The Money Laundering Market: Regulating the Criminal Economy

PART I

MONEY LAUNDERING

1

AN INTRODUCTION TO THE CHALLENGES OF MONEY LAUNDERING

Svenja Berg and Killian J. McCarthy

1.1 INTRODUCTION

Globalization is the process by which businesses or other organizations develop international influence or start operating on an international scale. Globalization has been encouraged by many organizations, such as the European Union (EU), the North American Free Trade Agreement, as well as the World Trade Organization. These institutions have fostered and enabled the opening of economies for international trade and cooperation in the past decades because globalization has been a force for good; it has increased global wealth, by growing economies and creating employment; and it has brought more people out of poverty than has been achieved at any other point in history.

An essential part of globalization is the incorporation of capital, information and technological expertise into one market, allowing the participants in this process to approach other parts of the world at a more rapid pace and with lower costs (Schroeder 2001). The financial sector, therefore, gains particular benefits from globalization. In fact, it is often stated that the financial market is the only sector that has realized globalization in the true sense of ‘globalization’ (Shangquan 2000). One of the unintended effects of a globalized financial system, however, has been the globalization of crime.

Variously defined as deviant behaviour [that] violates the prevailing norms and cultural standards on how humans ought to behave, as a public wrong and as an exploit injurious to the community (Ormerod 2005), crime exists and endures because it offers the individual an opportunity to gain. Crime provides the individual with a cost-effective source of power, influence and authority, and so crime, it must be recognized, is the unavoidable consequence of human ambition and creativity, and the flip side of entrepreneurial spirit. It is held to be wrong and injurious because the private gains it creates typically benefit the criminal far less then they cost society. Estimates place the cost of crime to the US, for example, at about $1 trillion per annum (Anderson 1999; Reuter & Truman 2004; Takats 2007). Thus, inevitable as it may be, society can tolerate only a low level of crime, and all injurious behaviour must be criminalized.

In observing that crime is often motivated by profit, regulators are faced with three options: (a) increase the risk of capture; (b) increase the severity of the punishment; (c) decrease the profitability of crime by denying the criminal the rights to use a criminally derived income in the legitimate economy. The third option, by direct intention, effectively taxes criminals’ income at a rate equal to the state’s interest in tackling crime. Because crime already pays less (Wilson & Abrahamse 1992), any loss in profitability implies an adverse shock to the supply of crime, and so criminal activity will be reduced. As an unintended consequence, however, a demand for money laundering services will be created. Broadly defined as financial services conducted to conceal or disguise the nature, location, source, ownership or control, the aim of the money laundering (ML) service is to make it possible for criminals to invest or to consume the proceeds of crime, and to circumvent the crime-stopping efforts of government. ML, in other words, keeps crime profitable, and ML, therefore, must be tackled if crime is to be effectively reduced.

This volume is dedicated to the topic of ML. It looks at the current ML market, and the ways in which ML is being tackled, and considers the threats to the fight against crime, in the form of emerging technologies, such as digital currencies, and emerging markets, such as online gambling. This chapter beings with a review of the literature on ML, asking a number of simple questions: (a) What is ML, how and by whom is it defined? (b) Who are the main players in the fight against ML? (c) Why does ML occur? (d) Why is it a problem, beyond the obvious fact that it facilitates crime? (e) How is money laundered? (f) How big is the problem, and what techniques are being employed to measure ML? And finally, (g) what are the current tools and techniques that are being used, at the international level, to tackle ML?

1.2 WHAT IS MONEY LAUNDERING

ML is a complex process, and its study is made all the more complex by the fact that there are a variety of definitions. So what is ML? And what are the common elements across the definitions?

1.2.1 Institutional definitions

There are many variations in the definitions of ML, all of which are based upon the United Nations Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances (Vienna Convention) of 1988 and the 2000 United Nations Convention against Transnational Organized Crime (Palermo Convention; World Bank 2011a). One of the most complete definitions, perhaps, is found under US law. There, ML is defined as the process by which criminals attempt to conceal or disguise the nature, location, source, ownership or control of their ill-gotten gains,¹ so as to make it possible to invest or consume the proceeds of crime. Similar definitions are employed by other anti-money laundering (AML) bodies, such as Interpol, the international police agency, the United Nations Office on Drugs and Crime (UNODC), and the Financial Action Task Force (FATF) – an intergovernmental body nested within the Organization for Economic Cooperation and Development (OECD) and responsible for developing and promoting policies to combat ML – although the emphasis can vary per body. Table 1.1 provides an overview of the various definitions that these organizations employ.

