Researc h GroupHafnerlTrepp

Project:Money Laundering with Derivatives Zrich Box,CH-8026 Zwinglistrasse 30, P.O. p h o n e+ 4 1 1 2 4 2 2 1 6 8 fax + 4 1 1 2 9 10 8 2 0 pop.agri.ch e - m a i l :h a f n e r / t r e p p @

Gian Trepp and lVolfsang Hqfner would v,elcome any commenlson the text belo'9,

llorking Paper,May 1998 Money laundering with derivatives

Abstract This paperarguesthat financial derivativesi.e. futures,optionsand swapshavethe potentialto build a firewall againstthe disclosureand subsequent confiscationof illegally gained property.The paperdiscusses this assumption both in theory and in practice.Finally it tries to put this new methodof money launderingin a historical perspective.

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generate 'dirty' cashor direct payments

SYSTEM Even complex transaclions int'olving dffi renI insti tuti ons and j uri sdic ti ons cannot fitlly disguisean illegal,source.

+ BANKING
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Monev tainted Y DERTVATTVE MARKETS Derivatives can erect afirewall againstan illicit source and legitimize ov,nership of property.

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CleanMonev

A projectfinanced National Foundation by the Swiss Science

Contents

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Summary Introduction 1. Instruments replacetransactions 2. Marketsreplacebanks lags behind 3. Law enforcement 4. Someremarksabouthistorv Conclusion Bibliography

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Summary The global war againstmoney launderingon one side and the ever rising supply of 'dirty' money on the other side hasprompteda new and more effrcient way of doing the trick: the derivativeslaundry. The key to money laundering with derivatives is to manipulatethe two sides of the contract in such a way that the losing side is associatedwith the dirty money. Thus the winning sidegets cleanmoney from successful futures,optionsand swap contacts - a well-defined,legal and economicallylegitimatesourceof income. This procedurecan be defined as the third stqgein the historical developmentof money laundering. Before World War I dirty money was laurdered by depositing and transfening it using multiple bank accounts.The secondstagewas reachedin the twenties with the introduction of cross-border transactions. The third stagecamein the late eightieswith the conceptof derivativesas firewalls.

lntroduction the illicit origin of property.A Money-launderingis a mechanism that conceals confiscationof suchproperty. mechanism that builds a firewall againstdetectionand subsequent of a given financial system. on the stageof development How this mechanism functions depends The methodsof money launderingdevelopaccordingto the dynamicsof challengeand response betweenthe law and the outlaw. On one side there are thosewho try to erecta firewall against confiscation.And on the other side there is the law of the nation statetrying to removethe firewall and collect the dirty money. The idea of launderingmoneyby using financial instrumentsand their matkets,insteadof betweeninstitutionsandjurisdictions, was a true simply addingmore layersof transactions A. This eminenteconomistdefined innovationas innovationin the sense Joseph Schumpeter. of "the settingup of a new productionfunction. This coversthe caseof a new commodity, as well as suchas a merger,or the openingup of new markets,and so that of a new form of organisation on." @usiness Cycles,Vol. I p.87) again "do not remain isolatedevents,and are not "Innovations"to quote Schumpeter evenly distibuted in time, but on the contrarythey tend to cluster,to happenin bunches,simply because firstly some,and then most companies follow in the wake of successful innovation; secondlyinnovationsarenot at any time distributedover the whole economicsystemat random, (op.cit. p. l0l) In the presentcontext but tend to concentrate in certainsectorsand surroundings." this meansthat other techniques using financial instrumentsin the underlying marketsor eventhe internetcould alsobe usedto erecta firewall. Nevertheless we are restrictingour discussion to derivatives.

L lnstruments replacetransactions The dynamicsof post-communist, free-enterprise capitalismproducefast-risingprofits from any sort of illegal behaviour. Apart from the global drug trade and other activities of organised crime, dirty money flows mainly from three more sources:comrptiorgthe black market andtor-evasion.Internationallythere is somedisagreement as to whetherprofits from tax evasion global andthe black marketshould be includedin antilaundering efforts againstorganised crime. But this disagreement doesnot affect the discrssion aboutthe different methodsof money laundering. An ideal situationfor the money launderers one might think. But not quite. At the same time the world has also witnesseda re-regulation of nation statebanking systems,contary to the global trend of deregulation.This was done in the name of the war against money laundering - the secondfront of the USJed war againstdrugs. Developmentsin Switzerland are an example of this trend. The country introduced a paragraphinto its criminal law eight years ago to make money laundering a crime. Today the new Swiss "Federal Law on Combating Money Laundering in the FinancialSector"active since April l, 1998,appliesfor the first time not only to banksbut alsoto financial intermediarieswtro deal professionally both for their own account as well as for others in "bank notes,coins,money-marketinstruments, foreign curency, preciousmetals,commodities, securities and in derivativesbasedthereon". Parallel to money laundering becoming a criminal act in the framework of national law, there has beengrowing international co-operationbetweenthe police andjudiciaries of diflerent countries.Countlessspecialised agencies have developedthe know-how to understand complex transactionsinvolving different financial institutions, minimally regulated offshore-centresand

