Illicit finance is the lifeblood of many groups and organizations acting directly to the interests of global security. From the high-rises of Moscow to the corridors of power in Tehran to the expanses of Sinaloa, rogue actors use a complex set of tools, legal and illegal, in their efforts to conceal capital flows and commercial transactions. Here, Juan Zarate, a former assistant Treasury Secretary and deputy national security advisor with a special focus on combating illicit finance, unpacks this complex issue — and the knot of risks that surround it.
Octavian Report: Where are the main risks in illicit finance coming from today, both on the technical and strategic sides?
Juan Zarate: There are three ways to categorize the threats that are most challenging in the illicit finance space. One is the idea of blended actors. It’s often in the space of illicit finance that you find various actors colluding and cooperating together, not only to evade currency controls but to try to profit and move capital across borders in ways that are advantageous to their organizations. The blend of organized crime and terrorism, the blend of high-end kleptocracy and financial crime, the ability for actors like Hezbollah or Mexican drug cartels to have a more global presence, the ability to use elements of the global financial-commercial system to their advantage, often in parallel or in unison, is a real challenge to authorities. The threat of illicit finance is no longer just the problem of drug money laundering within jurisdictions. It’s the threat of billions dollars of illicit capital moving across borders and touching multiple actors. That’s one big area of risk and concern moving forward.
The second is what we’re seeing in terms of high-order corruption and illicit finance at the highest levels of governments. You’ve seen this, for example, in the 1MDB scandal where you’ve got the blend of high-order politics in Malaysia, the involvement of sovereign wealth funds, and the involvement of legitimate Western actors, be they investment banks or law firms. That becomes a real challenge to the system. When you’re talking about billions of dollars of assets, you’re talking about a lot of influence and a lot of capital that can be deployed in ways not in line with international standards and norms — and certainly not in line with the interests of protecting the integrity of the financial system. That’s the second category.
The third is the emergence of cyber as a real threat. Not just to the safety and stability of the financial system, where we’ve seen blunders and challenges to that (or at least threats). The SWIFT heist involving Bangladesh, the Philippines, and the New York Fed warned us that a part of the financial system could be attacked and manipulated potentially in a way that presents real systemic risks. Taken into account with the fact that you have cyber attacks that are growing more sophisticated, not just in intensity but in what the actual attacks and malware are able to do, you begin to see a potential blend between cyber security and illicit finance that I think is going to be a challenge to the financial industry moving forward.
OR: Were you surprised to see the 1MDB affair prove to be a scandal of the magnitude it did?
Zarate: Yes and no. I was surprised in its magnitude of scope. Certainly the more we learn, the more we see different threads of it that are somewhat surprising. At least in 2015 or 2016 you would assume there would be more awareness around how funds are used for politically exposed persons and how they’re used by governments, and the protections and integrity around those kinds of investments and money movement. You would assume there would be more care and caution, especially among legitimate actors around how to protect the integrity of those kinds of transactions. It’s clear there wasn’t that kind of consciousness around what was happening. Certainly there were not enough questions asked around the nature of this investment vehicle.
The “no” part is: we know there is high-scale, high-order corruption and kleptocracy that happens in the world. The same can be said for the Panama Papers: there’s no general surprise that there is tax evasion, sanctions evasion, and layering of transactions to hide sources of wealth and capital, often for illicit purposes. But it’s always a bit of a shock to see the specifics of what that looks like. I think that’s what the 1MDB scandal has revealed, it’s what the Panama Papers leak revealed. It gives form and detail to what we already know is happening in the system.
OR: How much are events like that driven by successful evasion efforts, and how much by policy-motivated lack of enforcement?
Zarate: I think it’s a combination of two factors. I think the illicit actors, be they high end kleptocrats or the functionaries of drug cartels — people like Juan Manuel Alvarez Inzunza, nicknamed King Midas, of the Sinaloa Cartel, who over a decade moved about $4 billion worth of proceeds through the Mexican banking system, the money exchange system, through the use of shell companies and layered transactions — are showing greater and greater sophistication and a greater awareness of how authorities operate. The bad actors are always adapting, they’re smart, they have resources, and they have the ability to move value, goods, and money across borders.
