## _wp1642 - 12.      The FATF standards were developed mainly with the conventional financial sector in mind.

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### I. INTRODUCTION / CONTEXT
- Following a peak in interest post 9/11, relatively little critical attention has been devoted so far to the study of money laundering and terrorist financing (ML/TF) risks in Islamic finance.
- ML, TF and the related predicate crimes create financial flows that may threaten a country’s financial stability and macroeconomic performance, including:
  - risks to the soundness and stability of financial institutions, including Islamic finance institutions;
  - increased volatility of international capital flows;
  - a dampening effect on foreign direct investment.
- Money launderers and terrorist financiers exploit loopholes and differences in national AML/CFT systems and move funds to or through jurisdictions with weak or ineffective legal and institutional frameworks.
- The note’s objectives:
  - review key characteristics of Islamic financial institutions and products;
  - discuss what ML/TF is and how the FATF standards address it;
  - examine whether there are ML/TF risks specific to Islamic finance;
  - consider the applicability of the FATF standards to Islamic finance and potential implementation challenges;
  - conclude with policy recommendations.

### Key characteristics of Islamic finance (as described)
- Main principle: adherence to “Riba” (usury)-free financial transactions.
- Other principles: risk sharing, prohibition of excessive uncertainty and short sales, recognition that money does not have an inherent value in itself.
- Shari’ah prohibits investing in businesses that provide goods or services considered forbidden (Haram), such as tobacco and other drugs, alcohol, pork products, gambling, speculation, pornography, and armaments and destructive weapons.
- Main products include: Murabahah, Mudarabah, Musharakah, Ijarah, Salam, Istisna. Sukuk financing constitutes partial ownership in assets financed according to one or mix of these modalities. Islamic financial institutions have developed other hybrid financial contracts based on these traditional instruments.
- Global footprint and scale:
  - Institutions offering Islamic financial services are present in more than 70 jurisdictions.
  - As of October 2014, there were nearly 400 Islamic banking institutions worldwide with assets estimated to have reached more than US$1.4 trillion.
  - Banking assets currently account for about 80 percent of total assets of the industry.
  - Assets concentrated in the Middle East (mostly in Iran and member countries of the Gulf Cooperation Council) and in Southeast Asia (mainly in Malaysia).
- Standard-setting and industry bodies:
  - Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
  - Islamic Financial Services Board (IFSB).
  - These organizations have not yet developed comprehensive standards or best practices related to AML/CFT in the Islamic finance context (the IFSB published in April 2015 its Standard-17 which addresses under CPIFR 33 the abuse of financial services for criminal activities, including ML/TF, retaining the provisions of Basel Core Principle (BCP) 29 unchanged).

### II. WHAT IS ML/TF AND HOW DO THE FATF STANDARDS ADDRESS IT?
- Definitions and core concerns:
  - Money laundering: process by which illicit sources of assets obtained or generated by a criminal activity are concealed to obscure the link between the funds and the original criminal activity.
  - Terrorist financing: solicitation, collection or provision of funds with the intention that they may be used to support terrorist acts or terrorist individuals or organizations; funds may stem from legal and/or illicit sources.
- Preventive measures centered on Customer Due Diligence (CDD):
  - Effective CDD requires:
    - identification of a customer and/or beneficial owner;
    - verification of the identity of the customer or beneficial owner;
    - understanding and, if appropriate, collection of information on the purpose and intended nature of the business relationship and the source of the funds;
    - ongoing monitoring of the business relationship.
  - Financial institutions are required, where appropriate, to report suspicious transactions to competent authorities.
  - AML/CFT programs include internal policies, procedures and controls, compliance management arrangements, and adequate screening procedures for hiring employees.
- Implementation and effectiveness challenges:
  - The FATF and other stakeholders place CDD and preventive measures at the heart of effective AML/CFT frameworks.
  - The level of compliance with FATF standards is still relatively low.
  - Peer reviews and assessments revealed important weaknesses mainly in: CFT measures, ML/TF prosecutions and convictions, implementation of preventive measures, and international cooperation.
  - 2012 FATF standards revision set a higher benchmark focused on risk-based implementation and effectiveness; a new round of assessments started in 2014 based on more demanding standards and methodology.
  - It has proven challenging for countries to demonstrate the effectiveness of their ML/TF risk mitigating measures.

