The USA Patriot Act has securities and investment firms scrambling to evaluate systems and figure out exactly what they must do to comply with the new anti-money laundering and terrorist-financing regulations.
Although pink slips are rapidly being delivered at most Wall Street firms, there is one post that is in high demand --- that of the anti-money-laundering chief. Every financial institution is on the look out for one, and a good one, as they will be critical in helping financial-services firms avoid potential fines, jail time, or, worse, putting their firm's reputation at risk.
Naming an anti-money laundering (AML) watchdog is one of the initial requirements mandated by the USA Patriot Act. Since October, when the Act was signed by President Bush, securities and investment firms have been scrambling to figure out what they need to do to comply. Although there are very few cases where money laundering has actually been conducted through a securities or investment firm, (most occur at banks), this is one time new regulations are not causing the industry to grumble. Mirroring the industry sentiment, Merrill Lynch Chief Technology Officer John McKinley, says, "I am proud to be a patriot and I think it is our duty to comply." That is because the act was created shortly after Sept. 11 as a means to ensure that the U.S.-securities industry would not be used to harbor terrorist dollars or as a place to launder money.
THE FIRST FOUR REQUIREMENTS
As of April 24 all financial institutions, including broker/dealers, futures-commission merchants, investment companies, domestic banks and domestic operations of foreign banks, were mandated to comply with an initial four requirements. First, they must designate a compliance officer to spearhead the firm's AML program. Next, they have to create internal AML policies and procedures, as well as institute an ongoing training program. Lastly they are expected to create an independent-audit process to test their procedures.
Creating a workable plan is no small feat. Just ask Stephen Shine, senior vice president and senior counsel, Prudential Securities. Although the Patriot Act imposes the first rules mandating that securities firms institute AML policies, his firm started a program eight years ago of its own accord. And although the broker/dealer has a solid plan and system in place, Shine notes that his firm is always on the look out for new systems or processes that can enhance its program.
Prudential is not alone. Surprisingly 20 percent of securities firms had started programs before the Sept. 11 tragedy, according to a U.S. General Accounting Office study. These include such firms as Prudential, Merrill Lynch and Morgan Stanley. Despite having a jump start, they all have work to do in order to ensure that they are compliant with the U.S. Treasury Department's new rules. Many of the firms that have started followed the lead of their sister banking institutions, which have been regulated by Treasury's Bank Secrecy Act since 1970.
As for the other 80 percent who have not yet begun, they have a more arduous road ahead. The investment is sizable. Larry Tabb, vice president of securities and investment practice at TowerGroup, estimates the cost to run at least $5 million for larger firms. And he adds, "I think it will go upwards to $10 to $20 million."
This 80 percent is where the majority of the smaller firms reside. Due to time constraints, these small investment companies have three choices: they can contract with a service bureau, bring a vendor solution in-house or obtain assistance from their correspondent clearer to help the firm internally track transactions and report suspicious activity to Treasury. It is very unlikely that they would build a system, notes Tabb. He believes the smaller firms will opt for assistance from their clearing firm. "They will look to the Pershings to help them out," he suggests.
As for the larger firms, that is open to debate. Prudential, for example, has essentially developed a system in-house. Although the broker/dealer based its AML technology on a Thomson system, it has customized and enhanced it so much over the years that it has essentially become a proprietary system. For years, many institutions have been incorporating AML detection into their compliance systems, as a result Shine believes most large firms will enhance existing systems, much like Prudential. "Our systems are more than adequate right now to handle the problem," though, he does admit, Prudential will be open minded. "We've had pretty good success in developing our own, but we are looking at what is out there. Clearly we want to remain cutting edge on this stuff," he adds.
Shine emphasizes the importance of having a strong team in place, suggesting it requires about six to 10 people. He cautions, "You've always got smart people out there with a lot of money at stake who are trying to find holes and get money into the financial system, but we also have some pretty smart people on our end who are trying to stop that from happening."
Merrill Lynch is taking a different approach. The broker/dealer already uses an off-the-shelf solution from Fairfax, Va.-based Mantas in one department, and is reviewing both Mantas and London-based Searchspace for other areas of the institution. Merrill has swiftly transitioned from a build shop to one that favors buying. "I want best in class," McKinley says, "I think the two players that I mentioned represent the best-in-class answer here. They are better than spoke solutions."
