Our financial systems are at risk. Enabled by the digital economy, new threats have sprung up in recent years. Especially between 2020 and 2023, cryptocurrency-related crimes exploded. In 2021 alone, over $14 billion was transferred to illicit addresses.
Criminal organizations can now use worldwide money transfers to hide their tracks and easily convert their money to digital currencies and back. These advancements have enabled new forms of financial crime, and the most threatening among them is reverse money laundering.
So what is reverse money laundering exactly?
Criminals use reverse money laundering to turn legally acquired funds into dirty money, rendering it untraceable. They can then use it for all kinds of dirty business, including bribery, tax evasion, and even for financing terrorist activities. Terrorist organizations use reverse money laundering in combination with traditional money laundering, making use of illegally gained money as well. By mixing dirty money with legitimate funds, they can finance illegal activities.
As a result of these actions, the Bank Secrecy Act was implemented in 1970. It formed the basis of our current financial regulations policies, and the mandates it enforced are still in use today. It has undergone many changes since it was first enacted, and these days, it works with the PATRIOT Act to prevent money laundering. It has a list of protocols the financial institutions must follow, including the methods currently in use.
Right now, we use a variety of tools like anti-money laundering policies, Know Your Customer (KYC) systems, Counter-Terrorism Financing (CTF) systems, and a few others. But reverse money laundering methods keep evolving, and we need to catch up.
The crypto and gaming sectors have invested heavily in quick and easy digital transactions to maximize ease of use. Unfortunately, criminal organizations have co-opted these systems, and have started using them for reverse money laundering.
As a result, the financial services and fintech businesses need to improve their systems to keep up with this new form of crime. However, we need to understand this form of crime before we can fight it effectively.
How reverse money laundering works
Anti-money laundering and monitoring systems have evolved a great deal over the past few decades. Illegally acquired funds often raise red flags in our financial system, especially when transferred in large quantities. To avoid these monitoring mechanisms, criminals have now started using legally acquired funds to conceal their illicit activities.
The process of reverse money laundering consists of four stages. The criminal organizations have to raise clean money legally, store it securely, move it while avoiding detection, and then put it to use.
Raise
Acquiring funds is the first hurdle, and these organizations have developed ingenious ways of doing so. Supporters of the organization often take up salaried positions and send a portion of their salaries back as financial support. Other than that, criminal organizations target wealthy people and solicit donations from private individuals, or even start charitable organizations to funnel funds where they need to go. Because this is clean money, our financial institutions cannot detect suspicious transactions easily at this stage.
Store
Once the funds have been raised, they are stored in ways that make them harder to track. This includes converting them into foreign exchange, cryptocurrencies, gaming currencies, private wallets, and other forms of digital currencies or cash.
Move
Once the criminal organizations have stored the money, they need to move it where it needs to go. For this, they use a web of complex financial transactions and transfer it to different organizations or shell companies. Once it reaches its destination, they invest it into assets or other large purchases or intertwine it with fully legal inflows of cash. This way, they seamlessly blend the clean money with the dirty money of the terrorist organizations.
Use
Once done, terrorist groups or criminal organizations can use the money obtained as they please, either by selling off the assets, making use of them, or even just using the funds directly. It is primarily used for nefarious activities, terrorist financing, or tax evasion.
Detecting reverse money laundering in the first stage is extremely difficult since legitimate funds do not raise red flags in our financial system. It is in the second and third stages that AML systems can most accurately track suspicious activity. The third stage is the most critical one because that is when the money is in the process of being hidden. By tracing the transactions, law enforcement agencies can map out the methods that the terrorist organizations are using, along with their locations.
But if they fail, the consequences of reverse money laundering are severe. Let’s take a look at the damage that has already been done.
Importance of combating reverse money laundering
Reverse money laundering acts as a major source of funding for terrorist groups and criminal organizations, often resulting in serious harm to many. Combating reverse money laundering has now become a priority for many organizations, including the UN and worldwide police forces. Unfortunately, there are many challenges when it comes to identifying and monitoring reverse money laundering.
