[By Anubhav Patidar]
The author is a student at Narsee Monjee Institute of Management Studies.
Introduction
In an era of increasingly sophisticated financial crimes, regulatory bodies worldwide are intensifying their efforts to combat money laundering and terrorist financing. On 06 June 2024, the Securities and Exchange Board of India (SEBI), proposed a comprehensive Master Circular (Circular) on Anti-Money Laundering (AML) Standards and Combating the Financing of Terrorism (CFT). This circular, aimed at securities market intermediaries, seeks to consolidate and update existing guidelines under the Prevention of Money Laundering Act, 2002 (PMLA) and its associated rules.
The proposed Master Circular comes at a crucial time when India is strengthening its financial regulatory framework to align with global best practices. According to a 2022 report, India’s Financial Intelligence Unit (FIU-IND) processed over 1.42 Lakh Suspicious Transaction Reports (STRs) in the fiscal year 2021-22, highlighting the increasing vigilance in the financial sector. This blog post aims to unravel the key elements of SEBI’s proposed Master Circular, examine its implications for various stakeholders, and understand how it fits into the broader landscape of India’s fight against financial crimes.
Decoding AML/CFT and SEBI’s Circular
Anti-Money Laundering encompasses the legal and regulatory framework aimed at preventing the transformation of illicitly gained funds into legitimate assets. Closely related, Combating the Financing of Terrorism focuses on preventing the funding of terrorist activities. In India, these efforts are primarily governed by the PMLA and its associated rules. Section 4 of the PMLA criminalizes money laundering related to property derived from offences listed in the Act’s Schedule, termed as “proceeds of crime.”
The Master Circular on AML/CFT is a detailed document designed to unify and update the earlier existing guidelines on anti-money laundering and Standards and Combating the Financing of Terrorism for securities market intermediaries. It establishes the key principles for combating money laundering and terrorist financing, providing detailed procedures and responsibilities that has to adhered by registered intermediaries.
Client Due Diligence
Client Due Diligence (CDD) forms the cornerstone of the circular’s provisions. The circular mandates that intermediaries must conduct thorough due diligence procedures for all clients, with a special underlining on identifying beneficial owners. The process extends beyond merely verifying the immediate client but also understanding the entire ownership and control structure, especially for non-individual clients. For example, the circular requires registered intermediaries to identify the natural persons who ultimately own or control a company client, using thresholds like ownership of more than 25% of shares, capital, or profits. This level of scrutiny aims to prevent the use of complex corporate structures to mask the true beneficiaries of financial transactions.
Risk Based Approach
The circular introduces a risk-based approach to AML/CFT measures, recognizing that not all clients and transactions pose the same level of risk. Intermediaries are required to categorize their clients into low, medium, and high-risk categories based on various factors such as the client’s background, country of origin, nature of business, and transaction patterns. This approach allows for more efficient allocation of resources, with enhanced due diligence measures applied to higher-risk clients. For the First Time, “Clients of Special Category” (CSC) are specifically defined by the circular and also provided elaborated list who will be considered as CSCs which include the non-resident clients, high net-worth individuals, trusts, charities, NGOs, politically exposed persons (PEP), and clients from high-risk countries. These CSCs are subject to enhanced scrutiny and continuous monitoring.
Monitoring and Reporting
Monitoring and reporting form another crucial pillar of the circular. Intermediaries are required to have robust systems in place to detect and report suspicious transactions. The circular provided a detailed definition of suspicious transactions, including those that seem to lack any economic or lawful purpose, unusually complex, or show patterns inconsistent with the client’s normal activity. It mandates that intermediaries should not only monitor individual transactions but also pay attention to the overall financial behaviour of their clients. The circular sets specific timelines for reporting of different types of transactions such as Cash Transaction Reports, Suspicious Transaction Reports, and Non-Profit Organization Transaction Reports to the Director, FIU-IND.
Record Keeping
The Circular imposes obligation on intermediaries to maintain detailed records of transactions, client identification and account files for a five years after the business relationship has ended or the account has been winded-up. The retention of data is a pivotal step for securing the data for future audit and investigations. The circular specifies the exact nature of the information to be maintained, including the nature of transactions, amount and currency, date of transaction, and parties involved. This meticulous record-keeping not only aids in investigations but also helps intermediaries in their ongoing monitoring efforts.
Compliance Structure
The circular places significant emphasis on the compliance structure within intermediaries. It mandates the appointment of a Principal Officer who will act as a central point of contact for all AML/CFT related matters. Additionally, a Designated Director must be appointed to ensure overall compliance with AML/CFT obligations. These appointments underscore the importance of top-level commitment to AML/CFT efforts within organizations. The circular provides specific definitions and responsibilities for these roles, ensuring that there is clear accountability and a structured approach to compliance.
Employee Training and Investor Education
Lastly, the circular recognizes the importance of ongoing education and awareness in the fight against financial crimes. It requires intermediaries to have comprehensive and ongoing training programs for their employees. These programs should cover various aspects of AML/CFT measures, including the latest techniques and trends in money laundering and terrorist financing. Moreover, the circular emphasizes the need for investor education. The requirements of AML/CFT measures and the rationale behind requesting certain personal information shall be explained to clients by intermediaries. This two-pronged approach of employee training and investor education aims to create a more informed and vigilant ecosystem that can effectively combat financial crimes.
