It’s All Hedge Fun(d) and Games Until Someone Launders Money

When it comes to fighting money laundering and organized crime, there are a wealth of rules requiring most financial institutions to monitor for suspicious activity. Given that organized crime usually has a financial component (criminals don’t work for free), banks and investment firms are in a unique position to help identify and stop these nefarious enterprises.

Current estimates suggest that the number of assets under hedge fund management is an estimated $3.2 trillion and private equity firms an estimated $2.8 trillion – the combined figure is more than the entire yearly economic output of Japan (GDP $5.2 trillion). Considering the huge amount of money held and controlled by these companies, it may come as a surprise that they are not subject to the same anti-money laundering (AML) regulations as other financial institutions, such as retail, investment and commercial banks – the question is why?

It’s not for lack of need. For example, the Troika Laundromat (the name given to the 70 offshore shell companies involved in the scheme) moved about $4.6 billion with the help of staff at an independent arm of the Russian investment bank, Troika Dialog. The Organized Crime and Corruption Reporting Project (OCCRP) investigation highlighted that”the Troika Laundromat is unique among the Laundromats that have been uncovered in recent years in that it was created by a prestigious financial institution”.

This is not the first time that a “prestigious” organization has turned out to be anything but. The most famous and largest of the scandals was Bernie Madoff’s $64-billion Ponzi scheme he orchestrated through his hedge fund, Bernard L. Madoff Investment Securities, LLC. Americans are still reeling more than a decade later; some will never recover.

It’s also not for lack of effort. In the wake of the September 11 attacks, the Patriot Act was passed in an effort to prevent another terror attack from happening on U.S. soil but also to combat money laundering and organized crime in general by cutting off organizations’ access to money. This is done by requiring most financial institutions and even casinos to collect specific information about their customers and adopt transaction monitoring systems to look for suspicious behavior that could signal larger criminal activity, from organized terror groups to human trafficking and child sex rings. Investment firms were exempted at the time.

In the wake of the financial crisis of 2008, the Dodd-Frank Wall Street Reform Act increased regulation across the entire financial services landscape. But it didn’t do anything to bring hedge funds and private equity firms under the same AML and anti-terrorism regulations that exist for all other financial institutions. Eighteen years since the Patriot Act and several attempts from the Financial Crimes Enforcement Network (FinCEN) later, they’re still exempt and attracting dirty money from all over the globe.

Clark Gascoigne, deputy director of the Financial Accountability and Corporate Transparency Coalition said,”You’ve got several trillion dollars, the management of which nobody is required to ask any questions about where that money is coming from. This is very problematic.”

Because rules with investment banks are looser than other financial institutions, they are much more attractive to criminals and corrupt politicians seeking to retain their anonymity and hide the source of their ill-gotten gains. These funds look to attract large investments where hundreds of millions in deposits is the norm. Once the money is in the fund, all interest or any money withdrawn is clean and can be used to further illegal activities or extravagant lifestyles.

Lack of regulations not only make it easier for criminals to launder money, but it also makes it impossible for investment banks or their managers to be held responsible for failing to take steps to prevent it. The reality is, criminals are going to use the path of least resistance and right now for the Western financial system that includes hedge funds and private equity firms, as well as tax havens.

Those who have opposed the slew of regulations passed within the last two decades argue that the very last place criminals would want to stash their money is in a private equity fund because almost all of them require investors to keep their money in for 10 years – not exactly an ideal scenario for criminals looking for quick cash. As evidenced by recent Laundromat cases, it’s clear that criminals are more than happy to put their money away for this length of time if it successfully moves their money and makes it appear legitimate, plus the extra interest is an added bonus.

Many investment firms also receive money from other regulated banks, and some have monitoring systems in place, although it’s unclear how comprehensive they are. Suspicious Activity Reports are rarely disclosed but, of course, not detecting money laundering doesn’t mean it’s not happening.

In fact, even the institutions that are governed by robust AML compliance have a hard time spotting financial crime in this sector. It’s only through recent advancements in artificial intelligence that transaction monitoring systems have been able to move beyond just behavior-based detection to spotting the relationships that exist between transacting parties to uncover entire criminal networks. It’s time private equity firms and hedge funds got onboard.