ta<-havens. Thus they are now betterequippedto identifu the hidden economicalbeneficiaryto confiscate the fruits of illegal activities and bring the culprits to justice. The relationsbetweenItaly and Switzerlandare a good exampleof this development. Until the breakthrough called'manipulite'or'clean handsagainst of a groupof Milan prosecutors comrption' in January1993there was a kind of Chinesewall betweenthe police andjudiciary of the two countries.Inespectiveof laws and declarations, traditionally the ltalians did not really want to know and the Swissdid not really want to tell. Suchwas the casein the twentiesand thirties when the big Italian family-capitalistslike Agnelli, Olivetti or Pirelli usedSwitzerlandto protecttheir fortunesfrom the greedyta>rman of the fascistdictator Mussolini. And suchwas the casefrom the fifties to the beginningof the ninetieswhen Mafia thoseinvolved in broad-scale comrption and tax-evaders did the sameon a much larger scale.Sincethe beginningof 'mani pulite' in spring 1992the Swiss authoritieshavereceivedmore than 1000 lettersfrom the prosecutors' office in Milan askingthem to lift banking secrecy,which they did in most cases. Today eventhough old habits may comeback it is fair to say that the cozy daysof the Chinese wall are gone. All in all the global war againstmoney launderingcombinedwith a rising demandfor launderingservicesfrom the legitimateeconomyhasmadethe work of money launderers more difficult and increased the risk of confiscation.At the sametime the party with fundsto launder hashad to pay more and more for this illegal service.What the laundrymenneededagainstthe growing arsenalof global anti launderingweaponswas somethingnew an effectivetool with real cleaningpower. This situationtriggeredan innovation.And this is u*rerederivativescome in. Within the last twenty years derivatives have evolved from an obscureinstrument for into a pillar of today'sglobal capitalism.They have movedto the financial mainsteam speculators and now operateon apar with their more traditional counterparts, stocksand bonds.Modern derivativescome in threevarieties:futures,options and swaps.Basicallythey are a bet on the direction of price movementof someunderlying value,be it a commodity,a financial asset, foreign exchange or an index thereof.The party that is betting that the price of the underlying will go down is said to be "short" on the contract.The party that betsthat the price will go up is said to be "long" on the contract.If the price of the underlying value movesthere will be a winner and a loser in respectto the contract.If the price goesup, the long side will win. If the price goesdown, the short side will win. Such losses happenby the billion every day the world over. Sometimes they are very big asthe DeutscheMetallgesellschaft, BaringsBank, UBS or Robert Citron can tell. Theselossesare the key to exploiting the launderingpotentialof derivatives:let the dirty moneybe on the losing side. Thanks to the 'zero sum' nature of the contract the winning side gets the sameamount of money. The money has moved from A to B and no one can trace how it got there. A appearssmart or lucky, andB is simply out of luck. The problem for the party with funds to launderis to manage the money flow from different "dirty" and "clean" accounts accordingly. Let us quote an example for this processfrom someonewho should know, Orlin J. Crrabbe, derivatives expert and former FinanceProfessor at the Wharton BusinessSchool of the University ofPennsylvania- At the NewYork Mercantile Exchange(NYMEX), the crude oil futurescontractis basedon the price ofWest TexasIntermediateCrude.Each futurescontract represents 1000barrelsof oil. So if the price of crudegoesfrom $22.50per barrel to $23.00,the long side of the futurescontractwill gain $(23.00-22.50)x1000= $500.The short side will lose $500.As anotherexample,eachlive cattle futurescontractat the ChicagoMercantile Exchange (Clt) represents 40,000Ib. of cattle.So if the price falls from 64 centsto 63 cents,the short side of a single futurescontractreceives$(.6a-.63)xa0,000: $400,wtrile the long side losesthe same amount.

