market intermediaries and


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instruments as channels to launder money. The present study tries to fill the gap existing

with respect to comparison between development of domestic as well as international

legislation for prevention of money laundering, identifying the socio-economic impact of

money laundering on developing economy such as India, assessing the anti-money

laundering compliances used to deter laundering of money through capital markets in

India.

1.4OBJECTIVES OF THE STUDY

1. To compare and contrast various money laundering methods/techniques being

practiced in India and abroad

2. To assess and evaluate socio-economic impact of money laundering activities as a

whole to the economy, with special focus on financial markets

3. To compare and contrast legislative measures presently existing for anti-money

laundering in India and abroad.

4. To examine the checks used by stock brokers and intermediaries for ensuring

effective anti-money laundering compliance.

1.5RESEARCH METHODOLOGY

Sources of Data:

The Methodology for the project is based on Secondary sources of Data. The collection

of primary data was not possible. This is because by its very nature, money laundering is

an illegal activity carried out by people with criminal intent which occurs outside of the

normal range of economic and financial statistics and hence data on such activities is

scant. And also money laundering activities are making full use of newer technologies

and offshore jurisdictions to conceal the proceeds of crime. Public sources of data were

chiefly relied on for the study; primarily the regulatory agencies that are entrusted with


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the job of curbing money laundering activities and from Organizations that collect data

and publish newsletters and reports from the governmental agencies and multilateral law

enforcement agencies. Other resources that were utilized in the course of project work

were, websites accessed via internet, journals, newspapers and magazines. Further

additional sources of information utilized were circulars issued by SEBI (Securities

Exchange Board of India) and Bombay Stock Exchange on Anti-Money Laundering

compliances by financial intermediaries.

1.6LIMITATIONS OF THE STUDY

The present study is mainly based on secondary sources of data because money

laundering is a secretive activity and hence primary sources of data could not be

obtained. So the inherent limitations of secondary source of data may be termed as alimitation of this study.

Money Laundering is an illegal activity and the techniques used to launder money tend to

fluctuate dramatically. Hence exact quantity of money laundered and latest techniques

used to launder money could not be obtained.

Financing of terrorism is a topic which has come to attract serious attention in recent

times. And combating Financing of Terrorism has become an integral part of anti-money

laundering efforts. Since the purpose of terrorist financing is very different from that of

money laundering and the scope of the terrorist financing is a very wide, hence for the

purpose of this project the scope of this study has been restricted to money laundering

only.

1.7CHAPTERISATION SCHEME

The entire project work is divided into seven parts for the purpose of simplification and

easy understanding. The seven parts as shown in seven chapters are as follows.


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Chapter I:Introduction to Money Laundering

This chapter comprises of background of money laundering, importance and relevance of

the study, literature review, objectives of the study, research methodology, limitations of

the study and chapterisation scheme.

Chapter II: Money Laundering

This chapter comprises of introduction to the chapter, stages in the money laundering

process, techniques used by launderers to launder money and the principal laundering

methods detected or suspected in India.

Chapter III: Money Laundering Through Capital Markets

This chapter comprises of introduction to the laundering through securities market,

money laundering through international financial market, money laundering throughstock exchanges in India and conclusion.

Chapter IV:Impact of Money Laundering

This chapter comprises of introduction to the chapter, problem for emerging markets,

impact of money laundering and conclusion.

Chapter V: International and Domestic Initiatives Against Money Laundering

This chapter comprises of introduction to the chapter, anti-money laundering legislations

and initiatives and conclusion.

Chapter VI: Anti-Money Laundering Measures and Compliances

This chapter comprises of introduction to the chapter, anti-money laundering measures

and compliances to combat against money laundering and conclusion

Chapter VII: Findings, Conclusions and Suggestions

This chapter comprises of introduction to the chapter, summary, findings and conclusion.


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CHAPTER 2: MONEY LAUNDERING

2.1 INTRODUCTION

This chapter looks to understand the concept of money laundering and its global size. A

typical money laundering exercise goes through a series of stages, each stage in the series

has its own particular distinctive characteristics. Hence it is important to assess the

particular characteristics which distinguish each stage. Money launderers use a variety of

methods and techniques to launder funds, each stage in the money laundering process

utilizes certain methods and techniques. This chapter has sought to delve into these

methods. Further it is also important to understand the methods and techniques used to

launder funds in the Indian context.

2.2 MONEY LAUNDERING?

Illegal arms sales, smuggling, and the activities of organised crime, including for

example drug trafficking and prostitution rings, can generate huge amounts of proceeds.

Embezzlement, insider trading, bribery and computer fraud schemes can also produce

large profits and create the incentive to legitimise the ill-gotten gains through money

laundering.

When a criminal activity generates substantial profits, the individual or group involved

must find a way to control the funds without attracting attention to the underlying activity

or the persons involved. Criminals do this by disguising the sources, changing the form,

or moving the funds to a place where they are less likely to attract attention.

Money laundering is the criminal practice of filtering ill-gotten gains or dirty money

through a series of transactions, so that the funds are cleaned to look like proceeds from

legal activities. Money laundering is driven by criminal activities and conceals the true

source, ownership, or use of funds. Money laundering involves the taking the proceeds of

crime and creating the illusion that the person who uses that wealth has obtained it by

legal and lawful means. Money laundering is the processing of criminal proceeds to


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disguise their illegal origin. This process is of critical importance, as it enables the

criminal to enjoy these profits without jeopardising their source.

As a 1993 UN Report noted: The basic characteristics of the laundering of the proceeds

of crime, which to a large extent also marks the operations of organised and transnational

crime, are its global nature, the flexibility and adaptability of its operations, the use of the

latest technological means and professional assistance, the ingenuity of its operators and

the vast resources at their disposal.

2.2.1 CHARACTERISTICS OF MONEY LAUNDERING

1. Money laundering is a group activity

2. Money laundering is a criminal activity and once begun, normally there is no end

to it.3. Money Laundering recognizes no boundaries. It has been internationalized.

4. Money Laundering activities do not end on one transaction. These involve a chain

of transactions and are undertaken at a large scale

5. Money Laundering activities involve very sophisticated and complex process

In most financial transactions, there is a financial trail to link the funds to the person(s)

involved. Criminals avoid using traditional payment systems, such as checks, credit

cards, etc., because of this paper trail. They prefer to use cash because it is anonymous.

Physical cash, however, has disadvantages. It is bulky and difficult to move. For

example, 44 pounds of cocaine worth $1 million equals 256 pounds of street cash worth

$1 million. The street cash is more than six times the weight of the drugs. The existing

payment systems and cash are both problems for criminals. Regulations and banking

controls have increased costs and risks. The physical movement of large quantities of

cash is the money launderers biggest problem.Money laundering is a diverse and often

complex process that need not involve cash transactions. Money laundering basically

involves three independent stages that can occur simultaneously:


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2.3 STAGES IN THE MONEY LAUNDERING PROCESS

2.3.1 PLACEMENT

Placement is the first stage in the money laundering process. It is during the placement

stage that physical currency enters the financial system placing, through deposits or other

means, unlawful proceeds into the financial system and illegal proceeds are most

vulnerable to detection. When illicit monies are deposited at a financial institution,

placement has occurred.