1.2.2 Common elements across definitions

Although there are, clearly, differences, almost all academic and institutional definitions agree that there are a number of common denominators across the definitions. First, all definitions agree that ML is a criminal act. Almost all academic and institutional definitions address this point. Masciandaro (2007), for example, defines ML as an autonomous criminal economic activity, Buchanan (2004) describes it simply as a financial crime, and Manney (2001) states that, it is a hidden cancer that allows criminal activity to seep through all sectors of legitimate business.

Second, most definitions also recognize that ML is a process. Schroeder (2001), for example, defines ML as the process used by criminals through which they make dirty money appear clean. ML is about converting illegal funds to legal funds. Manney (2001), for example, and the Board of Governors of the Federal Reserve System (2002) talk about the three stages of the ML process, distinguishing between the placement stage – in which illegally derived proceeds are shifted to a place that appears less suspicious – the layering stage – in which the illicit proceeds are deployed throughout the system in order to conceal the revenues – and the integration stage, in which the funds are transformed into clean incomes.

Table 1.1 Definitions of money laundering

Although many agree on this system (Manney 2001; Buchanan 2004; Van Duyne 2003), others point out that theses phases should rather be considered as guidelines and do not necessarily have to be fulfilled (Van Duyne 2003); the crime can be performed in a single stage, as well as in two, three, four or more phases, depending on the imagination and ability of the criminal (Durrieu, n.d.). The essential function [of money laundering] lies in the transformation of liquidity of illicit origin, or potential purchasing power, into actual purchasing power usable for consumption, saving, investment or reinvestment (Masciandaro 2007), and not necessarily in chronologically completing these steps.

Finally, most definitions recognize that the purpose of ML is to allow criminals to participate normally in economic transactions (Masciandaro 2007), although scholars distinguish between the first degree process (Stessens 2000) and the complete or full process of money laundering. (Durrieu, n.d.). First degree ML, these authors suggest, involves processes by which the criminal or illegal origin of the funds is concealed, so as to transform the nature of the proceeds of crime (Durrieu, n.d.), but without reinvesting them. Full process ML differs in the sense that the criminal completes all aforementioned stages by reinvesting the proceeds in legal economies, making them appear legal and enjoying these assets by, for example, purchasing luxury goods (Stessens 2000).

1.2.3 Expansion of the definition due to increase in terrorist activities

Most of the current definitions of ML have been developed by international organizations looking to deal with drug trafficking. However, terrorist groups are increasingly making use of ML practices, and do so for quite different purposes, expanding, in the process, our understanding of the ML phenomenon. Terrorists and criminals handle the ML process differently. Criminals, such as the Mafia, have been and are still concerned with the proper concealment of the source of their funds, because they want it to appear that their assets are legal, so that they can reinvest them in the formal economy. Terrorist groups, by contrast, although they are often concerned with disguising the source of their income, are, most of the time, happy to openly deploy their ill-gotten gains. Terrorists, in other words, are often less concerned with making profit by investing in legal economies. This can be seen in the looting of the banks in Mosul, in Iraq, in 2014, which netted the Islamic State (IS) hundreds of millions of dollars, which it then used directly to buy military supplies (Coker 2016).

1.2.4 A classic example of money laundering

A classic example of the ML process is the Franklin Jurado case, described by a United Nations Department of Public Information (1998) report. Franklin Jurado, a Harvard-educated Colombian economist, was sentenced to seven and half years’ imprisonment in 1996, after pleading guilty to laundering $36 million on behalf of the Colombian drug lord Jose Santacruz-Londono. Figure 1.1 describes the process of ML in this case. By wiring the money from Panama to Europe, Jurado engaged in placement, concealing the money’s origin by moving it to less suspicious-looking entities, namely banks in Europe. The layering stage depicted in Figure 1.2 (De Maillard 2002) clearly shows how Jurado tried to prevent the money being traced back to its origins by dispersing it to different accounts in different banks all over Europe, while keeping the account balances below €10,000 in order to avoid suspicion. In the integration stage, European front companies were set up to legally invest the cleaned money back into Santacruz’s companies.

Figure 1.1 The Franklin Jurado case.

