Academic journal article Economic Commentary (Cleveland)

Understanding the Wash Cycle

Academic journal article Economic Commentary (Cleveland)

Understanding the Wash Cycle

Article excerpt

Money laundering has gone on since the first crime was committed for profit, but it has been explicitly illegal only since 1986. Interest in this topic soars whenever a major "laundromat" is uncovered. This Economic Commentary describes the money laundering process, summarizes the evolving statutes, and describes the Federal Reserve's role in assisting in their enforcement.

Although the phrase "money laundering" did not even appear in print until the Watergate scandal, criminal investigators have long adhered to Deep Throat's sound advice. While not officially outlawed until 1986, money laundering-or failure to do it well-has figured in many prominent cases. Two of the century's most notorious criminals were undone by failure to cover their financial tracks. Al Capone was finally convicted of tax evasion, not racketeering, and Bruno Richard Hauptmann, who kidnapped Charles Lindbergh's son in 1932, was caught because he failed to launder the ransom money successfu11y.2 And, as we saw last year, when concerns arose about funds that may have been obtained illegally in Russia possibly entering the U.S. banking system, the problem of dirty money has not gone away.

Because criminals have a strong incentive to disguise their activities, the amount laundered is not known precisely, but the International Monetary Fund has estimated that the annual total is equivalent to around 3 to 5 percent of the world's output. Alternatively, the Group of Seven (G7) nations' Financial Action Task Force puts the figure at $300 billion to $500 billion worldwide. More than $2 trillion courses daily through the U.S. economy alone, so law enforcement is necessarily a needle-in-ahaystack effort. This Economic Commentary describes the money laundering process, examines the motivation behind the evolving statutes, and explains the Federal Reserve System's supporting role in enforcing them.

Wash-Cycle Basics

Money laundering involves three steps, which sometimes overlap: placement, layering, and integration. During the placement stage, the form of the funds must be converted to hide their illicit origins. For example, the proceeds of the illegal drug trade are mostly smalldenomination bills, bulkier and heavier than the drugs themselves. Converting these bills to larger denominations, cashier's checks, or other negotiable monetary instruments is often accomplished using cash-intensive businesses (like restaurants, hotels, vendingmachine companies, casinos, and car washes) as fronts.

In the layering stage, the launderer tries to obscure further the trail linking the funds with the criminal activity by conducting layers of complex financial transactions. For example, sophisticated criminals with large sums to launder set up shell companies in countries known either for strong bank-secrecy laws or for lax enforcement of money laundering statutes. The tainted funds are then transferred among these shells until they appear clean.

These transactions must be disguised to blend in with the trillions of dollars of legitimate transactions that occur every day. Variations of "loan-backs" and "double invoicing" are common techniques. With a loan-back, the criminal puts the funds in an offshore entity which he secretly controls and then "loans" them back to himself. This technique works because it is hard to determine who actually controls offshore accounts in some nations. In double invoicing-a scam for moving funds into or out of a country-an offshore entity keeps the proverbial two sets of books. To move "clean" funds into the United States, a U.S. entity overcharges for some good or service. To move funds out (say to avoid taxes), the U.S. entity is overcharged.

Other layering techniques involve buying big-ticket items-securities, cars, planes, travel tickets-which are often registered in a friend's name to further distance the criminal from the funds. Casinos are sometimes used because they readily take cash. …

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