2.3.2 LAYERING

Layering describes an activity intended to obscure the trail which is left by dirty money

this is done by separating proceeds of criminal activity from their origin through the use

of layers of complex financial transactions. During the layering stage, a launderer mayconduct a series of financial transactions in order to build layers between the funds and

their illicit source. For example, a series of bank-to-bank funds transfers would constitute

layering. Activities of this nature, particularly when they involve funds transfers between

tax haven and bank secrecy jurisdictions, can make it very difficult for investigators to

follow the trail of money.

2.3.3 INTEGRATION

During the final stage in the laundering process, using additional transactions to create

the appearance of legality through the purchase of assets illicit funds are integrated with

monies from legitimate commercial activities as they enter the mainstream economy. The

illicit funds thus take on the appearance of legitimacy. The integration of illicit monies

into a legitimate economy is very difficult to detect unless an audit trail had been

established during the placement or layering stages.


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TABLE 2.1: Stage Wise Classification Of Money Laundering Activity

Money laundering is generally described as a three-stage process intended to make theprofits or proceeds of crime appear legitimate.

1. In the initial or placement stage ofmoney laundering, the launderer introducesthe criminal proceeds into the financialsystem

This might be done by breaking uplarge amounts of cash into lessobvious smaller sums that are thendeposited directly into a bank

account. The criminal might put themoney into other forms such ascheques or money orders that arethen collected and deposited intoaccounts at another location.

It is at this stage that potentialmoney laundering can be mosteasily detected.

2. After the funds have entered thefinancial system, the secondlayering

stage takes place. In this phase, thelaunderer engages in a series of changes, ormoves the funds several times to createdistance from the source.

The funds might be used to buy andsell investments such as stocks and

bonds. The launderer might wire thefunds through a series of accounts atvarious banks around the world.

In some instances, the launderermight disguise the transfers aspayments for goods or services.This would give them a legitimateappearance.

3. Having successfully processed thecriminal proceeds through the first two

phases of the money laundering process,the launderer then moves them to the thirdstageintegrationin which the fundsre-enter the legitimate economy

The launderer might choose toinvest the funds in real estate,

luxury assets, or business ventures.

At this third stage, it is very difficultto distinguish between legal andillegal funds.


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FIG 2.1: Stages In Money Laundering Process

Source: How stuff works 2005

TABLE 2.2: Summarises The Procedure Depicted In Fig 2.1PLACEMENT STAGE LAYERING STAGE INTEGRATION STAGE

Cash paid into bank(sometimes with staffcomplicity or mixed withproceeds of legitimatebusiness)

Wire transfers abroad (oftenusing shell companies orfunds disguised as proceedsof legitimate business)

False loan repayments orforged invoices used as coverfor laundered money.

Cash exported. Cash deposited in overseasbanking system

Complex web of transfers(both domestic andinternational) makes tracingoriginal source of funds

virtually impossible.Cash used to buy high valuegoods, property or businessassets.

Resale of goods/assets. Income from property orlegitimate business assetsappears "clean".


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FIG 2.2: Depicts The Estimates Of Money Laundered In Different Regions Of The

World According To Different Research Agencies And Governmental

Organizations.

42.8

45.5

60

179

231.3

257

325.5

590

856.6

1500

2850

0 500 1000 1500 2000 2500 3000

Billions (USD)

1

Estimate

Extent of Money Laundering

Model Estimate Worldwide

(John Walker 1998)High Estimate Worldwide (IMF

1996)Worldwide (Private Research

Firm 2002)

Low Estmate Worldwide (IMF

1996)Americas (Private Research

Firm 2002)

Asia/ Pacific (Private Research

Firm 2002)

Europe (Private Research Firm

2002)United States (US Government

2003)Caribbean (CFATF 2000)

United Kingdom (UK

Government 2003)

Middle/East Africa (Private

Research Firm 2002)

Source: Kenneth Bryant

The International Monetary Fund (IMF) has estimated that the aggregate size of the ill-

gotten proceeds has increased from circa 2% of global GDP in the early 1990s to around

3.5% today, which translates to a whopping US$ 1.5trillion to US$ 2.4trillion annual

problem based on a global GDP of US$48.3trillion in 2006. Money laundering now ranks

as the third largest business globally after foreign exchange and oil.

However it must be understood that overall it is absolutely impossible to produce a

reliable estimate of the amount of money laundered.

In response to mounting concern over money laundering, the Financial Action Task

Force on money laundering (FATF) was established by the G-7 Summit in Paris in 1989

to develop a co-ordinated international response. One of the first tasks of the FATF was


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to develop Recommendations, 40 in all, which set out the measures national governments

should take to implement effective anti-money laundering programmes.

TABLE 2.3: Differences Between Money Laundering And Terrorist Financing

Money Laundering Financing of Terrorism

Definition Processing of proceeds ofcrimes to disguise theirillegal origin and use themin the legal economy

Use of funds from legal orillicit sources to financeterrorist activities

Source of funds From illegal activities Can be from legal sources(donations from charitableorganization or individuals)

Use of funds To legitimize illegal funds Funding of terroristactivities, may be in smallamounts difficult to detect.

TABLE 2.4: Stage Wise Classification of Techniques/Methods Used by Money Launderers

PLACEMENT LAYERING INTEGRATION

Smurfing Tax Haven and OffshoreBanks

Use of haven bank creditcards

Shipping Money Abroad Bank Secrecy Receiving as consulting ordirector fee

Placement through Banks Corporations and Shellcompanies

Arrangement of corporateloans

Use of Pass through orPayable through accounts

Use of trusts Proceeds of gambling

Electronic Wire transfer Use of walking accounts Real estate transactionInsurance Products Establishing self owned

bank accountsStock purchase

Investment relatedtransaction

Use of Intermediaries Use of Business

NBFC International importing and

exporting


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2.4 TECHNIQUES USED BY MONEY LAUNDERERS TO LAUNDER MONEY

2.4.1 Structuring Deposits/ Smurfing

Also known as smurfing, this method entails breaking up large amounts of money into

smaller, less-suspicious amounts. The money is then deposited into one or more bank

accounts either by multiple people (smurfs) or by a single person over an extended period

of time.

2.4.2 Offshore Banks

Offshore banks are banks that allow for the establishment of accounts from non-resident

individuals and corporations. A number of countries have well-developed offshore

banking sectors. Offshore banks are popular with money launderers (for layering funds),

tax evaders and corrupt officials.

In contrast, a shell bank is incorporated in and authorised to carry on banking business in

a foreign country, but does not have a physical place of business or any employees in that

country.

Money launderers often send money through various "offshore accounts" in countries

that have bank secrecy laws, meaning that for all intents and purposes, these countries

allow anonymous banking. A complex scheme can involve hundreds of bank transfers to

and from offshore banks. According to the International Monetary Fund, "major offshore

centers" include the Bahamas, Bahrain, the Cayman Islands, Hong Kong, Antilles,

Panama and Singapore

The financial centres that host offshore banks can be very large and help facilitate many

illegitimate cross-border financings. For example, the Cayman Islands are estimated to be

the fifth largest financial centre in the world. Some offshore centres combine loose anti-

money laundering procedures with strict bank secrecy rules. Criminals can easily


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number. The receiver awaits the man with the number, provides cash in local currency,

and takes a premium of about two percent.