- Detection: Since the funds are acquired legally, they do not trip the monitoring systems in place. This makes it harder for investigators to trace the destination of the money.
- Transaction Complexity: Criminal organizations often create globe-spanning webs of accounts and transactions, making it difficult to follow the trail of the money.
- Global Coordination: Another major hurdle in the path of investigators is coordinating with agencies from other countries. Jurisdiction issues tend to trip up the majority of investigations, and the lack of proper data-sharing infrastructure slows things down further.
In order to get past these challenges, KYC and AML guidelines have been set in place to protect our financial system.
KYC protocols are our best defense against reverse money laundering systems. Their main task is to thoroughly verify the identities of everyone using a particular financial institution and to monitor transactions well enough to track the flow of legal funds.
Financial institutions have now started using AML guidelines to track and identify suspicious transaction patterns. These patterns are then sent up the chain of command, allowing investigators to start narrowing down the people involved.
Unfortunately, due to the difficulty in detecting it, reverse money laundering has already contributed to multiple major events, chief among them being the 9-11 attacks in the US. The terrorists used funds from completely clean sources to plan and execute their attacks, resulting in nearly three thousand deaths and a great deal of human suffering.
Other than this, a California State Senator was also implicated in reverse money laundering activities related to the Chee Kung Tong organization, a fraternal order started in 1880. An affidavit was filed against them in 2014, detailing a number of allegations, including using reverse money laundering to smuggle guns and perform drug trafficking.
Reverse money laundering has already caused plenty of damage, but it can always get worse. Let’s take a look at what it can do in the long term.
Risks and consequences
Due to its scope, reverse money laundering has far-reaching consequences, affecting financial systems worldwide. Let’s take a look at what happens if it goes unchecked.
Regulatory and legal implications
Reverse money laundering processes make it clear that our current laws and monitoring systems are not enough to keep up. In order to stop them, governments are creating and enforcing stronger laws. Consequently, strict reporting requirements have been imposed on financial institutions, and violations are dealt with swiftly. Financial institutions must now implement rigorous KYC and AML procedures as part of their normal workflow.
But if these measures fail, the government freezes all assets of the people and organizations involved in the process.
Reputational damage and loss of trust
If a particular financial institution is repeatedly targeted, its reputation is damaged. It starts being perceived as a hub for illicit activities, making it harder for them to attract legitimate investors. Left unchecked, this can turn into a death spiral for the institution in question.
The discovery of reverse money laundering also destroys the public trust in that financial institution, causing it to lose stability.
These two effects can create a feedback loop, resulting in severe financial losses.
Financial losses and penalties
Reverse money laundering has serious consequences for financial institutions. It often causes direct financial losses due to criminal activity, in addition to the indirect costs needed to combat it. Compliance costs and regulatory efforts can further burden economic systems. On top of this, financial institutions can face legal penalties if they fail to combat reverse money laundering effectively. They can be subject to fines and penalties, and can even have their licenses revoked.
In 2023 alone, a number of institutions were hit with steep fines. Binance, a cryptocurrency exchange, was hit with a whopping $4.3 billion fine for its involvement in money laundering, unlicensed money transmission, and sanction violations.
Deutsche Bank was also fined $186 million due to insufficient AML controls and programs, and risk and data management issues.
The Crown Resorts casino was also hit with massive fines, totaling $450 million, as a result of AML breaches, Their Melbourne and Perth casinos also came under fire for failing to assess risks related to money laundering and terrorist financing.
Identifying red flags
Nowadays, financial institutions have to be on the lookout for certain patterns signifying reverse money laundering. These red flags are much more subtle, and as such, harder to spot. Let’s take a look at the most common patterns.
