Trade finance firms under pressure after stern warnings to improve financial crime controls

• United Kingdom

• Fraud and financial crime
• Litigation and dispute management

06-12-2021

The Financial Conduct Authority (“FCA”) has called on trade finance firms to fundamentally re-evaluate business-wide AML compliance arrangements, promising regulatory action for those who fail to improve. But it’s not clear that this sector has the knowledge, expertise and technological solutions to meet the regulator’s expectations. Zia Ullah, Steve Smith, Ruth Paley and Rory Brown take a look at recent developments in AML regulation of trade finance.

Introduction

Trade finance is a form of working capital finance, usually in the form of letters of credit (LOC), guarantees or insurance. It generally works on a confirmed order basis: when a purchase order arrives from a customer, trade finance enables the seller to buy the stock or inventory required to meet that order. The goods can be shipped as soon as possible, and the seller need not be out of pocket whilst waiting for the customer to pay.

Intermediaries such as banks and financial institutions facilitate these transactions by financing the trade. They provide services which are used by importers and exporters, bridging the financial gap between them, and in doing so, reducing risk and making it easier to trade. It's thought that up to 90% of global trade is reliant on trade financing.  

Trade finance services are critical to the world economy, but they are also increasingly coming under scrutiny from regulators across the globe, given the risk that trade finance can be used as a conduit for money laundering. It’s the financial institutions engaged in this activity to whom the FCA is directing its focus, with interest in this high-risk business only set to intensify over the next few months, set against a backdrop of the recent Dear CEO letter, and as changes to important industry guidance on managing the money laundering risks of this business come into force.

What are the risks associated with Trade Finance?

The Financial Action Task Force recently published a helpful list of trade-based money laundering risk factors, many of which are associated with trade finance, relevant to both the public and private sector. It also encouraged firms to cross-compare data, including on transactions, customs, market prices, due diligence information, and financing methods.

From a more general perspective, the factors which make this type of finance attractive to money launderers can be summarised as follows: 

• trade finance is cross-jurisdictional and the international element means it can be harder to apply oversight across the different geographical locations associated with the parties, counterparties, and the goods themselves – particularly as the goods move across the globe to their destination
• trade finance is complex, with multiple screening requirements which apply to many parties involved in the transaction, some of whom may change as the transaction proceeds (e.g. vessels, ports, and transport companies; all in addition to due diligence to be performed on the parties and financial institution counterparties). This creates a significant administrative burden
• in many countries trade finance is still largely a manual, paper-based activity. The lack of automation means that transaction monitoring solutions may not work as effectively and trends and suspicious activity may not be detected, especially where staff do not receive specialist training in the risks associated with this type of business
• it can be difficult to ascribe a fair value to the goods in transit, particularly as what’s considered a reasonable price may differ between jurisdictions
• trade finance is a high-volume business involving multiple parties from different jurisdictions, presenting money launderers with the opportunity to hide illegal activities behind a huge mass of transactional activity

In view of the potential for misuse, and noting a number of recent scandals involving trade finance including the Punjab National Bank fraud which involved extensive use of trade financing facilities, it’s perhaps unsurprising that the FCA has turned its attention to how UK financial institutions are managing the risks associated with this business line.

Dear CEO Letter

On 9 September 2021, the FCA and Prudential Regulation Authority (“PRA”) together published a ‘Dear CEO’ letter targeting trade finance firms’ credit risk analysis and financial crime controls.

The letter pulls no punches. Prompted into action following a series of less than satisfactory firm assessments and a number of recent high-profile failures of commodity and trade finance firms, the regulators make clear their purpose to “reiterate” expectations of firms operating in what they consider to be an inherently risky sector.

The letter outlines a long list of actions that firms should be taking, split across the four categories considered below.

Risk assessment

Front and centre of the letter is the call for firms to complete a financial crime risk assessment. According to the FCA and PRA, assessments reviewed to date are “too generic” to allow firms to understand the different types of risk exposure that exist in trade finance client relationships and often lack sufficient focus on the “identification and assessment” of financial crime risk factors.

A failure to understand these risks means that firms do not have the full picture when they take decisions to onboard clients and transact with other parties in the market. The regulators give the example of due diligence for individual trade finance transactions; without an accurate risk rating of the client and the proposed transaction, firms might choose to forego important enhanced due diligence measures (such as completing additional pricing checks and using independent document verification tools) in ignorance of the their true risk exposure.

