Bank Secrecy Act |
Trade Finance Activities—Overview
Objective. Assess the adequacy of the bank’s systems to manage the risks associated with trade finance activities, and management’s ability to implement effective due diligence, monitoring, and reporting systems.
Trade finance typically involves short-term financing to facilitate the import and export of goods. These operations can involve payment if documentary requirements are met (e.g., letter of credit), or may instead involve payment if the original obligor defaults on the commercial terms of the transactions (e.g., guarantees or standby letters of credit). In both cases, a bank’s involvement in trade finance minimizes payment risk to importers and exporters. The nature of trade finance activities, however, requires the active involvement of multiple parties on both sides of the transaction. In addition to the basic exporter or importer relationship at the center of any particular trade activity, relationships may exist between the exporter and its suppliers and between the importer and its customers. Both the exporter and importer may also have other banking relationships. Furthermore, many other intermediary financial and nonfinancial institutions may provide conduits and services to expedite the underlying documents and payment flows associated with trade transactions.
In transactions that are covered by letters of credit, participants can take the following roles:
- Applicant. The buyer or party who requests the issuance of a letter of credit.
- Issuing Bank. Issues the letter of credit on behalf of the Applicant and forwards it to the Advising Bank for notification to the Beneficiary. The Applicant is the Issuing Bank’s customer.
- Confirming Bank. Typically in the country of the Beneficiary, at the request of the Issuing Bank, joins the Issuing Bank in honoring draws made by the Beneficiary, provided the terms and conditions of the letter of credit are met.
- Advising Bank. Branch or correspondent bank near the Beneficiary’s domicile, to which the Issuing Bank sends the letter of credit or notification of its issuance, with instructions to notify the Beneficiary. The Advising Bank advises the Beneficiary without taking other active engagement in the letter of credit.
- Beneficiary (Drawer). The seller or party to whom the letter of credit is addressed.
- Negotiating Bank. Usually the Beneficiary’s bank. Agrees to purchase the draft and pay the Beneficiary after satisfying itself that documentary requirements have been met.
- Accepting Bank. Incurs a legal obligation to pay the draft at maturity. Drafts are drawn on the Accepting Bank that dates and signs the instrument.
- Discounting Bank. Discounts a draft for the Beneficiary after it has been accepted by an Accepting Bank.
- Reimbursing Bank. Authorized by the Issuing Bank to reimburse the Drawee Bank submitting claims under the letter credit.
- Paying (Drawee) Bank. As named in the letter of credit, the bank where drafts are to be paid. The Paying Bank is typically the Issuing Bank, but is often a branch or correspondent of the Issuing Bank. Once paid or accepted by the Paying or Drawee Bank, there is no recourse to the drawers.
As an example, in a letter of credit arrangement, a bank can serve as the Issuing Bank, allowing its customer (the buyer) to purchase goods locally or internationally, or the bank can act as an Advising Bank, enabling its customer (the exporter) to sell its goods locally or internationally. The relationship between any two banks may vary and could include any of the roles listed above.
Risk Factors
The involvement of multiple parties can make the process of due diligence more difficult. Also, since trade finance can be more document-based than other banking activities, it can be susceptible to documentary fraud, which can be linked to money laundering, terrorist financing, or the circumvention of OFAC sanctions or other prohibitions.
While banks should be alert to transactions involving higher risk goods (e.g., trade in weapons or nuclear equipment), they need to be aware that goods may be over- or under-valued in an effort to evade AML or customs regulations. For example, an importer may pay a large sum of money from the proceeds of an illegal activity for goods that are essentially worthless and are subsequently discarded. Alternatively, trade documents, such as invoices, may be fraudulently altered to hide the scheme. Variations on this theme include double invoicing, partial shipment of goods, and the use of fictitious goods. Illegal proceeds transferred in such transactions thereby appear sanitized and enter the realm of legitimate commerce.