Now the obvious questionarises:how do you predict the right price direction?If prices fall, the short side will gain money and the long side will lose,so you want the long (losing) side to possess the dirty money.If prices are rising, you want the dirty money to be on the short side. Let us suppose you expectthe price of the notional bond contractat the ParisMATIF to fall, so you arrangefor the dirty money frrturesaccount to be long futures contracts.You also open another"clean"money futuresaccountin anothernameto be short futuresconfiacts.You then wait for pricesto fall, expectingthe dirty money to disappear into the black hole of futureslosses, while cleanmoney comespouring into the "clean" account. But instead,to your surprise,prices rise! The dirty money accountthus collectsmore cash,while cleanmoney is suckedout of the other account.It's a laundry in reverse:cleanclothes in, dirty clothesout. To preventa problem like this, it helpsto havethe cooperationof a helpful futuresbroker.Let's call this broker/facilitatorby the nameof Merlin Lynch. Merlin Lynch will createa long futures position to match the position of the party that is short futures, and a short futuresposition to matchthe party that is long futures.Merlin Lynch will, of course,exract a profit for itself - let's say in the form of a nice, fat round-turncommissionof $13 per confiact. Let's say the dirty moneyis held in an accountunderthe nameof Dirty Dick. It is intended that cleanmoney be accumulated into an accountunderthe nameof CleanJane.Now therewill be price fluctuations during almost all trading days, so Merlin Lynch makesmatchedtrades at two materially different prices during the day. Let's say Merlin has customermoney that needs laundering,and decidesto do so using the copper futures contract at the COMEX. At a random time in the morning,Merlin Lynch entersthe marketand buys (goeslong) 100 contracts,say at a price of 94.20centsper lb., while simultaneously selling (going short) 100 contacts, say at a price of 94.l0 centsper lb. The price of 94.l0 represents the market'sbid price: the price at which the marketwill purchase the futurescontractswtrich Merlin is selling.The price of 94.2O represents the market'saskingprice: the price at which the market will sell to Merlin the futures contacts Merlin is buying. Later, at a randomtime shortly beforethe close of trading,Merlin Lynch sells (goesshort) the 100 contracts,say at aprice of 92.30 centsper lb., and simultaneously purchases (goeslong) 100 contracts at 92.40 centsper lb. Now Merlin is readyto laundersomemoney. Sincethe price hasfallen"Merlin assigns the purchase of 100 contractsat94.20 to the Dirty Dick accoun! along with the saleof 100 contacts at 92.30. SinceeachCOMEX futurescontractrepresents 25,000 lb. = $47,500. of copper, the net lossto the Dirty Dick accountis $(.9420-.9230)x25,O00xl00 Meanwhile,Merlin assigns the saleof 100 contractsat 94.10to the Clean Janeaccount, along with the purchase of 100 contractsat92.40. The net gain to the CleanJaneaccountis = $42,500. $(.9410-.9240)x25,000x100 The $5,000difference is the amountpaid to the market for the launderingservice.In addition,Merlin Lynch gets a brokerage fee of $l3xlO0x2 = $2600, to give a net co$ of $7,600for laundering$47,500.This amountsto a proportional laundering cost of 160.Atthis price, the processis not tenibly ef;ficient, but workable in somecases. The natural evolution of the market will be to createmore efficien! less costly laundering structures. This can be done in the cuffent example by squeezingcommission costs and bid/asking spreads. To avoid raising suspicion"the Dirty Dick account should be held by a party apparently unaffiliated with the holder of the Clean Janeaccount.For example,the Dirty Dick account could be held by Gant CopperTraders,wtrile the CleanJaneaccountis held by the Wire Company.The clean cashaccumulatesto the benefit of the Wire Company, who returns the favor by paying premium (above average)prices to Giant Copper Traders for supplies of copper. The Wire Company,naturally, will want to gain something for its role in assistingthe laundry process,so the premium price they pay for copper should not eat up the entire anount of its futures profit. This will increasethe cost of laundering funds for Giant Copper.

Of course,if your intent is simply to bribe somepolitician, then the Dirty Dick account shouldbe assigned to the companyor other party paying the bribe, while the CleanJaneaccount shouldbe assigned to the politician receivingthe bribe (or to one of his trustedfriends or relatives). So much for Orlin J. Grabbe.

