by Matt Rizzo
September 30, 2022
“Know Your Customer” (KYC) is a phrase that crops up every time you mention anti-money laundering (AML). But what does the term mean? The keyword here is “know”. Knowledge, according to Plato, is “beliefs that have been rightly justified”. When applied to AML, KYC therefore means that we must look for and analyse evidence to rightly justify that our client is not involved in any money laundering or illicit activity.
Verifying the client’s identity is the first step in understanding who our client is. This is, however, not enough. We need to dig deeper. One important area that sometimes gets overlooked is understanding where the client’s money comes from. Here is where we encounter the terms “Source of Wealth” (SOW) and “Source of Funds” (SOF). If you’re confused about what these terms mean or why they are two distinct concepts, you’re not alone.
This article will explain what these terms mean and their role in effective anti-money laundering processes.
Source of Wealth (SOW) refers to the activities that generated an individual’s wealth throughout their lifetime. Some people are born into wealthy families, others build vast amount of wealth quickly while others build their wealth by saving up over time.
Some examples of source of wealth are:
Source of Funds (SOF) is applicable when looking at a transaction that your client is involved in and refers to understanding where the money to fund that transaction is coming from. Consider a scenario where you are assisting an individual in setting up a company; What is the source for the capital being injected into the company? Is it coming out the individual’s personal savings? Are they coming from the sale of an individual’s assets? Is it coming from a loan?
Some examples of source of funds are:
In most cases, when looking at an individual’s SOW and SOF, we need to dig deeper than just pigeon-holing the type of SOW/SOF. After all, our belief that there is no illicit activity involvement needs to be justified. In fact, we may also need to obtain evidence for the stated SOW/SOF. As per the Risk Based Approach (RBA), the level of detail we should go through; the amount of time invested in digging deeper; and the evidence that is collected needs to be commensurate with the customer’s risk level. Below are some aspects that we may want to consider, especially in cases of higher-risk individuals:
Whether we are talking about accumulated wealth or the funding of an individual transaction, we need to take the numerical values into account. Is the individual a high-net worth individual and is the transaction unusual in value given the customer’s profile and his source of wealth and source of funds? If an individual’s source of wealth is employment, is their net worth in line with salary benchmarks and the number of years they have been in employment?
In some cases, it is important to dig deeper. For example, if the client’s source of wealth is business ownership, we may need to understand what the business is, what industry it operates in, who the business’s customers are, and whether the business was profitable. When looking at source of funds, we may also want to know who owns the account from where the funds are being transferred or the activity that generated those funds in the first place.
Another facet of source of wealth and source of funds is the jurisdiction where the wealth was generated or where the money for the transaction is coming from. For example, if the source of wealth is inheritance, did the inherited assets come from a local individual, or did they come by someone from a high-risk country? Similarly, when looking at source of funds, is the money being transferred coming from a bank account in a high-risk country?
Sometimes, it may be necessary to travel back in time to get to the original source of wealth or funds. For example, consider an individual funding a transaction via the sale of a property. We may need to understand how the property purchase was funded in the first place.
Depending on your risk policy and the customer’s risk classification, you may want to obtain different documents to sustain the claimed source of wealth or source of funds. For example, you may need to obtain a copy of the audited accounts for an individual’s business, their employment contractor, or a copy of a will.
Both source of wealth and source of funds are important aspects of an effective KYC process. Here are ways in which understanding where the money is coming from helps:
If a client cannot justify their source of wealth or source of funds, this is an automatic red flag. It is also important to understand the link between the SOW and SOF. In some cases, the link is obvious – for example, an individual funding a transaction via personal savings (SOF) that were accumulated via 20 years of employment (SOW); where the value of the transaction and the individual’s net worth make sense. In other scenarios, there is no link between the two but there is limited scope to suspect illicit activity – for example, the same individual winning a national lottery (SOF) and funding a transaction from these winnings. However, there may be scenarios where the relationship between the two gives rise to suspicion. For example, the same individual selling a high-value property (SOF) that he could not afford in the first place given his employment salary (SOW).
Not all sources of wealth and sources of funds are equal when it comes to AML risk. An individual funding a transaction via personal savings, from wealth that was accumulated via employment poses a lower risk than an individual with limited wealth who is funding a high-value transaction via gambling wins or loans from non-regulated entities. In fact, it is a good idea to devise your Customer Risk Assessment (CRA) such that the risk of a customer is affected by their SOW and SOF. This would then allow us to scrutinize higher risk clients more thoroughly.
Your firm may have a policy that limits exposure to AML risk but setting some boundaries on accepted customer’s SOW or SOF. For example, you may have a policy to not accept individuals funding transactions through bank loans from outside the UK or the EU.
As with any aspect of your AML processes, understanding the customer’s source of wealth and source of funds should be supplemented with the following three actions:
As discussed, once you understand a customer’s source of wealth and source of funds, you may become suspicious that the client is involved in money laundering activities. Once you have such a suspicion, you must report it to the authorities via a Suspicious Activity Report (SAR).
All information collected should be documented and kept within the client’s file. This ensures that it is easily available when carrying out a Customer Risk Assessment (CRA). It also helps at a later date, when comparing the client’s behaviour to our understanding of their source of wealth or funds. Finally, having everything documented is proof (both internally to management as well as to supervisors and authorities) that your actions are in line with your firm’s AML policy and local legislation and AML guidelines.
As with all aspects of AML, things change. An individual’s source of wealth may change over time and a customer who was funding transactions via a particular source may start employing a different source. As a result, it is important to keep your information updated and make sure that your understanding of the customer’s source of wealth and source of funds is correct throughout the lifetime of your business relationship.
The terms “source of wealth” and “source of funds” are not interchangeable and understanding both is crucial to really knowing your customers, being able to stratify them by risk level, and ensure that your exposure to AML risk is minimized. It is worth asking yourself if the details, and where appropriate evidence, for SOW and SOF are being collected during the onboarding stage, updated during your ongoing monitoring process, and documented correctly. After all, truly understanding a client’s SOW and SOF goes a long way in ensuring you have an effective AML policy.
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