Herein lies the main elements of the system: trust, oral communication, and anonymity.

There is complete secrecy in content, form, and procedure. Furthermore, with a coding

system for identification, virtually no physical movement of cash, and a code of honor

that quickly weeds out the disingenuous, it is no surprise that counterterrorism agencies

see hawala as a black box. The very characteristics that account for hawalas success

have made it an impenetrable haven for illicit and criminal transactions.

2.4.4 Shell Companies

These are fake companies that exist for no other reason than to launder money. They take

in dirty money as "payment" for supposed goods or services but actually provide no

goods or services; they simply create the appearance of legitimate transactions throughfake invoices and balance sheets. A shell corporation is a company that is formally

established under applicable corporate laws but does not actually conduct a business.

Instead, it is used to engage in fictitious transactions or hold accounts and assets to

disguise the actual ownership of these accounts and assets.

Sophisticated money launderers use a complex maze of shell corporations in different

countries. Most money transfers take place through these shell corporations. At times,

money is transferred through numbered accounts rather than through named accounts. To

further avoid unwanted attention, money launderers build the transaction history of the

shell corporation so that it looks as if it has been in business for a long time.

In many countries (particularly offshore banking centres), the reporting and record-

keeping requirements for corporations are quite minimal, which makes it easy to disguise

ownership of the corporation. In a number of countries, ownership in corporations can be

represented by 'bearer shares. In these corporations, the holder of the bearer share

certificate is regarded as the owner of the shares. This makes it easy to disguise and

transfer ownership.


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2.4.5 Investing In Legitimate Businesses

Launderers sometimes place dirty money in otherwise legitimate businesses to clean it.

Legitimate businesses that also serve as conduits for money laundering are referred to as

'front businesses. The principal requirement when using businesses as fronts is that they

have high cash sales and/or high turnover. This way it becomes easy for criminals to

merge illegal funds and difficult for the authorities to spot the scheme.

They may use large businesses like brokerage firms or casinos that deal in so much

money it's easy for the dirty stuff to blend in, or they may use small, cash-intensive

businesses like bars, car washes etc. These businesses may be "front companies" that

actually do provide a good or service but whose real purpose is to clean the launderer's

money. This method typically works in one of two ways: The launderer can combine his

dirty money with the company's clean revenues -- in this case, the company reports

higher revenues from its legitimate business than it's really earning; or the launderer cansimply hide his dirty money in the company's legitimate bank accounts in the hopes that

authorities won't compare the bank balance to the company's financial statements.

2.4.6 Electronic Transfer

Electronic transfer is a common placement technique. Also referred to as a telegraphic

transfer or wire transfer, this money laundering method consists of sending funds

electronically from one city or country to another to avoid the need to physically

transport the currency. Typically, layers are created by moving money through electronic

funds transfers into and out of domestic and offshore bank accounts of fictitious

individuals and shell companies.

Electronic transfers can be compared to alternative remittances in that both are person-to

person transfers that do not require sending funds through the formal banking system.

Criminals make use of the electronic financial system because it enables the transfer of

large denominations of money instantly to offshore jurisdictions.


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2.4.7 Asset Conversion

Asset conversion is a common placement technique. Asset conversion simply involves

the purchase of goods. Illegal money is converted into other assets, such as real estate,

diamonds, gold and vehicles, which can then be sold. Generally, money launderers prefer

to purchase high-value items that are small and easy to sell or transport to another

country. Often these assets will be purchased in the name of a friend to avert suspicion.

2.4.8 Insurance Purchase

Illegal money is used to buy insurance policies and instruments, which can be 'cashed in'

at a later date. The end result is that the illegal funds have been legitimised by being

washed through a legitimate insurance business.

Single premium insurance products can be particularly vulnerable. They involve asingle payment 'up-front' and the ability to immediately purchase a fully paid instrument.

To a money launderer, these products are attractive because they:

involve a one-time payment

have a cash surrender value

may be transferable

2.4.9 Trusts

Trusts are legal arrangements for holding funds or assets for a specified purpose. These

funds or assets are managed by a trustee for the benefit of a specified beneficiary or

beneficiaries. Trusts can act as layering tools because they enable the creation of false

paper trails and transactions. Trusts are principally governed by a deed of trust drawn up

by the person who establishes the trust. Trusts are more complex to use than corporations,

but they are less regulated.

The private nature of trusts makes them attractive to money launderers. Secrecy and

anonymity rules help conceal the identity of the true owner or beneficiary of trust assets.

Also, the presence of a corporate trustee provides an appearance of legitimacy.


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In addition, offshore trusts may contain a 'flee clause. This clause allows the trustee to

shift the controlling jurisdiction of the trust if it is in danger because of war, civil unrest

or, more likely, the activities of law enforcement officers or litigious investors and

consumers. Typically, trusts are used in combination with corporations in money

laundering schemes. Trusts are used less frequently than corporations because of their

complexity and their disuse in business transactions.

2.4.10 Walking Accounts

A walking account is an account for which the account holder has provided standing

instructions that all funds be transferred immediately on receipt to one or more other

accounts. By setting up a series of walking accounts, criminals can automatically create

several layers as soon as any funds transfer occurs.

Money launderers use this layering technique because it is extremely difficult to detect

and money moves very fast through accounts across the world. The term 'walking

account' was coined because the money in these accounts appears to 'walk away.

2.4.11 Intermediaries

Lawyers, accountants and other professionals may be used as intermediaries between the

illegal funds and the criminal. Professionals engage in transactions on behalf of a

criminal client who remains anonymous. These transactions may include the use of shell

corporations, fictitious records and complex paper trails.

Money launderers like to use intermediaries because they lend credibility and decrease

suspicion. In addition, these professionals generally have confidentiality obligations to

their clients so the risk of money launderers getting caught is low.

Many countries have realised that criminals are increasingly using non-financial

professionals as intermediaries. To counter these activities, many countries have included

non-financial professionals in new anti-money laundering legislation.


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2.4.12 Import/Export Transactions

To bring 'legal' money into the criminal's country of residence, the domestic trading

company will export goods to the foreign trading company on an over-invoiced basis.

The illegal funds are remitted and reported as export earnings. The transaction can work

in the reverse direction as well. In many cases, there is no actual export of goods or only

the export of fake goods. In such cases, the trading companies may also exist only on

paper. Bankers may be able to spot these transactions if the underlying trade

documentation is inadequate or the underlying pricing is incorrect.

2.4.13 Corporate Financing

Corporate financing is typically combined with a number of other techniques, including

the use of offshore banks, consultants, complex financial arrangements, electronic funds

transfers, shell corporations and actual businesses. This allows money launderers to

integrate very large amounts of money into the legitimate financial system. Money

launderers may also take a tax deduction on interest payments made by them in corporate

financing.

From appearances alone, such transactions are identical to legitimate corporate finance

transactions. Financial service professionals serving legitimate businesses need to look

closely to find peculiarities in their dealings, such as:

large loans by unknown entities

financing that appears inconsistent with the underlying business

unexplained write-offs of debts.

