BUSINESS COMMENTARY

Does ‘Know Your Customer’ work?

Paul Byles

by Paul Byles

Monday,  July 25, 2005

There remains increasing pressure on Offshore Financial Centres (OFC) like the Cayman islands to adopt higher Know Your Customer (KYC) standards. But it is questionable whether following stringent KYC procedures and carefully filtering new account applications actually makes as much difference in the fight against money laundering and the financing of terrorist activities as some think it does.

A report from the Scarman Centre for studying criminology at the University of Leicester found that KYC had fairly limited impact on reducing money laundering. According to the banks and other financial institutions surveyed as part of the report, KYC procedures may make it more difficult for someone to just walk in off the street and start laundering money, but serious criminals can easily overcome the KYC checks.

The survey also found general skepticism among financial professionals and banks about the effectiveness of suspicious transaction reports (STRs) – the other mainstay of efforts to counter money laundering. Traditionally, banks and other institutions must file an STR for any transaction that shows any signs of being suspect. But they get little, if any, feedback from the authorities because the regulators are overwhelmed by the number of reports being filed. The US Financial Crimes Enforcement Network (FinCEN), which oversees anti-money-laundering efforts, is notorious in US banking circles for having a huge backlog of STRs. 

In addition, a report issued by the UN in September 2002 found that the drive to close down the sources of terrorist finance had slowed sharply after the initial flurry of activity. Indeed, the UN’s report could hardly have been less encouraging. For the UN found that the fight against terror financing was failing, and al-Qaeda had as much money as it is needed and could move it wherever it wanted, while international cooperation was faltering – not least in terms of the enhancement of KYC procedures.

Furthermore, most of the money used to finance terrorism doesn’t flow through the global financial structure but via an alternative banking system. This system, known in India as hawala, and in Pakistan, Afghanistan and the Middle East as hundi, is hundreds of years old.

The US has now recognized this fact. In 2002, Washington unveiled a new money-laundering strategy that makes identifying and closing down informal financial structures like the hawala money transfer system a top priority. This development represented a clear policy shift for the US government, which had previously focused on dirty money shunted through the formal financial system. 

Though the initiative was welcome, no one should be under any illusions about the size or nature of the task in hand. Suppose, for example, that someone working in the US wants to send money back to a village in Pakistan. A bank transfer, which would have to take place at the official exchange rate, would be of little use since the village in Pakistan is unlikely to have a bank. It’s more likely that the Pakistani would approach a hundi broker, often a local small businessman, and give him the money. After a short time his contacts back home will deliver the money – at the black market rate, in local currency and minus a handling fee – to his relatives. 

Hundreds of thousands of Americans from overseas use systems such as these to remit money to relatives who live anywhere from the Middle East to the Pacific. There is no paper trail, no fuss and no money ever crosses a border. Discrepancies in the two-way flow are settled up at the end of the month, or perhaps every half-year. Consequently the system is ideally suited to drug traffickers – Afghan drug smugglers have used Pakistani hundi brokers for years – other criminals and, of course, terrorists.

More recently, the Chinese ‘chop’ system has been used by the Afghan drug and arms trade. In this system, no money changes hands at all, and instead ‘tokens’ (often now passwords sent by e-mail) are used as the equivalent letters of credit for gold or diamonds deposited with trusted third parties.

To sum up even the most stringent KYC procedures are unlikely to deter the most determined criminals, while many drug traffickers and terrorists can also use alternative systems of financing that can be almost impossible to close down. Given this background, it is not surprising that some people wonder whether the drive to improve regulatory standards across the globe has more to do with eliminating competition to the major Organisation for Economic Cooperation and Development (OECD) countries, and less to do with tackling money laundering and terrorist financing. What is certain is that notwithstanding the introduction of the fiercest anti-money laundering regime the Financial Action Task Force (FATF) could devise, no significant (some say any) money laundering has been revealed in any of the established OFCs. 

Paul Byles is a former Head of Policy at the Cayman Islands Monetary Authority and Director of consulting at Deloitte. He was instrumental in drafting the Cayman Islands’ anti-money laundering guidelines and in the development of formal regulatory policy for the financial services industry. He is currently Managing Director of Focus Consulting.

This article is an extract from his recent book Inside Offshore, which focuses on offshore issues from the perspectives of politics, regulation, economics, media and taxation. It explores what offshore really means and how the system relates to the international economy, providing the first multi-disciplinary insight into the world of offshore finance. It tackles difficult and complex topics including the anti-terrorist financing in a world after 9/11, the Patriot Act and the recent wave of corporate scandals in terms the layman can understand.

    Back...