And there has been a lack of enforcement attention around the world to the high-order cases that actually make a systemic difference. I think part of this is the fact that outside of the U.S., there have been very few investigations of high-order corruption. The cases do occur but they’re more sporadic, and historically, at least, they’ve been less consistent and certainly not well-resourced. These are hard cases to investigate. Sometimes they take years to develop. You need real resources on the enforcement side and cooperation around the world to investigate these kinds of cases. The kind of cooperation you’re now beginning to see for example, in the FIFA cases spurred by U.S. and Swiss investigation and enforcement. It is also interesting that in the context of sanctions and sanctions investigation, it’s really only been the United States that has had a dedicated office, the Office of Foreign Asset Control based at the Treasury Department, charged with administering and enforcing sanctions programs — and charged as well with helping the private sector understand what the boundaries are with respect to the application of sanctions and sanctions regulations.
The world is now catching up to the need to actually enforce the laws and regulations that have long been on the books. It takes time, it takes resources, and it takes political will to be able to bring these kinds of cases and to, frankly, create systems that are preventative, that actually create a deterrence around the placement of illicit funds or the engagement of money laundering. That is a key component of the post-9/11 environment: trying to prevent illicit capital from making its way into the system and trying to prevent illicit actors from accessing the international financial and commercial system.
OR: How crucial a role does combating illicit finance play in the larger fight for national security?
Zarate: I think the issue of illicit finance and the threat it poses are important along three strands. The first is from a law-enforcement, intelligence, and national security perspective. There’s no question now that everyone appreciates that in order to disrupt, dismantle, and deter illicit actors, you have to figure out ways of making it harder, costlier, and riskier for them to raise and move money around the world. If you can affect the bottom line of illicit organizations or rogue regimes, you can begin to affect their strategic calculations and global reach. That is now an understood dimension of our national security, in a way that even right after 9/11 it wasn’t. I think that’s been the evolution of the past 15 years: that any issue of international security import has a key financial component to it.
The second has to do with the importance of deterring and preventing illicit financing vis-à-vis international development. If you look at some of the estimates as to how much is taken out of the financial and commercial systems of developing economies by illicit finance, you’re talking about hundreds of billions of dollars. Some estimates take it up to a trillion dollars, depending on the calculus. When you have high levels of corruption, you not only have distortion of economies, but you have the empowering of actors that are profiting themselves or illicit organizations as opposed to profiting the local economy, local population, and local citizenry.
That issue is often thought of as a different component of illicit finance. I think more and more people see it as neatly married with these broader security questions.
Finally, there’s the systemic question of how we ensure the safety and soundness of the international financial system and commercial system. What are the norms and rules by which that system will operate? Are these rules about transparency, accountability, traceability? Or are we going to have norms and rules that allow for cheating, corruption, and illicit finance embedded within legitimate commercial and financial activity? I would argue that part of what the United States has tried to do, especially over the last 15 years, is to continue to not only establish but to also enforce transparency-based norms in ways that continue to reinforce the need for financial integrity and the protection of the financial and commercial system. There’s a systemic argument about why you don’t want illicit capital blended with the legitimate financial system. It’s corrosive, it undermines its integrity, and is actually an inefficient allocation of capital at the end of the day.
All three of these are big-ticket items, and are all implicated by the fight against illicit finance and the drive towards financial integrity and transparency.
OR: What is your take on the argument — made elsewhere in this issue by Kenneth Rogoff, and by others in other venues — that limiting the use of cash to low-value transactions will help choke off illicit finance?
Zarate: Long ago, when I was at the Treasury Department and we were talking to the European Union before they launched the 500-euro note, we advised against it. This is a note that is easily used by illicit actors. It certainly could be counterfeited in ways that would profit various actors — including the North Koreans, who are very good at counterfeiting notes. It’s probably not wise in terms of creating that kind of denomination of a currency, especially at the outset. In any event, I had long argued with European colleagues that is was probably not a wise choice. I think they’re realizing that now.
OR: What was their argument for going ahead with it?