2.4.14 Consultants

The use of consultants in money laundering schemes is quite common. The consultant

might not even exist. For example, the criminal could actually be the consultant. In this

case, the criminal is channelling money back to him/herself. This money is declared as

income from services performed and can be used as legitimate funds.


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In many cases, the criminal will employ an actual consultant (e.g. accountant, lawyer or

investment manager) to do some legitimate work. This could involve purchasing assets.

Often, the criminal transfers funds to the consultant's client account from where the

consultant makes payments on behalf of the criminal.

2.4.15 Credit and Debit Cards

Credit and debit cards are efficient ways for money launderers to integrate illegal money

into the financial system. By maintaining an account in an offshore jurisdiction through

which payments are made, the criminals limit the financial trail that leads to their country

of residence.

2.4.16 Bank Secrecy

Bank secrecy (or bank privacy) is a legal principle under which banks are allowed toprotect personal information about their customers, through the use of numbered bank

accounts or otherwise. Effective bank secrecy is better achieved in certain countries, such

as Switzerland or in tax havens, where offshore banks adhere to voluntary or statutory

levels of privacy.

Created by the Swiss Banking Act of 1934, which led to the famous Swiss bank, the

principle of bank secrecy is sometimes considered one of the main aspects of private

banking. Advances in financial cryptography (e.g. public-key cryptography) could make

it possible to use anonymous electronic money and anonymous digital bearer certificates

to achieve financial privacy and anonymous internet banking, given enabling institutions

(e.g. issuers of such certificates and digital cash) and computer systems that are secure

against attackers. Under the principle of bank secrecy, privacy is statutorily enforced,

with Swiss law strictly limiting any information shared with third parties, including tax

authorities, foreign governments or even Swiss authorities, except when requested by a

Swiss judge's subpoena. However anonymous banking is not strictly true as a term as all

Swiss bank accounts, including numbered bank accounts, are linked to an identified

individual under Swiss banking law. This law only permits a bank to share information


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with others in cases of severe criminal acts, such as identifying a terrorist's bank account.

Any bank employee violating a client's privacy is punished quite severely by law.

Currently in the news United Bank of Switzerland is under severe international pressure

to declare the names of those who evaded taxes. The case is currently continuing.

2.4.17 Stock Purchase

This point has been discussed at length in chapter 3.

2.5 The Principal Money Laundering methods detected or suspected in INDIA are

as follows:

Transfers through the hawala systemhawala is a money remittance system.

Such transfers are quite prevalent in India and Pakistan. These transfers are

outside the normal banking channels and are thus anonymous and secretive. Under-invoicing of exports and over invoicing of importsBy under invoicing

of exports, launderers are able to transfer funds in the form of goods, which when

sold shall realize cash. Hence enabling the launderer to transfer funds. By over

invoicing imports the launder is able to transfer funds as legal transfer towards

purchase of goods.

Loan Back MethodIn this method launderers loan illegal funds to legimitate

businesses, which can be used to fund expenses of the business or loan to front

companies of the launderer. Further the business is able to gain tax deduction on

the interest paid to the launderer on the loan.

Smuggling of Currency Indian and Foreign currency notes of high

denominations, particularly currency of notes of Rs. 500 denominations are

smuggled through couriers to countries like Dubai, Singapore and Hong Kong

where they are converted into convertible foreign exchange at a discount.

Similiarly, foreign exchange acquired locally from unauthorised sources is

smuggled out of the country through couriers.


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Import of Worthless GoodsLaunderers usually import high value goods such

as expensive cars, jewellery etc. which cannot be productively employed. Such

high value foreign goods can be easily sold in the domestic market.

Export of Paintings, Antiquities and ArtifactsPaintings and Antiquities are

usually high value items which launderers can easily employ to transfer funds.

They may purchase paintings using criminal funds, as a result they are able to

convert high large amounts of cash into an item such as painting and then export

the paintings, thereby avoiding any suspicion.

Funds transferred out of India by adopting one of the above methods are

deposited initially in tax havens with the help of financial and tax

consultants. Such funds are subsequently transferred to shell corporations. From

these shell corporations, funds are invested in India through Overseas Corporate

Bodies (OCB) set up for the purpose, in places like Mauritius, Singapore, HongKong, Bermuda, Cayman Islands etc.

2.6 Conclusion

The form of money laundering has changed with globalization, introduction of newer

technology and setting up of offshore financial centres. Launderers can now move

funds across the globe in a matter of seconds and that too several times. Money

laundering today has become an international activity and a professional activity, it

involves a complex web of transfers alongwith change in form. Further newer money

laundering techniques have gained importance with globalization of financial centres

and improvement in technology. However inspite of the changes in form, the basic

characteristic of money laundering has not changed. A typical money laundering

transaction still follows a three stage process i.e. Placement, Layering and Integration.

Each stage in the money laundering process employs a set of techniques. These

techniques differ from country to country and from region to region. The techniques

vary depending on the anti-money laundering controls prevalent in the country or

region. In India money laundering techniques which are quite prominent are use of

Hawala System, smuggling of currency and use of Tax Havens.


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CHAPTER : MONEY LAUNDERING THROUGH CAPITAL MARKETS

3.1 INTRODUCTION

The Securities Market is characterised by frequent and numerous transactions, and

several mechanisms can be used to make proceeds appear as legitimate earnings from the

financial markets. Inaddition, securities transactions are often international. The sector

most commonly is used during the layering and integration phases, since most law-

abiding brokers do not accept cash transactions. However, this is not an issue for

criminals operating within the financial sector itself, such as embezzlers, insider traders,

or perpetrators of securities frauds, because their (usually non-cash) funds are already

present in the financial system. During the layering phase, a launderer can simply

purchase securities with illicit funds transferred from one or more accounts, then use the

proceeds from selling these securities as legitimate money. Unlike regular securities,

bearer securities (common in some European countries) do not have registered owners,

and when they change hands the transaction involves physically handing over the

security, thus leaving no paper trail. The securitys owner is simply the person who

possesses it. Many but not all countries and jurisdictions have phased out the use of

bearer shares because of their potential role in money laundering and tax evasion.

FIG 3.1: Money Laundering By Global Industry Sectors

Money Laundering by Industry Sector

Money

Services

4%

Credit Cards

5%

Banks

55%

Insurance

Firms

9%

Brokerage &Investment

Firms

27%

Insurance Firms Banks Credit Cards Money Services Brokerage & Investment Firms

Source:Celent Finsight Risk and Compliance Summit 2007


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FIG 3.1 depicts that brokerage and investment sector occupies the second highest

position with a share of 27% in terms of susceptibility to money laundering activities.

The above pie chart clearly brings out the importance of brokers and stock exchanges

being used by money launderers as a vehicle for laundering money. This emphasizes the

need for proper regulatory measures and supervision of brokers and exchanges for

ensuring a healthy and vibrant capital market.

In its annual typologies reports on recent trends in money laundering, the FATF reports

that some countries have seen a significant shift in laundering activities from the

traditional banking sector to the non-bank financial sector.

3.2 MONEY LAUNDERING THROUGH INTERNATIONAL FINANCIAL

MARKETS

3.2.1 Money Laundering Through Secondary Markets Globally

Secondary Markets are used during the layering stage of the money laundering process.

