Fighting Financial Crime: Making Due With the Omnibus Account

A bank or broker-dealer opens an account in its name with a securities depository. One of its customers — a fund manager, broker-dealer or other firm — is involved with either money laundering activities or violating regulations involving sanctions against an individual, country or corporation. Even worse, one of their clients did the dirty deed.

Should the securities depository be held accountable for this illegal activity even if it has no clue of who committed it? The obvious answer is no, but depositories are worried they might be hit with big financial penalties from regulators for not knowing. Ignorance may be easier, but in this case it could turn out to be very costly.

The industry’s proposed solution: take a preemptive step and release a high level list of principles. Released late last month by a working group of the Zurich-headquartered International Securities Services Association (ISSA), the voluntary guidelines are designed to help depositories and other financial intermediaries dodge a regulatory bullet. The presumption is that regulators would be comforted that each firm in the chain of securities service providers did its utmost to prevent and detect financial crime. The “Financial Crime Compliance Principles for Securities Custody and Settlement” mirror those followed by correspondent banks known as the Wolfsberg Anti-Money Laundering Principles for Correspondent Banking.

“We are trying to codify what has become market practice by setting best practices for our participants and their customers,” explains Robert Almanas, head of international strategy and alliances for custodian and securities depository SIX Securities Services in Zurich who serves on the ISSA working group. “We feel the principles will go a long way to minimizing the potential for wrongdoing by a participant or its client.” In addition to SIX, securities depositories Clearstream and Euroclear are represented on the working group as are custodians Deutsche Bank, UBS, Citi, BNP Paribas and Standard Chartered.

No Free Pass

Until recently, regulators had given securities depositories a free pass of sorts. Depositories didn’t have to worry about whether one of their participants committed any wrongdoing as long as they didn’t know about it. But that’s no longer the case as evidenced in settlements that Clearstream and custodian Brown Brothers Harriman (BBH) reached in 2014 with the US Treasury and the Financial Industry Regulatory Authority (FINRA) respectively.

In hitting Clearstream with a US$152 million fine, the US Treasury’s Office of Foreign Asset Control (OFAC) said that Clearstream couldn’t plead ignorance of the end investor’s identity as a defense for violating US sanction laws. The end investor happened to be the Central Bank of Iran. BBH paid FINRA US$8 million and its global AML director paid US$25,000 with a one month suspension for allowing lots of trades in penny stocks to be executed or transferred on behalf of foreign individuals the bank should not have been doing business with. The fine was the largest ever paid to FINRA for an anti-money laundering (AML) violation.

Securities depositories have a more difficult time than their bank or broker-dealer participants battling financial crime simply because of the way accounts are registered. All depositories typically know is the identity of their participant custodian banks and broker-dealers, but in most cases there is no way for the depository to understand whether participants might be settling trades for their proprietary accounts or on behalf of their clients. The participant banks and broker-dealers are typically registered on the books of the securities depository in their own names, not the names of their customers — a process known as the omnibus account.

Only a fraction of the accounts held at a depository are registered in the name of the financial intermediary — and the underlying client. International securities depository Clearstream International, for instance, says that about twenty five percent of the accounts on its books are segregated into the name of the participant’s customer.

What’s the Drill?

Here is what the ISSA-led group has proposed in a nutshell: when a bank or broker-dealer opens an account at a depository, the depository must perform due diligence in determining just how risky a member the bank or broker-dealer will be. Such a risk-profile will dictate whether the depository even wants to accept the bank or broker-dealer in the first place and what procedures it will put in place to monitor the activities of the bank or broker-dealers — as in watching which securities trades they settle, for how much and when.

That’s just for starters. The bank or broker-dealer of the depository must then contractually agree with the depository that it has put in place anti-money laundering procedures to verify the identity and risk profile of its customer, as well as the end client’s activities. “Although the securities depository or custodian cannot dictate what those procedures will be, the contractual agreement it has with its participant will at the very least require the participant to make a commitment it will impose AML procedures on its customers,” says Mark Gem, chief compliance officer for international securities depository Clearstream, who heads up the ISSA working group. “The precise rules will be left to the depository participants and their clients.”

So what can the securities depository do if it thinks that one of its participants may be involved in illegal business activities? “Based on the principles set by the ISSA working group, the depository can now ask the participant to identify who the underlying client is and the purpose of the transaction,” says Olivier Goffard, head of group compliance and ethics for all of the depositories operated by Euroclear.

Apparently until now there have been diverse or unclear contractual obligations across the financial services industry requiring the depository’s participant — such as the custodian or broker-dealer — to provide that information to the depository. Such a right — to be informed of the investor and the purpose of the transaction — is also expected to be part of the contracts between the participant in the depository and its clients, explains Goffard.

Room for Negotiation

Under what specific circumstances can a depository or its participant ask about its participant’s underlying fund manager or other client? The principles set by the ISSA working group didn’t specify, instead opting to leave it to each depository and depository member to work out in the terms of the contracts with each other and their clients based on their respective services, business models, geography, jurisdiction and client mix. The ISSA will publish an “adoption guide” at SWIFT’s annual SIBOS event in October which will offer some guidance.

What can a depository do after it has the names of the alleged wrongdoers? Again the ISSA working group’s principles left that decision up to the depository and its participant based on the type of activity involved and the terms of their contract. In a worst case scenario, a securities depository could always decide to ask its participant to terminate its account, but it cannot explicitly require a participant to end its business with its client.

Of course, it would be a lot easier for depositories if there were no omnibus account structure in the first place and the identities of all of the entities in the chain of custody were known because they were registered in their own names. For now there is little chance segregated accounts will become the norm, but the number of participants opening segregated accounts is on the rise, say Gem and Almanas. Still, it won’t make much difference to regulators. “They may hold depositories equally liable when it comes to accounts held in omnibus or segregated name,” says Almanas.

Will the ISSA working group’s principles succeed in helping depositories meet AML requirements and avoid regulatory penalties? No one will likely know until a potential investigation actually takes place or until a depository finds it necessary to ask a participant for further information on one of its customers. Experts anticipate potential difficulties in enforceability, especially because of cross-border transactions. “Given the different regulatory regimes involved in cross-border transactions, it is unclear just how much the depository and its participant can enforce the principles even contractually for information on beneficial ownership when the depository is located in one country, the participant in another and the participant’s client — the fund manager in a third country.” one compliance manager at a US headquartered global fund management shop tells FinOps Report. “It is uncertain whose law will control the contract and whether the contract can even be legally enforced.”

ISSA is hoping that all securities depositories and financial firms — not just its members – will start revising their current contracts with participants and complete the process by 2018. The ISSA working group already represents some of the biggest names in depositories as well as their mega participants. Clearstream alone owns depositories in Luxembourg and Germany while Euroclear owns the international depository Euroclear Bank in Brussels as well as the national depositories in Belgium, the Netherlands, France, the UK and Ireland, Sweden and Finland. Given the business muscle of this group, the new principles appear to have a big head start toward universal adoption.