AML and KYC: Preventive Measures Against Money Laundering

AML and KYC: Preventive Measures Against Money Laundering

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Jaya Sharma
Assistant Manager - Content
Updated on Dec 20, 2023 23:26 IST

Anti Money Laundering (AML) and Know Your Customer (KYC) are two terms that are complimentary to each other. Without the completion of KYC, AML cannot be successfully achieved.

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Let us start with understanding what anti money laundering is and how KYC plays a significant role in its implementation. Before we talk about AML, we must understand money laundering in detail. 

Table of Contents

What is Money Laundering?

Money laundering is the illegal process of concealing the origin of money obtained from illegal activities. The aim is to show that the money is being generated through legal activities. It is considered a serious financial crime since criminals use this money to fund illegal activities such as buying weapons or funding terrorists.

How money laundering takes place?

Money laundering turns this illicit money into clean or legitimate money in the following three main steps. 

  1. Placement: This ensures that the money enters the financial system through multiple deposits, investments, and transfers. 
  2. Layering: The aim is to create distance between money, source and perpetrators. This is important to prevent keen eyes from identifying link between money and perpetrators.
  3. Integration: The money is turned legal (white money) and is brought back to perpetrators.

Strategies used for Money Laundering

The following strategies are used by money launderers for making the money legal in the system:

1. Smurfing

It is an illegal activity used by money launderers to evade government scrutiny. In smurfing, large transactions are broken into smaller transactions to limit money under the reportable threshold. In this money laundering strategy, criminals deposit smaller and cumulative transactions into multiple bank accounts. Criminals can also divide these smaller deposits among geographically dispersed accounts. To prevent smurfing, authorities may need financial institutions to file a currency transaction report. 

2. Smurfers (Mules)

These individuals (mules) transfer the illegally acquired money through different methods on behalf of others. Mules are paid a sum of money for the amount that they transfer. In many cases, these individuals are not aware of the crime in which they have inadvertently participated.

These individuals are trapped with job advertisements such as money transfer agents, local processors or even payment processing agents. Legitimate companies hire escrow services for such activities. Online recruited mules transfer proceeds from online frauds such as malware or phishing scam. The criminal keeps his identity and location hidden from authorities.

3. Shells

While many shells are legitimate businesses, many are leveraged by fraudsters to disguise illegal activities and evade tax payments. Individuals set up fake shell companies in those jurisdictions that guarantee anonymity. This allows businesses to make deposits and transfer money in different accounts in the name of raising money and funding startup companies. Such companies allow people to avoid reporting income and paying taxes. 

What is Anti Money Laundering?

Anti money laundering (AML) is a collection of regulations, law, practices, and preventive measures to stop money laundering. These are formulated by government authorities to prevent criminals from turning illegal money into legal.

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Initiatives for Anti-Money Laundering

The following initiatives are undertaken by government bodies and financial institutions such as banking sector to facilitate anti money laundering practices:

  1. In 1989, on the initiative of G7, an intergovernmental organization called the Financial Action Task Force (FATF) was founded. FATF develops policies to prevent money laundering as well as terrorism financing. The organization sets standards and promotes the implementation of regulatory, legal and operational measures for AML. Since criminals upgrade and change the techniques for money laundering, FATF must update its guidelines and recommendations every year. The organization has been consistently working to ensure that most countries accept AML guidelines. 
  2. Through CDD, financial institutions investigate whether there have been any money laundering strategies used. Financial institutions need to implement a written AML compliance policy approved by senior management. This policy must be developed under the guidance of an AML compliance officer.
  3. To prevent money laundering, financial institutions are required to perform due diligence. For this purpose, KYC has been one of the most important steps.

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What is KYC?

‘Know your Customer’ (KYC) is a verification and authentication process to ensure that you have contacted the genuine person. Through a proper KYC process, many frauds and financial crimes can be prevented or identified in the worst cases. 

Know Your Customer Process

This process takes place in the following three different steps:

1. Customer Identification Program (CIP)

This is a due diligence requirement that is mandatory for financial institutions to fulfill to meet KYC and risk assessment obligations. It is a necessary customer onboarding process that takes into account official government-verified documents to authenticate customers. CIP is the first step in detecting and preventing money laundering. For CIP of individuals, businesses need to get the full name, dob, place of birth, address and identification document. In case the CIP of a company needs to be done, the company name, business address, and issuance documents are required.

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2. Customer Due Diligence

It is a process during which the credentials of customers are collected to verify their identity. This also helps in evaluating the risk profile of the customer. Through CDD, financial institutions can discover any potential risks that might be associated with the customers. Through due diligence, many crimes, such as fraud, sanctions busting, terrorist financing, and money laundering, can be prevented. As a part of corporate governance, due diligence is extremely important. For CDD, organizations require the following documents:

  1. Public and private data sources
  2. Sanction lists issued by territories and governments
  3. Information provided by the customer itself 

For a thorough CDD in the KYC process, the following information is collected:

  1. Identity of customers, including their company address
  2. Activities in which customers are engaged and markets in which they operate
  3. Entities with which customers do business
  4. The risk profile of the customer

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3. Enhanced due diligence (EDD)

This is the third step in the KYC process which involves a thorough investigation of the client. For this step, financial institutions require detailed information about customers’ financial history and reputation. EDD is mostly performed in case of high-net-worth clients or those who may present a high risk, such as the following:

  1. Customers that conduct large transactions.
  2. Non-resident customers belonging to countries subjected to economic sanctions.
  3. Companies having shares in bearer form or have nominee shareholders.
  4. Customers that belong to countries with no proper AML/CFT systems and regulations.
  5. Prospect customers belonging to nations that fund or support terrorist activities or have identified terrorist organizations operating within them.

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Conclusion

To ensure that the system is successfully adopting AML practices, it is important to complete the KYC process. With the completion of KYC process, half the battle against money laundering is already won. Financial institutions can keep better track of entities that are transacting and circulating the money within the system. This will help in identifying elements that have a history of laundering funds.

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About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio