We all know that participants in the capital market range from huge conglomerates to a single person like a retail investor, spreading across the globe. The nature of the capital market, such as the huge volumes, numerous participants, speed of transactions, liquidity, ability to convert funds into a different asset class, international nature of markets, etc., provides an avenue for fraudsters to mask and transform the identity of illegal funds.
Capital markets are used as a platform for money laundering. Let us see how:
Before going into finding the connection between money laundering and the capital market, let us understand what money laundering is.
What is money laundering?
Money laundering is the illegal process of making the money generated from illegal activities appear to have come from a legitimate source. It mostly includes 3 steps:
- Placing, where illegal funds (mainly in the form of cash) are converted into a non-cash instrument
- Layering, the conversion and movement of the illegal funds to conceal their source and to obscure the trail for law enforcement agencies and regulators
- Integration, the return of these illegal proceeds to the launderers in a form that gives them an appearance of being legitimate funds
What are the common methods of money laundering?
The classic methods of money laundering include,
- Smurfing: Structuring of large amounts of money into multiple small transactions at banks
- Mules: Cash smugglers to move money across borders
- Shells: Creating shell companies
- Investing in high-value and movable commodities like gold, diamonds, artwork, etc.
- The use of foreign exchanges or securities markets, etc.
Let us see some examples from the past to know how the securities market is used for money laundering.
- In 2015, SEBI barred 129 entities suspected of money laundering and tax evasion. It was found that the stock market mechanism was used by two companies, its promoters and related entities for booking long-term capital gains in crores and converting their unaccounted income into an accounted one. The companies allegedly issued new shares through preferential allotment to certain entities. The promoters and preferential allottees indulged in manipulative trading to artificially increase the price of the share. One month after the share split, the preferential allottees and promoter related entities started selling the shares to entities related to the company, completing the circle.
- In 2015, a debenture trustee was sentenced to 7 years imprisonment along with a fine of Rs 2.5 lakh as he was responsible for floating secured non-convertible debentures during 2001-2002, 2004-2005, 2005-2006, and in 2007-2008 of a Real Estate Construction Company and had pleaded guilty for the offence of money laundering.
- In 2019, a case was busted in Mumbai where brokers indulged in fictitious derivative trade nexus where they used synchronised trades to convert a client’s black money into white. The broker who indulged in manipulative trading was arrested by the Enforcement Directorate (ED) and SEBI barred the brokerage firm from the market.
What are the anti-money laundering (AML) rules in place for securities markets in India?
The Government of India has enacted the Prevention of Money Laundering Act (PMLA), 2002 to prevent money laundering in India. Along with Banking companies and Financial institutions, security intermediaries are recognised as ‘Reporting Entities’ and are required to carry out AML measures under PMLA.
SEBI monitors and regulates the security intermediaries under Obligations of Securities Market Intermediaries under the Prevention of Money Laundering Act, 2002.
The securities intermediaries are obliged to implement the following essential features in the PMLA to minimise money laundering through the securities market.
- Mandatory Know Your Customer (KYC) norms
- Identification of Beneficial Ownership (BO)
- Enhanced Due Diligence for high-risk customers (including Politically Exposed Persons)
- Reliance on third parties for Customer Due Diligence
- Use of the banking system as a payment mode
- Disallowing third party payment/delivery of funds and securities
- Holding and settlement of securities in the electronic/dematerialized form
- Use of Bearer Shares
- Anti Money Laundering focused inspections and sanctions, etc.
Market manipulations, securities fraud schemes and other market mechanisms may be used to convert illegal money into a legal one. As an investor, you must be aware and not get lured into any such schemes that have hidden motives of money laundering, tax evasion or any other fraudulent schemes. Make sure you are well informed of the products and the persons or entities you are dealing with in the securities market. We suggest you do your homework before making any new move in the securities market.