The Applicant may substitute third-party nominees, such as shell companies, to disguise the Applicant’s role in a trade finance agreement. This substitution results in a lack of transparency, effectively hiding the identity of the purchasing party, thus increasing the risk of money laundering activity.
Risk Mitigation
Sound customer due diligence (CDD) procedures are needed to gain a thorough understanding of the customer’s underlying business and locations served. The banks in the letter of credit process need to undertake varying degrees of due diligence depending upon their role in the transaction. For example, Issuing Banks should conduct sufficient due diligence on prospective import or export customers before establishing the letter of credit. The due diligence should include gathering sufficient information on Applicants and Beneficiaries, including their identities, nature of business, and sources of funding. This may require the use of background checks or investigations, particularly in higher risk jurisdictions. As such, banks should conduct a thorough review and reasonably know their customers prior to facilitating trade-related activity and should have a thorough understanding of trade finance documentation. Refer to the core overview section, “Customer Due Diligence,” for additional guidance.
Banks taking other roles in the letter of credit process should complete due diligence that is commensurate with their roles in each transaction. Banks need to be aware that because of the frequency of transactions in which multiple banks are involved, Issuing Banks may not always have correspondent relationships with the Advising or Confirming Bank.
Documentation should be reviewed, not only for compliance with the terms of the letter of credit, but also for anomalies or red flags that could indicate unusual or suspicious activity. These anomalies could appear in shipping documentation, obvious under- or over-invoicing, government licenses (when required), or discrepancies in the description of goods on various documents. Identification of these elements may not, in itself, require the filing of a Suspicious Activity Report (SAR), but may suggest the need for further research and verification. In circumstances where a SAR is warranted, the bank is not expected to stop trade or discontinue processing the transaction. However, stopping the trade may be required to avoid a potential violation of an OFAC sanction.
Issuing Banks maintain foreign correspondent relationships to facilitate international trade. Trade finance transactions frequently use Society for Worldwide Interbank Financial Telecommunication (SWIFT) messages. U.S. banks must comply with OFAC regulations, and when necessary, licensing in advance of funding. Banks should monitor the names of the parties contained in these messages and compare the names against OFAC lists. Refer to overview section, “Office of Foreign Assets Control,” for guidance. Banks with a high volume of SWIFT messages should determine whether their monitoring efforts are adequate to detect suspicious activity, particularly if the monitoring mechanism is not automated. Refer to expanded overview section, “Funds Transfers,” for additional guidance.
Policies, procedures, and processes should also require a thorough review of all applicable trade documentation to enable the bank to monitor and report unusual and suspicious activity, based on the role played by the bank in the letter of credit process. The sophistication of the documentation review process and management information systems should be commensurate with the size and complexity of the bank’s trade finance portfolio and its role in the letter of credit process. In addition to OFAC filtering, the monitoring process should give greater scrutiny to:
- Items shipped that are inconsistent with the nature of the customer’s business (e.g., a steel company that starts dealing in paper products, or an information technology company that starts dealing in bulk pharmaceuticals).
- Customers conducting business in high-risk jurisdictions.
- Customers shipping items through high-risk jurisdictions, including transit through non-cooperative countries.
- Customers involved in potentially high-risk activities (e.g., dealers in weapons, nuclear materials, chemicals, precious gems; or certain natural resources such as metals, ore, and crude oil).
- Obvious over- or under-pricing of goods and services (e.g., importer pays $400 an item for one shipment and $750 for an identical item in the next shipment; exporter charges one customer $100 per item and another customer $400 for an identical item in the same week).
- Excessively amended letters of credit without reasonable justification.
- Transactions evidently designed to evade legal restrictions, including evasion of necessary government licensing requirements.
Unless customer behavior or transaction documentation appears unusual, the bank should not be expected to spend undue time or effort reviewing all information. The examples above, particularly for an Issuing Bank, may be included as part of its routine CDD process. Banks with robust CDD programs may find that less focus is needed on individual transactions as a result of their comprehensive knowledge of the customer’s activities.
