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Uncovering secret market fraud - Price Waterhousecoopers

NO HONEST, competent banker would believe in a secret market for banks where profits of two per cent a week can be earned without any risk to capital. Nevertheless, there are numerous intermediaries who say they have been introduced to bankers who say they trade in such a market.
By Richard Coleman

Myth - banks trade in discounted instruments

Banks issue instruments at substantial discounts to other banks. The instrument is called a prime bank guarantee , a standby letter of credit , a blocked funds certificate or something similar. They all offer some kind of promise that a bank will pay a sum of money at a future date - an instrument for which there is no recognized market.

Attention tends to focus on the instrument rather than the substantial discount. Standby letters of credit do, of course, exist but by their nature they cannot logically be traded separately from the obligation they guarantee; blocked funds also exist and it is easier to imagine a market for them similar to the market in third world debt.

Typically the issuing bank is said to be one of the top 25 world banks (a prime bank) and instruments from a selection (or menu ) of issuing banks may be offered. The discount is said to be much more than the amount required to allow for interest. The issuing bank will be said to be receiving, typically, 86 per cent of face value for an instrument with a 7.5 per cent coupon maturing in a year and a day.

Such generosity is, of course, unthinkable. Why would any banker wish to incur such losses? Some appear to believe the instrument has been carefully. designed to have a maturity date of one year and a day - and so, according to the fraudster, it does not have to be included on the bank's balance sheet. The logical extension of this proposition is that the banks issuing such instruments are preparing false accounts and may be hopelessly insolvent.

The secret market is said to be well known to the banking regulators throughout the world who condone it as a necessary way of managing the money supply. It is also claimed that banks use the money received to fund credit card business at interest rates of 30 per cent or so, leaving plenty of margin to pay for the extra discount on the instrument. This presupposes that other sources of borrowing at cheaper rates have been exhausted.

Myth - banks trade in secret market

Banks are said to trade among themselves in a secret market in instruments and will, reluctantly and on conditions of the utmost secrecy, permit privileged investors to participate provided they have the resources and introductions to do so. Banks are said to deny that the secret market exists or that they participate in it.

Against this it is said that banks would be expected to deny the existence of the market because if too many people know about it the huge profits would disappear. However hard investors may try, they will be unable to locate the secret market as it is said to have no physical location - it is an inter-bank market.

At an early stage in the trading process the instrument , which is for a large sum, is said to be divided up into smaller, more saleable denominations. This process is said to be carried out by a cutting house, by someone descended as a master cutter. The smaller denomination instruments are said to be fresh cut and after they have been around for a while they become seasoned. The reader should, of course, take this with a large pinch of salt.

Trades in the secret market always seem to be at a profit and never at a loss. The profit on each trade is typically described as being two per cent (even though elementary arithmetic says that if you buy at 86 and sell at 88 your profit is more than that).

After a number of banks have traded the instrument it is sold on to an institutional investor, at a discount which corresponds to the interest rate, who holds until maturity.

Myth - banks run "roll programmes"

Banks run roll programmes where an investor deposits say $5 million at a bank which is said to be managing a regular series of purchases and sales of instruments for a group of investors. This enables much larger sums to be invested and is said to be a market for big players. Investors with a mere $10 million may find this is their only way to enter the market.

Investors will be given plausible reasons why the money has to be sent to an overseas bank. The more likely reason is that it reduces the fraudsters' risk of being prosecuted. When investors ask for the return of their money they may be told that the programme is in the middle of a roll or that they cannot withdraw from the programme until there is another investor willing to join. In reality the money is probably long gone.

How has this fraud survived for so long?

It was the subject of warnings by the British Bankers Association as long ago as 1992 and banks have long had standard procedures to deal with funny money or ghost money . Bankers who recognize that their customers are thinking of making this type of investment tend to discourage their clients but not in terms sufficiently strong enough to persuade customers that they are likely to incur substantial losses.

Fraudsters will tell customers that they can well understand the warnings the banker has given; they are a natural consequence of the bad press given to the market. But they say they have access to another bank that actively trades in the market and will therefore confirm that the market is genuine.

Myth - money invested is not at risk

Investors may be told that their capital can be held by a fiduciary banker and will not actually be invested in an instrument or in a roll programme but will remain on deposit, can be withdrawn at short notice and will not be at any risk at any time. Nevertheless, the roll programme manager will be able, extraordinarily, to trade in the market and to earn substantial profits for investors.

It beggars belief that anyone would fall for this story. If managers can trade on credit they do not need, it would be extraordinarily generous if they shared the (illusory) profit with investors.

Fraudsters laugh all the way to the bank

The fraudsters who design the pseudo-legal documents typically found in these schemes seem to have a well developed sense of humour. Usually the gullible would-be investor is required to state that his funds are "good clean funds of a non-criminal origin". A recent variation provided that the agreement would be dissolved "should any party be found guilty of any unlawful acts; and/or be found guilty, under a United States, Canadian, Switzerland, United Kingdom, any nation, or Interpol indictment for international bank fraud".

What can bankers do to stop this fraud?

On 29 march 1994 The Bank of England sent a letter to all authorized institutions asking that any such schemes should be brought to the attention of its Special Investigations Unit, notwithstanding any action the institution might take to disclose to the relevant law enforcement authorities.

Publicity may be helping. Perhaps some would-be investors are being deterred by reading articles such as this. However fraudsters continue to find victims willing to sacrifice large sums of money. Bankers approached by customers seeking to open bank accounts through which trading will be conducted politely decline to open the account and suggest to customers that they should not get involved. However they are frequently not sufficiently open with customers to dissuade them.

Fraudsters are likely to tell their intended victims that such a response demonstrates the market exists but cannot be accessed through that particular bank on that particular day. Bankers should leave customers in no doubt that they are about to be a victim of fraud and lose a great sum of money.

About the author
Richard Coleman is a forensic accounting principal in PricewaterhouseCoopers. He is a founder member of the National Fraud and Investigations Group and specialises in investigating banking and investment frauds. In recent years he has investigated numerous frauds involving instruments in prime bank guarantees and similar fictitious instruments .

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Recommended further reading:
The Informed Investor - "Prime Bank" Scams
View of FBI on "Letter of Credit" and "Prime Bank Note"
Investment Scheme Advisory Alert by the Federal Reserve Bank of New York
"Prime bank" schemes
ICC alert on "Prime Bank Instrument" scams
SEC - So-Called "Limited Edition" United States Treasury Securities
SEC - How Prime Bank Frauds Work
SEC on Primebank

Books on Financial Instruments

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