CFE Exam Quiz 53

Alternative remittance systems are largely regional. Each system has unique features and goes
by a certain name, including the following:

• Hawala (Middle East, North Africa, Horn of Africa)
• Hundi (Indian subcontinent)
• Fei chien (China)
• Poey kuan (Thailand)

After the rise in popularity of Bitcoin, many similar alternative digital currencies also began to appear. Many have different features, so the money laundering potential varies between them. Generally, digital currencies give parties the ability to:

• Send and accept payments from any user in the world with an Internet connection for little or no transaction fee.
• Send or accept payments without the need for any identifying information (other than the users’ randomly-generated “addresses”).
• Conduct transactions in unlimited volume (assuming funds are available).
• Conduct transactions anonymously (there are investigative techniques to identify parties to digital currency transactions, but a sophisticated user
  could make the process very difficult).
• Confirm transactions within minutes or less.

CLOSED-LOOP
Closed-loop prepaid systems are those where the user may only use the stored value to purchase items from the issuing organization or its affiliates, making them less versatile than open-loop items. Furthermore, closed-loop items generally may not be redeemed for cash, even at the issuing organization.

Shell Entities:
Money launderers often use shell entities to purchase real estate with illicit funds. Generally defined, shell entities are organizations without active business or significant assets, and they can take the form of limited liability companies, trusts, business trusts, corporations, and other legal entities. Because there is a lack of transparency in the formation of shell entities, money launderers often use them to hide the identity of the true owner, the source of the money, or the destination of the money.

The two methods most commonly used to hide assets or launder money through a front business are:

• Overstating reported revenues and expenses
• Depositing, but not recording, revenue

Using a Front Business to Launder Funds:

One of the most common methods of laundering funds is to filter the money through a seemingly legitimate business, otherwise known as a front business. A front business can be a very effective way to launder money for a number of reasons. Front businesses provide a safe place for organizing and managing criminal activity, where the comings and goings of large numbers of people will not arouse undue suspicion. In addition, a front that conducts legitimate business provides cover for delivery and transportation related to illegal activity. The expenses from illegal activity can be attributed to the legitimate enterprise, and the illegal revenues can be easily placed into the enterprise.

Placement:
Placement is the first stage of the money laundering process. In this stage, the launderer introduces his illegal profits into the financial system. It is at this stage that legislation has been developed to prevent launderers from depositing or converting large amounts of cash at financial institutions or taking cash out of the country.

There are many ways that criminals can launder funds, but the process itself is generally divided into three stages:

1. Placement
2. Layering
3. Integration

Insider Trading:

Insider trading occurs when an insider—someone who possesses inside information about security—buys or sells securities on the basis of material information about the security that is not available to the public. Inside information is any material, nonpublic information about a security that is not generally available to the public and that could affect the security’s price.

Examples of insider trading include:

• Corporate officers, directors, and employees who traded their corporation’s securities after learning of significant, confidential business developments
• Friends, business associates, and family members of corporate officers, directors, and employees who traded the corporation’s securities after learning of significant, confidential business developments
• Employees of law, banking, and accounting firms who were given inside information to provide services to the corporation whose securities they traded
• Government employees who traded a corporation’s securities after learning of inside information about the corporation because of their employment with the government

Market Manipulation

Market manipulation is a type of securities fraud consisting of a series of transactions designed to artificially raise or lower price or to give the appearance of trading activity for the purpose of inducing others to buy or sell. Market manipulation is especially common with penny stocks or micro-cap stocks. Penny stocks are low-priced (usually less than $5), speculative securities that are registered but do not meet the listing requirements of an exchange. Microcap stocks are the stocks of companies with very small market capitalization. In market manipulation schemes, the stock is sold to unsuspecting victims once the price has been artificially inflated.

