Hedge Funds’ Critical Role in Anti-Money Laundering

Additionally, much can happen between the time an investor wires money into and subsequently redeems out of a fund. Let's look at the Office of Foreign Assets Control (OFAC) and watch list checks that occur on money movements between banks, and, with some recurring frequency (daily, weekly, etc.), across all customers of banks. 

A hedge fund typically needs a bank account to accept subscriptions and pay redemptions, the two primary ways that investors transact within a fund.

Let's say Mr. "Not Yet Identified by OFAC as a Terrorist" sends money from his bank account into a hedge fund.  At the time, he hasn't been identified on the watch lists, so both banks are fine with the wire from this investor.

Two years later, Mr. "Not Yet Identified by OFAC as a Terrorist" is named on the OFAC list. The bank that accepted the wire from Mr. "Now Identified by OFAC as a Terrorist" into the hedge fund's account from two years ago may have long forgotten him because it conducted AML only on the deposit transaction.  Because he didn't open a customer account at that bank, the investor would likely not be subject to the bank's ongoing AML program. If he still has an account at the sending bank, that bank will likely identify him, freeze his present assets and notify OFAC.  

However, the hedge fund might not be notified. Law enforcement may be able to follow his trail to the hedge fund by looking at his bank records, but perhaps not in time.

When Mr. "Now Identified by OFAC as a Terrorist" realizes his bank assets have been frozen, he could submit a transfer request to the hedge fund asking to assign a hedge fund position to someone else (a friend, family member, etc., who hasn't been added to the OFAC list). 

At this point, the hedge fund's AML program (either in-house or through its administrator) could be a line of defense, as this transaction falls outside the traditional banking system. The hedge fund can check the OFAC list for both the new investor and the original investor prior to approving the transfer. Otherwise, if the transfer goes through, the new investor could redeem, and that wire may appear clean when the banks perform their AML checks as Mr. "Now Identified by OFAC as a Terrorist" no longer appears associated with the transaction.

Illiquidity Revisited

Illiquidity arguments generally ask "Why would a money launderer want their money locked up in a hedge fund?"

While that may be a valid point, the issue with this argument is that not every criminal starts off as a criminal, or is afoul of the law when he first invests in a hedge fund. So a hedge fund's liquidity could dissuade a prospective investor who is already a money launderer, but it may not affect someone who at the time of his hedge fund investment is a legitimate businessperson and later runs afoul of the law.

In Conclusion

Arguments can certainly be made that hedge funds are not the most attractive (i.e., liquid) option for money launderers and that banks are performing AML procedures already. However, those arguments may overlook some critical gaps. Not only is the hedge fund's bank account typically structured in a way that the investors are not the actual customers of the bank, but some transactions (e.g., transfers) are done outside the traditional banking system altogether.