This creates additional problems as criminal money arriving to be invested in the Stock

Exchange is more likely to come from another reputable financial centre than a country

with discernible links to organized criminal activity. The increased globalization of

financial marketplaces also throws up other difficulties: such as criminals establishing a

trading account in the office of a financial institution in one country and then having it

transferred to another country.

Organised criminal mafia, terrorists, and intelligence agencies seek to covertly use the

stock markets for earning funds as well as causing economic instability in a target

country. They generally use two methods for this purpose: stock market operationsand

stock market manipulation.

Stock market operations help them to earn money and launder black money, and stock

market manipulation helps them to earn and launder money as well as cause economic

instability.


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For a stock market operation, they use individual stock traders or companies -- either

floated by them or their surrogates -- for buying and selling shares and making profits --

like any other person interested in the stock market.

Terrorists indulge in stock market manipulation -- that is, artificially pushing stock prices

up or down either to earn money or to cause economic instability. Since the terrorists

know in advance the dates of their planned terrorist strikes, which often have an impact

on the stock market, they can use this advance knowledge to push prices up or down.

In the days before and after the 9/11 terror strikes in the US, there were erratic

movements in not only the New York Stock Exchange, but also in the stock exchanges of

some European countries. (B Raman, Are terrorists manipulating Indian Stock Markets?,

February 16, 2007)

Some of these erratic movements affected the shares of airline companies. This gave rise

to widespread speculation and fears that Al Qaeda, which had advance knowledge of the

date of its terrorist strikes, had used this knowledge in an attempt to make money and in a

futile attempt to cause an economic collapse.

Stock Exchanges can also be utilized as money laundering vehicle through listed

companies which are nothing more than a laundering operation themselves. Eg. The now

infamous YBM Magnex International Inc was delisted by the Toronto Stock Exchange in

December 1998 (Proximal Consulting). A US class action suit claimed that YBMs only

successful business is the laundering of criminal proceeds. Red flags have already been

raised about the money laundering possibilities inherent in the listing of dotcom

companies with no track record and unsustainable market valuations. (B Raman, Are

terrorists manipulating Indian Stock Markets?, February 16, 2007)


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3.2.2 MONEY LAUNDERING THROUGH DERIVATIVES EXCHANGES

Derivatives can also be used by initiating simultaneous put and call transactions on

behalf of the client. The UK experience showed that the futures market, through Capcom

Commodities, a BCCI (Bank for Credit and Commerce International) related institution

was another area that money launderers were taking advantage of for their money

laundering schemes. Because of the anonymous nature of the trading strategies, all

brokers trading as principals and not in their client's name, the true identity of the

beneficial owner is not known. Derivatives therefore are a zero sum game, which means

you can only buy if someone is willing to sell, and vice versa. Launderers can take

advantage by a strategy of buying and selling the same commodity, thereby taking a

small hit for the commission charged by the broker. They pay the losing contract out of

dirty money and receive a cheque that legitimises their profits and creates a paper trail for

any one who asks where the money came from.

3.3 MONEY LAUNDERING THROUGH STOCK EXCHANGES IN INDIA

Laundering black money through the secondary market is a common practice in India.

Unaccounted wealth that got laundered though the secondary market could well run into

several thousand crores of rupees. Tax officials have estimated about Rs 300400 crore

could have been laundered via the stock market in Mumbai alone.

3.3.1 CASE 1: USE OF PENNY STOCKS

Given that hundreds of penny stocks have been brazenly manipulated, large-scale

ramping up of penny stocks provided a convenient cover for launderers. A number of

companys shares have been manipulated through this route. The modus operandi is as

follows:

A group prepares the ground by ramping up shares of scores of companies that were

traded at just a few rupees each or sometimes less than a rupee. For instance, if X wants

to launder Rs 1,000, the racketeers would give him 10 physical shares of a company

quoting on the bourses at around Rs 100. This would be accompanied by a back-dated


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Presume there is an existing BSE-listed company, which is closed and is not trading at

all. Today, there are over 8,000 companies listed on the BSE, of which more than 50%

companies are in the B2 and Z category and are hardly traded. It can happen that two or

three people form an alliance and take over such a company changing its name to an

infotech company. It is even probable that the existing promoters of the company simply

change the name of their company to a software company. In actual practice, these

companies do not have the necessary infrastructure or the requisite workforce essential to

run a software company. The next step is to form a subsidiary overseas by renting a place

or just even employing a person to carry out the operations. Most of the exports are made

to duty free ports such as Hong Kong, Singapore or Dubai where the money can be

remitted back.

After that, the promoters conduct Hawala/ alternate remittance transactions by payingcash over here and getting dollars from abroad through the subsidiary. The same dollars

transferred from abroad are shown as software exports in the company's books. In this

way the company is able to report decent sales figures in its balance sheet by the way of

export income. The next step is to grab a flashy share broker or market operator whose

gossips about the company can be floated in the market. The share broker or the operator

then spreads stories such as the company has got big software development orders or tie-

ups and is going to post superb profit numbers. Obviously, the fake export income

compels the net profit stating strong Earnings per Share for the company.

Since, the P/E of the company appears to be quite low in comparison with the industry

P/E; the stock appears to be an excellent buy. The market operators start providing

liquidity in the counter by creating demand for the stock by them. As a result the volumes

in the counter start increasing. The stock price of the company starts touching upper

circuits in sequence. The promoters start taking advantage of this situation by reducing

their own stake and offering it to the small investors who will be willing to buy. In the

end we have the small investors who are left holding the stock which they have

purchased at the high prices. Thus the promoters are able to take advantage in two ways.


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Firstly they are able to get a superior price for the dead stocks of their company, which

were not being traded at all and secondly are able to exchange their cash into official

export income at a low premium without paying any income tax.

3.3.3 CASE 3: USE OF PARTICIPATORY NOTES

Offshore derivatives instruments (ODIs) are investment vehicles used by overseas

investors for an exposure in Indian equities or equity derivatives. A participatory note is

the most popular offshore derivative instrument. FIIs issue these instruments to overseas

investors against ownership of underlying shares in an Indian company. Foreign investors

need to register as FIIs or as a sub-account of a registered FII to invest in equities listed in

India. To circumvent this process, they also have the flexibility to route their money

through FIIs or sub-accounts of FIIs. The document used to route money in this manner is

the Participatory Note. The identity of foreign investors gets masked when they earmarkfunds for investment in India through PNs. A participatory note is a form of equitylinked

note: basically, a derivative instrument, typically issued by a broker registered with Sebi,

against an underlying Indian security. The broker issuing the P-Note purchases the

underlying security and then passes through the dividends and capital gains and losses

generated by the security to the noteholder, effectively giving the holder indirect

exposure to the investment returns associated with the Indian security. Here, brokers

become the medium through which investors, most of whom wish to remain anonymous,

invest in the exchange. The brokers execute trade and use their internal accounts to settle.

Ever since the India growth story caught on, P-notes have become quite the rage with

overseas investors.

FII Sub-Accounts

Sub-accounts are special purpose vehicles floated by foreign funds in which they manage

money on behalf of their overseas clients. FIIs also form proprietary sub-accounts to

invest their own money.


