Anti-Money Laundering: Efforts in the Securities Industry
Released: 2001-10-24T00:00:00

Letter

Background

Illicit activities, such as drug trafficking, robbery, fraud, or racketeering, produce cash. Money laundering is the process used to transform the monetary proceeds derived from such criminal activities into funds and assets that appear to have come from legitimate sources. Money laundering generally occurs in three stages. As shown in figure 1, in the placement stage, cash is converted into monetary instruments, such as money orders or traveler’s checks, or deposited into financial institution accounts. In the layering stage, these funds are transferred or moved into other accounts or other financial institutions to further obscure their illicit origin. In the integration stage, the funds are used to purchase assets in the legitimate economy or to fund further activities.

There is no way to determine the actual amount of money that is being laundered in general, let alone through a single industry such as the securities industry. However, experts have estimated that money laundering in the global financial system is between 2 to 5 percent of the world’s gross domestic product. Estimates of the amount of money laundered in the United States have been as high as $100 billion.

The Securities Industry Has Various Participants

Money launderers can target any of the various types of businesses that participate in the U.S. securities industry. Broker-dealers, for instance, provide a variety of products and services to retail (usually individual) and institutional investors—buying and selling stocks, bonds, and mutual fund shares. As shown in figure 2, two types of broker-dealers—introducing brokers and clearing brokers—perform different roles that can affect the extent of their anti-money laundering responsibilities.

Provide brokerage services and offer financial advice to customers.

Some broker-dealers regulated as clearing firms may clear only their own firms’ transactions and not those of other firms. These firms are known as a self-clearing firms.

Mutual funds are another major participant in the securities markets. Mutual funds are investment companies that pool the money of many investors and use it to purchase diversified portfolios of securities. The administrator of a mutual fund, which in most cases is the fund’s investment adviser, contracts with other entities to provide the various services needed to operate the fund. Figure 3 shows some of these entities, the services they perform, and some of the institutions that usually perform them. Depending on the extent to which these entities interact with the fund’s customers or accept customer payments, their responsibilities for conducting anti-money laundering activities may also vary. to perform other services. payments. broker-dealers, or banks) (Broker-dealers, banks, or nonfinancial firms)

Sells fund shares, including customer payments. for fund securities and cash. (Broker-dealer, bank, or (Banks) other financial institution)

SEC Is the Primary Regulator of Securities Activities, but Other Organizations Also Provide Oversight

SEC has primary responsibility for overseeing the various participants in the U.S. securities industry, including broker-dealer and mutual fund firms. It promulgates regulations, performs examinations, and initiates enforcement actions against alleged violators of the securities laws. Before conducting business with the public, broker-dealers are required to register with SEC and must also join and submit to oversight by an SRO. These SROs, which include NASDR and NYSE, oversee members’ compliance with their own rules, rules enacted by SEC, and the securities laws. Federal regulators of depository institutions have oversight responsibilities for banks, thrifts, and their holding companies. Prior to the passage of GLBA in 1999, banks conducting securities activities directly were subject to regulation and supervision by their respective banking regulators rather than SEC. After GLBA is fully implemented, banks and thrifts conducting certain securities activities will have to do so in entities registered as broker-dealers subject to oversight by SEC and securities industry SROs. The role of the depository institution regulators, with regard to the securities activities of the entities that they regulate, now involves sharing information with SEC, although under certain circumstances these regulators may conduct examinations of the subsidiaries.

Under current legislation governing money laundering, the Secretary of the Treasury has a variety of responsibilities. These include issuing anti-money laundering regulations applicable to financial institutions and other organizations, such as banks, broker-dealers, casinos, and money transmitters. Within Treasury, the authority to issue and administer these regulations has been delegated to the Director of the Financial Crimes Enforcement Network (FinCEN). FinCEN was established in 1990 to support law enforcement agencies by collecting, analyzing, and coordinating financial intelligence information to combat money laundering.

The Securities Industry Is Viewed as a Potential Target, but the Extent of Actual Money Laundering Is Unknown

Although the extent to which broker-dealers and mutual funds are being used to launder money is not known, law enforcement officials were concerned that the securities industry would increasingly be a target for potential money launderers. All financial sectors, and even commercial businesses, could be targeted by money launderers. The securities industry has characteristics similar to other financial sectors but also has some significant differences. Criminals seeking to convert their illegal proceeds to legitimate assets have targeted banks, which take cash for deposit, as a means to initially introduce illicit income into the financial system.

Law enforcement and securities industry officials said that because securities activities generally do not involve cash, broker-dealers and mutual funds are not as vulnerable as banks during the initial placement stage of the money laundering process. However, some structuring schemes used in the placement stage involve monetary instruments such as money orders, and money launderers could attempt to use broker-dealers and mutual funds that accept these forms of payment.

According to law enforcement officials, money launderers would more likely attempt to use brokerage or mutual fund accounts in the layering and integration stages of money laundering, rather than for the placement stage. Similar to their use of banks, money launderers could use brokerage or mutual fund accounts to layer their funds by, for example, sending and receiving money and wiring it quickly through several accounts and multiple institutions. The securities industry could also be targeted for integrating illicit income into legitimate assets. In one case, illicit proceeds from food stamp fraud were used to open brokerage accounts and invest in stocks through an ongoing stream of deposits that ranged from less than $1,000 to almost $10,000.

Law enforcement officials were concerned that various characteristics of the securities industry and securities transactions were particularly attractive to money launderers. For example, the U.S. national money laundering strategy for 2000, issued by the Secretary of the Treasury and the U.S. Attorney General, notes that the general nature of the securities industry provides criminals with opportunities to move and thus obscure funds. The report suggests that money launderers may target the industry because funds can be efficiently transferred among accounts and to other financial institutions, both domestically and internationally. For example, like some banking organizations, several large broker-dealers have offices located throughout the United States and in many foreign countries. Some law enforcement officials noted that wire transfers, specifically those that involve offshore accounts, can be particularly vulnerable to money laundering. The national strategy report also suggests that money launderers may be attracted to the industry because of the high degree of liquidity in securities products, which can be readily bought and sold.

Some law enforcement officials pointed to the high volume, large-dollar amounts, and potentially profitable nature of securities transactions. On a typical day, for example, an estimated 3 billion shares of stock worth over $85 billion are traded on the main U.S. markets—a dramatic increase from about $20 billion in 1995. (Appendix III provides additional information on the size and growth of the U.S. securities industry.) Officials noted that the rapid growth of the securities markets and increasing popularity of investing in stocks and mutual funds may also have raised the industry’s profile with money launderers, who are becoming increasingly sophisticated and are attempting to find as many avenues as possible to launder funds.

Law enforcement and securities industry officials also identified several specific financial activities that securities firms conduct and that they viewed to be more at risk for potential money laundering. For example, law enforcement officials expressed concern that on-line brokerage accounts were vulnerable to use by money launderers, and such accounts have grown substantially in the last few years, jumping from an estimated 7 million in 1998 to almost 20 million in 2000. On-line brokerage services provide little opportunity for face-to-face contact with customers or for verifying the identity of those logging into accounts—a safeguard that is important to anti-fraud as well as anti-money laundering initiatives. Although the industry already conducts much of its customer contacts solely by telephone, securities regulators and industry officials acknowledged that on-line activities pose particular challenges from a money laundering perspective. Law enforcement officials also noted that some large broker-dealers are offering private banking services (broadly defined as financial and related services provided to wealthy clients) that are deemed vulnerable to money laundering. These services generally attempt to offer considerable confidentiality as part of the client relationship, routinely involve large-dollar transactions, and sometimes offer the use of offshore accounts.

Some law enforcement officials maintained that the securities industry lacks adequate anti-money laundering requirements and thus represents a weak link in the U.S. regulatory regime that can be exploited by money launderers in their search for new ways to hide their funds. These officials described the securities sector as a “money laundering loophole” within the financial services industry that should be closed, particularly as other financial sectors are being required to improve their defenses against money laundering. For example, Treasury issued rules for banks in 1996 and for money services businesses in 2000 requiring these firms to report suspicious activities, including potential money laundering. However, similar requirements do not yet apply to all broker-dealers and mutual fund firms, and law enforcement officials saw this fact as a reason that criminals may seek to use such firms to facilitate money laundering. Some law enforcement officials also suggested that as financial institutions continue to merge in response to GLBA, the need for consistent and adequate anti- money laundering requirements in all financial sectors is becoming even more pronounced.

Securities industry officials acknowledged that money launderers could potentially target their industry. SEC staff have noted that the large volume of money generated by illegal activities creates a risk for broker-dealers as well as other financial institutions. In a May 2001 speech, an SEC official stated that firms in the securities industry face great risks if they allow themselves to be used for money laundering. The official noted that trillions of dollars flow through the industry each year, and criminal activity within the industry could taint important U.S. capital markets.

The Number of Identified Cases in Which Money Has Been Laundered Through Securities Accounts Is Limited

Despite concerns regarding potential money laundering in the securities industry, the extent to which money launderers are actually using broker- dealers and mutual fund firms is not known. According to law enforcement officials, no organization currently collects information in a way that lends itself to readily identifying cases in which funds generated by illegal activity outside of the securities industry were laundered through brokerage or mutual fund accounts. Legal searches of cases primarily identify money laundering cases in which broker-dealers or others committed securities law violations, such as insider trading, market manipulation, or the sale of fraudulent securities, and then laundered the proceeds from their illegal activities through banks or other financial institutions.

Law enforcement and securities industry officials acknowledged that a limited number of cases involving money laundering through broker-dealer or mutual fund accounts could be readily identified to date. At our request, the Internal Revenue Service and the Executive Office for U.S. Attorneys collected information from some of their field staff that identified about 15 criminal or civil forfeiture cases since 1997 involving money laundering through brokerage and mutual fund accounts. The laundered funds in these cases came from a number of activities, including drug trafficking, illegal gambling, and food stamp fraud, and the estimated amounts of laundered funds varied widely, ranging from $25,000 to $25 million per case. In contrast, during 1999 alone, the United States reported having 996 money laundering convictions, most of which involved funds that were laundered through banks or other means. SEC and industry officials also pointed out that the industry has not had a history of money laundering cases.

Law enforcement officials suggested that several factors could have contributed to the limited number of known cases involving money laundered through brokerage or mutual fund accounts. These factors include the difficulty of detecting money laundering at the layering and integration stages and the lack of adequate systems to detect money laundering activities in the securities industry. Specifically, they noted that the absence of a SAR rule may be limiting the identification of money laundering through broker-dealer and mutual fund accounts. A few officials also explained that some investigators faced with time constraints and multiple leads may choose to trace illegal funds through bank rather than brokerage or mutual fund accounts because banks are subject to SAR rules and thus are expected to have SAR-related procedures and documentation needed for investigations.

Law enforcement officials anticipated that more cases may surface in the future as criminals continue to search for new ways to launder their funds and turn to the securities industry. One U.S. attorney stated that although, historically, money laundering through the securities industry has not been an apparent problem, some pending investigations involving the movement of Russian funds through various types of financial accounts, including brokerage accounts, indicate that activity in the area may be increasing. Other law enforcement agencies were also attempting to identify and develop additional cases in which brokerage and mutual funds accounts were used to launder money. For example, staff at one agency was in the process of analyzing whether money orders made payable to broker- dealers, mutual funds, and other financial institutions were being used for money laundering.

Broker-Dealer and Mutual Fund Firms Are Not Subject to All Anti- Money Laundering Regulatory Requirements

Broker-dealers and the firms that receive and process customer payments on behalf of mutual fund groups (hereinafter referred to as mutual fund service providers) can be held criminally liable if they are found to be involved in money laundering. They are also subject to certain reporting and recordkeeping requirements. However, unless a broker-dealer is a subsidiary of a depository institution or of a depository institution’s holding company, or a mutual fund service provider is itself a depository institution (as are some transfer agents), it is not subject to regulations requiring it to file SARs for transaction that could involve money laundering. SEC and the SROs monitor the industry’s compliance with the currency and related reporting and recordkeeping requirements during examinations and, according to SEC officials, are planning to conduct more extensive reviews of firms’ anti-money laundering efforts starting in the fall of 2001.

Broker-Dealer and Mutual Fund Firms Can Be Prosecuted for Aiding Money Launderers and Are Subject to Certain BSA Requirements

Broker-dealers and mutual fund service providers that accept customer funds are subject to the Money Laundering Control Act of 1986, which is a statute that applies broadly to all U.S. citizens. This act makes knowingly engaging in financial transactions that involve profits from certain illegal activities a criminal offense. As a result, individuals and companies conducting financial transactions on behalf of customers can be prosecuted if they are found to have conducted transactions involving money from illegal activities. Broker-dealers and mutual fund service providers can also be prosecuted if they knew or were willfully blind to the fact that a transaction involved illegal profits. Penalties under the Money Laundering Control Act include imprisonment, fines, and forfeiture.

Like other financial institutions, broker-dealers and those mutual fund service providers that accept customer funds are required to comply with various BSA or similar reporting and recordkeeping requirements. Such requirements are designed to be useful in tax, regulatory, or criminal investigations, including those relating to money laundering. As shown in table 1, firms subject to these requirements are to identify and report currency transactions exceeding $10,000 with FinCEN, file reports on foreign bank and financial institution accounts with FinCEN, and report the transportation of currency or monetary instruments into or out of the United States with the U.S. Customs Service.

In addition to imposing reporting requirements, the BSA requires broker- dealers and mutual fund service providers to maintain certain records. For example, broker-dealers and other financial institutions conducting transmittals of funds of $3,000 or more (including wire transfers) are required to obtain and keep information on both the sender and recipient and to record such information on the transmittal order. Broker-dealers also are required to have compliance programs in place for ensuring adherence to the federal securities laws, including the applicable BSA requirements.

Regulations under the BSA also require that banks report suspicious transactions of $5,000 or more relating to possible violations of law, but these requirements do not currently apply to all broker-dealers and mutual fund service providers. Amendments to the BSA adopted in 1992 gave Treasury the authority to require financial institutions to report any suspicious transaction relevant to a possible violation of a law. In 1996, Treasury issued a rule requiring banks to report suspicious activities involving possible money laundering to FinCEN using a SAR form. In 1996, the depository institution regulators promulgated regulations that require broker-dealer subsidiaries of bank holding companies, national banks, and federal thrifts to file SARs if the subsidiaries identify potential money laundering or violations of the BSA involving transactions of $5,000 or more. Until Treasury promulgates SAR rules for broker-dealers, only broker-dealers that are subsidiaries of depository institutions or of their holding companies are subject to SAR requirements. Depository institution regulators have also issued regulations that require banks to have BSA compliance programs in place, including (1) developing internal policies, procedures, and controls; (2) independently testing for compliance; (3) designating an individual responsible for coordinating and monitoring compliance; and (4) conducting training for personnel.

Efforts to Develop a Securities SAR Rule Renewed

Treasury is engaged in renewed efforts to develop a SAR rule for the securities industry and anticipates that a proposed rule will be issued for public comment before the end of 2001. Working with SEC, Treasury initially attempted to develop a SAR rule for the securities industry in 1997. Treasury officials explained that this effort was set aside so that the Department could focus first on cash-intensive businesses, such as the money services businesses and casinos, that are viewed as more vulnerable to money laundering at the placement stage. During 2001, Treasury resumed working with SEC to develop a SAR rule for the securities industry. Key issues being discussed include determining the appropriate threshold for reporting suspicious activities, ensuring that the SAR rule will not interfere with existing procedures for reporting securities law violations that apply to broker-dealers, and providing for compliance program requirements.

One question being debated is whether the $5,000 threshold for reporting suspicious activities that applies to banks should also apply to the securities industry. Securities industry and regulatory officials explained that this reporting threshold reflects the cash-intensive nature of the banking industry and its vulnerability to money laundering at the placement stage and, as such, should not be applied to securities firms. They also noted that the banking threshold does not reflect the typically high-dollar amount of securities transactions. Instead, these officials have proposed thresholds ranging from $25,000 to $100,000. Officials from a few large firms stated that they currently use thresholds ranging from $250,000 to $1 million in their proprietary systems for monitoring suspicious transactions. They explained that $5,000 transactions would be too difficult to identify in the accounts of several million customers and too burdensome for processing and review purposes. In responding to our survey, five broker-dealer subsidiaries of bank holding companies, which are required by bank regulators to file SARs, suggested that the threshold for the securities SAR rule needed to be raised. A few broker-dealer subsidiaries said that the thresholds should be the same for both the banking and securities industry rules, and the remaining 18 respondents did not offer any comment on tailoring the SAR threshold to the securities industry.

Results from our surveys did suggest that the average securities transaction tends to be much larger than $5,000. For example, broker-dealers reported that the average size of an individual transaction processed for retail customers was about $22,000, although the size of these transactions ranged anywhere from $200 to $150,000. Appendix V provides additional survey information on the size of average transaction amounts.

Securities industry representatives also pointed out that a low SAR threshold could result in an inordinate number of SAR filings from the industry, undermining the ability of law enforcement agencies to use the reports effectively. Federal Reserve officials supported a higher SAR threshold for the securities industry, in part because they thought it could help justify a higher reporting threshold for the banking industry as well. Finally, some law enforcement officials also viewed the reporting threshold as too low for the securities industry but did not propose an alternative amount. Although they acknowledged that the securities industry appears to be engaged in larger dollar transactions than other types of financial institutions, a few officials expressed concerns about having different reporting thresholds for the banking and securities financial sectors.

Another issue being discussed is the scope of suspicious activities that should be reported to FinCEN on the SAR form. Financial regulators, industry, and law enforcement officials agree that any rule requiring the securities industry to report suspicious activities involving money laundering should not replace existing procedures that require broker- dealers to report suspected violations of securities laws. Currently broker- dealers are to report possible securities law violations to SEC, SROs, or a U.S. attorney’s office. In turn, SEC and the SROs are to refer criminal money laundering offenses that are reported along with suspected securities law violations to the appropriate U.S. attorney’s office. To minimize any potential confusion on the part of the industry, officials emphasized that the language of the SAR rule should be written to ensure that firms understand that they are to continue to report potential securities violations to the appropriate securities regulators.

Both securities industry and law enforcement officials recognize the value of requiring compliance programs for reporting suspicious activities and are discussing whether the SAR rule is the most appropriate mechanism for imposing such requirements. Law enforcement officials said that industry participants cannot fully implement a suspicious activity reporting regime unless they are also required to set up systems to monitor their customers’ activities to prevent and detect transactions involving money laundering. In addition, securities industry officials said that the SAR rule should provide that broker-dealers with systems for reasonably detecting suspicious transactions, appropriate procedures for filing SARs, and no basis for believing that these procedures are not being followed, have a defense against being cited for violating the SAR reporting requirement. Such a provision would be an effective incentive for broker-dealers to develop and maintain up-to-date programs designed to monitor and report suspicious activities that may involve money laundering.

In addition to issues relating to the SAR rule itself, some unique characteristics of the securities industry, including the variety of business structures and processes, product lines, and client bases among broker- dealers and mutual funds, will make implementing the rule more challenging. Not all firms in the industry perform similar activities and thus may have to work with other firms to fulfill their SAR-related responsibilities. For example, determining whether particular transactions are suspicious may require information from an introducing broker on a customer’s identity and business activities or investment patterns and information from a clearing broker on the customer’s payment and transaction histories. Regulators and others have also noted that addressing anti-money laundering considerations will be more challenging within the securities industry because firms may not collect the same type of information about customers as banks. Broker-dealers are expected to collect enough information about their customers to ensure that any recommended investments are suitable. However, for some accounts this may not include all information, such as the customer’s source of the wealth or income, that can be important for assessing whether this customer’s activities are suspicious. Further, with the securities industry, there is a greater need to focus on the layering and integration stages of money laundering.

Securities Regulators Examine Broker-Dealers and Mutual Fund Firms for Compliance With Applicable Requirements and Plan for Broader Reviews

SEC and the securities industry SROs oversee broker-dealers’ compliance with BSA reporting and recordkeeping requirements involving currency and other related transactions. After Treasury granted SEC the authority to examine broker-dealers for compliance with these BSA requirements, SEC adopted Rule 17a-8 under the Exchange Act, incorporating these requirements into its own rules. As a result, SEC and the SROs have the authority to both examine broker-dealers for compliance with these requirements and bring action against firms that violate them.

Along with SEC, the SROs are to perform examinations of broker-dealers, including reviews to assess compliance with anti-money laundering reporting and recordkeeping requirements. These examinations do not routinely include assessing compliance with BSA SAR requirements that do not yet apply to the industry. During 2000, NASDR reported that it conducted 1,808 broker-dealer examinations, and NYSE reported that it conducted 319 examinations. Both SROs found that some broker-dealers had deficiencies in supervisory procedures pertaining to the currency reporting and recordkeeping requirements under SEC Rule 17a-8.

Although most broker-dealers are not subject to SAR requirements, National Association of Securities Dealers (NASD) and NYSE representatives noted that they have reviewed broker-dealers’ procedures relating to suspicious activities. In 1989, NASD and NYSE issued guidance advising their members that reporting suspicious activities could prevent firms from being prosecuted under the Money Laundering Control Act. In its issuance, NASD specifically warned its members that failure to report suspicious transactions could be construed as aiding and abetting violations of the act and could subject the broker to civil and criminal charges. In its guidance, NYSE cautioned its members to establish procedures to detect transactions by money launderers and others who seek to hide profits obtained from illegal activity. In conducting reviews of their members’ procedures relative to such guidance, these SROs cited a few firms for deficiencies such as failing to maintain written supervisory procedures to identify and record suspicious transactions.

Although the SROs conduct most examinations of broker-dealers, SEC staff also perform them and examinations of certain transfer agents. For instance, SEC staff conduct oversight examinations of broker-dealers that are designed to test both the firms’ compliance with securities laws and SEC rules (such as SEC Rule 17a-8) and the quality of SRO examinations. SEC staff also perform “cause examinations” that are initiated in response to special concerns related to a firm. These examinations can sometimes cover compliance with Rule 17a-8, even though BSA compliance may not have been the initial reason for the examination. During 2000, SEC completed 422 oversight examinations and 283 cause examinations but found no violations of anti-money laundering requirements that had not already been identified by the SROs.

SEC also conducts examinations of mutual funds and their transfer agents that address some money laundering issues. Among the firms that act as transfer agents for mutual funds are broker-dealers, banks, and nonfinancial firms that provide other services to mutual funds. Although Rule 17a-8 does not apply to transfer agents that are not broker-dealers, SEC staff explained that the examiners also inquire about these firms’ policies for detecting transactions that may involve money laundering. Most mutual fund shares, however, are sold by broker-dealers or other financial intermediaries that have primary responsibility for complying with the BSA or other currency reporting requirements (such as those contained in the Internal Revenue Code).

Recognizing the need to strengthen the securities industry’s efforts to combat money laundering, and anticipating a SAR rule for the industry, SEC and the SROs are in the process of developing a “refocused” approach to anti-money laundering examinations. According to SEC officials, this enhanced approach will result in a broader review of securities firms than the current approach, which focuses on compliance with Rule 17a-8. The new approach is intended to assess firms’ overall anti-money laundering strategies to determine whether they include policies, procedures, and internal control systems for monitoring suspicious activities. SEC officials anticipated that the expanded procedures would be used during examinations starting in the fall of 2001. They also indicated that once Treasury adopts a SAR rule for the securities industry, SEC and the SROs plan to develop additional examination procedures to review firms for compliance with this rule.

Some Firms Reported Implementing Anti- Money Laundering Measures That Go Beyond Existing Requirements

In responding to our survey, broker-dealers and direct-marketed mutual fund groups reported taking steps to combat money laundering that go beyond the BSA requirements applicable to the securities industry at large. Many firms have gone beyond currency reporting requirements by restricting the acceptance of cash and other forms of payment that may be used to launder money in the placement stage. Survey results also showed that some broker-dealers and direct-marketed mutual fund groups had implemented voluntary anti-money laundering measures designed to identify and report suspicious activities that may involve money laundering, but most have yet to take such steps. Clearing brokers were more actively engaged in such voluntary anti-money laundering efforts than introducing brokers. In some cases, introducing brokers relied on their clearing brokers to conduct anti-money laundering activities for them, but not all clearing firms performed such activities or subjected introducing broker transactions to such measures. The largest broker-dealers and direct-marketed mutual fund groups, which represent the majority of assets and accounts in the securities industry, were reportedly much more actively engaged in such voluntary anti-money laundering efforts than small and medium-sized firms, although these represent the majority of industry participants.

Most Broker-Dealers and Mutual Fund Groups Restricted Cash Transactions and the Use of Some Monetary Instruments

A vast majority of the broker-dealers and direct-marketed mutual fund groups surveyed reported having policies that prohibit the acceptance of cash. By prohibiting cash transactions, firms reduce their vulnerability to money laundering at the placement stage and the number of instances in which they must report certain currency transactions. Our survey showed that 95 percent of a projected 2,979 broker-dealers among our survey population and 92 percent of the 310 mutual fund groups never accept cash in the normal course of business. The remaining firms accept cash only as an exception. For example, these firms might accept small amounts (less than $1,000) or conduct cash transactions approved by a legal or compliance department. Industry officials explained that most securities firms and mutual funds are not set up to handle cash. Conducting securities business in cash is generally viewed as too burdensome, and many firms have chosen not to develop the needed infrastructure, including policies and procedures, storage facilities, and internal controls. Furthermore, industry officials note that prohibiting the use of cash is a prudent business practice that helps to reduce risks, other than money laundering, commonly associated with handling cash, including theft and embezzlement.

Although most broker-dealers and direct-marketed mutual fund groups have reduced their vulnerability to money laundering that involves cash transactions, many may still be vulnerable to money laundering using other forms of payment or deposit, such as traveler’s checks, money orders, and cashier’s checks. As shown in figure 4, over 55 percent of direct-marketed mutual fund groups reported always accepting money orders. According to law enforcement officials, such forms of payment or deposit can be used as part of structuring schemes in which cash is converted into monetary instruments and deposited in increments of less than the $10,000 reporting threshold. In addition, a large portion of mutual fund groups and broker- dealers also reported accepting cashier’s checks, which can also be used in money laundering schemes. A securities industry official pointed out that cashier’s checks are a common form of payment that firms tend to monitor rather than restrict for money laundering purposes. Personal checks are the most widely accepted form of payment but, according to industry officials, are viewed with less concern since they can usually be traced to accounts at depository institutions that have their own anti-money laundering requirements.

Industry representatives also pointed out that although the survey responses reflect the proportion of firms that accept certain forms of payment, these figures do not likely correspond with the extent to which the cited forms of payment are actually used to deposit funds into broker- dealer or mutual fund accounts. For example, officials from a mutual fund industry association said that considerable amounts of money are deposited into mutual funds through electronic fund transfers from bank accounts or through payroll deposits.

Some Broker-Dealers and Direct-Marketed Mutual Fund Groups Reported Implementing Additional Voluntary Anti-Money Laundering Measures

Although not subject to SAR requirements, some broker-dealers and direct- marketed mutual fund groups reported having implemented anti-money laundering measures designed to identify and report suspicious activities. According to our survey, 17 percent of broker-dealers, or an estimated 513 of 3,015 firms, reported implementing anti-money laundering measures that go beyond BSA provisions for the securities industry at large. In our survey, we asked firms to identify the type of voluntary anti-money laundering measures, if any, they have implemented. We divided these types of measures into four broad categories: written policies and procedures, such as those requiring staff to learn more about customers and the nature of the customers’ businesses; internal controls, including supervisory reviews to ensure that anti- money laundering policies and procedures are being followed; tools and processes, such as an automated transaction monitoring program to facilitate the detection of potential money laundering; and formal training programs for staff, such as those that provide guidance on how to identify suspicious activities that may involve money laundering.

These categories were used to determine the general nature of industry efforts and do not represent a comprehensive list of anti-money laundering efforts. which firms that reported implementing anti-money laundering measures were actually adhering to them. In addition, the effectiveness of these measures at any firm would depend on various factors, including the level of a firm’s management commitment to detecting and preventing money laundering and the degree to which the employees responsible for following anti-money laundering policies and procedures are being supervised and held accountable.

Although 17 percent of broker-dealers overall reported implementing at least one voluntary anti-money laundering measure, broker-dealers that clear trades for themselves and other firms reported being more active in the area. According to our survey analysis, 15 percent of introducing brokers and 63 percent of clearing brokers reported implementing voluntary anti-money laundering measures. As shown in figure 5, the extent to which introducing brokers reported implementing the various voluntary measures identified in our survey ranged from 2 to 10 percent. The extent to which clearing brokers reported implementing the various voluntary measures identified in our survey ranged from 5 to 53 percent.

Our survey results also showed that the transactions processed by 40 percent of direct-marketed mutual fund groups were subject to some type of voluntary anti-money laundering measures. Over 30 percent of these groups reported that they or their transfer agents had put in place policies and many of the tools and processes for identifying and monitoring suspicious activities (fig. 6).

The extent to which firms had implemented multiple anti-money laundering measures varied. For example, for broker-dealers that reported having implemented voluntary anti-money laundering measures, almost 20 percent indicated they had three or fewer of these measures in place. Almost 30 percent of these broker-dealers reported having implemented more than 10 measures.

Even when firms reported implementing the same measures, the scope of their efforts differed. For example, officials at one firm explained that its transaction monitoring system, although still in the process of being implemented, was specifically designed for anti-money laundering purposes and focused on the overall financial activities of its customers, including deposits, wire transfers, and transactions involving cash equivalents. This firm’s system will eventually use customer profiling techniques to identify unusual spikes in account activity and will have the ability to make links among related customers to identify any suspicious patterns of activity that may involve money laundering. In contrast, officials at another firm that reported having a transaction monitoring system told us that that their system involved the manual review of transactions identified by a reporting system designed to identify fraud to determine if the transactions might also involve money laundering. Similarly, some firms described having ongoing training programs specifically tailored to money laundering issues, including guidance on how to identify suspicious activities. A few firms addressed money laundering issues only as part of the orientation training provided to new employees.

Industry officials noted that, in general, a firm’s vulnerability to money laundering will vary, depending upon such factors as its type of business activities, customer base, and company size. They suggested that this variance in vulnerability among firms may account for some of the observed differences in the extent and scope of voluntary anti-money laundering measures implemented by broker-dealers and mutual fund groups.

Our survey results also disclosed that a relatively small number of broker- dealers and direct-marketed mutual fund groups filed SARs during calendar year 2000, although they were not legally required to do so. Specifically, 12 of 152 broker-dealer respondents and 6 of 65 mutual fund group respondents indicated that they had filed SARs. Almost all were larger firms. Most indicated that they had submitted 25 or fewer SARs during 2000, but 1 reported submitting over 200 reports during the year. An industry association official noted that, rather than filing SARs, some firms informally refer suspicious activities that may involve money laundering informally to appropriate regulatory or law enforcement authorities.

Industry officials explained that firms have generally chosen to adopt voluntary anti-money laundering measures to protect themselves from becoming unwitting participants in money laundering activities. The firms hope that implementing such measures will also help to reduce the likelihood of prosecution or civil enforcement actions for violations of money laundering laws and mitigate sanctions in the event that a violation does occur. Industry trade associations encourage voluntary efforts, noting that firms are less likely to be subject to a regulatory penalty (or may have a penalty reduced) if a violation occurs when an effective compliance program is in place. Firms also believe that being associated with criminal elements or activities such as money laundering can threaten their reputation and have a tremendous impact in terms of lost business and costly legal fees. Lastly, firms note that they are taking voluntary actions in anticipation of a SAR rule for broker-dealers.

Extent to Which Introducing Brokers’ Transactions Were Covered by Anti-Money Laundering Activities Is Unclear

Although a relatively small portion of introducing brokers reported having implemented voluntary anti-money laundering measures, many other introducing brokers reported relying on their clearing brokers to conduct anti-money laundering activities on their behalf. According to our survey, more than half of the introducing brokers indicated that they had not undertaken such efforts, relying instead on their clearing brokers (fig. 7). Almost another third reported that they had no voluntary measures of their own and did not rely on their clearing brokers to undertake such measures for them.

We found that the allocation of anti-money laundering responsibilities between introducing and clearing brokers was not always clear. Of the many introducing brokers that reported relying on clearing brokers to conduct anti-money laundering activities, most did not know exactly what types of anti-money laundering activities the clearing brokers performed. Several introducing brokers indicated that they thought their clearing brokers monitored customer accounts to identify suspicious activities that could involve money laundering and would report such activities to them. Few of the introducing brokers indicated that they received regular transaction reports from their clearing brokers for anti-money laundering purposes.

In addition, many of the clearing brokers responding to our survey reported that they either did not engage in voluntary anti-money laundering activities or performed them only for their own firms’ transactions, not for those of introducing brokers. As a result, some introducing brokers may have been mistaken in assuming that their clearing brokers performed anti- money laundering activities on their behalf. We were not able to determine whether any of the introducing brokers in our survey population used the clearing brokers that reported performing anti-money laundering activities. Six of the 29 clearing broker respondents that provided clearing services for other broker-dealers reported that they did not engage in any type of voluntary anti-money laundering measures. While the remaining 23 clearing broker respondents reported having voluntary anti-money laundering measures for their own trades, only about half of these firms indicated they applied the same measures to their introducing brokers’ transactions. Only a few of the clearing brokers reported that they provided other broker-dealers with transaction exception reports for anti- money laundering purposes. SEC officials explained that existing NYSE and NASD rules, which require introducing and clearing brokers to clearly delineate their respective responsibilities in a written agreement, will require them to include any expanded anti-money laundering responsibilities that will result from the issuance of a securities SAR rule in such agreements.

Large Firms Were More Actively Engaged in Voluntary Anti-Money Laundering Efforts

Although most broker-dealers and direct-marketed mutual fund groups have yet to implement voluntary anti-money laundering measures, larger firms reported having done so to a greater degree than had medium-sized or small firms. Larger firns also reported having implemented anti-money laundering programs that included a broader range of measures. Specifically, from the results of our survey, we estimated that 66 percent of the 111 large broker-dealers had implemented measures that go beyond those required by applicable BSA regulations compared with 14 percent of the 1,738 small firms (table 2). An estimated 77 percent of the large direct- marketed mutual fund groups had implemented measures beyond those required, compared with 38 percent of the other mutual fund groups. Appendix VI provides information on the types of voluntary anti-money laundering measures implemented by broker-dealers and mutual fund groups, by size.

The largest firms have also been the most active in implementing anti- money laundering measures. For example, 18 firms in our broker-dealer population had assets exceeding $10 billion; together, these firms held about 80 percent of the industry’s total assets as of year-end 1999. We received responses from the nine firms we surveyed in this population. According to their responses, eight of these firms had implemented voluntary anti-money laundering measures, with each reporting to have nine or more measures in place. SEC officials told us that having such measures in place at firms like these was particularly important because money launderers would likely attempt to blend their activities with those of the vast numbers of customers and transactions handled by large broker- dealers.

However, SEC officials as well as industry officials representing some of the major broker-dealers and mutual fund groups acknowledged that no firms in the industry, including small and medium-sized firms, are immune to money laundering schemes. They suggested that small and medium- sized firms also need to protect themselves from being inadvertently drawn into charges of assisting with money laundering. But the officials stressed that these firms should be allowed to develop anti-money laundering programs that are commensurate with their size, available resources, and— most importantly—any identified risks of vulnerability to money laundering. For example, some small firms with an established and limited client base may know their customers well enough to be able to monitor their business transactions with little need for expensive tracking systems or formal training programs.

Certain Bank-Affiliated Respondents Also Reported Implementing Measures to Identify and Report Suspicious Activities

All 25 respondents to our survey of securities subsidiaries of bank holding companies, along with an additional 14 firms identified as securities subsidiaries of depository institutions during our other industry surveys, reported having implemented anti-money laundering efforts to comply with the SAR rules to which they were subject. For example, at least 85 percent of these bank-affiliated respondents reported having written procedures for identifying and reporting suspicious activities, a formal training program, and internal audit reviews to ensure compliance with anti-money laundering policies and procedures. Most of these firms had also hired compliance staff with knowledge of and expertise in money laundering. In addition, 12 of 25 respondents that were securities subsidiaries of bank holding companies and 3 of 14 respondents that were subsidiaries of depository institutions reported having filed SARs during 2000.

Most Foreign Countries Have Anti- Money Laundering Rules for Securities Firms, but the Effectiveness of These Rules Is Unclear

U.S. and foreign officials from law enforcement and financial regulatory agencies have been working together within various international forums to develop anti-money laundering standards. These standards call for participating countries to require their financial institutions, including securities firms, to take steps to prevent money laundering. Among other things, the recommended standards call for firms to identify their customers, report suspicious activities, and implement anti-money laundering programs. Many foreign countries reported having issued most or all of the recommended requirements for their financial institutions, including their securities industry, whereas efforts in the United States are still under way. However, assessing the effectiveness of the measures other countries have taken is difficult because many requirements have only recently been issued. In addition, most countries have also yet to report many cases involving financial institutions, including securities firms.

International Forums Have Developed Anti-Money Laundering Standards

Money laundering issues are the focus of several internationally active forums, including FATF, which is the largest and the most influential intergovernmental body seeking to combat money laundering. Established in 1989, FATF has 31 members, including the United States. Its activities include monitoring members’ progress in implementing anti-money laundering measures, identifying current trends and techniques in money laundering, and promoting the adoption of the organization’s standards. Many of these activities are conducted during plenary meetings attended by delegations from each member country. Smaller international groups that address money laundering issues are also able to attend FATF plenary meetings. These groups are often regional, like the Caribbean Financial Action Task Force (CFATF), which includes 25 countries from the Caribbean, Central America, and South America. Other regional forums include the Asia Pacific Group on Money Laundering and the Financial Action Task Force on Money Laundering in South America.

Some international bodies have recommended countermeasures against money laundering to their members. These recommendations cover criminal justice and enforcement systems, financial systems, and mechanisms for international cooperation. Some recommendations apply specifically to financial institutions, including securities firms (table 3).

Many Countries Reported Complying With FATF Recommendations for Financial Institutions

Many of the countries participating in international forums reported being in compliance with the FATF recommendations relating to their financial institutions, including the securities industry. For example, 24 of the 26 FATF member countries that participated in a recent self-assessment reported having in place most of the key FATF recommendations that apply to stockbrokers. These included three FATF recommendations suggesting that stockbrokers record customers’ identity, pay attention to unusually large transactions that have no apparent economic purpose, and report suspicious activities to authorities. A fourth recommendation suggested that guidelines be issued to assist stockbrokers in detecting suspicious activities. Canada, one of the two member countries that had not implemented the specific recommendation that stockbrokers be required to report suspicious activities to competent authorities at the time of the self-assessment, has since published suspicious activity reporting regulations that cover the securities industry and are expected to come into force in November 2001. In a recent report on the anti-money laundering systems of its members, FATF observed that countries such as Canada and the United States, which have federal systems of government and a division of responsibilities for financial institutions sectors, generally take longer to implement controls for institutions regulated at the state or provincial level. CFATF officials also observed that 8 of the 11 CFATF members with organized securities exchanges had enacted legislation or adopted regulations requiring their securities firms to report suspicious transactions.

The United States has applied some of the FATF recommendations to its securities industry. For example, U.S. requirements for currency reporting and funds transfers that apply to the securities industry already comply with international recommendations. According to U.S. officials, many of the existing customer identification requirements for broker-dealers in the United States also are consistent with FATF recommendations. However, the United States has not issued requirements on suspicious activity reporting and related anti-money laundering programs for the securities industry but, as previously discussed, is in the process of developing a SAR rule.

The Effectiveness of Implementing Anti-Money Laundering Standards in Many Countries Is Unclear

Determining how well international anti-money laundering standards have been implemented around the world is difficult because of the limited amount of information available. Some countries have only recently issued anti-money laundering requirements for their financial institutions, including securities firms, and have had little time to fully implement and enforce them. In addition, FATF reports that limited law enforcement tools and resources in some countries may hinder the effective implementation and enforcement of anti-money laundering requirements.

Most FATF countries have only a few years of statistics on suspicious activity reporting by banks, and few countries have data on suspicious activity reporting by other financial institutions. Only six countries provided information to FATF on SARs filed by their securities firms, and all six countries showed limited activity in the area. Specifically, securities firms filed a relatively small portion of the total SARs filed in these countries—from nearly 0 percent to just over 4 percent (table 4).

In some countries, suspicious activity reporting requirements for financial institutions are relatively new, and it may be too early to judge the effectiveness of implementing these measures. As previously noted, 8 of 11 CFATF members with organized securities exchanges had implemented legislation or regulations requiring firms to report suspicious activities, but 7 did not enact these laws until 1998 or later. Similarly, FATF’s three newest members issued their anti-money laundering laws covering suspicious activity reporting requirements in 1997, 1998, and 2000.

Some countries may not have the necessary enforcement tools and resources to implement anti-money laundering measures properly. FATF reported that while some member countries have sanctions in place for firms that fail to report suspicious activities indicative of money laundering, other countries do not. In the United Kingdom, for example, we were told that officers of firms that do not report suspicious activities can be sentenced to up to 15 years in jail. In general, however, FATF reports that few members have applied such sanctions. In some member countries where the regulatory framework and mechanisms for monitoring suspicious activities are in place, the resources fall short of what is needed to make full use of these systems. FATF identified limited staff resources as a particular problem that has resulted in a backlog of SARs that have not been investigated. However, these countries are planning to allocate more resources to the units responsible for collecting, analyzing, and disseminating suspicious transaction information.

Most countries had not reported many money laundering cases involving nonbank financial institutions, and data on securities-specific cases are generally not available. Overall, other countries reported having much lower rates of enforcement activity related to money laundering than the United States. FATF reported that law enforcement statistics showed marked differences in the anti-money laundering activities of its member countries and in some cases indicated that members had undertaken few prosecutions or confiscations of funds. Law enforcement statistics for CFATF members also showed limited activity in the area, including few money laundering prosecutions and convictions. In contrast, the United States has reported relatively large numbers of prosecutions, convictions, confiscations, and seizure rates involving money laundering. During 1999, for example, the United States had 996 money laundering convictions, the highest number reported by any of the FATF member countries.

Conclusions

The extent to which money laundering is occurring in the securities industry is not known, although law enforcement officials believe that various characteristics of the industry may make it a target like other financial industries. An assessment of the industry’s vulnerability must also consider the extent to which the industry is covered by anti-money laundering regulatory requirements and the actions broker-dealers and mutual fund firms themselves have taken to prevent their use by money launderers. Although firms in the securities industry are subject to criminal prosecution for facilitating money laundering and must comply with certain BSA reporting and recordkeeping requirements, all broker- dealer and mutual fund firms are not yet required to report suspicious activities that could be evidence of potential money laundering. As a result, the extent to which firms in the industry have taken steps to detect and prevent money laundering also varied. We found that many of the larger firms, which hold the majority of accounts and assets in the industry, had implemented voluntary anti-money laundering measures, but most of the small and medium-sized firms that represent the majority of broker-dealer and mutual fund firms in the industry had not. Although efforts by regulators to develop a SAR rule applicable to the securities industry are under way, they are not yet complete. As a result, regulators, broker- dealers, and mutual fund firms have more to do to further reduce the securities industry’s overall vulnerability to money laundering.

Agency Comments and Our Evaluation

We received written comments on a draft of this report from Treasury’s FinCEN and SEC. FinCEN, whose written comments appear in appendix VIII, generally agreed with the draft report. FinCEN noted that the report provides information that will be useful in identifying and evaluating the operational effects of any future anti-money laundering regulatory requirements pertaining to the securities industry. This includes FinCEN’s current efforts to promulgate a draft rule that would require registered broker-dealers to establish programs to identify and report suspicious activities. FinCEN also provided technical comments, which we incorporated in this report as appropriate.

SEC, whose written comments appear in appendix IX, similarly agreed with the observations contained in the draft report and noted that the draft provided a helpful overview of issues facing the securities industry, securities regulators, and law enforcement agencies as they continue their efforts to block money laundering. In its view, SEC said that our draft report identified two insights that would be particularly helpful to the government’s continued fight against money laundering. First, because more than 90 percent of broker-dealer and mutual fund firms reported never accepting cash, SEC noted that placement of physical currency into the financial system is not a significant risk for the securities industry.

Secondly, SEC’s letter highlighted that our survey results indicated that the firms responsible for most of the U.S. securities industry’s accounts, transactions, and assets have implemented a broad range of voluntary anti- money laundering measures. We agree that the larger firms were more likely to report having implemented a variety of anti-money laundering measures. We note, however, that we did not attempt to verify the information provided by firms responding to our survey. In addition, the effectiveness of firms’ anti-money laundering programs also depends on such factors as the extent of management support and the level of supervision over employees and customer activity. In its letter, SEC also noted that the implementation of an effective SAR requirement for broker- dealers—one focused on layering and integration—should help all regulators and law enforcement officials address money laundering. SEC also provided technical comments, which we incorporated in this report as appropriate.

Justice provided us with informal comments in which it generally concurred with the substance of the draft report and offered a few additional observations. Justice noted, for example, that most of its enforcement efforts have focused on the large broker-dealers, leaving a significant segment of the securities industry unaddressed. It also emphasized that the opportunities for laundering illegal proceeds through on-line brokerage accounts require further scrutiny.

As agreed with your office, unless you publicly release its contents earlier, we plan no further distribution of this report until 14 days from its issuance date. At that time, we will send copies of this report to interested congressional committees and members. We will also send copies to the Secretary of the Treasury, the U.S. Attorney General, and the Chairman of SEC. Copies will also be made available to others upon request.

Key contributors to this report are listed in appendix X. If you have any questions, please call me at (202) 512-5431 or Cody Goebel, Assistant Director, at (202) 512-7329.

Scope and Methodology

Determining Potential for Money Laundering and the Extent to Which Existing Regulations and Oversight Apply to the Securities Industry

To develop information on the potential for money laundering in the U.S. securities industry, we obtained the views of securities industry representatives and regulatory officials as well as the perspectives of several law enforcement agencies. At the Department of the Treasury, we spoke with officials from the Financial Crimes Enforcement Network (FinCEN), U.S. Customs Service, Internal Revenue Service, U.S. Secret Service, Office of Foreign Assets Control, and Office of Enforcement. At the Department of Justice, we spoke with officials from the Drug Enforcement Administration, Federal Bureau of Investigation, and Executive Office for U.S. Attorneys. We reviewed relevant reports, including the National Money Laundering Strategy for 2000 issued by Treasury and the U.S. Attorney General, International Narcotics Control Strategy Report issued by the U.S. Department of State, and Report on Money Laundering by the International Organization of Securities Commissions. We also conducted an independent legal search of cases involving money laundering through the securities industry and reviewed indictments, news articles, and other supporting documentation (provided primarily by the Internal Revenue Service and the Executive Office for U.S. Attorneys) to identify relevant cases.

To describe the anti-money laundering legal framework applicable to the U.S. securities industry and related regulatory oversight, we interviewed officials at the Securities and Exchange Commission (SEC), New York Stock Exchange (NYSE), National Association of Securities Dealers (NASD), Federal Reserve Board, Office of the Comptroller of the Currency, and Office of Thrift Supervision. We also reviewed U.S. anti-money laundering laws, rules, and regulations; accompanying congressional records; SEC and self-regulatory organization (SRO) examination procedures covering compliance with Bank Secrecy Act (BSA) requirements and related anti-money laundering guidance; semiannual reports to Treasury summarizing SEC and SRO examination findings pertaining to BSA, SEC correspondence on anti-money laundering issues, and other relevant documentation.

Determining the Extent to Which Broker- Dealers and Mutual Funds Have Implemented Anti- Money Laundering Activities

To determine the nature of the anti-money laundering efforts of broker- dealers and mutual funds, we interviewed industry officials at their respective companies and held roundtable discussions with panels of industry officials representing some of the nation’s major broker-dealer and mutual fund firms. We also spoke with representatives of industry trade associations, such as the Securities Industry Association and Investment Company Institute, and reviewed available reports and other documents covering money laundering issues relative to the securities industry.

To determine the extent to which firms were undertaking anti-money laundering activities, we also surveyed representative probability samples of broker-dealers and mutual funds. For our survey of broker-dealers, our target population was all broker-dealers conducting a public business, including firms that carry customer accounts, clear trades, or serve as introducing brokers. These firms were selected because their activities may expose them to potential money laundering, unlike brokers who do not conduct transactions for customers. For our survey of mutual fund firms, our target population was direct-marketed, no-load mutual fund families that sell shares directly to investors and would have some anti- money laundering responsibilities because of their direct contact with customers. The majority of other mutual funds are sold by other financial institutions, such as broker-dealers, banks, and insurance companies, and these entities would have the contact with customers potentially seeking to launder money.

Our representative probability samples included three groupings: (1) broker-dealers, (2) securities subsidiaries of bank holding companies and foreign banking organizations, and (3) mutual funds. For each grouping, we used survey data to estimate what types of monetary instruments are accepted and what anti-money laundering activities are conducted, including voluntary measures such as implementing written anti-money laundering procedures to identify noncash suspicious activities, establishing related internal controls, providing personnel training, and filing suspicious activity reports (SAR). Appendix II is an example of one of our survey instruments.

Sample Design

Our three statistically valid random samples were drawn so that each sampled firm had a known, nonzero probability of being included in our survey. In the broker-dealer and mutual fund surveys, the samples were allocated across several categories, or strata, defined by the size of the firm, so that proportionally more of the sample was allocated to the strata with larger firms. This makes our estimates of anti-money laundering activity, which tends to vary by size of firm, more precise. To produce the estimates from this survey, answers from each responding firm were weighted in the analysis to account for the different probabilities of selection by stratum and to make our results representative of all the members of the population, including those that were not selected or did not respond to the survey.

For our survey of broker-dealers, our target population was all broker- dealers conducting a public business, including firms that carry customer accounts, clear trades, or serve as introducing brokers. Using these specifications, we requested year-end 1999 financial and operational reports filed with SEC by 5,460 firms. From this list, we eliminated 1,626 NASD-member firms not conducting a public business and carrying or clearing trades, such as those that act as floor brokers on the various exchanges or that sell mutual funds, direct participation plans, or units of mutual funds, but that nevertheless file broker-dealer reports with SEC. We also removed the 53 section 20 subsidiary firms identifiable in the dataset at that time, resulting in a population of 3,781 broker-dealers for sampling purposes. Table 5 provides additional information on the selected characteristics of this broker-dealer population.

From these 3,781 firms, we drew a random probability sample of 231 broker-dealers. We distributed that sample over three size strata defined by total assets of the firms.

For our survey of mutual funds, our target population was direct-marketed funds whose shares are sold directly to retail or institutional customers. We developed a list of 363 of these direct-marketed mutual fund groups from lists of no-load mutual fund families (those fund complexes most likely to distribute shares of their funds themselves) from publications widely available at the time of our survey. We drew a random sample of 92 fund families across two strata defined by the year-end 1998 asset size of firms.

