Fintech adoption impedes terror financing and increases counterterror tracking abilities

The Cross-Border Payment System Is a Stumbling Block for Both Financial Inclusion and Combatting Money Laundering and Terrorist Financing.

Policy makers across the world have devoted years of effort and study to two high priority goals: improving financial access and combating money launderers and terrorists. While inroads have been made in both areas, progress remains unacceptably slow, especially in the area of cross-border payments.

The current system for global funds transfers is based on old and outdated technology, employed primarily by a shrinking network of correspondent banks.6 Payments moving through the correspondent banking system are handled by multiple intermediaries, most of which are unaware of the identity of the others. Indeed, the path a cross-border payment will take as it moves around the globe is usually not known to any of the participants in advance. The opacity and uncertainty inherent in such a system provides myriad opportunities for undetected operational failures or intentional manipulation. Many significant AML/CFT prosecutions and enforcement actions of the past 10 years have arisen out of conduct designed to obscure identifying information as a payment moved through the payment chain.7 The costs inherent in operating a system of this operational complexity and opacity present huge challenges for making services like remittances more affordable for underserved populations. The high risk inherent in the market as it currently functions renders it unattractive to potential providers who are more risk-averse. The lack of competition further contributes to the high costs of remittances.

Risk-Based Approach and De-Risking Responses

The correspondent banking system has been deeply affected by both rising compliance expectations and industries’ continuing dependence on aging payments technology. Increasingly since the 1970s, and accelerating after 9/11, policy makers and those in law enforcement have insisted that banks better understand the nature, source and destination of payments moving through their accounts, including the true sender and recipient of the funds involved.

While such an expectation may be quite sound, it can be difficult and expensive for a bank in the correspondent network to determine the nature of the funds it is passing on to another participant bank. Because the system relies on a network of global banks to move funds on behalf of others, a participant bank often has no direct relationship with either the customer sending or receiving a particular payment. Since many banks have been reluctant to take on the expense of upgrading their international payments infrastructure, most of which dates from the 1980s or earlier, granular analysis of payments data generally involves multiple manual processes, making detailed inquiries cumbersome, costly, and insufficiently effective at catching bad actors.

In terms of the current system, banks place heavy reliance on the risk management abilities of correspondents in the banking remittance network. Increasing sensitivity to the risks of correspondents that may not be able to mitigate the relevant risks to the standards required by the bank have led to the practice of correspondent “de-risking.” De-risking refers to the large-scale practice of banks terminating relationships with counterparties and classes of customers, and even exiting entire countries or regions in an effort to limit compliance risk and its attendant costs. The de-risking phenomenon has to be viewed in the context of the mandatory risk-based approach to AML/CFT.

Concerns about the need to limit and direct compliance spending led to the adoption of a mandatory risk-based approach to AML/CFT by the Financial Action Task Force (FATF) in 2012. This approach was intended to shift compliance resources to higher risk areas and, simultaneously, to increase financial inclusion8 of lower risk customers. Costs and barriers to inclusion could be limited by creating exemptions from the AML/CFT regime where risks were assessed as low and by allowing simplified due diligence where risks were lower, for example in relation to small value payments in jurisdictions with low crime and minimal terrorist financing risks.

Regulators and financial institutions in developing countries have been cautious to make use of the space to simplify due diligence,9 especially as they are hesitant to run afoul of international assessors of compliance with the FATF standards. Important steps have nevertheless been taken by countries such as India, Pakistan, Nigeria and Uganda to simplify AML/CFT due diligence in lower risk cases.10 Such steps are, however, largely confined to domestic financial services. Little has yet been done to move forward on simplifying or improving due diligence in relation to cross-border remittances as that requires an alignment between the risk assessments and risk approaches of the relevant national regulators and their foreign counterparts.

The increased focus on risk, combined regulatory uncertainty, with very large fines for non-compliance levied in the US and UK, and concerns about profitability of business lines, have led to a post-2012 cycle of de-risking.11 The Committee on Payments and Market Infrastructure (CPMI) summarized this cycle as follows: “increasing costs, regulatory pressure and an increased perception of risk are reducing the profit mar- gins associated with this activity in some countries and/or with some customers and could be making [cross-border payment services] increasingly unappealing to a growing number of correspondent banks.”12 In the same report, the CPMI noted that the “threat that cross-border payment networks might fragment and that the range of available options for these transactions could narrow” is real and growing.13

As part of the current cycle financial institutions began employing risk-based principles to re-examine customer relationships, asking whether particular customers generate sufficient income to justify additional compliance investments. Firms undertaking this analysis increasingly have chosen to terminate or restrict business relationships with remittance companies and smaller local banks in certain regions of the world. Those most vulnerable in the de-risking cycle are the low margin customers, not necessarily high- risk, high-value customers. This is because risky customers that generate substantial fees often prove more attractive than less profitable customers with lower risk, even when the high-risk customers require expensive monitoring.14

Frustratingly for policy makers, therefore, the victims of de-risking cycles are disproportionately lower income migrant workers attempting to send money to family members in their home countries, as opposed to higher-risk potential bad actors who launder money or finance terror.