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FIG 3.2: Shows the increasing Number of FIIs and Sub-Accounts from 2005 to 2007

0

500

1000

1500

2000

2500

3000

3500

4000

No.

in

thousands

Years

Increasing Number of FIIs and Sub-Accounts

End year number

of FIIs

823 1044 1219

End year number

of Sub-Accounts

2273 3045 3644

2005 2006 2007

Source: Economic Survey 2007-2008

FIG 3.2 shows that the number of Sub-Accounts has exceeded the number of FIIs. The

number of times the sub-accounts have exceeded the number of FIIs registered with

SEBI is almost three-fold. For the year 2004-2005, the Sub-Accounts exceeded FIIs by2.76 times. For the year 2005-2006, the Sub-Accounts exceeded registered FIIs by 2.92

times. And for the year 2006-2007, the Sub-Accounts exceeded registered FIIs by 2.99

times. These facts clearly show the popularity of sub-accounts as tools for investments

into India.

P-Notes became very popular with foreign investors seeking exposure to Indian equities

markets due to the registration requirement India imposes for direct investment. These

investors approach a foreign institutional investor (FII), who is already registered with

SEBI. The FII makes purchases on behalf of those investors and the FIIs affiliate issues

to them ODIs. The underlying asset for the ODI could be either stocks or equity


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derivatives like Nifty futures. These investors are not registered with SEBI, either

because they do not want to, or due to regulatory restrictions.

FIG 3.3: Depicts The Cumulative Net Investments Made By Fiis For The Period

Ranging From 1992 To 2008 In Comparison With The Sensex

Growth of Sensex in comparison with Cumulative Net Investment by FIIs

0

10000

20000

30000

40000

50000

60000

70000

80000

1992-

1993

1993-

1994

1994-

1995

1995-

1996

1996-

1997

1997-

1998

1998-

1999

1999-

2000

2000-

2001

2001-

2002

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

2007-

2008

Year

Cumulativenetinvst(US$mn)

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

SensexValue

Cumulative net investment (US $ mn.) Sensex

Source:Compiled from Sebi and BSE sources

FIIs are very important source of investment in Indian Capital markets. If we look at FIG

3.3 we can see that the reason behind the market booms is the investments made by FIIs.

They are the major contributors to the stock markets. They are very active while trading

in the Indian Securities market. The past boom in the stock markets in 2001-02, 2003-04,

and 2005-06 have been attributed to the FIIs. But still FIIs are looked with a word of

caution and a sense of worry for market regulators.

Whenever, investment climate in the country is not good, they will indulge in capital

flights and overnight withdraw their money from the markets thus making the conditions

in the market worst. They have a very strong influence in Indian markets and

Governments and regulators cannot take the risk of taking them lightly. Their strong


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presence in the Indian markets has cautioned the government to address the issue of

participatory notes very carefully because otherwise they may adversely affect the FIIs

inflow into India. FIIs that dontwish to register with SEBI or fails to get registration or

are ineligible to get registration, make entries in the Indian capital markets through the

participatory notes. FIIs also earn huge commission while facilitating investment of

participatory notes holders like unregistered FIIs, hedge fund, university endowments,

etc in the Indian Capital markets. The influence of Participatory Notes in Indian Capital

markets can be gauged from the simple fact that, according to one estimate, 51% of FII

investment till August, 2007 were via Participatory Notes and that is equal to 3, 53,484

crores.

Issues Concerning Participatory Notes

The principal concern is the masking of identity of the foreign investor. Hedge funds tend to use this route.

There is also the possibility of resident Indians channeling unaccounted money

through this route.

The crux of the problem lies in identifying the "real" and "final" beneficiaries of

transactions using PNs. Company A could be controlled by Company B which, in

turn, could be controlled by Company C in a country over which the Indian

government has no jurisdiction. Technically, Sebi officials can try and establish

an "audit trail" up to three layers of beneficiaries although even this is rather

difficult. Thus, the Indian regulator is unable to ascertain the actual source of

funds or the colour of the money coming in through PNs.

It is apprehended that part of the money that is coming into the country actually

belongs to persons of Indian origin who had kept their money abroad at a time

when the government used to have restrictions on the use of hard currency. Such

"round-tripping" funds are now returning to India through tax havens like

Mauritius. With the rupee having appreciated against the US dollar, it is believed


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that higher flows of such funds are coming to India to finance election campaigns

of politicians.

There are fears that P-Notes are being used as a vehicle by promoters, market

operators, and politicians to repatriate illegitimate funds parked abroad. Quite a

few promoters are said to be using this route to ramp up their stocks.

The fact that Sebi can lift the "corporate veil" only up to a point to identify the

true beneficiaries of transactions using PNs. As per SEBI rules, the FII issuing

ODIs/P-Notes should know the eventual beneficiary to whom the instruments are

being issued to. But through multiple layering, it is possible to conceal the

identity of the original client. Then there are concerns that too much money

flowing into the derivatives segment through the P-Note route is adding tovolatility, not to mention the pressure on the currency.

The possibility of criminal money getting deployed is also a risk. There is the fear

(justified to a large extent based on experience in other markets) that such flows

can be `hot money that could move out in a jiffy, leaving behind negative

consequences for the broad economy.


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TABLE 3.1: Recent Initiatives By Sebi To Curb Participatory Notes

DATE ACTION TAKEN BRIEF PARTICULARS

October 2007 Sebi imposed a slew of curbs on theuse of PNs for share transactions**

FIIs had pumped in $18 billion intothe countrys stock markets during2007, these same institutions hadwithdrawn around $13 billionbetween January and October 2008

October 2008 Sebi reversed its decision to restrict theuse of PNs ostensibly on the groundthat FIIs needed encouragement tocontinue to invest in India.

May 27, 2008 Disclosure norms on offshorederivatives instruments (ODI), marketregulator Sebi asked FIIs to give anundertaking that these investment toolsare not issued to non-resident andresident Indians, who otherwise do notneed the FII route.

Sebi wants to track how muchmoney is coming from FIIs and fromIndian investors separately.

October 31,

2008

Sebi released historical data on short-

sales by FIIs that indicated that onOctober 9 there had been short-sellingin 224 specific stocks worth around Rs6,500 crore

Among the entities whose shares

were "short-sold" (Lending sharesthat did not belong to them andbuying them back by obtaining loansfrom third parties.) are HDFC, ICICIBank, Axis Bank, RelianceIndustries Ltd, Bharti Airtel, Infosys,Reliance Capital and RelianceCommunications in other words,the blue chips of the countryscorporate world.

October 23,

2008

Sebi disapproves of lending to offshoreentities and asked them to reverse such

transactionsPOST

OCTOBER

2008

The lending/borrowing activity of FIIsis being monitored and, if necessary,stronger measures will be taken bySebi as considered appropriate". Butnothing has happened.