Risk assessments also perform an important evidentiary function for firms, in that they show the regulators how they are following the risk-sensitive approach demanded of them. The regulators warn that, going forwards, they may ask to see firms’ risk assessments and the follow-up actions they have taken to mitigate the financial crime risks identified.

Counterparty analysis

The regulators also use the letter to restate their expectations on counterparty analysis. Firms must undertake credit analysis of all trade finance counterparts (not limited to the borrower and credit insurer) prior to credit limits being put in place. They should ensure that their policies and procedures set this requirement out clearly.

Much of what the FCA and PRA advise here is common sense. Counterparty checks are a useful way of answering some of the basic questions which firms should already be asking – to identify who the related parties are, the rationale of the transaction and whether this fits with their clients’ expected activities and any previous interactions with the parties to the transaction.

Transaction approval

The regulators also stipulate that firms must consider whether “further specific analysis” is required before approving a transaction. Again, firms should look at factors such as the rationale of the transaction and the financial and non-financial risks of end-buyers (i.e. borrowers) in order to assess risks and red flags. The letter urges firms to do this in a “more structured” way, which might be achieved through tighter and more clearly defined policies and procedures. It also queries whether the risk assessment work undertaken by firms’ first line business and operations functions in this regard is adequately monitored, suggesting that firms may wish to consider recording and scrutinising examples of discounted red flags and transaction approval rationales.

Transaction payments

Finally, the letter sets out the regulators’ “best practice” standards in relation to transaction payments. As above, many of the suggestions listed by the FCA and PRA are relatively obvious, such as ensuring that security is appropriately valued and maintained and correctly perfecting that security.

JMLSG Updates

Firms engaging in trade finance activity should also note the latest update from the Joint Money Laundering Steering Group, in which it revised its guidance for financial services firms who operate in this sector. This revision now sits with HM Treasury for approval. The latest version of the guidance, which disseminates good practice in respect of anti-money laundering and counter-terrorist financing, is accessible here. There are a number of key changes, which mark essential reading for firms operating in this area, including:

• useful additional information about factors to be taken into account when performing a firm-wide risk assessment including in correspondent relationships, non-customer third parties, commodities, and supply chains
• additional guidance on customer due diligence (“CDD”), including a table outlining the parties on whom CDD (or other due diligence) must be conducted, and further related information, as well as accompanying advice on due diligence for third parties
• a very detailed set of illustrative red flags covering customer, document, transaction, and shipment warning signs

We’ve produced a ‘compare’ document between the old and new guidance here for anyone interested in the fine detail of the changes.

Commentary

The FCA’s latest Dear CEO letter is undoubtedly a warning to firms conducting trade finance activity. The strong implication of the regulators throughout the letter is that these firms should already be taking these steps. It’s right that much of the criticism isn’t fresh, and accordingly, there’s some sense of impatience from the regulators here, and what is likely to be an increasing willingness to intervene to correct the “significant issues” observed in this sector to date.

The letter should serve as an important tool for those responsible for implementing the measures above (MLRO, MLCO, Head of Compliance), to be used as a lever to obtain full buy-in from senior leadership. In particular, firms will want to ensure that trade finance documentation is up-to-date including the following: 

• a risk appetite statement covering trade finance business;
• trade finance operating procedures; and
• recent audit documentation relevant to trade finance business.

Firms should also ensure that it’s possible to break down individual trade finance business figures, and that trade finance-specific management information (including revenues, high risk client and transaction numbers, and alerted transactions) are recorded and reviewed.

Whilst there’s no substitute for staff alertness, the sheer volume of transactional data generated by trade financing arrangements means that the use of automated tools is becoming more and more widespread in this sector. Firms will therefore want to consider whether they’re making the best use of technology to onboard and screen trade finance client activity. Automation can help in detecting wider trends, as well as off-key customer behaviour. There are also opportunities in managing information collected about the wide array of third parties upon whom due diligence must be collected and making sure it’s used to identify suspicious patterns or unusual features. Firms should ensure that whoever is calibrating these automated tools has an intimate understanding of the sector-specific risks that attach to this type of finance, and that decisions about parameter-setting for alerts can be justified with regard to the firm’s risk profile.