Zarate: I think they wanted to provide flexibility. You would have to go back and talk to them. I remember some of the arguments being they wanted to provide a full spectrum of flexibility around cash transactions. That means having lower- and higher-denomination notes. Part of the purpose of a common currency and common markets is to allow the easy flow of capital, goods and people across borders. Allowing for currency that makes commercial activity in the common market more easily done is something they were striving for. I don’t think it was a negative instinct on their part. I just think we were much more sensitive to the role of cash and illicit finance, and frankly, the travails of counterfeit high-end notes. We were dealing for a long time with the North Korean super note, the best counterfeit of $100 bills in the world. That was something perpetrated by the North Koreans to generate revenue and to undermine confidence in the $100 bill. We were hypersensitive to a lot of these issues as we were dealing with them directly. I’m not sure the Europeans were as sensitive, especially those that were dealing with the imperatives in the common market and common currency.
That said, I think there’s reasons to have cash. I think the arguments against cash are because of what it allows illicit actors to do. It has implications for privacy and in financial transactions. I think the reality is illicit actors will find ways of transacting. It may be harder and costlier to do so, but they’re going to find ways to do it. Whether it’s with prepaid cards or other forms of currency. We saw that with the Silk Road network where you had this online digital currency platform and market for all forms of illicit goods and commerce. I don’t think getting rid of cash alleviates the problem of illicit commerce. It certainly does help if you get rid of the higher-denomination notes. I think it’s not the silver bullet that many make it out to be.
OR: What makes sanctions effective, and what are the political obstacles to putting effective sanctions in place?
Zarate: I think the long and short of it is that the types of sanctions applied prior to 9/11 are very different from the financial measures, including sanctions, that have been effective in the post-9/11 period. It’s not that certain sanctions pre 9/11 weren’t effective, it’s that we had a very different focus and different paradigm we applied to how we thought about the use of financial measures. We were trying to find financial measures that would ultimately serve as a campaign of financial exclusion. We weren’t necessarily trying to hermetically seal jurisdictions based on trade sanctions or the broad sanctions of old.
What we were trying to do was apply measures that over time, especially in the Iranian context, would exclude the Iranians from the global financial and commercial system. Not because it was part of a diplomatic diktat, or American predilection, but based on the illicit activity of the regime itself. The argument in the post-9/11 period that was effective in respect to terrorist groups, effective in respect to Iran — and I think could be effective in respect to North Korea and Russia if applied in a more concerted way — is to say these are regimes engaged in illicit financing in a variety ways, allowing them to engage in activity that is dangerous for international security. It’s a combination of not just being worried about their nuclear program, but also worrying about the underlying illicit and suspicious activity that they were engaged in to actually fuel the nuclear program development, or human rights abuses, support to terrorism, support to Assad, or all the other things for which they’ve been sanctioned.
It wasn’t just that we had sanctions against Iran. We had decades of sanctions against Iran. It was that we began to make the case, based on real data, that Iran was misusing the financial system to engage in all of these dangerous activities. The regime was using more and more of its control of the economy to do that. That has not been the maximalist approach that we’ve applied to Russia, and it has yet to be the maximalist approach that we’ve applied to North Korea. We began that approach with North Korea in 2005. The initial stages of it were so effective that it became the centerpiece of discussions with the North Koreans, and the price of re-entry to the Six-Party Talks with respect to the lessening of those pressures. Those concessions were made and the diplomacy continued. The main point here is we’ve applied a variety of financial and commercial constriction campaigns against rogue actors as a way of using their own illicit activity against them.
That’s why, when I commented on the JCPOA publicly and before the Senate and the House when the nuclear agreement was being debated and discussed, I argued that there was inherent tension in the nuclear deal. We were promising Iran reintegration into the financial and commercial system while also promising to pursue sanctions and financial measures against a range of activities the Iranians were engaged in (absent Iranian change of behavior on the underlying activity). That’s why you see the stickiness of the sanctions and financial measures to date. There is still the stickiness and risk that Iran continues to engage in illicit activity, suspicious activity, and uses its financial and commercial system to the advantage of the regime in aid of these issues that are of international security import — even beyond the nuclear program.
I think what we’ve done over the last 15 years is to apply a very different set of tools, with a very different paradigm, to pressure regimes and rogue actors in ways that have really hurt them and that have gotten their attention and have been an aid to our diplomacy.
OR: How do you see the struggle over these issues playing out in the medium term between the U.S. and Iran? The U.S. and North Korea?