Despite their different approaches, both agree for those who are just beginning to tackle this issue, building a system is not the answer. At this point, the last thing that an institution can afford is a long development project. "As you move forward and the revenue models become more and more constrained, more and more firms are going to be outsourcing and using vendor-based software. You can't afford to have these development projects that don't go anywhere," Tabb points out.
THE VENDORS As can be expected, there are numerous vendors jumping into the fray to take advantage of the new opportunity. Some of them had catered to the banking industry prior to the Patriot Act and are tweaking their systems for the securities industry. Others had systems that focused on insider trading or fraud detection, which had tracking mechanisms similar to those needed to monitor AML and terrorist-financing activity. Industry experts suggest that currently the two dominant vendors in this space are Mantas and Searchspace.
The AML systems on the market are designed to develop historical patterns for each client so that the system can recognize the client's normal trading patterns. When activity occurs that is an exception to the norm, it will kick the transaction to a compliance officer who can review it further. "The core of this technology is experiencial. A trade only looks suspicious relative to past transactions that you have told it are not suspicious. Loading the appropriate historical database is the art form here," notes Mark Greene, global GM of banking at IBM, which has recently formed an alliance with Searchspace. He adds, "This is what Searchspace knows how to do well."
Searchspace ( www.searchspace.com) has been in the market since 1993 focusing on money-laundering detection, check fraud, operational risk, insider dealing and best-execution monitoring, among other things. Within the last two years it has begun to focus on AML for brokerage firms - some of its clients include Royal Bank of Scotland, London Stock Exchange and Archipelago. Currently Searchspace is available as an in-house solution, however it is expected that it will be available as a service-bureau as well.
The other major player, Mantas (www.Mantas.com), touts itself as "using advanced knowledge-discovery technology, developed with banking and brokerage experts." It, like Searchspace, has a platform that collects and analyzes transaction data, then highlights and disseminates relevant information. One of Mantas' newest customers is Charles Schwab. The goal of both systems is to help the end user better understand a client's behavior.
Two years ago, Mantas hired Don Temple, a special agent from the Internal Revenue Service, who ran a financial-investigative task force, investigating money-laundering activities. Temple uses his expertise to help Mantas keep up with changing regulations and track new ways money launderers are getting around the law.
Temple suggests the financial-services firms look at the long term when buying a system. "I don't think that financial institutions should look at a software solution as just an outlay of cash ... There is cost, but (software) diminishes the cost of fines and penalties and with that comes the devaluation of the brand name, with that also comes horrendous consulting fees." More importantly, he says, "You can leverage the data for positive purposes to provide services to your customers that they didn't realize were available."
Merrill's McKinley agrees. He emphasizes the wealth of knowledge that an institution can glean from a good system. "Having a world-class AML infrastructure will be incredibly powerful in terms of mining your own customer base for other value added things." He points to three uses which all boil down to better customer service: life-events detection, attrition analysis and householding.
A system will highlight customer patterns that might point to life events, such as a child going to college or a death in the family. "When you detect aberrant behavior, it is an opportunity to know your customer and the ability to act more timely on life events," McKinley notes. He adds that attrition analysis - finding indicators of behavioral changes that ultimately could lead to the loss of customers - can help an institution be more proactive in retaining clients. Lastly, the tracking mechanisms will allow a firm to better understand relationships by detecting money flows between households. McKinley notes that some systems, such as Mantas, are able to show you strong financial affinities between accounts that you may not have known about, which, again, may allow you to better understand your customer. "Having a solid infrastructure will have significant value beyond the near-term issues," he notes.
With this vision in mind, understanding a systems' scalability before making a purchase should not be underestimated. "We have to make sure it scales for our day-one needs, as well as for our day-100, day-300 needs (and beyond). Scale represents the bolder view of where we want to take this ... it will be part of our overall selection criteria."
Tabb agrees that an AML infrastructure can do more than ward off and catch money launderers. He believes having a good system in place can help create a straight--through-processing environment. "A large portion of the project will be about integrating your transactional-processing system - you will have to tap into all of these systems. The extent that you are automated improves your STP capability." Customer-relationship management, STP, householding and wealth management are all areas that will benefit from leveraging a good AML system, whether homegrown or vendor-based.