Some broker-dealers and mutual fund groups have been subject to additional money laundering regulation because of their affiliation with banks or other depository institutions—specifically, as subsidiaries of depository institutions or of their holding companies. As a result, we attempted to remove this group from our overall survey population of broker-dealers and administered a separate survey for such bank-affiliated brokers. However, we were unable to develop a survey population that included all securities subsidiaries of depository institutions or of their holding companies because comprehensive data on the extent and the identities of all such subsidiaries were not available. However, the Federal Reserve maintained data on the securities subsidiaries of the bank holding companies and foreign banking organizations that it oversees. These bank-affiliated broker-dealers were subject to banking SAR requirements. As of December 31, 1999, the Federal Reserve oversaw 53 of these firms, and we randomly selected 37 of them for our survey.

Administration of the Surveys

We contacted all sampled firms by telephone to determine their eligibility for the survey and to determine who in each firm should receive the questionnaire. We sent questionnaires primarily by fax to firms beginning in December 2000. We made telephone follow-up contacts to some of the firms that did not respond within several weeks, to encourage them to return a completed questionnaire or to answer our questions by telephone. We stopped collecting completed questionnaires in April 2001. We used several variants of the questionnaires tailored to each industry and to whether the firm was subject to the banking SAR requirements. Although we conducted follow-up work with some of the respondents to clarify their responses and obtain additional information, we did not systematically verify the accuracy of survey responses or the extent to which firms were adhering to reported policies and procedures.

Disposition of Samples

We received 164 usable broker-dealer responses, 67 mutual fund responses, and 25 responses from securities subsidiaries of bank holding companies. After adjusting for those sampled firms that were discovered to be ineligible for our survey because they were no longer independent entities in their respective industries, the number of usable responses resulted in final response rates of 87 percent, 83 percent, and 69 percent, respectively (tables 6 to 8). Because not all respondents provided an answer to each question that they were eligible to answer, the item response rate varies and is generally lower than the unit response rate for each industry.

During the course of administering the surveys of broker-dealers and mutual fund groups, we identified 12 broker-dealers and 2 mutual fund groups that indicated that they were subject to the banking SAR requirements. Responses of these 14 firms were analyzed in conjunction with responses of the securities subsidiaries of institutions overseen by the Federal Reserve.

Survey Error and Data Quality

Point estimates from sample surveys are subject to a number of sources of error, which can be grouped into the following categories: sampling error, coverage error, nonresponse error, measurement error, and processing error. We took a number of steps to limit these errors.

Sampling error exists because our random sample is only one of a large number of samples that we might have drawn. Since each sample could have produced a different estimate, we express the precision of our particular sample's results as a 95-percent confidence interval. This is the interval (e.g., ±7 percentage points on either side of the percentage estimate) that would contain the actual population value for 95 percent of the samples we could have drawn. As a result, we are 95-percent confident that each of the confidence intervals cited in this report will include the true values in the study population.

Surveys may also be subject to coverage error, which occurs when the sampling frame does not fully represent the target population of interest. We used the most up-to-date lists that were available to us, and we attempted to remove firms that were no longer in the industry of interest. For the mutual fund survey, our results are representative only of those mutual fund groups that are direct marketed and that offer predominantly no-load funds, which we believe is closest to the target population of mutual funds that are self-distributing. Also, we discovered a small number of firms in our broker-dealer sample that was affiliated with depository institutions and subject to banking SAR requirements. These firms would have been excluded from our overall broker-dealer sample frame had we known this before conducting our survey; their responses were analyzed with those from our sample frame for bank-affiliated securities subsidiaries, which represented broker-dealers subject to banking SAR requirements.

Measurement errors are defined as differences between the reported and true values. Such errors can arise from the way that questions are worded, differences in how questions are interpreted by respondents, deficiencies in the sources of information available to respondents, or intentional misreporting by respondents. To minimize such errors, we asked subject matter experts to review our questionnaires before the survey, and pretested the questionnaires by telephone with respondents at several firms of various sizes and levels of anti-money laundering activity.

Nonresponse error arises when surveys are unsuccessful in obtaining any information from eligible sample elements or fail to get valid answers to individual questions on returned questionnaires. To the extent that those not providing information would have provided significantly different information from those that did respond, bias from nonresponse can also result. Because the seriousness of this type of error is often proportional to the level of missing data, response rates are commonly used as indirect measures of nonresponse error and bias. We took steps to maximize response rates, such as sending multiple faxes of the questionnaires and making several telephone follow-ups to convert nonrespondents.

Finally, surveys may be subject to processing error in data entry, processing, and analysis. We verified the accuracy of a small sample of keypunched records by comparing them with their corresponding questionnaires, and we corrected any errors found. Less than 1 percent of the data items we checked had random keypunch errors that would not have been corrected during data processing. Analysis programs were also independently verified.

We conducted follow-up work with many of the respondent firms to obtain additional information on or clarification of their survey responses. We also worked with FinCEN to corroborate survey responses on the extent that securities firms have filed SARs using procedures that attempted to maintain the confidentiality of the identities of our survey respondents.

International Anti- Money Laundering Efforts

To obtain information on international efforts aimed at addressing money laundering in the securities industry, we interviewed members of the U.S. delegation to the Financial Activities Task Force (FATF), officials of the Caribbean Financial Activities Task Force (CFATF), and representatives of the U.S. Department of State. We also spoke with foreign officials representing the financial supervising authorities, law enforcement or financial intelligence units, prosecuting offices, and securities industries in Barbados, Germany, Trinidad and Tobago, and the United Kingdom. In addition, we interviewed knowledgeable representatives at the U.S. embassies located in these jurisdictions. We reviewed FATF and CFATF annual reports; summaries of mutual evaluations, self-assessments, and the results of plenary meetings; documents provided by countries we visited on their anti-money laundering oversight and law enforcement efforts; and relevant reports issued by various international working groups and committees. Lastly, we researched the Web sites of selected foreign financial regulators and reviewed available documentation on their anti- money laundering regulations, policies, and industry guidelines. Information on foreign anti-money laundering laws or regulations is based on interviews and secondary sources and does not reflect our independent legal analysis.

We conducted our work between May 2000 and May 2001 in accordance with generally accepted government auditing standards.

Example of a Data Collection Instrument Used to Survey the Securities Industry

Please provide the following information in the event we need to clarify a response:

Demographic Information on the U.S. Securities Industry

One of the reasons that the U.S. securities industry is seen as potentially attractive to money launderers is the rapid growth in securities activities in the United States. As shown in figure 8, the value of securities traded on the NYSE and the Nasdaq markets has grown significantly since 1990.

The number of shares traded on these two major U.S. markets has also increased during the 1990s (fig. 9).

In addition to the increase in stock trading, mutual funds have also experienced considerable growth in the 1990s. As shown in figure 10, assets in mutual funds exceeded $7 trillion in 2001.

Securities markets are now more accessible to investors with the advent of on-line trading accounts that allow investors to open accounts and send transaction instructions to broker-dealers using the Internet. As shown in figure 11, research staff for one broker-dealer reported that the number of on-line brokerage accounts was close to 20 million at the end of 2000.

Although many countries have active securities markets, trading on markets in the United States continues to represent the majority of trading on all large markets (fig. 12).

Identified Cases of Money Laundering Through the U.S. Securities Industry

To obtain information on the extent to which the U.S. securities industry was used to launder money as well as the vulnerability of the industry to money laundering, we contacted various U.S. law enforcement agencies. Within Treasury, we contacted the Customs Service, Internal Revenue Service’s Criminal Investigation Division, Secret Service, FinCEN, Office of Foreign Assets Control, and Office of Enforcement. At Justice, we spoke with officials from the Drug Enforcement Administration, Federal Bureau of Investigation, and Executive Office for U.S. Attorneys.

Statistics on the number of cases in which money was laundered through brokerage firms and mutual funds were not readily available, but we compiled a listing of cases in which illegal funds were laundered through brokerage firms or mutual funds from information provided primarily by two of the law enforcement agencies we contacted. At our request, the Internal Revenue Service and Executive Office for U.S. Attorneys collected information from some of its field staff that identified about 15 criminal or civil forfeiture cases since 1997 that involved money laundering through brokerage and mutual fund accounts. Some cases in which money laundering is alleged involved securities fraud or crimes committed by securities industry employees who then moved their illegally earned proceeds to other institutions or used them to purchase other assets, thus violating the anti-money laundering statutes. However, we only included such cases if broker-dealer or mutual fund accounts were alleged to have been used to launder the money.

