There is no doubt that globalisation has been an incredible driving force in recent decades, powering businesses to transcend national and international borders. But the benefits of globalisation are also accompanied by certain responsibilities such as the need to comply with local laws. Without comprehensive compliance, it is merely a matter of time before any company’s business operations begin to unravel.
In a worldwide scenario of digital disruptions, volatility, and uncertainty, organisations need to keep innovating constantly. Innovation can be particularly pertinent when dealing with financial compliance norms. To achieve this objective, organisations must be up to speed on the rules and regulations of various geographies where they operate. But discovering the ideal balance between regulations and innovation is no walk in the park.
The threat of money laundering
Moreover, while technology can be instrumental in promoting innovation in diverse domains, it can also be leveraged by unscrupulous elements to promote their nefarious interests. One of the major threats to universal financial stability comes from money laundering.
Criminals across the world now turn funds garnered from various crimes such as terrorist activities and drug or human trafficking into clean money via money laundering. What’s worse, this is done by hard-core criminals and white-collar personnel too. While several money-laundering techniques are deployed to make dirty money seem clean, online banking and virtual assets facilitate this process through the easy transfer and withdrawal of funds without detection.
Consequently, preventing money laundering has emerged as a global priority, with the prevention of terrorist funding being one of its primary aims. Therefore, financial companies have instituted anti-money laundering (AML) policies for detecting and preventing such activities. In this regard, the financial industry has implemented a distinct set of stringent AML policies.
The focus on terrorism financing is crucial because it acts as a prerequisite for all organised forms of terrorist activities, making it a critical threat to the security and safety of societies and populations globally. According to estimates, between 2% and 5% of the world’s GDP – $800 billion to $2 trillion – could be the approximate amount of funds laundered annually across the globe.
Typically, money laundering supports activities such as the illegal arms trade, smuggling, insider trading, embezzlement, bribery, online fraud, and more. Naturally, this has disastrous consequences on societies at large and the world economy.
AML measures are closely linked to the counter-financing of terrorism, which is used by financial bodies to tackle terrorist funding. As a result, AML laws link money laundering (the source of funds) with terrorist financing (the destination of funds).
Financial innovation and AML
It is possible to promote financial innovation while complying with AML regulations. Comprehending the complexities of catering to unbanked members of society, regulators in numerous nations are implementing ‘tiered’ KYC norms that ease the cost and conditions of onboarding low-risk, lower-income customers. This permits access to basic financial instruments for those who would otherwise continue being unbanked because they lack personal identification or have other issues.
Besides money laundering and terrorism financing, financial entities use AML for other reasons. These include complying with regulations requiring them to report suspicious activities while monitoring customers and their transactions; safeguarding their brand reputation; avoiding civil and criminal fines that may be levied due to negligence/non-compliance; reducing costs from fines and capital allocated for risk exposure.
Combatting rising cybercrime
The pandemic has unfortunately generated new opportunities for cybercriminals. In addressing these threats, the FATF (Financial Action Task Force), the global money laundering and terrorist financing watchdog, has asked members to actively pinpoint and assess how criminals could exploit the pandemic. Additionally, the FATF urged the use of technology, including fintech, regtech (regulatory technology), and suptech (supervisory technology) to the maximum level so essential financial services, as well as the disbursal of government benefits to vulnerable sections, continues unhindered.
As with everything, the rise of fintech and financial innovation also has two sides to its story. For example, fintech firms have innovated and introduced new technologies that simplify, decentralise, and fast-track financial processes. These advances have enabled formerly underbanked people to carry out instant transfers from one end of the globe to the other, at practically any time.
On the flip side, digital transactions have triggered a rise in cybercrime. Recent studies indicate that fraud in fintech enterprises such as in neobanks has been occurring at roughly twice the rate of credit card firms. Online fraud and extortion have kept increasing steadily in the past few years. For instance, between 2020 and 2021, South Australia’s police reported a 29% surge in financial crimes.
Money laundering and risk-rating
Coming back to money laundering, financial institutions deploy customer risk-rating models as one of the primary tools to detect such activity. These are based on assessing risk factors such as a customer’s occupation, income, banking products used, etc. Collected when a customer account is opened, this information is updated infrequently. Going by the distinct weightage each factor is given, the inputs are useful in calculating a customer’s risk-rating score. Due to the infrequent updates, however, the scores are relatively inaccurate. Apart from failing to find some high-risk customers, the scores often miscategorise myriad low-risk customers as high risk.
Due to such anomalies, financial entities are forced to unnecessarily review numerous cases. In turn, this annoys low-risk customers subjected to extra scrutiny, inflates the cost of due diligence, and weakens the effectiveness of AML measures because resources are diverted to the wrong place.
To elaborate, the legacy AML of banks uses customer profiles and transaction history to create risk ratings and detect suspicious behaviour, such as cash deposits of more than $10,000. Although the rules-centric approach is vital, it does not detect funds laundered via a network of people in smaller, non-rounded dollar sums. It is no surprise that customer-risk rating and transaction-tracking models of many banks often show false positive rates exceeding 98%.
Most banks’ current systems lack the level of sophistication needed to accurately detect and differentiate between illegal and legitimate transactions. Since these systems process small data samples, they cannot view the entire picture that could help connect all the dots.
Tech-led solutions
Fortunately, fintech firms have the wherewithal to help banks address these problems. Big data analytics, machine learning, natural language processing, blockchain, and other AI-based tools can help in the war against money laundering. As digital currencies grow, blockchain holds the key to tracking these transactions. If payment is confirmed in the public distribution ledger, the entry cannot be altered, making each transaction to digital wallets traceable.
Similarly, machine learning could play a major role in AML by using algorithms to identify money laundering or other criminal activity even from obscure predictive variables that may go undetected by data scientists. With machine learning, banks can curb the number of false alerts, freeing investigators to pursue high-risk cases.
Ultimately, tech-led innovations can help banks and payment service providers combat the worldwide scourge of money laundering, benefitting both customers and financial service players.