“FinCEN regulations powerless to stop illegal international gem trade,” notes a scary headline of an article written by Professor John Zdanowicz, Ph.D. that is featured in an authoritative money-laundering publication. The professor is one of America’s top authorities on detecting trade-based money laundering – and his words reverberate loudly within the halls of governments. In new findings disclosed this week, Zdanowicz says that, “in 2004, an estimated $4.5 billion in laundered money may have crossed U.S. borders via international trade in precious metals and gems.”

Referring to the new FinCEN AML/CFT rules for the diamond and jewelry sector, Professor Zdanowicz dismisses the effectiveness of these regulations. He says, “They do not focus on analyzing abnormally priced international trade transactions that result in moving money into or out of the United States. Money can be moved out of the U.S. to a foreign country by importing precious metals and gems at overvalued prices or by exporting the covered goods at undervalued prices. Money can also be moved into the U.S. by importing precious metals and gems at undervalued prices or exporting the covered goods at overvalued prices.”

My gut feelings say that when it comes to the international diamond industry, the professor probably doesn’t understand its operations or its drivers. On the other hand, we may not fully understand the ramifications of his research methodology. For the moment, I find it difficult to reconcile his methods with my understanding of how the diamond trade works. Even if the professor’s conclusions were right, it doesn’t necessarily mean that there is a causal link between his methodology and his findings. Furthermore, I wonder if the researchers are aware of the Kimberley Process or that international trade values are being checked by customs officials all over the world. By the examples cited, the study seems to imply that the issue we have identified mainly applies to retailers. But this is not self-evident.

What is more interesting (and probably erroneous) is that the professor challenges the wisdom of FinCEN’s jewelry retail exemption, which, in most circumstances, allows retailers to operate without having an AML/CFT Compliance Program. Professor Zdanowicz, a professor of finance at Florida International University in Miami, stresses that, “drug dealers or terrorists are able to move money out of the United States through undervaluing exports of precious metals and gems without fear of detection.”

His explanation is as follows, “The transaction will require the money launderer to purchase diamonds, gold, rubies, sapphires, and emeralds from retail jewelers, who are exempt from the new FinCEN regulations because they sell "primarily" to the public. These purchases will be made with dirty cash and will be in amounts less than $10,000 per transaction to avoid a form 8300 filing. Two hundred purchases of $5,000 will convert $1 million of dirty cash into $1 million of precious gems or metals. The $1 million dollars of precious gems and metals are exported to a colluding partner in Yemen or Colombia for an invoiced value of $1,000. When the merchandise arrives in the foreign country it is sold for its true market value of $1 million. The money has been moved, and the transaction avoided the regulations of precious gems and metals dealers and the reporting regulations of financial institutions.”

Is that scenario possible? Yes. Is that scenario likely to happen? Here I categorically take issue with the professor. Looking at opportunity costs and doing a cost/benefit analysis of money laundering, getting stuck with two hundred pieces of jewelry to launder money is probably a most inefficient and very costly way to get your dirty money spread around the globe. There are far easier and more cost-effective methods. The professor clearly holds a different view: “The conclusions of an exclusive computer analysis of 2004 U.S. trade data (performed for prestigious Money Laundering Alert newsletter) revealed that $1.8 billion was moved out of the United States through false invoicing in precious metals and gems. The same analysis also revealed that $2.7 billion was moved into the United States.” These figures are presented in the following table:

Source: Computer analysis for Money Laundering Alert by Dr. John Zdanowicz, a professor of finance at Florida International University, in Miami, and a member of Money Laundering Alert's Editorial Board of Advisors.

Professor Zdanowicz explains that his “study evaluated every reported import and export transaction in precious metals and gems between the U.S. and all countries during 2004. This transaction data is contained in the U.S. Merchandise Trade Data Base, which is produced by the U.S. Department of Commerce, Bureau of Census.

The analysis determined every U.S. over-valued and undervalued import transaction in precious metals and gems from all countries. The study also determined every under-valued and over-valued export transaction of precious metals and gems from the United States to all countries. Abnormal import and export prices were determined based on the criteria as defined in the Internal Revenue Service (IRS) 482 transfer pricing regulations. These regulations assume that the arms-length price range is represented by the interquartile range of prices.”