### III. ARE THERE ML/TF RISKS SPECIFIC TO ISLAMIC FINANCE?
- Overall finding:
  - There is no evidence that the ML/TF risks in Islamic finance are any different from those posed by conventional finance. Choice of conventional or Islamic financial institutions to launder proceeds or finance terrorism appears dictated by convenience and opportunity rather than inherent differences.
- Important considerations and gaps:
  - Very limited study exists on ML/TF risks arising from Islamic finance. No ML/TF typologies or indicators related to Islamic finance have been published by AML/CFT agencies or FSRBs.
  - International standards for AML/CFT make no special provision for Islamic finance; FATF Recommendations apply equally to conventional and Islamic financial systems.
  - Most countries with an Islamic finance presence have AML/CFT regimes based on FATF standards but have not assessed ML/TF risks posed by specific features of Islamic finance nor incorporated lessons into their regimes.
  - AML/CFT regimes of some countries with a strong Islamic finance presence remain relatively weak; poor compliance issues are compounded by political threats and vulnerabilities independent of Islamic finance features.
- Areas meriting further study:
  - Specific nature of the relationship between a financial institution and its customers.
  - Modus operandi of Islamic financial institutions and the complexity of certain transactions.
  - Management of the high volume of Zakat by Islamic financial institutions.
- Specific potential vulnerabilities identified:
  - Nature of the customer relationship:
    - An Islamic financial institution’s “partner” relationship with clients (rather than “institution to customer”) could diminish transparency and make obligations such as ongoing CDD or suspicious transaction reporting more difficult to fulfill.
    - Partnership dimension may create potential conflict of interest, compromising effectiveness of preventive measures.
    - Risk of joint liability: e.g., if a mudarabah investment involves illicit activities, both partners could be considered to have perpetrated the offense and be criminally liable.
  - Complexity of Islamic finance products:
    - Islamic products are asset based, introducing layers of complexity that may be exploited.
    - Tawarruq or murabaha-style commodity and asset trading: transfers of commodities back the transfer of funds; tawarruq can provide quick access to funds and thus may be misused for frequent or large recycling of criminal proceeds.
    - Use of Special Purpose Vehicles (SPV) in connection with Islamic finance transactions, often established in offshore financial centers, can introduce opacity regarding origin/destination of underlying assets and valuation.
  - Management of Zakat and Sadaqat:
    - Zakat and Sadaqat funds are collected and managed by Islamic financial institutions, often in large volumes, with discretion to designate beneficiaries including non-profit organizations (NPOs).
    - High volume of such activity, absent sound ML/TF risk management, can increase exposure to reputational, operational, compliance and concentration risks.
- Conclusion on current evidence:
  - While no conclusive evidence to date suggests that features associated with Islamic finance represent different or greater actual ML/TF risks, additional work on typologies and better understanding of these features is called for.

### Specific features of FATF standards and Islamic finance (paragraphs 12–13)
- Core observation:
  - The FATF standards were developed mainly with the conventional financial sector in mind. Further work is needed to determine whether they need to be modified to address the specific features of Islamic finance. (12)
- Two specific features of the FATF standards would not appear to fully take into account the specific features of Islamic finance: the concept of a “customer” and the definition of a “financial institution.” (13)

- Definition of a “customer”:
  - A key element of an effective AML/CFT framework is the identification of the “customer.”
  - The concept of “customer” is not defined in the standards and its meaning is not entirely clear.
  - It is not clear whether it applies to the types of partner-based relationship (rather than an “institution to customer” relationship) that are a key feature of Islamic finance.
  - To the extent that such parties are not considered to be “customers,” they would fall outside of the provisions of the standards requiring countries to have in place robust regimes for customer identification and due diligence.
  - While it may be argued on the basis of the rationale for customer identification requirements that such parties should be considered to be “customers” for the purposes of the standards, it would be useful to make this explicit.
  - It should also be clarified that the FATF standards CDD measures apply to the other party in the contractual relationship, including the partner in the type of “partnerships” used in Islamic finance.

- Definition of a “financial institution”:
  - The definition included in the glossary of the FATF Recommendations does not encompass comprehensively the reality of Islamic financial institutions.
  - Financial institutions are defined as natural or legal persons conducting one or more financial activities (e.g., deposits, lending) listed in the glossary, which do not seem to incorporate the variety of existing Islamic finance’s products and services.
  - The glossary defines a financial institution as acting for or on behalf of a customer, whereas Islamic financial institutions engage for or on behalf of partners.