Reasons For

Reluctance On

Part Of

Ministry of

Finance In

Curbing

ParticipatoryNotes

The finance ministry justifies the use of PNs on the ground that it enables

higher inflows through FIIs, adds to liquidity and trading volumes, leads

to better price discovery and lower transaction costs and overheads

Source: Compiled from newspaper article Asian Age dated Friday 8th

May 2009


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** P-Notes with stocks as underlying assets can be issued by an FII, subject to a limit of

40% of the overall assets under the custody of that FII. Simply put, if an FII has $100

million worth of assets under custody (AUC), only $40 million of those assets can be in

the form of equity-based P-Notes. Where P-Notes with equity derivatives are the

underlying assets, SEBI has proposed that these cannot be issued anymore, and the

existing positions have to be unwound over a period of 18 months.

3.3.4 CASE 4: USE OF DEPOSITORIES FOR MONEY LAUNDERING

Market intermediaries are using the stock market to convert black money into white by

using benami entities as fronts. The operation requires a slew of demat accounts and a

network of investors ready to lend their demat accounts. Typically a person who wants to

convert some of his idle money approaches these brokers who offer the facility for a

price. The broker makes the necessary arrangements for the client to participate in theIPO by using a network of benami demat accounts. Profit from the IPO proceeds can be

taken away as white income by paying 10% short term capital gains (STCG) tax.

Now, market manipulators are taking advantage of the buoyant primary market. In

calendar 2005 till date, around Rs 22,000 crore has been mobilized from the market

through 45 issues, a mix of initial public offerings (IPOs) and follow on public offerings

(FPOs).

This is how it works: An investor with a high risk appetite and idle money say Rs 2 crore,

approaches the broker who provides such services. The broker charges a 5% flat fee (Rs

10 lakh) for the end-to-end solution he provides.

He applies in the IPO on behalf of the investor through his network of benami accounts,

keeping in mind factors like levels of likely oversubscription in particular categories and

the possible basis of allotment.


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Most of the time, the allotment is in line with the expectation and within days of listing,

the entire lot of allotted shares is disposed of. Since the secondary market was buoyant in

the recent past, the listing of most IPOs in the recent past has happened at a huge

premium to the issue price. Taking advantage of this buoyancy, the allotted shares in the

IPOs are disposed of within a very short period after listing, thus attracting short term

capital gains (STCG) tax of 10%. Even after paying the STCG, the investor walks away

with a hefty profit and an added bonus of converting the idle funds into white income.

(Financial Express, 19/12/2005, Demat scam being used to convert black money)

How the System Works:

Broker-operators keep their network of benami demat accounts ready and offer

the facility to those wishing to invest idle funds in the IPO market

Charge flat fee on amount invested, and then put the network to use by applyingin the new issues

Once the allotments come, they quickly disinvest after listing and the investor

pays short-term capital gains tax (STCG) at 10% and walks away after turning

black into white

The practice of using multiple demat accounts to corner shares in an IPO is well known

and prevalent one. In the cases of Yes Bank IPO and IDFC IPO, benamis and front

entities were used to act as conduits for laundering of ill-gotten funds.

The modus operandi used was to submit many applications for shares in the retail

category of an IPO using fictitious names and multiple demat and bank accounts. An

investor approaches a broker if he knows anyone who has a demat account is not

applying for the particular IPO. The broker helps the investor find such a person after

which the rent is fixed. Once the allotments are made to these various accounts, the

investor and his associates consolidate the holding through off-market transactions before

the shares list.


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This is possible as the transfer of shares from one demat account to another is allowed

without having to route this through the exchanges. That means even if the investor's

shareholding crosses 1%, the exchanges have no clue. Once listed the shares are then

traded by the investor and his associates who control the consolidated accounts. The case

of Yes Bank and IDFC indicates to the systemic lapses by depository participants,

merchant bankers, banks, and registrars.

3.4 Conclusion

In the Global context, Brokerage and Investment Firms rank second in terms of

susceptibility to money laundering worldwide. Stock Markets are usually employed by

launderers during the layering phase of the money laundering process. Launderers use not

only equity markets but also derivatives market to launder funds. India in the recent past

has generated a lot of interest globally as a fast growing economy and hence funds havebeen flowing into India ever since. However even launderers have taken a keen interest in

the Indian growth story as a means to launder funds. In India the key methods used to

launder funds through capital markets have been by using Penny Stocks, Listed

Companies, Participatory Notes and Depositories. In the case of Participatory Notes the

Indian government has shown reluctance in curbing such flows since the volume of flows

coming through this channel is huge and such flows are essential for a developing

country like India.


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CHAPTER 4: IMPACT OF MONEY LAUNDERING

4.1 INTRODUCTION

Money Laundering is associated with large flows of money. Such large flows are

beneficial for an emerging economy like India in the short term but is detrimental in the

long term. This chapter tries to comprehend the impact that money laundering can have

on the various constituent parts of the economy.

4.2 PROBLEM FOR EMERGING MARKETS

1. Increased vigilance by authorities in the major financial centres to combat

money laundering activity provides an incentive for launderers to shift their

activities to emerging markets.

2. As ill-prepared emerging economies open up their financial markets, they

become increasingly attractive targets for money laundering activity.

3. Countries with loose detecting / recording systems attract inflow of criminal

funds. This is evidenced by rising funds movement to such centres

4. Developing states cant be too selective about the sources of capital they

attract.

5. Postponing action on vigilance steps may allow organized crime to become

entrenched.

4.3IMPACT OF MONEY LAUNDERING

4.3.1IMPACT ON THE FINANCIAL SECTOR

First, money laundering erodes financial institutions themselves. Money

laundering impairs the development of important financial institutions and

intermediaries.

Second, particularly in developing countries money laundering impairs customer

trust. A reputation for integrity is the one of the most valuable assets of a financial

institution.


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Table 4.1: Specific Risks Faced by Financial Institutions and Intermediaries

TYPE OF RISK SYNOPSIS OF RISK

Reputational

Risk

The potential that adverse publicity regarding a intermediaries

business practices, whether accurate or not, will cause a loss of

confidence in the integrity of the institution

Operational

Risk

The risk of direct or indirect loss resulting from inadequate or failed

internal processes, people and systems or from external events

Weaknesses in implementation of AML programmes, ineffective

control procedures and failure to practise due diligence

Legal Risk The possibility that lawsuits, adverse judgements or contracts that

turn out to be unenforceable can disrupt or adversely affect the

operations or condition of an intermediary

Intermediary may become subject to lawsuits resulting from the

failure to observe mandatory KYC standards or from the failure to

practise due diligence

Intermediaries can suffer fines, criminal liabilities and special

penalties imposed by supervisors

4.3.2 IMPACT ON THE REAL SECTOR

Money laundering has a more direct negative effect on economic growth in thereal sector by diverting resources to less-productive activity, which in turn depress

economic growth.

Money laundering also facilitates crime and corruption within developing

economies, which is antithetical to sustainable economic growth.

As can be seen from the various money-laundering typologies reports, money laundered

through channels other than financial institutions is often placed in what are known as

"sterile" investments, or investments that generate little additional productivity for the

broader economy, such as real estate, art, antiques, jewellery, and luxury automobiles.

For developing countries, the diversion of such scarce resources to less productive


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domestic assets or luxury imports is a serious detriment to economic growth. Moreover,

criminal organizations can transform productive enterprises into sterile investments by

operating them for the purposes of laundering illicit proceeds rather than as profit-

maximizing enterprises responsive to consumer demand and worthy of legitimate

investment capital.