Table 9 provides a list of criminal cases in which proceeds from illegal activities were laundered through brokerage or mutual fund accounts. Table 10 provides a list of forfeiture cases in which property, including assets held in brokerage or mutual fund accounts, obtained from proceeds that were traceable to certain criminal offenses were taken by the United States to be distributed to the victims of such crimes as restitution. These lists contain examples of cases that involve charges of money laundering through brokerage or mutual fund accounts and do not represent an exhaustive compilation of all such known cases. For example, law enforcement officials indicated that they were unable to provide information on many relevant pending cases in the area and further emphasized that not all field offices and staff had been formally queried. Specific case information presented in the tables was extracted from public documents provided primarily by the Internal Revenue Service and Executive Office for U.S. Attorneys.

Survey Information on the Average Dollar Size of Transactions Processed for Retail Customers

The overall average dollar size of individual transactions processed for retail customers among firms responding to our survey was $22,000 for broker-dealers and $11,000 for mutual funds groups, as shown in table 11. The median, or middle value for the full range of responses, was substantially lower than the average for each of the two types of firms. The combined range of the average transactions varied widely—from $200 to $200,000.

Additional Information on Voluntary Anti- Money Laundering Measures From Surveys of Broker-Dealers and Mutual Fund Groups

For those broker-dealers that indicated that they had voluntary anti-money laundering measures in place, large broker-dealers tended to implement more of the anti-money laundering tools and processes than the medium- sized or small firms, as shown in figure 13. Implementation of the other types of voluntary anti-money laundering measures varied.

For those mutual fund groups that indicated they had voluntary anti-money laundering measures in place, large mutual funds reported implementing more of the various voluntary anti-money laundering measures, but medium-sized and small funds have also implemented many of the same measures (see fig. 14).

Additional Information on the Caribbean Financial Action Task Force

CFATF is the Caribbean basin counterpart of FATF that works to assist member governments in implementing anti-money laundering mechanisms. Its 25 members are countries and territories from the Caribbean, Central America, and South America. CFATF was created as the result of meetings held in the early 1990s by representatives of the Western Hemisphere countries to develop a common approach to combat the laundering of drug trafficking proceeds. In 1992, CFATF developed 19 recommendations on the basis of this common approach, which have specific relevance to the region and complement the 40 recommendations of FATF. Member governments have signed a memorandum of understanding, known as the Kingston Declaration on Money Laundering, which confirms their agreement to adopt and implement various internationally accepted standards and recommendations and CFATF’s 19 regionally focused recommendations. The CFATF Secretariat monitors members’ implementation of the Kingston Declaration through various mechanisms, including self-assessment questionnaires, mutual evaluations of anti-money laundering regimes, training technical assistance programs, and plenary and Ministerial meetings.

Laws Requiring Securities Firms to Report Suspicious Transactions in Some CFATF Jurisdictions Were Recently Enacted

According to CFATF officials, most CFATF jurisdictions that have organized securities exchanges require their securities firms to report suspicious transactions; however, almost all of these requirements were enacted recently. CFATF officials noted that 11 member jurisdictions (i.e., the Bahamas, Barbados, Bermuda, the Cayman Islands, Costa Rica, the Dominican Republic, Jamaica, Nicaragua, Panama, Trinidad and Tobago, and Venezuela) have at least 1 organized securities exchange. Eight of these members have enacted legislation requiring their securities firms to report suspicious transactions to relevant authorities (fig. 15).

CFATF officials noted that, with the exception of Panama, which has required its securities firms to report suspicious transactions since 1995, the remaining seven CFATF members with organized securities exchanges enacted such requirements only since 1998. The Bahamas and Trinidad and Tobago, for example, enacted anti-money laundering legislation in 2000 requiring, among other things, securities firms to report suspicious transactions to relevant authorities; Jamaica enacted similar legislation in 1999.

Implementation Efforts in Other CFATF Jurisdictions Have Been Criticized

Although CFATF officials indicated that most CFATF jurisdictions require their financial institutions to report suspicious transactions, U.S. and international anti-money laundering authorities have criticized legislation and implementation in some CFATF jurisdictions. Treasury documents based on the mutual evaluations of CFATF members’ activities indicate that anti-money laundering results in the region are very limited, noting that few cases of money laundering have actually been prosecuted or convicted. A June 2000 FATF report cited six CFATF jurisdictions as having significant deficiencies in their anti-money laundering systems and labeled them as “non-cooperative countries and territories.” In addition, during 2000, FinCEN issued a series of advisories to U.S. businesses describing deficiencies in the anti-money laundering systems of six CFATF jurisdictions, including three jurisdictions with organized securities exchanges. FinCEN reported in a July 2000 advisory, for example, that the Bahamas did not require its financial institutions to report suspicious activities and that, although the Cayman Islands did have this reporting requirement, it lacked any sanctions for financial institutions that failed to comply. FinCEN also criticized the effectiveness of Panama’s suspicious transaction reporting procedures that allowed the Office of the President of Panama to screen reports before referring them for investigation. However, in 2001, FATF removed the Bahamas, the Cayman Islands, and Panama from its list of noncooperative countries, noting that they had adequately addressed their deficiencies through legislative reforms and implementation efforts. FinCEN also retracted its advisories on the basis of the improvements made by these jurisdictions.

Securities Industry Viewed as Less Vulnerable Than Other Sectors of Caribbean Economies

Securities regulators with whom we spoke in Barbados and Trinidad and Tobago believed that the Caribbean securities markets would likely not be appealing to money launderers and other criminals because of their small size and low trading volumes. For example, compared with over 7,000 registered broker-dealers in the United States, regulatory officials stated that the Barbados stock exchange has only 17 member-brokers and the local securities market in Trinidad and Tobago has only 5 participating brokers. They also explained that trading activity in these markets is limited to 2 days a week in Barbados and 3 days a week in Trinidad and Tobago. Finally, regulatory officials believed that the small size of these markets would make it relatively easy to detect any unusual or suspicious activities.

Law enforcement officials and financial experts in the CFATF jurisdictions we visited considered other sectors of Caribbean economies more vulnerable to money laundering than the securities industry, citing, as an example, the increased use of local commercial businesses to launder money. Trinidad and Tobago law enforcement officials, for one, stated that they were aware of specific cases in which drug dealers invested in legitimate businesses such as supermarkets for the sole purpose of laundering illicit funds. Barbados authorities also stated that they were aware of money laundering through businesses engaged in the import or export of goods, sometimes involving high-volume, cash sales.

Comments From the Financial Crimes Enforcement Network

Comments From the Securities and Exchange Commission

GAO Contacts and Staff Acknowledgments

GAO Contacts

Acknowledgments

In addition to those named above, Evelyn E. Aquino, Emily R. Chalmers, Bradley D. Dubbs, Tonita W. Gilllich, May M. Lee, Christine J. Kuduk, Carl M. Ramirez, and Sindy R. Udell made key contributions to this report.

Related GAO Products

Money Laundering: Oversight of Suspicious Activity Reporting at Bank- Affiliated Broker-Dealers Ceased (GAO-01-474), Mar. 22, 2001.

Suspicious Banking Activities: Possible Money Laundering by U.S. Corporations for Russian Entities (GAO-01-120), Oct. 31, 2000.

Money Laundering: Observations on Private Banking and Related Oversight of Selected Offshore Jurisdictions (GAO-T-GGD-00-32), Nov. 9, 1999.

Private Banking: Raul Salinas, Citibank, and Alleged Money Laundering (GAO/T-OSI-00-3), Nov. 9, 1999.

Private Banking: Raul Salinas, Citibank, and Alleged Money Laundering (GAO/OSI-99-1), Oct. 30, 1998.

Money Laundering: Regulatory Oversight of Offshore Private Banking Activities (GAO/GGD-98-154), June 29, 1998.

Money Laundering: FinCEN’s Law Enforcement Support Role Is Evolving (GAO/GGD-98-117), June 19, 1998.

Money Laundering: FinCEN Needs to Better Manage Bank Secrecy Act Civil Penalties (GAO/GGD-98-108), June 15, 1998.

Money Laundering: FinCEN’s Law Enforcement Support, Regulatory, and International Roles (GAO/GGD-98-83), Apr. 1, 1998.

Money Laundering: FinCEN Needs to Better Communicate Regulatory Priorities and Timelines (GAO/GGD-98-18), Feb. 6, 1998.

Private Banking: Information on Private Banking and Its Vulnerability to Money Laundering (GAO/GGD-98-19R), Oct. 30, 1997.

Money Laundering: A Framework for Understanding U.S. Efforts Overseas (GAO/GGD-96-105), May 24, 1996.

Money Laundering: U.S. Efforts to Combat Money Laundering Overseas (GAO/T-GGD-96-84), Feb. 28, 1996.

Money Laundering: Stakeholders View Recordkeeping Requirements for Cashier’s Checks as Sufficient (GAO/GGD-95-189), July 25, 1995.

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