Analysis and implications of the Circular
The proposed Master Circular has far-reaching implications for various stakeholders in the Indian securities market. For registered intermediaries, the circular represents a significant enhancement of their AML/CFT responsibilities. The emphasis on a risk-based approach means that intermediaries will need to develop more sophisticated systems for client risk assessment and transaction monitoring. This risk-based approach aligns closely with the Financial Action Task Force (FATF) guidance. The FATF emphasizes that countries, competent authorities and financial institutions should identify, assess and understand the money laundering risks to which they are exposed and take AML/CFT measures commensurate to those risks in order to mitigate them effectively. This approach allows for a more flexible and targeted allocation of resources to address the highest risks. Thus, even though this alignment could potentially lead to increased operational costs in the short term but should result in more effective risk management in the long run.
For investors, the enhanced due diligence procedures may lead to more rigorous onboarding processes such as stringent identity verification, background checks, monitoring, and thus potentially longer processing times for account openings and transactions. However, these measures are ultimately designed to protect the integrity of the financial system and safeguard investors’ interests.
From a regulatory perspective, the Master Circular demonstrates SEBI’s commitment to aligning India’s AML/CFT framework with global standards. This alignment is crucial in today’s interconnected financial world, where regulatory consistency across major markets helps prevent regulatory arbitrage and strengthens the global fight against financial crimes. For instance, in the European Union, the new AML Rule Book aims to harmonize customer due diligence requirements across member states, including enhanced measures for identifying beneficial owners. The United Kingdom’s Money Laundering Regulations 2017 mandate a risk-based approach to customer identification, with specific guidance for different sectors. In the United States, FinCEN’s proposed rule strengthens customer identification programs, particularly for legal entities, aligning with the CDD Rule. By aligning with these international standards while tailoring requirements to Indian context, SEBI is ensuring that India’s securities market maintains global best practices in AML/CFT measures. By consolidating and updating existing guidelines, SEBI is providing clearer and more comprehensive direction to market participants. This should lead to more consistent implementation of AML/CFT measures across the industry enhancing the overall integrity of Indian market internationally.
The circular’s emphasis on beneficial ownership identification is particularly significant. The emphasis on beneficial ownership identification ties in closely with Section 90 of the Companies Act, 2013, which deals with significant beneficial ownership. Section 90 requires individuals who are significant beneficial owners to declare their beneficial interest to the company. In complex corporate structures, identifying the ultimate beneficial owner can be challenging. This requirement may necessitate more in-depth investigations by intermediaries and could potentially uncover previously opaque ownership structures thereby enhancing transparency in ownership structures.
Challenges and Mitigating Measures
However, the implementation of these enhanced measures is not without challenges. Smaller intermediaries may find it resource-intensive to develop and maintain the sophisticated systems required for effective risk assessment and transaction monitoring. There’s also the potential for over-reporting of suspicious transactions as intermediaries err on the side of caution, which could strain the resources of the FIU-IND. Additionally, the circular’s emphasis on identifying beneficial owners may prove challenging, especially for complex corporate structures. The enhanced due diligence requirements for PEPs could also pose operational difficulties. Maintaining comprehensive records for the mandated five-year period may strain storage capacities, particularly for smaller entities. Furthermore, intermediaries operating across borders may face challenges in aligning these new regulations with varying international standards. The absence of clear guidelines on how to implement the risk-based approach for entities of different sizes may lead to inconsistent application across the industry. Lastly, the potential increase in compliance costs could impact the competitiveness of smaller players in the market.
To address these challenges, a multi-faceted approach is necessary. For smaller intermediaries struggling with resource constraints, industry collaborations and shared compliance platforms could offer cost-effective solutions. Clear regulatory guidance and staff training can help mitigate over-reporting of suspicious transactions. To tackle complex beneficial ownership identification, leveraging technology like blockchain-based registries could enhance transparency. A blockchain-based beneficial ownership registry would provide an immutable, easily accessible record of ownership structures. This could significantly reduce the time and resources needed for due diligence, as ownership information would be readily available and more difficult to falsify. For PEP due diligence, automated screening tools and prioritization strategies can optimize resource allocation. Advanced AI-powered screening tools can quickly scan vast databases to identify potential PEPs.
Further, cloud-based storage solutions can address record-keeping challenges, while global harmonization of AML standards could ease cross-border compliance issues. While full harmonization may be challenging, increased cooperation between regulators in different jurisdictions could lead to more standardized reporting requirements and mutual recognition of KYC procedures. Tailored regulatory guidance based on entity size would promote consistent application of the risk-based approach. Finally, regulatory relief for micro-enterprises and cost-sharing initiatives could help maintain market competitiveness. By Implementing these suggestions, the regulator can ensure more effective compliance across the financial market.
Conclusion and Way Forward
SEBI’s proposed Master Circular on AML/CFT represents a significant step forward in India’s efforts to combat money laundering and terrorist financing in the securities market. By providing a comprehensive and updated framework, the circular aims to strengthen the country’s financial defenses and align them with global best practices.
While the implementation of these enhanced measures may pose initial challenges for market participants, the long-term benefits in terms of improved risk management and increased market integrity are likely to outweigh these short-term hurdles. As India continues to integrate more deeply with the global financial system, such robust AML/CFT measures will be crucial in maintaining investor confidence and ensuring the country’s financial stability. Therefore, it will be essential for SEBI to provide adequate guidance and support to market participants as they adapt to these new requirements.