### Conclusion and policy recommendations (paragraphs 14–15)
- Overall assessment:
  - There would appear to be no fundamental differences between ML/TF risks in Islamic and conventional finances.
  - FATF, FSRBs and their member countries are imposing the standards and best practices similarly on conventional and Islamic finance institutions.
  - The issue of Islamic finance ML/TF risks requires further study. (14)

- Three recommendations (15):
  - Recommendation 1 — Standard setters and regulators:
    - The standard setter and regulators should develop a better understanding of the ML/TF risks in Islamic finance, including through an enhanced dialogue with supervisors, Islamic finance institutions, and practitioners.
    - A better understanding of the nature and scale of ML/TF risks would require a more in-depth analysis of the intrinsic characteristics of instruments and arrangements used in Islamic finance.
    - This would require an analysis of ML/TF methods, trends, and typologies in Islamic finance and of the related risks arising from the nature of the contractual relationship between the institutions, their customers, and the providers of assets.
    - Building on the findings of this work, customized mitigating measures to maintain the integrity of Islamic finance and safeguard the industry against ML/TF may be developed, if necessary.
    - (Footnote: FATF, in coordination with AAOIFI, the IFSB and the relevant FSRBs.) (22)

  - Recommendation 2 — Islamic financial institutions:
    - Islamic financial institutions should build additional experience in assessing the ML/TF risks they are facing, and in effectively implementing preventive measures tailored to the characteristics of their products and services.
    - The lack of supervisory experience and capacity that prevails in certain countries with a strong Islamic finance presence should be addressed.
    - Areas meriting further attention include:
      - (i) the specific nature of the relationship between a financial institution and its customers;
      - (ii) the modus operandi of Islamic financial institutions and the complexity of certain transactions; and
      - (iii) the management of the high volume of Zakat by Islamic finance institutions.

  - Recommendation 3 — Assessors and competent AML/CFT authorities:
    - Assessors and competent AML/CFT authorities, including in the context of the ongoing round of assessment of the effectiveness of AML/CFT regimes, should seek to understand whether the current recommendations set out in the FATF standards require further adaptation to mitigate any ML/TF risks that might be specific to Islamic finance.

*Source: Excerpt from IMF working paper _wp1642 - 12. The FATF standards were developed mainly with the conventional financial sector in mind.*

### REFERENCES .............................................................................................................

### _wp1642 - REFERENCES

### I. INTRODUCTION
- Following a peak in interest post 9/11, relatively little critical attention has been devoted so far to the study of money laundering and terrorist financing (ML/TF) risks in Islamic finance.
- ML, TF and the related predicate crimes create financial flows that may threaten a country’s financial stability and macroeconomic performance, including:
  - risks to the soundness and stability of financial institutions, including Islamic finance institutions;
  - increased volatility of international capital flows;
  - a dampening effect on foreign direct investment.
- Money launderers and terrorist financiers exploit loopholes and differences in national AML/CFT systems and move funds to or through jurisdictions with weak or ineffective legal and institutional frameworks.
- The note’s objectives:
  - review key characteristics of Islamic financial institutions and products;
  - discuss what ML/TF is and how the FATF standards address it;
  - examine whether there are ML/TF risks specific to Islamic finance;
  - consider the applicability of the FATF standards to Islamic finance and potential implementation challenges;
  - conclude with policy recommendations.

### Key characteristics of Islamic finance (as described)
- Main principle: adherence to “Riba” (usury)-free financial transactions.
- Other principles: risk sharing, prohibition of excessive uncertainty and short sales, recognition that money does not have an inherent value in itself.
- Shari’ah prohibits investing in businesses that provide goods or services considered forbidden (Haram), such as tobacco and other drugs, alcohol, pork products, gambling, speculation, pornography, and armaments and destructive weapons.
- Main products include: Murabahah, Mudarabah, Musharakah, Ijarah, Salam, Istisna. Sukuk financing constitutes partial ownership in assets financed according to one or mix of these modalities. Islamic financial institutions have developed other hybrid financial contracts based on these traditional instruments.
- Global footprint and scale:
  - Institutions offering Islamic financial services are present in more than 70 jurisdictions.
  - As of October 2014, there were nearly 400 Islamic banking institutions worldwide with assets estimated to have reached more than US$1.4 trillion.
  - Banking assets currently account for about 80 percent of total assets of the industry.
  - Assets concentrated in the Middle East (mostly in Iran and member countries of the Gulf Cooperation Council) and in Southeast Asia (mainly in Malaysia).
- Standard-setting and industry bodies:
  - Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
  - Islamic Financial Services Board (IFSB).
  - These organizations have not yet developed comprehensive standards or best practices related to AML/CFT in the Islamic finance context (the IFSB published in April 2015 its Standard-17 which addresses under CPIFR 33 the abuse of financial services for criminal activities, including ML/TF, retaining the provisions of Basel Core Principle (BCP) 29 unchanged).

