07/06/2023 Alexander

Benefits of KYC and issues for implementation in traditional finance and fintech

Dr. Henry Balani, Global Head of Industry and Regulatory Affairs at Encompass, joins Pawel to discuss the benefits of KYC and issues with implementation in traditional finance and fintech. Henry starts by explaining that when banks take in a new corporate customer, they need to identify what the customer’s corporate structure looks like with the intent of identifying the beneficial owner (the one who owns majority shares). This is done to determine the risk, if any, that comes with the new customer because they could be a sanctioned entity or a high risk politically exposed person.

Banks need to make these regulatory compliance checks to avoid the consequences of failing to comply with regulations when they are onboarding a client.

Compliance for DeFi

Pawel strongly disagrees with Decentralised Finance (DeFi) players claiming that they do not have to be regulated or apply Anti-Money Laundering (AML) Rules because they need to maintain privacy. Pawel claims that financial crime which comes with non-compliance and not applying AML rules devalues the crypto industry.

Are regulations good for banks?

What impact do regulations really have on banks if money laundering still happens even though banks are receiving penalties?

Upon researching what happens to a bank’s stock price itself instead of the number of people being put behind the bars, Henry found the bank’s stock prices went up. Henry explains that because there is now greater transparency in terms of what banks have to do, how they detect money laundering and encourage clarity for investors and shareholders, regulations bump up the bank’s stock prices.

Are regulations necessary?

When Pawel asks how regulations benefit the banks, Henry argues that if there were no regulations, banks would not do AML or perhaps put minimal effort to actually go through the process.

When regulations are complied with, it provides a degree of certainty, clarity and consistency across banks. For example, US Suspicious Activity Reporting (SAR) requires a certain form or trigger points in terms of reporting. The consistency of this process provides predictability that is greatly appreciated by investors. While it would not be right to say that banks would do it anyway without regulations, Henry finds comfort in the fact that as an investor, regulations make the banks risk-averse.

How regulations started

Henry cites that regulations have always led to good things. The Great Depression, Enron crisis and 1929 Stock Market Crash all led to regulations which made a difference in future cases. Unfortunately, in all these cases, regulations came after the fact as a reaction to each crisis. However, those who remain in the industry will feel that their money is safe and protected going forwards.

Know-Your-Client (KYC) is an essential process because when a bank or institution brings in a new customer, they need to know who you are. The US has the largest transaction volume in the entire world which means that everyone else needs to play by US rules and part of it is implementing KYC. However, the way this process is carried out can be cumbersome and slow. So the real question is not if KYC should be done, but how it is done. Technology can make the KYC process easier and seamless but a failure of the fintech industry at the moment is that the cost and implementation can be quite burdensome. However, Henry says that just because it may be difficult and expensive to do does not mean we should not be doing KYC at all.

Watch the whole discussion:

Corporate onboarding

Individual onboarding is comparatively easier than corporate onboarding because for the latter, you start getting a large number of shell companies where a company is set up not to trade but to act as a cover for illicit transactions. When you look at these companies situated in different tax havens or offshore, it is designed to cover a certain set of transactions be it legitimate or illegitimate. The first question to such non-transparency would be: why hide?

Traditionally, the argument is to protect the owner’s assets and avoid impacting a particular market and its value. However, in most cases, these transactions are illicit and have been obtained from corrupt and criminal activities. A whole industry exists to create these shell companies to make it very difficult to know where the beneficial owner is. Banks don’t have the ability to identify who these shell companies are and find it a real challenge. This is why corporate onboarding is so much more difficult than individual onboarding.

The million dollar question

What is the size of money laundering through shell companies? Traditional numbers reference 2-5% of Global GDP as per the UN, which amounts to 2-3 trillion dollars. However, that is based on a study done in Australia about 15 years ago on the basis of drug trafficking. However, one cannot measure the amount of dirty money directly because by definition, dirty money is hidden money. Typically, the amount of VAT you should receive on the basis of products and services sold can be predicted in Europe. Pawel states that the 2-3% that comes from VAT in the budget is missing on an annual basis indicating a significant portion.

Henry adds that because we cannot measure directly, we use proxies, so VAT is just another proxy. VAT is counting for the non-white market, not the grey or the black market, so there are more factors which need to be added before understanding how much money is being lost to money laundering. Considering tax evasion, it was a predicate offense for money laundering in the early 1990s, so if tax evasion is added to the number of dirty money, the number is likely to increase.

To calculate money laundering, the closest one can do is identify the proxies and get an estimate as close as possible to the actual figure.

Will regulators, banks and other corporations be fully committed to fight financial crime?

Money laundering is connected with corruption. By design, not all follow-ups and investigations are being done properly to determine the factors of money laundering in order to prevent it. Undeniably, it is a systemic issue inherent in all organizations. Potentially, there is a high level of corruption in the sectors involving Politically Exposed Persons (PEP). When discussing this issue with Members of the European Parliament (MEP), some MEPs were on the list of PEPs. So there are also challenges where individuals who are making regulations are themselves more susceptible to corrupt activities.

Not a victimless crime

Money laundering has been considered a victimless crime because people think that it is not affecting them personally. However, there are victims who suffer the consequences directly because money laundering includes other crimes such as child trafficking, human trafficking and drug trafficking. The public needs to be aware that this is a problem and not a victimless crime.

The definition of corruption is different across the world. While certain transactions are considered a bribe in Europe, it could be considered a facilitation payment in the US which is allowed institutionally. In some countries, if you are pulled over, you can even pay cash to the individual pulling you over and ask for a receipt. It is therefore very difficult to generate a specific definition for the word corruption.

Corporations in Delaware

While the population of Delaware is in hundreds of thousands, the number of corporations incorporated in Delaware is 1.6 million. So the number of companies incorporated far exceeds the number of people living in a certain area and even though it makes no sense, it reflects on the purpose of corporations.

Regulation and enforcement

While the EU makes a lot of great regulations, the enforcement is poor. On the other hand, the US has great enforcement but the regulations are poor. The point is that this is a roll of the dice which goes back to the systemic issue. What leads to a continuation of this is the thought that “I won’t be thrown in jail, only the company will be fined.”

As you can see, while KYC is beneficial for anti-money laundering, there are a variety of barriers to implementation ranging from the technological to the systemic.