To prove such a scheme, the fraud examiner will need to obtain and analyze all of the following items:

• The monthly brokerage recap of the salesman
• Copies of all order tickets written by the salesman for the time period in question (brokerages must keep the hard copies for several years)
• A copy of the telephone audio recording of the placement of the order and reported fill from the trading floor (all calls to the trading floor are recorded  and  archived)
• Copies of the “daily equity statements” provided to the salesman by the brokerage firm detailing account numbers, and account names.

Selling Away:

Selling away is a securities fraud scheme that occurs when an investment professional (e.g., a registered representative, stockbroker, or financial advisor) trades, or solicits the trade of, securities not held or offered by the brokerage firm with which he is affiliated.

Selling away violates rules that prohibit investment professionals from engaging in any private securities transactions that fall outside the scope of their employment unless they have obtained written consent from their employer.

International Swaps and Derivatives Association:

The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. The ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business.

International Council of Securities Associations

The International Council of Securities Associations (ICSA), which is an association of a wide range of financial market self-regulatory and trade associations, aims to:

• Aid and encourage the sound growth of the international capital market by promoting and encouraging harmonization and, where appropriate, mutual recognition in the procedures and regulation of that market.
• Promote mutual understanding and the exchange of information among ICSA members.

World Federation of Exchanges

The World Federation of Exchanges (WFE), formerly the Federation Internationale des Bourses de Valeurs (FIBV), is the trade association of regulated stock, futures, and options exchanges around the world. The WFE develops and promotes standards in markets, supporting reform in the regulation of OTC derivatives markets, international cooperation, and coordination among regulators.

MARKETS IN FINANCIAL INSTRUMENTS DIRECTIVE

The EU implemented the Markets in Financial Instruments Directive (MiFID) in 2007, which was intended to help integrate Europe’s national security markets. In Europe, the legal relationships between the parties in securities transactions have historically been a matter of private law—handled under the same principles that would remedy a contract dispute or tort. MiFID played a part in transitioning securities laws in Europe from the private to the public realm, meaning increased regulations and government oversight.

The powers of ESMA include:

• Drafting technical standards that are legally binding on EU members
• Resolving disputes between national securities authorities
• Prohibiting financial products that threaten financial stability
• Performing on-site inspections
• Monitoring systems risk of cross border financial institutions
• Supervising credit rating agencies
• Entering into administrative agreements with supervisory authorities

European Securities and Markets Authority

There has been a push in the European Union (EU) to protect investors and provide confidence for investments by promoting common goals for securities regulators. The European Securities and Markets Authority (ESMA) is a securities supervisory organization set up by the EU, and it is another product of efforts to remedy the financial oversight shortcomings that led to the economic crisis in 2008. The organization was created as an EU Authority on January 1, 2011.

International Capital Market Association

The International Capital Market Association (ICMA) is a self-regulatory organization for participants in the capital markets, but it has a European focus. The ICMA aims to promote high standards of market practice, appropriate regulation, trade support, education, and communication.

Principles for the Enforcement of Securities Regulation

• The regulator should have comprehensive inspection, investigation, and surveillance powers.
• The regulator should have comprehensive enforcement powers.
• The regulatory system should ensure an effective and credible use of inspection, investigation, surveillance, and enforcement powers and implementation of an effective compliance program.

IOSCO’s main objective is to assist its members to:

• Cooperate to promote high standards of regulation in order to maintain just, efficient, and sound markets.
• Exchange information on their respective experiences in order to promote the development of domestic markets.
• Unite their efforts to establish standards and an effective surveillance of international securities transactions.
• Provide mutual assistance to promote the integrity of the markets through a rigorous application of the standards and effective enforcement against offenses.

Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision (Basel Committee) provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.

The Basel Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements—statutory or otherwise—that are best suited to their own national systems. In this way, the committee encourages convergence toward common approaches and common standards without attempting detailed harmonization of member countries’ supervisory techniques.