### II. WHAT IS ML/TF AND HOW DO THE FATF STANDARDS ADDRESS IT?
- Definitions and core concerns:
  - Money laundering: process by which illicit sources of assets obtained or generated by a criminal activity are concealed to obscure the link between the funds and the original criminal activity.
  - Terrorist financing: solicitation, collection or provision of funds with the intention that they may be used to support terrorist acts or terrorist individuals or organizations; funds may stem from legal and/or illicit sources.
- Preventive measures centered on Customer Due Diligence (CDD):
  - Effective CDD requires:
    - identification of a customer and/or beneficial owner;
    - verification of the identity of the customer or beneficial owner;
    - understanding and, if appropriate, collection of information on the purpose and intended nature of the business relationship and the source of the funds;
    - ongoing monitoring of the business relationship.
  - Financial institutions are required, where appropriate, to report suspicious transactions to competent authorities.
  - AML/CFT programs include internal policies, procedures and controls, compliance management arrangements, and adequate screening procedures for hiring employees.
- Implementation and effectiveness challenges:
  - The FATF and other stakeholders place CDD and preventive measures at the heart of effective AML/CFT frameworks.
  - The level of compliance with FATF standards is still relatively low.
  - Peer reviews and assessments revealed important weaknesses mainly in: CFT measures, ML/TF prosecutions and convictions, implementation of preventive measures, and international cooperation.
  - 2012 FATF standards revision set a higher benchmark focused on risk-based implementation and effectiveness; a new round of assessments started in 2014 based on more demanding standards and methodology.
  - It has proven challenging for countries to demonstrate the effectiveness of their ML/TF risk mitigating measures.

### III. ARE THERE ML/TF RISKS SPECIFIC TO ISLAMIC FINANCE?
- Overall finding:
  - There is no evidence that the ML/TF risks in Islamic finance are any different from those posed by conventional finance. Choice of conventional or Islamic financial institutions to launder proceeds or finance terrorism appears dictated by convenience and opportunity rather than inherent differences.
- Important considerations and gaps:
  - Very limited study exists on ML/TF risks arising from Islamic finance. No ML/TF typologies or indicators related to Islamic finance have been published by AML/CFT agencies or FSRBs.
  - International standards for AML/CFT make no special provision for Islamic finance; FATF Recommendations apply equally to conventional and Islamic financial systems.
  - Most countries with an Islamic finance presence have AML/CFT regimes based on FATF standards but have not assessed ML/TF risks posed by specific features of Islamic finance nor incorporated lessons into their regimes.
  - AML/CFT regimes of some countries with a strong Islamic finance presence remain relatively weak; poor compliance issues are compounded by political threats and vulnerabilities independent of Islamic finance features.
- Areas meriting further study:
  - Specific nature of the relationship between a financial institution and its customers.
  - Modus operandi of Islamic financial institutions and the complexity of certain transactions.
  - Management of the high volume of Zakat by Islamic financial institutions.
- Specific potential vulnerabilities identified:
  - Nature of the customer relationship:
    - An Islamic financial institution’s “partner” relationship with clients (rather than “institution to customer”) could diminish transparency and make obligations such as ongoing CDD or suspicious transaction reporting more difficult to fulfill.
    - Partnership dimension may create potential conflict of interest, compromising effectiveness of preventive measures.
    - Risk of joint liability: e.g., if a mudarabah investment involves illicit activities, both partners could be considered to have perpetrated the offense and be criminally liable.
  - Complexity of Islamic finance products:
    - Islamic products are asset based, introducing layers of complexity that may be exploited.
    - Tawarruq or murabaha-style commodity and asset trading: transfers of commodities back the transfer of funds; tawarruq can provide quick access to funds and thus may be misused for frequent or large recycling of criminal proceeds.
    - Use of Special Purpose Vehicles (SPV) in connection with Islamic finance transactions, often established in offshore financial centers, can introduce opacity regarding origin/destination of underlying assets and valuation.
  - Management of Zakat and Sadaqat:
    - Zakat and Sadaqat funds are collected and managed by Islamic financial institutions, often in large volumes, with discretion to designate beneficiaries including non-profit organizations (NPOs).
    - High volume of such activity, absent sound ML/TF risk management, can increase exposure to reputational, operational, compliance and concentration risks.
- Conclusion on current evidence:
  - While no conclusive evidence to date suggests that features associated with Islamic finance represent different or greater actual ML/TF risks, additional work on typologies and better understanding of these features is called for.