Source: United Nations Department of Public Information (1998)

1.3 WHO ARE THE MAIN PLAYERS?

1.3.1 The good guys

The Bank of International Settlements, the OECD, the G8 and G20, the EU, several departments of the United Nations (UN), the World Bank, the International Monetary Fund (IMF) and the Financial Stability Forum are all involved in efforts to assess and reduce ML. The FATF is perhaps the most specialized AML unit.

Figure 1.2 The Franklin Jurado case.

Step 1: From Colombia, the money is gathered in a tax haven.

Step 2: The money is directed to the account of Jorge Pérez in Germany.

Step 3: From Germany, the money is directed to the account of Ruiz in Monaco.

Step 4: Ruiz spreads the money to accounts of organizations in Switzerland and Luxembourg.

Step 5: The money is wired to an account under a pseudonym in Austria.

Step 6: The money is reintegrated in Colombia through European organizations as industrial investments that are controlled by the members of the cartel.

Source: Adopted from De Maillard (2002)

The FATF (on Money Laundering), also known by its French name, Groupe d’action financière, is an intergovernmental organization founded in 1989 on the initiative of the G7 to develop policies to combat ML. It was established by the 28 signatories to the Vienna Convention, but the number of participating countries has since grown to 35.² The purpose of the FATF is to assist banks and financial institutions in their attempts to avoid laundering the revenues of criminal activities and to lobby countries to declare ML an illegal activity (Quirk 1997). To this end, the FATF first published 40 recommendations³ in 1990, aimed at providing a complete set of counter-measures against ML covering the criminal justice system and law enforcement, the financial system and its regulation, and international cooperation (FATF 2015). As these 40 recommendations aim to encompass all possible areas of ML, the FATF is internationally recognized as the standard-setter for AML achievements (World Bank 2011a).

1.3.2 The bad guys

There is no specific job description for a money launderer; in principle, any person, regardless of background and profession, could be a launderer. Chapter 2 introduces a taxonomy of launderers. It distinguishes between: (a) criminal launderers, (b) professional launderers, (c) organized criminal launderers (such as the Mafia) and (d) terrorist launderers

1.4 WHY DOES MONEY LAUNDERING OCCUR?

ML threatens to shake the very foundations of society (Directive 2005/60/EC), and therefore AML measures are required. In order to combat ML, however, and in order to deal with its negative consequences, it is essential to first understand why ML occurs. Schroeder (2001) identifies three reasons why people engage in ML. The first is the pursuit of money. Money is essential for any criminal group or organization to sustain their activities and fund their expenses and purchases, and so ML is a tool for transform[ing] potential wealth into effective purchasing power (Masciandaro 2007: 1). Second, ML is a means of concealing the connection between a particular criminal offence and the perpetrator. ML is used to frustrate the prosecutors efforts to follow the money, to track an offence back to the criminal. Indeed, Stessens stresses that the money is not usable as long as it can be used to trace the criminal (Stessens 2000). Finally, ML is deployed in order to protect the illegally attained proceeds from confiscation. ML is a tool, in other words, to ensure that the profits of crime stay with the criminal, so that crime remains profitable.

1.5 WHY IS MONEY LAUNDERING A PROBLEM?

ML is a financial service: it generates profits and investment. It is often referred to as a victimless crime, because no one suffers from the fact that the Colombian drugs mafia sends $10 billion from one country to another (Unger 2013). Why then should ML be tackled? Because research shows that ML has vast socio-economic and political implications that have disastrous short-as well as long-term effects (Unger 2007). So what do we know about the consequences of ML?

1.5.1 Money laundering promotes crime

Crime is an entrepreneurial act and, in many cases, a rational economic decision (Baumol 1990). Rational individuals choose to spend time in the criminal economy, earning a criminal income, and make their decisions to do so based on an analysis of its costs and benefits (Gnutzman et al. 2010). The benefits are, of course, the criminal proceeds that are generated, and the costs of crime include, for example, the risks of capture and punishment (Ehrlich 1973; Blumstein & Nagin 1977; Wolpin 1978; Cornwell & Trumbull 1994), and the reality that a dollar earned in the criminal sector is worth less than one earned in the legitimate economy, because dirty dollars have fewer uses; legitimate incomes can be invested or consumed, but criminal incomes can only be consumed. By making a distinction between criminal and legitimate incomes, therefore, policy-makers aim to reduce the profitability of crime and, thereby, the incentives for individuals to participate in criminal activities. Policy-makers look to discourage crime because the private benefits that the criminal derives are far less than the damage caused by criminal activity; in fact, estimates from the US place the net cost of crime in the region of $1 trillion per annum (Reuter & Truman 2004). Because about 80 per cent of criminal proceeds are laundered (Unger 2007), ML can be seen to be the lifeline that permits crime to remain profitable. ML encourages crime, confounds the crime-fighting efforts of policy-makers and contributes to losses through crime (Masciandaro 1999).