An Expert Advising the IRS; Research Financed by Government
According to the professor, Israel, Canada, Japan, Belgium, and Switzerland moved the most suspicious money out of the U.S. through precious metals and stones. However, when ranked by the amount of suspicious money moved out of the U.S. as a percentage of trade in precious metals and gems, Sri Lanka, Japan, Lesotho, Sierra Leone, and Botswana ranked the highest. (The professor provides detailed tables with the data, but without getting specific permission, I hesitate to publish these at this time.) The tables show that the countries moving the most suspicious money into the U.S. through precious metals and gems were Italy, Costa Rica, Singapore, Israel, and Belgium. However, when comparing suspicious money moved into the U.S. as a percentage of trade, Costa Rica, Zambia, Singapore, Congo, and Kenya ranked the highest.

For our industry, the immediate problem arises from the professor’s unequivocal conclusion that, “the U.S. government will not be able to monitor and detect money laundering or terrorist financing through the abnormal pricing of precious metals and gems.” The professor argues that “the new regulations of dealers and retailers will monitor the front door of money laundering and terrorist financing. However, the quality and structure of the U.S. trade data on precious metals and gems reveals a wide open back door to launder money through international trade.”

The diamond trade may not be familiar with Professor Zdanowicz, but in the anti-money laundering community he is considered one of the greater experts, and his views are highly valued by the U.S. and other governments. Legislation signed into law by President Bush (in 2003) has designated Professors Simon J. Pak, Ph.D. and John S. Zdanowicz, Ph.D. as principal trade-based money-laundering investigators – and awarded them a $2 million grant – to continue their work in uncovering international pricing schemes. U.S. Senator Byron Dorgan, who was instrumental in getting that grant included in the relevant Appropriation Bill, said that these schemes cost the U. S. Treasury $45 billion in income tax revenues in 2000.

The government awarded that research money to enable the researchers to, “build on their previous work, which will help determine policies that will allow the IRS to collect taxes due, but avoided under such pricing schemes.” It is believed that the practice of abnormal international trade pricing shifts profits and enables individuals and firms to avoid or reduce their U.S. tax liability. From toothbrushes imported from the United Kingdom for $5,655 each and flashlights imported from Japan for $5,000 each to diamonds exported to Belgium for $3.08 a carat and bulldozers exported to Mexico for $528 each, Pak and Zdanowicz’s studies uncovered numerous commodities that were abnormally priced.

“If these suspicious transactions were investigated by the IRS, a significant amount of lost tax revenue could be collected,” Zdanowicz said at the time he was awarded the grant. According to Zdanowicz, “losses in U.S. tax revenues will continue to be a growing problem due to increased tax evasion and money laundering activities being facilitated by false invoicing in international trade. Tax evaders and criminals know that their activities are virtually undetectable because government agencies do not have the capability to analyze every U.S. Trade transaction.”

What is Abnormal? What is Abnormal in Diamonds?
In his methodology, the professor considers import and export prices to be abnormal if they deviate significantly above or below the pricing norms or the inter-quartile range, which is specified by IRS tax code. He also assumes that every dollar of taxable income shifted out of the U.S. would have been taxed at 34 percent. Professor Zdanowicz and his colleagues have developed the computer software necessary to analyze every U.S. trade transaction contained in the U.S. Department of Commerce’s “Merchandise Trade” database.

Every diamantaire knows that diamonds may range in values of only a few cents per carat to tens of thousands of dollars in carats. We believe that one shipment from the DRC or from Australia with extremely cheap diamonds would totally upset the statistics and show considerable statistical deviations. That has nothing, but absolutely nothing, to do with laundering. But as much as I cannot prove or disprove such linkage – neither can the professor. But he goes by the system: if there is a deviation, it must be laundering. And the U.S. Government (especially the IRS) listens closely to the professor.

The diamond industry must take early note of the research; some of the problems can be solved by creating a greater awareness among diamond traders of the importance of international customs codes. These problems are mounting. To give an example totally unrelated to the Zdanowicz research, the Israeli government reported that in the past two years Israel exported 6.2 million carats more than it imported. Any researcher would conclude that Israel has no domestic polishing industry anymore as there are no carats to process. Walking around Ramat Gan will surely show that there is still an active industry… so the government figures must be wrong. I have investigated this, and I unequivocally confirm that they are wrong. The government’s mistake is that it refers to gem quality rough, but quite a lot of gem quality rough is imported under an industrial customs diamond code. My research shows that, taken all carats together, Israel has a comfortable annual import surplus of some five million carats – which are processed domestically. But, statistically, we do not have carats….

So I have sympathy for some of the professor’s observations on customs codes, though he wants the codes to be more precise only to be able to detect deviations (and for government to collect more taxes and find launderers.) Says Zdanowicz, “The first problem with the U.S. trade data is that the number of export product codes is significantly less than the import product codes.

“During 2004 there were 130 product codes for U.S. imports of precious metals and gems while there were only 67 export product codes. This is the result of the U.S. government aggregating the export codes. For example, rubies, sapphires and emeralds each have their own unique import product codes (7103910010, 7103910020, and 7103910030 respectively). But, together, they only have a single export product code (7103910000). This aggregation of export product codes makes it difficult to determine abnormal trade pricing. If the government is truly interested in detecting money laundering it should significantly increase the number of product codes and have a one-for-one correspondence between import and export codes.” These findings of the professor are published in Money Laundering Alert.

“A second problem with the U.S. trade data,” continues the professor, “is that import or export transactions for certain products do not require reporting the quantity of the product being imported or exported. This makes it impossible for the government to determine the unit price of the transaction. Transactions related to importing natural and cultured pearls do not require quantities to be reported to the government. Transactions related to exporting rubies, sapphires and emeralds do not require quantities while importing the same products requires reporting the number of carats.”

The conclusion of the professor is scary: “Money launderers and terrorists realize that the lack of regulations and monitoring of abnormal pricing in international trade of precious metals and gems is a "gold mine" for moving money across borders. The U.S. government must focus on closing the back door of money laundering and terrorist financing if they are serious about preventing another 9/11.”

Remembering al-Qaeda
Here the professor makes an unwarranted link between gem laundering and “another 9/11.” When there was flimsy evidence (one newspaper report) about an alleged diamond link between al-Qaeda and diamonds a few years ago, the U.S. Congress quickly passed the Clean Diamonds Act (Kimberley Process); whether the link was real or imaginary became totally irrelevant. Professor Zdanowicz’s findings may have a similar impact. Washington may give it enormous credibility – but it is important that we try to understand the methodology.

It is my understanding, based on a working paper published by the Center for International Business and Education Research (CIBER) at the Florida International University, that the research method records all U.S transactions with a value of more than $2,500 for exports and $1,250 for imports. On average, the researchers analyze more than two million records per year. Each record identifies the item, quantity, and dollar value along with the mode of transportation, the U.S. customs district through which the goods passed, and the foreign country involved in the trade. Products are classified using the international standard Harmonized Commodity Code System, which contains over 15,000 categories of imports and over 8,000 categories of exports.

Then the researchers segment the total data set and enter the data for each individual transaction into a global price matrix. In that global price matrix, every country in the world is represented by over 230 columns, while every import harmonized code and every export harmonized code are represented by over 23,000 rows. The resulting matrix contains over five million cells. Each cell in the matrix contains the data on the population of transactions related to the United States' import or United States' export of a particular commodity from or to a specific country, as well as from or to the world. Some cells are empty if no transactions existed between the United States and a country for a particular commodity. Within each cell in the global price matrix, the researchers then determine the median price, the upper-quartile price, and the lower-quartile price.

Analysis and Determining Abnormal Prices
The researchers employ the inter-quartile range as the benchmark to determine if a transaction price is considered abnormal. They say that in 1994, the United States IRS issued its 482 transfer pricing regulations and stipulated that the inter-quartile price range should be used to determine the validity of transfer prices in international trade. In the professor’s analysis, imports at prices exceeding the import upper-quartile price, and exports at prices below the lower export-quartile price are considered abnormal.

It must be noted that in its transfer pricing regulations, the IRS also stipulates that prices outside the inter-quartile range should be adjusted and brought back to the median price when determining the dollar adjustment of abnormally priced transactions. This opens up the possibility of the IRS perhaps coming into one’s door with data that probably has normal explanations.

I don’t see the Zdanowicz research and finding problematic on the micro level, as each importer and exporter will find it easy to explain the legitimate and normal transactions. My concern comes from the macro-level. Just as fears of al-Qaeda or the forthcoming Blood Diamonds movie from Hollywood may inspire the public and governments to react (whether or not there is a real need to), and, just as many years ago the industry – somehow belatedly – embraced NGO’s and brought them into the industry, we ought to consider engaging into dialogue with professors such as Dr. John Zdanowicz and his colleagues. The last thing the diamond industry can afford is being tainted with such far-reaching findings, which represent a broad and general accusation on the entire U.S. diamond jewelry sector and its overseas trading partners.

The commitment of the international diamond industry towards full compliance with AML/CFT rules should not be allowed to be questioned. If there are problems, they can – and must – be addressed.

Have a nice weekend.