Securities regulation serves several purposes, the primary one being to balance the legitimate needs of businesses to raise capital against the need to protect investors. Other purposes served by securities regulation include:

• Fostering an active and competitive market
• Maintaining market confidence- Reducing financial crime
• Protecting investors
• Discouraging behavior that might harm the market

Some red flags of improper hedge fund activities include:

• The fund’s manager is resistant to due diligence or is resistant to provide the information necessary to conduct due diligence.
• The fund’s manager is not willing to provide information upfront, including verification of employee date of births, Social Security numbers, employment history, education, professional licensing, professional credentials, corporate affiliations, and so on.
• The fund’s manager is not willing to provide a signed release to allow the investigator to perform thorough checks.
• The fund’s structure is not appropriate.
• The fund does not have verifiable and reputable independent service providers (e.g., independent accountants, attorneys, fund administrators, and prime brokers).
• The fund or its key employees have criminal records and civil litigation issues.
• There are misrepresentations (e.g., misrepresentations of education, employment history, or professional credentials).
• The fund has omitted significant background information (e.g., prior employment, employment terminations, or prior fund closures).
• The fund has experienced relevant or repeated regulatory issues.
• The fund lacks independent or experienced service providers.

Hedge Funds

In general, hedge funds refer to private pooled investment vehicles managed by advisors who generally have a very large financial interest in the funds based on a management fee that includes a percentage of the fund’s performance. Put differently, hedge funds pool investors’ money and invest it in financial instruments with the goal of earning a positive return.

Hedge funds employ various speculative and aggressive strategies. For example, they often combine traditional investments with short sales, leveraging, and arbitrage strategies to maximize returns. In addition, hedge funds are often complex and lack transparency, and they are not as heavily regulated as other types of funds.

There are various partnership forms, including general partnerships and limited partnerships. General partnerships are associations of two or more persons acting as co-owners in a business for profit. In a general partnership, each general partner can incur obligations on behalf of the partnership, and each partner assumes unlimited liability for the partnership’s debts. Thus, a general partner has unlimited personal liability. Also, in a general partnership, the partners take an active role in the operation of the business (i.e., they have management responsibilities).

Typically, however, general partnerships are not considered securities because the profits derived from such structures are generated from the efforts of the investors, not from the efforts of others. Thus, because the partners take an active role in the operations of general partnerships, these arrangements do not qualify as securities.

Viatical

Insurance companies have historically offered policies with an accelerated death benefit option. This option allows the insured to receive up to 80 percent of the death benefit or face value of the policy within the last year of the insured’s projected life. The remaining 20 percent is paid upon death to the insured’s estate.

OVER-THE-COUNTER OPTIONS

Again, options can be traded over-the-counter. A security that does not trade on a major exchange is said to trade over-the-counter (OTC). Unlike the floor trading in physical exchanges, OTC trading is conducted electronically, through direct contact with a market maker, or through communication among professional buyers and sellers. Banks, large brokerage firms, insurance companies, and many other businesses are active in the OTC options markets.

The main difference between options contracts and futures contracts is that options confer rights and impose obligations, whereas futures impose obligations. More specifically, an option contract confers a right—not an obligation—to the option buyer to take delivery of (i.e., buy) the underlying asset and imposes obligations on the option seller. Futures impose obligations on both the buyer and the seller to either make or take physical delivery of the commodity or to agree to cash settlement at contract expiration.

TRADING ON MARGIN

Futures are traded on margin, which is the initial amount of money that is invested by both buyers and sellers of futures contracts to ensure performance on the terms of the contract (the making or taking delivery of the commodity or the cancellation of the contract by a subsequent offsetting trade). A margin in futures is not a down payment, as in the securities, but rather a performance bond. A buyer puts up an initial margin at the time a futures market contact is established to act as security for a guarantee of contract fulfillment. Only a small percentage, usually about 5 percent of the contract’s notional value, is required to establish a position (long or short) in a futures market (notional value is the contract size in units multiplied by the price per unit).