1.5.2 Money laundering damages the economy

One of the effects of ML is that there is an increase in the level of criminal investment in the economy (UNODC 2011). This is undesirable for a number of reasons. First, and perhaps least damagingly, criminal investment skews the statistics on national income and wealth distribution. This causes problems for policy-makers looking to use national statistical data to guide public policy decisions (UNODC 2011).

Second, criminal investments create disruptions in the economy. Normal investors look to create a profit, but criminal investors invest to conceal the illicit origin of the funds. This means that capital is diverted from solid, stable investments, with high return rates, to low-risk options in order to avoid detection (Bartlett 2002a). Because the real-estate sector is relatively opaque, many of these concealing investments are made in the real-estate market (Nelen 2007). This has two effects. First, the additional investment pushes real-estate prices up and prices legitimate investors, who rely on legitimate investments, out of the market (UNODC 2011). Second, real-estate investments become more volatile (UNODC 2011), as criminal investors distort the market, leading to more boom and bust periods.

Third, criminal investments distort import and consumption patterns. Criminals looking to spend criminal proceeds are more likely to consume high-value luxury goods; if illegal money cannot be readily invested, then it must be consumed directly. In many cases, an increase in the demand for luxury goods, however, implies an increased demand for foreign imports: more German cars, more Italian shoes and more French wine. This impacts the foreign trade balance, and although, in the short run and from a purely economic perspective, these investments can be positive, in the long run they create an unfavourable business situation for two reasons. First, they deteriorate the country’s trade balance (INCB 2002), which can cause exchange rates to be reassessed, and decrease the country’s competitiveness. Second, and as a consequence of this decrease in the country’s competitiveness, existing, legitimate companies can be driven out of business.

Fourth, economic growth requires well-established, well-functioning financial bodies (Bartlett 2002b), but criminal investments endanger the operation of the legitimate financial system in a number of ways. First, criminal investments increase the level of volatility in the financial sector, which can jeopardize the financial sector’s liquidity and solvency (World Bank 2011b). Second, criminal investments impact the credibility of the financial bodies and the systems in which they are operating (Bartlett 2002b), such that illicit transactions taint licit ones (IMF 2001), which can lead investors to disinvest.

Finally, criminal investments lead to an increase in the level of corruption – as officials are bribed to make the investments, and as officials, therefore, fall under the criminal’s economic influence – which leads to a loss of credibility in a country’s institutions.

1.5.3 Money laundering is particularly damaging to the developing world

Finally, as will be explained in this volume, the effects of ML are particularly damaging to the developing world. Globalization means that the costs and benefits of crime can be separated. For example, although Jose Santacruz-Londono murdered people in Colombia to generate criminal proceeds, the investments that he created were invested, and taxed, in Austria, Germany and Switzerland. Brettl and Usov (2010) show, in fact, that the EU 27 – and in particular the wealthier Western European countries – are the most attractive destinations for money launderers’ investments. Also, a study by Unger (2007) shows that about two-thirds of money laundered globally in the period 1997–2005 was laundered in the 20 richest countries. In other words, developing countries suffer more from the existence of an ML market than developed countries, and, for this reason, developed countries have a responsibility to stop ML.

1.6 HOW IS MONEY LAUNDERED?

In contrast to other crimes, money is laundered in a huge variety of forms, by a huge variety of players, in a huge variety of contexts (Reuter & Truman 2004). In this section, we consider the main ways in which money is understood to be laundered.

1.6.1 The beginnings of money laundering

The term money laundering was first used in the early twentieth century, to describe the way in which organized criminal groups, such as the Mafia, concealed the origins of their incomes. Probably the best-known criminal at that time was Al Capone, who is thought to have laundered about $100 million of illicit gains in the 1920s. Capone first set up a number of cash-operated laundromats to conceal the origin and destination of the illicitly acquired funds, and the term money laundering was soon coined. When Capone was arrested in the 1930s for tax evasion, his accountant, Meyer Lansky, professionalized the operation further. Lansky created a number of front companies for Capone, such as casinos, and, by wiring the proceeds from these to banks and companies in other countries, such as Switzerland, Hong Kong, Israel and South America, he