2. Markets reolacebanks Money launderingis definedby the laws of different nation states. Usually theselaws focus on the task of preventingthe bankingsystemand other financial institutionsfrom launderingthe proceeds of criminal activities.The samefocus on institutionsis shownby the definition of the "Dictionary of Finance"from Oxford University Press:"Launderingmoney: processing money acquiredillegally (asby theft, drug dealing,etc.) so that it appears to have come from a legitimatesource.This is often achievedby paying the illegal cashinto a foreign bank and transferringits equivalentto a bank with a good namein a hard-currency area. " But who needsbanks if there are derivatives at hand?Derivatives markets are fast and efficient and their trading volume hasvirtually exploded.True, the problem of placing dirty cash in a bank :rccountremainsa seriousproblem and things can go wrong for the money launderer. But once there,dirty money can be rapidly fed into the giganfic global derivativesbusiness. The countless options and futuresexchanges that exist everywherein the world present possiblemarkets.They were designedso that no otherpaffy is needed to buy and sell. A clearing systemis responsible for matchingup contractsand cancellingthem out. Most peopledo not hold the contractslong enoughto actually take delivery of the underlyingvalue.They just sell another contract to the clearing house. Another derivativesmarketfor the more sophisticated is the hedgefunds indust1/.tn many countriessuchhedgefunds are not controlledby financial regulators. The managers of these speculative funds place largebets on the direction of price movements. In thesederivatives contractsmoney laundererscan act as counterparties. For the momentthe called rocket scientistsof high-techfinanceare still beyondour reach They usethe price fluctuation itself to accomplishthe laundryby structuringcomplexderivatives transactions that suck in dirty cashtoday and dole out cleanderivativesgainsto the very same persontomorrow.

3. Law enforcement lagsbehind A compilationof all decisionsmadeby US-federalcourts interpretingUS-federalmonsy launderingstatutes from February3, 1997from the US Departrnent of Justicecontainsnot a single caseinvolving derivatives.The FBI hasthe samerecord.In March 1998the FBI databssc in Washington containedno money laundering casesinvolving the use of financial derivatives But this doesnot necessarily indicatethat thereweren't any such cases.It mayberarthc judges and the FBI just didn't seethem.Discussionswith severalintemationalanti moneylaunderingagencies in Switzerland the United Kingdom and the USA havemadeit clear that thesestateagencies act on the basisof what they considerto be securedknowledge.But the fastmoving and globalised derivatives markets are another story.

In their 1994publishedbook "Money-laundering in the UK: an appraisalof suspiconbasedreporting",Michael Gold and Michael Levi wrote the following: "Few of the cirses we looked at could be described (with placemen! layering,and as sophisticated moneyJaundering integration). They were often rather amateurishattemptsto bank the proceedsof crime, using someprecautions, but irsufficient to concealsuspicion.Arguably, on many occasions, the very fact that the perpetratorsuseda complex seriesof manoeuwesarousedthe suspicion,when perhapssimple depositof cashwould not have done! This is not to arguethat more sophisticated laundering doesnot exist: rather it indicatesthat such sophistication is not being caughtby the presentsystemof suspicion.' (p. 90)

4. Someremarks about historv A look back in time shows how money laundering has evolved from low tech to high tech. In the secondhalf of the l9th centuryall a bank robber like Jesse James had to do when thejob was done was to leave town and deposit the stolen cashin a bank accountinthe next town. In thesetimes in the Wild West money in abank accountwas more or lessthe sameas cleanmoney. But by the roaring twenties putting dirty money in a bank accountwas not enoughany more.The laundrymenalsoprogressed, addingnew features to their business: cross-border transactionsand the use of different jurisdictions. For instancetake the Canadianaccountsof Chicago mobster Al Cpone, or the invention of tiny Liechtenstein as a tar haven for rich Germansby somelawyers from Ztirich. Sixty years later, when the war on money launderingbegan in the mid eighties, even the smartestmix of domestic and cross-bordertransactionsproved fallible. Then camederivatives.

Conclusion The money laundering potential of buying and selling financial derivatives of all sorts deserves a closer look.

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Bibliogaph:r Bosworth-Davies, Rowan and SaltmarstuGraham: ,,I\rloneyLaundering; A practical guide to the new legislation";London, 1995 FederalMoney LaunderingCases, U.S. Deparrnent of Justice,February1997 Gol4 Michael and Levi, Michael: ,JVloney-Laundering in the UK: An appraisalof suspicon-based Reporting', London 1994 Crrabbe, Orlin J.: http://www.aci.net/kalliste implicationsof money laundering",IMF Working PaperJune Quirh Peter:,,I\4acroeconomic 7996 Schumpeter, JosephA: ,BusinessCycles;A Theoretical,Historical, and StatisticalAnalysis of the CapitalistProcess", Volume I and tr, New York andLondorL 1939

SwissFederalLaw on CombatingMoney Launderingin the Financial Sectorof October lA,1gg7 Laundering and the International Financial System",IMF-Working-Pryer, Tuui,Vito: ,JVIoney May 1996 Walter, Ingo: SecretMoney"; London 1985