How to Launder Money with Precious Metals, 101

(Presented by Michael Riess at the 30^th Annual

International Precious Metals Institute Conference, June 13, 2006)

Laundering and organized crime are like the obverse and reverse of a coin; one can’t exist without the other.  Organized crime follows economic activity, and there’s no doubt we’re having a commodity boom.  So if past is prologue, you w;ill soon be hearing more and more about the criminal use of the commodities markets.  The three areas we will look at are the physical, futures and forward markets.

Physical Markets:

First, let’s talk about laundering in the physical metals markets. 

Most of you do not deal in cash.  That means you probably avoid the laundering stage called placement, where you introduce cash into the financial system.  It’s the most dangerous and exciting part, and if you’re a launderer for hire, it’s also the best paying.

You are more likely to be involved in layering.  That is where you move money and metal around over national borders and in other complicated ways to hide the criminal origin of the funds.  It is less dangerous than the placement stage, so it pays less. 

With the exception of drug trafficking, most money laundering is done directly by the people that commit a crime—not by specialized money launderers.  So if you knowingly hide the proceeds of a crime in your own company, you could be laundering.   And if you do get involved in laundering for someone else, chances are its drug money.

Laundering fees run from 5% to 25% with 10% being sort of a norm.  So, if your business is jewelry or an item with a large fabricating or fashion premium, chances are the loss you would incur if you had to melt it down is too big a risk compared to the laundering reward.  That is why, even though jewelers have been important in laundering, they generally get involved through fine metal, or scrap or investment items rather than through jewelry.   

Laundering is for evasion, so patterns tend to be complicated.   The more steps the better.  The precious metals part might only be a small portion of the total scheme. 

Here’s an example of a simple laundering mechanism:   A customer pays cash for scrap and brings it to you for refining.  You return fine gold and buy it, or he sells it to a third party.  He uses the proceeds to buy tax-free cigarettes in South Carolina, which he sells on the black market in New York.  He delivers the dollars to an underground moneychanger, whose Colombian counterpart delivers Pesos to the drug cartel in Colombia.   You’d get paid maybe 2% or 3% for the metals part. 

Sometimes, you can reduce risk by keeping your laundering off shore.  Here is an example we have all come to know.  The gold is fabricated into a product—such as .9999 Inca statuettes that look a lot like ingots.  By exporting a manufactured item, the Peruvians—or Colombians or Argentineans—get a tax break or collect a government incentive.  That lets them sell the gold at an attractive price.

But how does buying the gold make you a money launderer?    Aren’t you just the beneficiary of a good deal?  Where is the predicate or underlying crime? --- Just by way of background,  money laundering is a crime, but to be convicted of laundering, you have to commit an underlying or predicate crime, such as drug trafficking, fraud, theft or market manipulation.

If bribery of a foreign official is involved, you are violating the Foreign Corrupt Practices Act.  If you misstate the nature of the metal import, you will be committing U.S. customs fraud.  And if you discussed or wrote about the deal, there is mail or wire fraud.   Those are all predicate crimes for which you can be prosecuted under U.S. law.

Even if you are not directly liable under the U.S. law, our Government is likely to support the foreign Government if it requests extradition or asks for U.S. support in prosecuting you.  Even if your foreign enterprise is not a crime in the U.S., as long as it is an extraditable offense in the other country, the U.S. Government will probably cooperate.  If the situation were reversed, we would expect them to cooperate with us.

Some of you negotiate with senior government officials for metal supplies.  In laundering parlance, your counterparts are known as politically exposed persons, or PEP’s.[1]  The exposure part comes from questions about the government official’s revenue sources and about confusion as to whether assets belong to the government or to the official.   Here is another example of a trade you have probably heard of.  I do not know whether it involved laundering, but it is certainly a prototype laundering transaction. 

The Russian Central Bank deposited $3.5 billion of palladium in DeutscheBank and borrowed against the metal.  DeutscheBank advanced funds even though the Central bank was insolvent at the time.  The money was transferred out of the country and its whereabouts are unclear.  When the loan came due, the Russians defaulted. 

Laundering with “paper” or the commitments that represent precious metals, is far more effective than moving the physical metal.   So most of what you can do with physical material, you can do a lot better and easier through, say,  pool accounts.  These are real numbers involving Ronel’s experience:

You can see that, in a year and a half, the refinery went from refining 10 kilos a day of smuggled gold to turning 300 kilos of pool account gold.

Another popular paper device is over- and under-invoicing. 

You can move money abroad by under-invoicing exported metal.  Once it gets to the destination, the importer sells it for the real market value, moving the difference from one country to another.  Or, you can import at an overstated price with the same result.  One study claims $4.5 billion in precious metals and gemstones were laundered by over- and under-invoicing in 2004.[2] 

Futures Markets

Let’s move on to futures markets.

