Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations: Our comments!

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Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations: Our comments!

The much-discussed Patriot Act, that was recently-passed with little debate, has been the nexus for many new rules and regulations promulgated by Treasury, and forced upon the banking, securities, and financial community in general. The financial community members are called Gate Keepers. Gate Keepers is a term of art that is being applied to anyone one or any profession that can facilitate the laundering of money or assets, to enable the conversion and ultimate inclusion of the assents in legitimate financial circles.

On the surface it makes sense, and is, in fact, a laudable goal: Secure the U.S.financial system from the use of terrorists, drug dealers and financial criminals. Unfortunately, all of the terrorist funds used in the September 11th 2001 attack not only complied with the rules at the time they were brought in, but would have been compliant with the new rules, so these new rules certainly would not have stopped the financing of the attack. This is no surprise, since most drug dealers and financial criminals use front companies that, in essence, appear legitimate.

The new Know Your Customer rules provide that the Gate Keepers need to be aware of a client company’s business and have some knowledge of this business. If they fail in this process, most of the Gate Keepers are threatened with jail time or worse: Punish the bankers not the criminals. The requirement for KYC is simple: Gather some basic facts. Most of the basic fact gathering is going to be passive in nature. A passive gathering of identification documents, corporation documents, maybe a business permit, or a brochure or two (only in rare cases will the cost of active due diligence appear cost-effective). Then, if the business is different from a supposed model of business, the Gate Keeper is required to report the anomaly in a Suspicious Activity Report (SAR) to the government. The problem is, what does a bank know about your business? Heck, what do they know about any of the businesses with which they deal? You get the point – a lot of useless SARs are going to be filed. But wait! The government has thought of that too: The Gate Keeper can get in trouble if they file SARs that are a waste of the government’s time (the Failure-of-the-Crystal-Ball penalty).

The end result is that stupid rules are being drafted by the Gate Keepers to comply with the new rules. Bankers, who used to make a pretense of being there for their clients, are now deputized by the government to report on their clients. The rules have forced the banks to move from attempting to be accommodating to punishing you for “banking outside the lines.” The brokerage community has no idea how this is going to hit them. Merrill Lynch estimates it will cost about 30 cents for each new customer. Heck, it will cost them $10.00 just to reprint the forms and collect all of the new required documents.

In extremely short summary, Gate Keepers have to scrub their clients through the OFAC list, and other unspecified databases to ensure the fidelity of the financial system. Initial due diligence, (passive), extra due diligence (responsive to the passive documents), and active due diligence (actually looking for 3rd party information) are the new de rigueur standard of the financial community.

Accounts that were opened in a few hours may now take days. The result of this is a slowing down of the economy and a new disincentive to bank or invest in the U.S. One client, a mutual fund registered in the Cayman Islands, with billions under management, told its broker inNew Yorkof some 12 years to “Go to Hell” when the broker required that due diligence documentation be provided on all of the tens of thousands of owners of the mutual fund to meet the AML KYC requirement. The fund’s account was closed and moved to a British brokerage firm, where it was easier to buy U.S. T-Bills than it is in the U.S.

All of this comes under the heading of stupid security tricks. In personal conversation with many of those behind the legislation, they fully admit that most of the new rules and regulations are about “butting up the U.S. Economy” in an effort to secure additional revenue through taxation. The actual effect is that we now have to fill out forms to get 100 bills; it takes three days to open a business checking account, and some businesses that used to use the U.S.as a financial haven (the U.S.is the largest offshore financial center in the world for non-U.S. residents) have pulled their funds from theU.S.and placed them elsewhere.

It much like an article in The Onion which said, “FAA bans all passenger from aircraft under the assumption (and it is a correct one) that the real security threat is passengers, and that if passengers are eliminated all of the security problems should be abated.” Like curing the common cold by killing all of those who sneeze. While it is both necessary and possible to attack the dual problems of money laundering and financial fraud, clearly, whoever drafted these regulations did not ask:

1. What problem is the measure trying to solve?

2. How can it fail in practice?

3. Given the failure modes, how well does it solve the problem?

4. What are the costs, both financial and social, associated with it?

5. Given the effectiveness and costs, is the measure worth it?

Since that didn’t happen, all in all the likelihood of success looks pretty dim. We will keep you posted on stupid due diligence tricks as this progresses.

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