Transaction patterns:
Individual transactions cannot be taken as proof of malicious behavior, since the methods used are all legal. As such, we need to take a look at patterns of how people transfer money over time. This is where transaction monitoring systems can help. Common red flags include:
- Instant or immediate transfer of funds to private wallets
- Instant or immediate conversion to cryptocurrencies
- Multiple transfers from accounts with low activity
- Transactions with unregistered or suspicious jurisdictions
Customer patterns:
Customer behavior patterns can also provide valuable information when trying to detect money laundering. Some behavior patterns to look out for are:
- Lack of transparency from customers: If they try to evade questions or avoid giving information, it should be taken as a warning sign of illicit activities.
- Ties to high-risk countries: Clients connected to high-risk countries should be scrutinized with greater care. These connections increase the chances of corruption.
- Connections to politics: Customers who are or have ties to Politically Exposed Persons (PEP) can be used to launder money due to their positions.
Documentation patterns:
Both money laundering and reverse money laundering systems have a vested interest in avoiding documentation, since it is one of the best detection methods we have. As a result, they do their best to avoid giving information. Here are the key things to watch out for:
- Issues with the Customer Due Diligence or KYC process: If the missing information makes it harder to track transactions, it should be taken as a red flag.
- Insistence of manual processing and physical paperwork: By overloading compliance officers with paperwork, criminal organizations can make it easier for important documents to slip through the cracks.
- Non-standard language in documentation: When answers are unclear or strange, it is often the result of covering up transfers.
- Unidentifiable Ultimate Beneficial Owner (UBO): The UBO of an organization is the person to whom the company belongs, whether they appear as the owner on paper or not. When UBOs remain hidden, those companies can be used to launder money, as the trail stops there. Therefore, finding the UBO is of critical importance. Hidden UBOs are often a sign that you are dealing with shell companies.
Combating reverse money laundering
While KYC and AML guidelines are good and useful, our current systems need an upgrade. Let’s take a look at the programs and controls that need to be implemented to put a stop to this form of crime.
The first step is complying with Anti-Money Laundering and Counter-Terrorism Financing (CTF) programs. Your AML/CTF program needs to be risk-based, taking into account how likely it is that your organization can be used for money laundering or terrorist financing. The analysis is based on several factors including size, complexity, customer profiles, services provided, method of service delivery, and interactions with foreign jurisdictions.
There is no AML/CTF program that is perfect for every single kind of institution. It must be customized to your requirements. That said, your program should include the following elements.
- A regularly reviewed and updated risk assessment
- Board approval and oversight of the program
- An AML/CTF compliance officer
- An employee due diligence program
- A risk awareness training program
- Ongoing Customer Due Diligence (OCDD) programs
Previous efforts to combat reverse money laundering have shown themselves to be insufficient. As a result, enhanced due diligence and ongoing monitoring are our best bets at stopping the problem.
Thankfully, we have the technology to keep up. Advanced technologies have given us a number of ways to improve our tracking systems, and worldwide interoperability is making things easier.
Terrorist groups keep using new accounts, but if they slip up, that makes them easier to catch. Suspicious individuals are placed on a global watchlist, and by screening the people on the watchlist, we can increase pressure on them. This is best done by using proper KYC compliance systems, which require the customers to provide enough details to make them easily identifiable.
Due to the sheer volume of data that comes into play, it is important to leverage advanced technologies and solutions to perform due diligence and monitoring. In particular, Machine Learning and Artificial Intelligence have shown great results in several fields, including:
- Transaction Monitoring
- Sanctions Scanning
- Customer Due Diligence
- Risk Assessment
- Data Analysis
The combination of Machine Learning and Artificial Intelligence allows the software to detect criminal activity based on prior patterns. This allows your detection and analysis systems to evolve based on the threats they face.
Conclusion
Reverse money laundering is a major threat in many different ways. Lives are lost, trust is destroyed, financial institutions are destabilized, and society is destabilized as a whole. We need to use every tool we have to stop it, and our best tools are compliance and risk management.
Here at HyperVerge, we are committed to supporting you in mitigating these risks and helping you fight this threat. Our real-time AML Screening and Monitoring Tool gives you everything you need for smooth and efficient AML compliance. If you’d like to know more, click here to book a demo.
