The tricks of trade-based money laundering

A US-based short seller with no pretensions of public interest brought the Indian markets to a crash with allegations against a major conglomerate. Everybody from the Supreme Court to Parliament to the regulators are currently seized of the matter. Many terms — circular trading, round-tripping, trade-based money laundering (TBML) — of a lexicon previously restricted to financial investigators are rolling down the tongues of ordinary citizens and occupying newspaper space. So, what really do these terms mean? What are their implications? And how do we address these problems?

The UN Convention Against Illicit Traffic in Narcotic Drugs & Psychotropic Substances, 1988, was the first such document that recognised the problem of money laundering as a critical cog in drug trafficking. It highlighted the need to “arrest the attempt to convert or transfer property which are the proceeds of crime”. As any investigator would tell you, follow the money trail to get to the crime and the criminal — and if you drain the money pool, you can also tackle the crime itself.

It was recognised that the proceeds of crime need not necessarily be generated only from narcotics. The next big step in the fight was the establishment of the Financial Action Task Force (FATF) in 1989. The FATF has issued 40 recommendations designed to target the proceeds of all kinds of crime. This was a clear recognition of the fact that “the primary motivation in committing crime is to make money” and that “money laundering is accordingly a feature of many types of crime”.

The FATF has defined money laundering as the processing of criminal proceeds to disguise their illegal origins and to legitimise the ill-gotten gains from crime. The World Economic Forum has estimated the size of the illicit market at about $2.2 trillion, or about 3 per cent of the world’s GDP. In the context of India, economist Prof Arun Kumar, who has done extensive work on the subject, has estimated that the illicit economy is about 62 per cent of GDP (at 2016-17 prices) -- about Rs 93 lakh crore. And this money, which is outside the tax net – ‘black money’—is of little use to the exchequer and the national economy. Not all proceeds need be laundered —it can be used for financing other criminal activities also, where cash is king. But a good amount does need to be laundered. To escape the clutches of the tax administrators, the next step of disguising criminal proceeds commences; or, in other words, the process of laundering the proceeds of crime, to cleanse the money, to convert it from ‘black’ to ‘white’.

The first step is to ‘place’ the money into the financial system by using various techniques. The next step is to ‘layer’ it -- conceal the criminal origins of the proceeds. Then comes the critical step of ‘integration’ —creating an apparent legal origin for the proceeds. Laundering has become increasingly sophisticated—from the use of cryptocurrencies to creation of offshore accounts to the use of professional enablers and intermediaries. And where trade is used as the means of laundering, we enter the world of TBML.

Trade-based money laundering is the process of disguising the proceeds of crime and moving value using trade transactions to legitimise their illicit origins. With volumes of trade dramatically increasing (UNCTAD estimates trade levels have crossed $28 trillion), this is becoming easier. This is possible by misrepresentation of price, quantity, or quality of imports and exports. What this means is that the price of the goods or services is mis-declared to transfer additional value between the importer and exporter.

By invoicing the good or service at a price below the correct price, the exporter can transfer value to the importer. The payment obviously will be lower; however, the remaining value is retained abroad. By invoicing the good or service at a price above the correct value, the exporter can receive higher payment than what is due. The methodology works for both imports and exports. In either case, trade becomes a means of transferring or receiving money over and above the actual value.

A key element in all such transactions is that there necessarily must be a nexus between the exporter and importer. Further, invariably, both the exporter and importer are controlled by the same entity. Again invariably, the exporter or importer is located in a tax haven; the conduit of trade is also one such ‘friendly’ location. There is a strong possibility of corruption, too -- of collusion between the importer/exporter and government officials.

Every over-invoicing and under-invoicing of exports and imports has significant tax implications. When overvaluation of exports takes place, undoubtedly more foreign exchange is earned, which is nothing but laundered proceeds. However, significantly, the exporter also gets additional export incentives which governments extend to genuine exporters. Similarly, an importer who undervalues pays lesser import duties. The settlement takes place by either under-valuation of exports or over-valuation of imports. Over-invoicing of imports could result in more duty being paid, but the larger purpose of over-invoicing is to transfer funds.

When this money makes its way back to the origin country in the form of investments or proceeds of trade, you have what is called ‘round-tripping’. Circular trading occurs when the
same goods go back and forth, the purpose being to manipulate prices and transfer funds, a phenomenon noticed in India most commonly in the context of diamonds.

Trade-based money laundering avoids the vulnerabilities of hawala transactions and is thus more challenging to detect. Peeling off the veneer of legitimate trade calls for coordinated action between multiple agencies -- in the context of India, this would mean, the Customs, the Enforcement Directorate, the Financial Intelligence Unit, the Income Tax authorities, the market regulator SEBI, and the Central Bureau of Investigation. Unfortunately, such coordinated response does not always happen.

(The writer is a former chairman of the Central Board of Indirect Taxes & Customs.)