Launderers need to move money in a big-time way.  Futures markets are bigger and more liquid than physical markets, and they have a history of abuse.  Treasury and the enforcement agencies are focused on the physical precious metals markets, but they do not exempt futures or forward contracts.

The good news for launderers is that futures markets have characteristics ideal for laundering.  The bad news is that they’re closely regulated to avoid just that:

1. On a futures market, the commodity you use doesn’t make much difference.  That’s a big plus, because it lets a launderer move from the inactive markets to the active ones, where liquidity and volume offer better cover.
2. Futures markets are inherently respectable because they are backed by layers of Government-regulated brokers and exchanges.
3. Transactions are anonymous.  You never know from whom you bought or to whom you sold. The exchange, or more accurately the clearing house, becomes buyer to every seller and seller to every buyer.  Once you have bought and sold a futures contract, it disappears.  All you have left is the paperwork from a respectable, highly regulated financial institution. 
4. The volume of business is potentially infinite.  It takes only a buyer and a seller to make a futures contract, and there is no limit to the number of contracts.
5. And leverage:  you can control a commodity futures contract with a deposit of roughly 5% of its value, so for the same amount of money, laundering potential can be 20 times greater than with physical material.  

The economic purpose of a futures market is to transfer price risk between speculators and hedgers.  Futures have also been used in riskless transactions to shift metals positions and funds.        

The last time we had metal markets as active as today’s was in the late ‘70’s and early ‘80’s.   At that time, we had the phenomenon known as Tax Straddles.  You could roll your tax liability from one tax period to the next.  Or you could move trades from an account being taxed as income to one being taxed at the capital gain rate.  And that was just a step away from moving money from Company A, where you didn’t want the money, to Company B where you wanted it.   Today, we would call a lot of what went on “money laundering.”

The tax business is long gone, but at the core of the abuses are two structural questions that are still with us: 

1. How do you allocate trades? and
2. How do you move the money? 

Every commodity fund, commodity trading advisor and hedge fund has trades at a range of prices.  Every day, they are obliged to allocate trades to their discretionary and managed account customers reasonably and fairly.  In the U.S., the Commodity Futures Trading Commission and the National Futures Association audit how companies under their supervision allocate trades. 

But not everyone is under their supervision.  For instance, offshore hedge funds, futures funds or omnibus accounts might operate on U.S. exchanges.  If the CFTC detects irregularities in the carrying broker’s account, it can act against the broker but might not be able to reach the offshore entity.   And if a fund is willing to ignore the Investment Advisers Act reckoning that getting caught is an occupational hazard, the field is wide open.

If you find the U.S. markets too closely controlled, there are alternatives. *  There are futures markets all over the world.  For instance, the LME still has no rules against breaking spreads or assigning contracts, so if NYMEX makes the Company-A / Company-B switch difficult, you can always go to London.

Third-party money transfers are a problem for any financial institution.  If you combine money transfers with variation margin calls, you have a really powerful money laundering engine.   Those of you using the futures markets the last few months know that variation margin payments can be a real cash flow problem.  Launderers have no cash flow problems; they are cash flow machines.   So if you have offsetting positions in different brokerage firms and can transfer funds between them, variation margin calls are a great rationale to move money around the financial system.

Forward Markets:

Let me touch briefly on forward markets.

Forward markets have a great many similarities to futures markets.  You can use both to transfer price risk.  Liquidation can be by offset rather than delivery.  Leverage can be as high or higher in forward markets than in futures markets. And unlike futures markets, forward markets are not regulated.  On forward markets, if you have collusion, you can do pretty much whatever you want. 

A disadvantage to forward markets is that they operate principal-to-principal, so you lose the benefit of anonymity.  But with a little complicity, you can almost have that too.  

Here is an example:

Company A and Company B have the same beneficial owner.  Company A sells a forward silver contract to Refco.  Company B buys the same quantity of silver for the same delivery from Enron Trading.  Enron and Refco do a cross to hedge their risk.  The market goes down, B liquidates and pays its loss to Enron.  A liquidates and gets a credit with Refco.  Refco gives A a sugar contract or a cocoa contract engorged with A’s silver profits. 

By extending the chain of companies and commodities, you can use forward trades to layer into virtual invisibility.  The paper mounts up and the trail gets more difficult.  And if one of those companies can hide behind secrecy laws, the trail ends.

For those of you who don’t want to launder, and don’t want to be used by launderers and just plain want to stay out of trouble, here are some of the red flags I have touched on:

1. Does the deal seem unnecessarily complicated.
2. If you did the deal here, rather than abroad, would you be violating the law?
3. Are you dealing with a politically exposed person?
4. Is there an unusually large number of pool account or paper transactions?
5. Do invoices depart from market values?
6. Do goods in shipping documents differ from the actual goods shipped?
7. Are the trades riskless?
8. Are trades done on foreign markets when it’s sensible to do them domestically?
9. Are trade allocations suspect?
10. Are there third-party transfers to worrisome parties?

And most important, is the deal normal for our industry and for the customer?