*Source: Excerpt from IMF working paper _wp1642 (REFERENCES and sections I–III).*

### 12.      The FATF standards were developed mainly with the conventional financial sector in

### _wp1642 - 12.      The FATF standards were developed mainly with the conventional financial sector in mind.

### Specific features of FATF standards and Islamic finance (paragraphs 12–13)
- The FATF standards were developed mainly with the conventional financial sector in mind. Further work is needed to determine whether they need to be modified to address the specific features of Islamic finance. (12)
- Two specific features of the FATF standards would not appear to fully take into account the specific features of Islamic finance: the concept of a “customer” and the definition of a “financial institution.” (13)

- Definition of a “customer”:
  - A key element of an effective AML/CFT framework is the identification of the “customer.”
  - The concept of “customer” is not defined in the standards and its meaning is not entirely clear.
  - It is not clear whether it applies to the types of partner-based relationship (rather than an “institution to customer” relationship) that are a key feature of Islamic finance.
  - To the extent that such parties are not considered to be “customers,” they would fall outside of the provisions of the standards requiring countries to have in place robust regimes for customer identification and due diligence.
  - While it may be argued on the basis of the rationale for customer identification requirements that such parties should be considered to be “customers” for the purposes of the standards, it would be useful to make this explicit.
  - It should also be clarified that the FATF standards CDD measures apply to the other party in the contractual relationship, including the partner in the type of “partnerships” used in Islamic finance.

- Definition of a “financial institution”:
  - The definition included in the glossary of the FATF Recommendations does not encompass comprehensively the reality of Islamic financial institutions.
  - Financial institutions are defined as natural or legal persons conducting one or more financial activities (e.g., deposits, lending) listed in the glossary, which do not seem to incorporate the variety of existing Islamic finance’s products and services.
  - The glossary defines a financial institution as acting for or on behalf of a customer, whereas Islamic financial institutions engage for or on behalf of partners.

### Conclusion and policy recommendations (paragraphs 14–15)
- Overall assessment:
  - There would appear to be no fundamental differences between ML/TF risks in Islamic and conventional finances.
  - FATF, FSRBs and their member countries are imposing the standards and best practices similarly on conventional and Islamic finance institutions.
  - The issue of Islamic finance ML/TF risks requires further study. (14)

- Three recommendations (15):
  - The standard setter and regulators should develop a better understanding of the ML/TF risks in Islamic finance, including through an enhanced dialogue with supervisors, Islamic finance institutions, and practitioners.
    - A better understanding of the nature and scale of ML/TF risks would require a more in-depth analysis of the intrinsic characteristics of instruments and arrangements used in Islamic finance.
    - This would require an analysis of ML/TF methods, trends, and typologies in Islamic finance and of the related risks arising from the nature of the contractual relationship between the institutions, their customers, and the providers of assets.
    - Building on the findings of this work, customized mitigating measures to maintain the integrity of Islamic finance and safeguard the industry against ML/TF may be developed, if necessary.
    - Footnote: FATF, in coordination with AAOIFI, the IFSB and the relevant FSRBs. (22)

  - Islamic financial institutions should build additional experience in assessing the ML/TF risks they are facing, and in effectively implementing preventive measures tailored to the characteristics of their products and services.
    - The lack of supervisory experience and capacity that prevails in certain countries with a strong Islamic finance presence should be addressed.
    - Areas meriting further attention include:
      - (i) the specific nature of the relationship between a financial institution and its customers;
      - (ii) the modus operandi of Islamic financial institutions and the complexity of certain transactions; and
      - (iii) the management of the high volume of Zakat by Islamic finance institutions.

  - Assessors and competent AML/CFT authorities, including in the context of the ongoing round of assessment of the effectiveness of AML/CFT regimes, should seek to understand whether the current recommendations set out in the FATF standards require further adaptation to mitigate any ML/TF risks that might be specific to Islamic finance. 

*Source: IMF working paper content unit _wp1642 - 12. The FATF standards were developed mainly with the conventional financial sector in mind.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1642.pdf_