Zarate: I think the Trump administration will have a lot to say about the contours of our sanctions and our sanctions-unwinding, frankly. It’s not just a matter of how we think about the application of sanctions. It’s also how we think about the strategic unwinding of sanctions that can equally meet our policy objectives. I think we’ve been less creative and less forceful in how we think about that unwinding, whether it be in the context of Cuba, Iran, or even Burma. I think there are a couple of common strands moving forward that any administration would have to acknowledge. The first is that these are tools central to how we think about the exercise of American and allied international power. How we preserve this power, how we strengthen it, how we reinforce it, and how we decide not to use it becomes very important strategically.
I think a new administration will likely want to take a fresh look about how we’ve thought creatively about pressuring any of these regimes, even around the diplomatic deals that have been agreed to. In the context of Iran, there’s certainly much more that could be done to try to bring pressure to bear outside the bounds of the nuclear deal. This is something that the Obama administration has not wanted to do for fear of upsetting the deal, precisely because it has this inherent tension that I described earlier. The Iranians will view any additional pressure on them financially or commercially to be in abjuration of the deal perhaps. Even though we have promised that we are willing to use sanctions to affect other Iranian activity, for example, support to terrorist, proxy or militia groups.
With respect to North Korea, I think there’s going to be a consideration as to how we think about not just pressuring North Korea, but how we pressure China in that context, and what is put at risk for China in the context of their willingness to continue to trade with or provide haven — financial, diplomatic, or commercial — for North Korea. We’re going to have to think creatively about how we continue to put pressure around the seams of illicit finance and norms of financial integrity that play to our great strengths, especially against regimes like North Korea and Iran.
OR: How much damage did the sanctions actually do to Iran?
Zarate: The financial constriction campaign against Iran had phases. It started in 2005; thankfully the Obama administration took it forward. The same Treasury team that was implementing the campaign before the Obama administration came in stayed in place. There was a continuation of that pressure to include Congressional action like the Comprehensive Iran Sanctions, Divestment, and Accountability Act and European action which eventually included the aforementioned unplugging of designated Iranian banks from the SWIFT system. What you had was a constriction campaign that began with the Iranian banks, moved to their insurance sector, moved to their shipping and transport sector, moved to their oil infrastructure sector, and finally ended with the designation of Iran and its central bank as primary money-laundering concerns and the unplugging of the Iranian designated banks from the SWIFT financial system, which was the last technical (as well as symbolic) act of unplugging those banks from the international order.
All of those steps built up over time served that strategic goal of unplugging suspected illicit and problematic Iranian activity from the legitimate financial and commercial system. It really was a constriction campaign that at the end of the day was strangling the Iranian economy — combined with their own mismanagement, combined with a lot of concerns internationally where they were headed from a security perspective, combined with the drop in oil prices. All of that was suffocating the Iranian regime, which is why they were willing to negotiate. It’s why Rouhani said that absent a deal, Iran would have been sanctioned into the economic Stone Age. All of that I think played in our favor. I’ve been highly critical that we gave up too much too soon and didn’t play the upper hand here.
I think one of the hopes that the Iranians have is that there is enough momentum to the opening of their market that it becomes very difficult politically, if not functionally, to re-impose sanctions. I think over time it gets harder and harder as the Iranian economy begins to open up to more actors, as more actors take to doing business in Iran and there’s more investment from the West. It does become a bit of an economic shield for the Iranians which they’re trying to accelerate as part of their strategy. I think that with the Trump administration, that may pause or retard some of the willingness of actors to go in until they see what the U.S. administration is going to do. We’re still in the middle of how this unfolds. It’s not the end of the story yet.
OR: How much do you think that the market in certain high-end hard assets — art, real estate, and jewelry, for example — is being driven by illicit finance? To what extent is that drying up, if it is at all?
Zarate: This is something I’ve written about as well, in the context of Russia. I think we should perhaps be focusing more attention on Western actors that are working with organized crime syndicates through the art markets or real estate. We should be looking at cyber economic espionage as well as profiteering around intellectual property that is being used by certain Russian actors or enabled by certain Russian actors. We should be focusing on the underlying activity that is in violation of international law, certainly in violation of our laws, and using that to identify Russian actors that need to be targeted as well as isolated from the formal financial and commercial systems. That is a different approach than what we’re currently applying.