Concerned about de-risking, FATF and national regulators issued statements calling on banks not to engage in large-scale de-risking terminations. The Financial Stability Board is also working jointly with the World Bank, the CPMI and FATF on a four-point plan to (i) deepen their understanding of the extent and impact of these terminations, (ii) provide increased regulatory clarity, (iii) support AML/CTF capacity building in affected low capacity countries, and (iv) harness technology to improve customer due diligence measures of correspondent and respondent banks. While these objectives are sound, no compelling evi- dence has yet emerged that these measures have reversed the de-risking cycle.

Current Pressures May Be Making an Opaque System Worse

Notwithstanding the toll that AML/CFT-related de-risking has taken on those seeking to access the global financial system for legitimate purposes, the current system of cross-border payments continues effectively to provide cover for bad actors who benefit from its inherent lack of transparency. Moreover, recent de-risking cycles may have the effect of increasing barriers to detection of money laundering and terrorist financing. The Global Center on Cooperative Security found that “[r]ather than reducing risk in the global financial sector, de-risking actually contributes to increased vulnerability by pushing high-risk clients to smaller financial institutions that may lack adequate AML/CFT capacity, or even out of the formal financial sector altogether.”15

Technological Innovation Holds Promise for Risk Reduction and Greater Inclusion, But Faces Regulatory Barriers to Adoption

The Promise of FinTech Innovation

Solutions to these problems are being developed. As the International Monetary Fund recently reported, “[t]he area of cross-border payments is especially ripe for change, and could benefit from new technologies.”16 Technological advances with the potential to lower radically the costs and risks associated with cross-border payments are developing at a furious pace.

A number of new innovations directly address well-known cross-border payment risks. One such risk, the danger that a payment will fail on its way through the correspondent banking network (sometimes referred to as Herstatt risk) can be eliminated by technologies that enable direct, point-to-point settlement of cross border payments.17 Addressing this risk in turn obviates the need for many operational processes embedded in the current cross-border payment system, all of which raise the cost and slow the pace of inter- national payments.

Reducing cost and time of international payments has the potential to vastly invigorate financial inclusion efforts. To date, many such efforts have sought to move forward primarily on a charitable basis, meaning that they are often unsustainable without substantial ongoing outside funding. Changing the cost structure for payments via increased automation can transform those who are financially excluded into potentially valuable customers for new financial products and services. Indeed, after exploring a number of alter- natives, the Gates Foundation’s Financial Services for the Poor initiative concluded that “the most effective way to significantly expand poor people’s access to formal financial services is through digital means.”18

FinTech innovation also offers the promise of improved transparency and security in cross-border payments. Greater automation of the cross-border payments process itself offers significant benefits in this area, as more and better automation could simplify the payments path

, bypassing the current correspondent banking system. Doing so could greatly reduce the number of manual steps necessary to effect a cross-border payment, and the consequent opportunity for error or illegality to occur.

Innovations such as portable digital identity offer additional promise for both lowering the cost of delivering financial services and improving financial transparency.19 While several portable digital identity frameworks have been articulated, and quite a number of digital identity products and services are in development, most share the following characteristics: identity details are collected only once and held or controlled by the individual to whom they relate, enabling that person to share identity details with various entities as needed to obtain financial services.20 This system stands in contrast with current practice, where identity details must be gathered separately by each service provider, which then holds the data for all of its customers, a repetitive and expensive process, and one that provides a convenient attack point for nefarious actors seeking to steal financial data.

Under the current cross-border payments regime, payment traceability is constrained because customer information is held at individual financial institutions. Thus, when payments move through multiple institutions, it can be difficult or impossible to connect an ongoing payment with its true origin, or with the identity information of the original sender or ultimate recipient. At the same time, the fact that personal information is held and replicated at multiple financial institutions increases the opportunity for security breaches and data theft. Identity portability offers the possibility that payments information could be traced globally, rather than remaining confined within silos managed by financial institutions.

FinTech also offers the benefit of more effective collaboration between financial institutions and law enforcement agencies. Money laundering and terrorist financing risks are in essence national security and law enforcement risks. The correct identification, assessment and management of these risks are heavily dependent on sensitive intelligence that governments generally do not share with financial institutions. Financial institutions therefore find it particularly difficult to combat money laundering and terrorist financing efficiently. New technology, especially new data technology, provides platforms for secure and meaningful public-private collaboration in this regard, while preserving privacy and commercial confidentiality.21