4.3.3 IMPACT ON EXTERNAL SECTOR

Money laundering can impair a developing country's economy through the

country's trade and international capital flows.

Moreover, the confidence that foreign investors and foreign financial institutions

have in a developing country's financial institutions is important for developing

economies because of the role such confidence plays in investment decisions and

capital flows. Money laundering can also be associated with significant distortions to a country's

imports and exports alongwith increased volatility of exchange rates.

4.3.4 IMPACT ON BUSINESS

The institution could become part of the criminal network itself. Evidence of such

complicity will have a damaging effect on the attitudes of other financial

intermediaries and of regulatory authorities, as well as ordinary customers.

There is a damping effect on foreign direct investment when a countrys

commercial and financial sectors are perceived to be subject to the control and

influence of organised crime.

Unpredictable changes in money demand.

4.3.5 IMPACT ON SOCIETY

Organised crime can infiltrate financial institutions, acquire control of large

sectors of the economy through investment, or offer bribes to public officials and

governments.


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The economic and political influence of criminal organisations can weaken the

social fabric, collective ethical standards, and ultimately the democratic

institutions of society.

Most fundamentally, money laundering is inextricably linked to the underlying

criminal activity that generated it. Laundering enables criminal activity to

continue. Ultimately influencing the democratic process.

4.4 Conclusion

Developed countries having stringent Anti-Money Laundering controls offer very little

opportunities to launderers. Hence money laundering activities are seeking countries with

poor Anti-Money Laundering controls. In line with such a trend money laundering has

been shifting focus to developing countries with poor or no Anti-Money Laundering

controls. India being a developing country is an attractive destination for launderers. Theimpact of money laundering can be very severe on an economy like India. Not only does

money laundering impact the financial institutions but also other key areas of the

economy. Further money laundering also brings about various negative changes in the

social and economic arena of the economy which hinder development and destroy the

fabric of the economy.


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CHAPTER 5: INTERNATIONAL AND DOMESTIC INITIATIVES

AGAINST MONEY LAUNDERING

5.1. INTRODUCTION

The world community has been taking money laundering very seriously. Since money

laundering has attained a global reach, every country must not only look to safeguard

their economy but also have systems which facilitate cooperation amongst countries. In

line with this view many legislations and initiatives have been taken by countries and also

international communities. The objective of this chapter is to examine important

outcomes of enactments and initiatives taken by the world community. Inaddition it is

also sought to examine the money laundering efforts being taken in the Indian context.

5.2ANTI-MONEY LAUNDERING LEGISLATIONS AND INITIATIVES

5.2.1 THE BANK SECRECY ACT (USA, 1970)was designed to fight drug trafficking,

money laundering, and other crimes. Congress enacted the BSA to help prevent banks

and other financial service providers from being used as intermediaries for, or being used

to hide the transfer or deposit of money derived from, criminal activity. Among other

items, the BSA created an investigative paper trail by establishing regulatory

reporting standards and requirements (e.g., the Currency Transaction Report), and,through a later amendment, established recordkeepingrequirements for wire transfers.

Key features of the Act were:

Established requirements for recordkeeping and reporting by private

individuals, banks and other financial institutions

Designed to help identify the source, volume, and movement of currency and

other monetary instruments transported or transmitted into or out of the United

States or deposited in financial institutions

Required banks to (1) report cash transactionsover $10,000 using the Currency

Transaction Report; (2) properly identify persons conducting transactions; and

(3) maintain a paper trail by keeping appropriate records of financial transactions


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The Financial Crimes Enforcement Network (FINCEN)acts as the designated

administrator of the Bank Secrecy Act (BSA).

A summary of various legislations and initiatives taken domestically as well as

internationally is provided in the table below:

TABLE 5.1: Timeline of Domestic as well as International Initiatives for Prevention

of Money Laundering

International Initiatives Indian Initiatives

1970 Bank Secrecy Act (USA) 1985 Narcotics drugs and PsychotropicSubstances Act

1986 The Money Laundering Control Act(USA)

1988 Benami Transaction (Prohibition) Act

1988 Basle Committee Statement ofPrinciples

1988 Prevention of Illicit Traffic in Narcotics Drugsand Psychotropics Substances Act

1988 The Anti-Drug Abuse Act (USA) 1999 Foreign Exchange Management Act

1988 Vienna Convention (UN ConventionAgainst Illicit Traffic in NarcoticDrugs and Psychotropic

Substances)

2002 Prevention of Money Laundering Act,

1989 Financial Action Taskforce (FATF) 2004 Unlawful Activities Act (UAPA) as amended

1991 European Union Directive Guidelines for anti-money launderingmeasures by Securities and Exchange Boardof India (SEBI)

1992 The Annunzio-Wylie Anti-MoneyLaundering Act (USA)

1992 IOSCO

1994 The Money LaunderingSuppression Act (USA)

1995 EGMONT Group

1997 Asia/Pacific Group on moneylaundering

1998 The Money Laundering AndFinancial Crimes Strategy Act(USA)

2000 The Palermo Convention (TheInternational Convention AgainstTransnational Organized Crime)

2000 The Financial Services And MarketsAct

2001 USA Patriot Act

2001 EU Second Money LaunderingDirective

2002 UK Proceeds of Crime Act of(PoCA)

2004 Intelligence Reform & TerrorismPrevention Act

2007 EU Third Money LaunderingDirective

Source:Compiled from various articles and magazines


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5.2.2 THE MONEY LAUNDERING CONTROL ACT OF 1986 (USA) amended the

BSA to enhance its effectiveness and to strengthen the governments ability to fight

money laundering by making it a federal crime and by making structuring transactions to

avoid BSA reporting requirements a criminal offense. Key features of the Act were:

1. Established money laundering as a federal crime

2. Prohibited structuring transactions to evade CTR filings

3. Introduced civil and criminal forfeiturefor BSA violations

4. Directed banks to establish and maintain procedures to ensure and monitor

compliancewith the reporting and recordkeeping requirements of the BSA

5.2.3 THE BASLE COMMITTEE STATEMENT OF PRINCIPLES

The increased international concern about organized crime and the concentration of

power and finance around drug and other criminals was shared by the bankingcommunity. The Basle Committee on Banking Regulations and Supervisory Practices

(the Basle Committee) stated in December of 1988.

The statements basic purpose is to ensure that banks are not used to hide or launder the

profits of crime. Its basic principles are in summary:

Know Your Customer:Banks should make reasonable efforts to determine the

customers true identity, and have effective procedures for verifying the bona

fides of new customers.

Compliance With Laws: Bank management should ensure that business is

conducted in conformity with high ethical standards, that laws and regulations are

adhered to and that a service is not provided where there is good reason to

suppose that transactions are associated with laundering activities.

Co-Operation With Law Enforcement Agencies: Without any constraints

imposed by rules relating to customer confidentiality, banks should cooperate

fully with national law enforcement agencies including, where there are


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reasonable grounds for suspecting money laundering, taking appropriate measures

which are consistent with the law.

Policies, Procedures And Training: All banks should formally adopt policies

consistent with the principles set out in the Statement and should ensure that all

members of their staff concerned, wherever located, are informed of the banks

policy. To promote adherence to these principles ban

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