Memo Rebuttal - It’s Money Laundering!

I have the good fortune of having Chaim Even-Zohar’s ear. I ask him simple questions, and true to the person that he is, he gives me answers full of figures, historical context and always with an interesting twist. In short, he keeps me on my toes.

Having him, dare I say, as a mentor, has its price. Chaim is an Old-School kind of guy, and when the student is out of line, the master whips him right back. This week the lesson was - understand the money trail.

Responding to last week’s Memo, he wrote me that I’m “on the right track but may have missed the real issues.” Chaim analyzed six-years of U.S. rough diamond trading, looking at publicly available Kimberley Process and U.S. International Trade Commission's data for the 2004-2009 period.

He concludes from comparing the data that the most obvious explanation for the volumes of rough trade to and from the U.S is money laundering. It may, however, not be the only one.

“The data shows that in that period, the U.S. imported about 19 million carats of rough and exported about 22 million carats of rough (…). There are no diamond mines in the U.S.,” he points out. In the Kimberley data, the rough diamond imports and exports are in balance, some 22 million carats. If the export figures are correct, than were some 3-5 million carats smuggled into the country? Why the higher figure? “The U.S. domestic manufacturing industry, as small as it is, may still manufacture some 100,000 carats a year.

For some twenty years since the 1970s, the U.S. government sold its rough diamond stockpile, a sizable amount of it to domestic buyers. Some argue that the excess exports are from this stockpile, slowly shipped abroad by American traders that bought this stash. That’s a valid argument. “Traders tell me,” says Chaim, “that there were considerable stocks of primarily low-quality goods in the U.S., at the time the KPCS started to function in 2003.” But why would those who bought it years before really “sit on it”?

Chaim conjectures that this explains only part of the story. “There seems no reasonable explanation for the figures except for pointing to money laundering, something I believe is taking place, mostly from anecdotal evidence and from looking at the origins and destinations of the movements. The problem is that the U.S. miserably fails in its minimum KPCS requirements and the money launderers of the world consider the U.S. an easy place to launder and secure ‘respectable’ certificates.”

“The interesting thing is (and that's the main challenge to FinCEN, the U.S. anti-money laundering watchdog) that you may have two different laundering movements, which may cancel each other out: those who want to bring dirty money back to the U.S. and use understated values for the rough that is going out, and those who want to move dirty money offshore (Switzerland, elsewhere) and they overstate the value of rough imports. Who can check? “

There is a difference between U.S. KP statistics and the official U.S. Government statistics, as seen below:

Under both, the total value of imports in the six-year period is $4.5 billion. But when exported, their value dropped to $2.7 billion. The $1.8 billion difference may be explained by the fact that the U.S. industry processes high value rough. According to Government data, the cutting and domestic processing is zero – and then there is a problematic 3 million carats which cannot be explained.

Based on the KP data, a small U.S. industry may process some 600,000 carats of rough, manufacturing about 100,000 carats of polished annually. “The value difference," Chaim adds, “suggests an average $300 million domestic manufacturing of rough per year. As the domestically processed rough is expensive, this is quite possible.”

This, one might argue, defeats the laundering argument. Not so. Why import 22 million carats if the sector consumes only 600,000 carats? By importing $4.5 billion worth of diamonds, U.S. money launderers have a legal way to move $4.5 billion out of the country - paying for the goods overseas. By subsequently exporting these goods for $2.7 billion, and collecting money from overseas, they are able to leave some $1.8 billion in bank accounts abroad. The reverse is true as well: by undervaluing imports of rough, which are subsequently locally sold (or exported) at higher values, one can bring dirty money home nice and clean.

Not like Columbus Discovering America

Nothing is spectacular or new about this, warns Chaim. “Professor Dr. John Zdanowicz, a professor of finance at Florida International University in Miami, has done studies on diamond movements and informed FinCEN of his finding that diamonds are used for so-called trade-based laundering. A study published in 2005 in the journal of Applied Financial Economics, which looked at the impact of Switzerland’s money laundering law on capital outflows through abnormal pricing and trade manipulation, supports the argument that faced with regulated financial systems, money launderers and terrorists will shift their activities to false invoicing in international trade. Zdanowicz in particular looked at diamonds, though his analysis may lack product understanding,” argues Chaim.

Why rough and not polished? The answer is: it takes place in both. But rough is “safer” – the authorities find it easier to find price references for polished than for rough. And here comes the “ironic” part: the KP certificates add an air of respectability to the transaction. Banks will transfer large amounts based on invoices and KP certificates, without suspicion.

“That is one of the reasons for the rough trade in the U.S. The U.S. government ought to analyze the origins and destinations of shipments. In 2008, for example, some $24 million went to Dubai, while $40 million was imported from there. Why? Last year some $37 million was exported to Dubai, while imports dropped to near nothing at $2 million.” Governments should measure capital outflows to certain destinations – and this provides the real cues to the analysis.

Beware of False Studies

There is one aspect that we should all be aware of: much of the so-called research is well intended, but ridiculously false. In 2007, for example, Nikos Passas, a financial crime professor at Northeastern University, concluded in an interview published on an anti-money laundering website: “If you have diamonds that are coming from Africa you have to know where they are coming from. And then you want to know what the country of transshipment is.”

He examined more than 25 years of rough diamond imports into the U.S. and found that the UK was the leading source of goods. “The UK doesn’t have any diamond mines,” he exclaimed, adding that crimes are “committed there.”

The professor neglected to notice De Beers’ Central Selling Organization (CSO), based in London. His conclusions are false. There was no crime – even though the crime-professor argues otherwise.

“What counts for the professor is also true for you and me,” said Chaim. What seems most likely may not always be the case. Caution is needed – anecdotal evidence from within must support the data.

Chaim offered a sobering finale that some may not like. “At some point the U.S. government should consider overhauling its domestic (mostly voluntary and outsourced) KP system to get a better handle on what is truly happening. Not to prove the laundering case – but also to create the tools to disprove it, which is infinitely preferred. There is one other thing we must keep in mind, warns Chaim. The U.S. has a huge economy. Any system-change, such as the introduction of KPCS, takes time to become fully operational. There may be importers getting their industrial diamonds by FedEx, unaware that the KPCS applies to them as well. Nothing should be ruled out – but the huge volumes of in and out really defy other obvious explanations.

I learned my lesson: take a broader look at the figures and, as Deep Throat advised, follow the money.