The critical role of transaction monitoring in fighting financial crime
What is transaction monitoring?
Transaction monitoring is exactly as it sounds; it’s the monitoring of customer transactions to ensure no suspicious or illegal activity is taking place.
While a lot of financial institutions use transaction monitoring systems to automatically analyse this data, some use manual processes to do so.
Automated monitoring systems: Pros and cons
Opting for the automated method of monitoring transactions is often the most sensible, especially for larger financial institutions who have to deal with thousands of transactions daily.
However, out-of-the-box settings for this type of technology are usually not what the financial institution using it requires, and this leaves them vulnerable to criminal activity slipping through the net.
Often, though, leaving transaction monitoring systems as they come is quite a common occurrence, and unless instructed otherwise, financial institutions will do so.
It is a legal requirement for a bank to ensure that their transaction monitoring rules are set up according to their risk appetite to detect suspicious transactions that may be associated with financial crime. If they aren’t, it leaves them vulnerable to financial transactions from a sanctioned entity, exposing their bank to the risks of handing criminal money.
Why is transaction monitoring important?
The purpose of transaction monitoring is to detect suspicious activities such as money laundering, terrorist financing, fraud, and other financial crimes. The monitoring process involves identifying patterns and trends that may indicate illegal activities and flagging suspicious transactions for further investigation.
If the transaction monitoring system is not tuned to a financial institution’s risk requirement, there’s a high likelihood the system will produce misses and false alerts, leading to regulatory intervention and resource allocation to resolve the unnecessary alerts.
It is a financial institution’s responsibility to ensure that their transaction monitoring system is validated. If it is neglected and uncared for, they could be seen to be facilitating criminal activity, such as modern slavery, tax evasion, terrorism financing or the illegal wildlife trade (IWT). With billions of dollars funnelled through criminal networks each year, crimes like human trafficking, drug trafficking, and wildlife trafficking remain some of the top financial crime threats globally.
These crimes are characterised through very particular transactional patterns that ideally must be mimicked to ensure peak system performance.
What is a red flag?
Before understanding how transaction monitoring systems can be tested and validated to ensure complete performance, a red flag must be understood.
A red flag is regulatory-referenced indicator that highlights potential illegal activity in a bank and are created from the knowledge of patterns that emerge from the analysis.
Regulators, law enforcement agencies and banking associations around the globe define their own red flags, and as a result, there are many to consider making acting against them more difficult.
What is Red Flag Tests?
AML Analytics has created a unique database of red flags that have been created in accordance with international best practice recommendations and guidance from the FATF, UNODC, OCC, Fence, HKMA and many more.
From these red flags, we’ve created our own “Smart Scenarios”, with each Smart Scenario covering different transactional behaviour to replicate the typical characteristics of a particular type of financial crime, such as the ones stated earlier in this article.
Red Flag Tests exercises these red flags within each Smart Scenario to pinpoint vulnerabilities in a system’s alerting capabilities. This makes financial institutions aware of these areas and can take the necessary remediation steps to rid a transaction monitoring system of time-wasting inaccuracies. This will also allow analysts within financial institutions to identify transactional patterns and behaviours consistent with known money laundering typologies more easily.
Red Flag Tests is also the solution we use in our transaction monitoring system Thematic Review, helping regulators test the performance of the transaction monitoring systems used by their regulated entities.
The benefits of Red Flag Tests:
- Identify system inaccuracies and incorrect thresholds
- Access a customisable library of red flags
- Use Smart Scenarios with synthetic data to reveal alerting gaps
- Test against regulator-expected red flags
- Reduce financial crime risk by exposing system weaknesses
- Minimise false positives and unnecessary alerts
- Help combat global crimes like human trafficking and IWT
Regulatory expectations for transaction monitoring systems
The FATF’s Recommendation 10 goes into great detail about customer due diligence (CDD) around transaction reporting. Namely, Recommendation 10d (page 14) states that the financial institution should prioritise:
“(d) Conducting ongoing due diligence on the business relationship and scrutiny of
transactions undertaken throughout the course of that relationship to ensure that the
transactions being conducted are consistent with the institution’s knowledge of the
customer, their business and risk profile, including, where necessary, the source of
funds.”
Where the customer fails to adhere with the financial institution’s CDD measures, it falls upon the financial institution to: not open the account, not commence the business relationship or perform the transaction, terminate the business relationship. Financial institutions should consider making a suspicious transaction report (STR) in relation to the customer.
Want to know more?
If transaction monitoring system validation is something you need assistance with, our AML/CFT experts at AML Analytics are on hand to answer any questions you might have. Please don’t hesitate to get in touch.