How Transaction Monitoring Systems are Missing the Mark with Mirror Trades

Jim Burnick, Managing Director of Financial Services, Pitney Bowes

Jim Burnick, Managing Director of Financial Services, Pitney Bowes

Outside the banking world, most people have probably never heard of the term “mirror trades,” but last month Deutsche Bank made headlines, thrusting mirror trades into the spotlight, and causing other financial institutions (FIs) to reconsider the efficacy of their transaction monitoring systems (TMSs).

Mirror trading, or copy trading, occurs when a trader buys and sells the same stocks, one right after the other. FIs have been making legal mirror trades for years in hopes of turning a profit, usually a guarantee if the trades are made through two different currencies (also known as currency monetization), which was the case of Deutsche Bank.

"A relationship-based approach adds a level of accuracy and precision often missed by traditional TMSs"

At first glance, it’s not evident why mirror trades are considered “bad,” or why FIs making them can be subject to multi-million dollar fines. For the savvy trader, it’s a quick, although risky, way to make extra cash, and for the standard compliance technology or TMS, it’s just another cross-border transaction. But peel back the layers and there’s a deeper, and potentially more dangerous story to be told. For financial regulators, it’s this story that is creating a cause for concern and forcing FIs to take a second look at how they’re monitoring mirror trades.

Cause of Concern

It’s impossible for anyone to forget the 2008 financial crisis. The fall of Lehman Brothers a decade ago was in large part due to bad, risky, and often unnecessary investments traders were making with investors’ capital. As financial institutions crashed, investors weren’t even able to pull out their capital investments—all were liquefied.

In light of this, it's perhaps not surprising that regulators are stricter today when it comes to financial regulations. Whether it's Know Your Customer (KYC) or the Bank Secrecy Act (BSA) in the United States, the Fourth Anti-Money Laundering (AML) Directive in the EU or any number of other country-specific legislative measures, banks are facing increased pressure to comply. Regulators, particularly those in the U.S., have been handing down record fines to FIs seen to be trading with sanctioned parties and countries, or failing to appropriately comply with AML initiatives. Mirror trades are just one example of the compliance crackdown because their existence implies lax compliance infrastructures. In the case of Deutsche Bank, the bank was on clear notice of serious and widespread compliance issues dating back a decade. Deutsche Bank and several of its senior managers missed key opportunities to detect, intercept, and investigate a mirror-trading scheme involving at least 12 entities across Moscow, London, and New York City.

For Deutsche, these missed opportunities highlight a systematic flaw that was not detected or flagged by the existing TMSs—and as these systems miss more red flags, they become more vulnerable to other financial crimes, such as money laundering.

The Missing Link in TMSs

So how do we actually monitor legal activities for illegal intentions? Should all cross-border transactions be treated with a high AML focus? This seems to always be a hot topic at the industry events I attend throughout the year, and the responses vary across the board.

For me, there’s no doubt large transactions, especially those being made across borders and through different currencies, should always receive higher priority when it comes to monitoring. But in order to do this, it’s critical that FIs have in place systems that are designed to detect this specific kind of potentially fraudulent activity.

Mirror trades are so covert that normal KYC and Customer Due Diligence (CDD) systems can’t pick them up. Even more challenging, mirror trades are often made across the wire, making their traceability much more complex.

This puts FIs in a difficult place, facing steep costs on both sides of the compliance coin and processes that are quickly being outpaced by regulators’ expectations. Compliance itself is an imperfect process, often made more difficult by the piecemeal configuration of legacy software that banks use as well as silos of information stored across systems and lines of business. This makes truly knowing customers a hard task.

A Relationship-Based Approach

Fortunately, recent technological developments allow FIs to bring down the cost of compliance without the need to rip and replace their TMSs. With a relationship-based approach that sits atop existing TMSs, institutions can achieve the dual purpose of reducing false positives while improving detection of suspicious activity overall.

This new approach combines data quality initiatives and entity resolution with a graph database that assists compliance in three ways: finding the data on transacting parties regardless of where that data exists within an institution, fixing the data where required, linking related parties and transactions, even when those relationships aren't obvious and/or deliberately obscured; and visualizing the relationships so anomalies can be quickly and more easily identified.

The relationship-based approach is critical to maintaining compliance because it allows TMSs to recognize entities that are associated with politically-exposed persons, have been subject to any negative press about their business or past transactions, or if their name appears on any watch lists that are monitored by the Patriot Act. In the case of mirror trading, relationship-based data has the ability to sift out any illegal intentions associated with legal activities.

By focusing on patterns and setting parameters that monitor for activities like mirror trades, FIs are better able to monitor for potentially fraudulent activity, and alert authorities for investigation. In turn, FIs become more efficient and effective, reducing investigative burden, and leaving more time to chase true positives, rather than the false positives that can account for over 98 percent of all TMS alerts in some institutions.

The U.S. financial system is the backbone of the world’s economy. While compliance regulations can be tedious and costly, they’re necessary for the success and the safety of the world and its citizens. A relationship-based approach adds a level of accuracy and precision often missed by traditional TMSs, and it ensures that FIs meet the ever-evolving compliance rules and regulations.

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