There is now much more attention on the real-estate markets being used by organized criminal actors, as well as those trying to evade sanctions or taxes, as a way of investing their capital, mingling it, laundering it, and holding it outside the gaze of authorities. It’s why FinCEN, the Financial Crimes Enforcement Network from Treasury, has put out geographic targeting orders. These are regulations that require additional information-gathering in the real estate market in particular markets for high value purchases. It started in Manhattan and in Miami because of the high levels of cash transactions and purchases by shell companies on behalf of Russian, Chinese, and Venezuelan actors. That geographic targeting order has now migrated to all the major markets in California — San Diego, L.A., San Francisco — and to other markets in New York as well as parts of the market in Texas.
This is also an issue in Europe. U.K. authorities are now looking carefully at high-end property values and investments by actors, including those from Russia, to determine whether or not Russian organized crime is using real-estate investment as a vehicle to hide their assets or to commingle their assets.
OR: Is there a substantial nexus in these investigations between organized crime and state actors?
Zarate: In terms of the connection between organized crime, hackers, and governments, certainly we have written about the case of the Russian government leveraging relationships with organized crime groups, hackers, and others for the purpose and benefit of Russian policy. We’ve seen that even with what the DNI and the U.S. intelligence community has said about the hack of the DNC and the email hacking — that it ultimately was a decision by the Kremlin that wasn’t necessarily perpetrated by the Kremlin but by actors associated with them. Yes, there are connections, and I think one of the things that happens in these kinds of campaigns is to reveal the connections between the government actors and these other organizations or networks and to warn the international community as to what those relationships look like. Sometimes they are cloaked. They are not clear to the private sector. It’s hard for the private sector to understand with whom they’re doing business. Part of the strategy here is to reveal where those relationships exist, which then underscores the heightened risk that commercial actors play in doing business with elements of these networks.
OR: Can you expand on the illicit use of intellectual property?
Zarate: I think an example are the Chinese. The Chinese are clearly vacuuming up as much data as they can — terabytes of data — as part of a strategy to not only gather as much as intelligence and information as they can, but to acquire commercially relevant data to give them competitive advantage in the marketplace. We’ve seen that with stolen designs and stolen IP. We’ve seen that as part of an economic strategy that the Chinese have used to not only get a foothold in particular markets, but then begin to take over particular markets. The solar energy field is a good example of that. There’s been an all-out strategy to not only acquire new technology and data, but to then use market mechanisms to destroy competitors and to acquire those that they can’t ultimately destroy.
I think that’s part of the strategy. That’s where IP becomes a strategic tool for countries that are willing to hack for economic-espionage purposes. That’s precisely why President Xi and President Obama signed an agreement where each country agreed not to engage in that kind of cyber economic espionage. It’s not what the U.S. does anyway, so the U.S. was agreeing not to do things it already doesn’t do. The Chinese were agreeing not to do something that they have done traditionally. Whether or not they abide by that is a subject of some debate currently. It was the threat of the use of sanctions, frankly, and the revelation of state-owned enterprises benefiting from cyber economic espionage that led the Chinese to sign that deal — which is a very important and interesting episode.
OR: Do you see a high-level, organized attack on financial infrastructure in the offing for the developed world? What is most frightening to you in the illicit-finance space at the moment?
Zarate: What’s most worrying to me is the fact that cyber actors continue to focus on the financial system itself. Not just as a source of capital — that’s where the money resides so that’s where illicit actors will flow, like bank robbers. It’s the fact that nation-states and irresponsible actors realize there is systemic vulnerability. I think we’ve seen a glimmer of this with the SWIFT case. Not only can people get away with high-order cyber heists and robberies, but they’re demonstrating the ability to begin to affect the backbone of the financial system and the trust inherent in it. I worry that you have irresponsible actors willing to undermine financial integrity in ways that could cause a systemic shock. That’s the dangerous convergence of national security, illicit finance, and cyber security that keeps me up at night, and I’ve been writing about it for a number of years now.
We’ve heard the U.S. intelligence community speak more openly about what those risks look like. The good news here, and I’ve been articulating this good news or some time, is that the legitimate actors that have a stake in that system — including the Chinese and the Russians — will at a certain point have to coalesce around the protection of that system, the norms by which that system operates, and the cyber security that goes along with that system. At the end of the day, the Chinese and the Russians don’t want their banking systems or exchanges to be compromised to the same degree that we don’t want ours compromised. At the end of the day, there’s heavy inter-dependence between those systems. I think the real risk is that irresponsible actors — like the North Koreans, or a sophisticated hacktivist group, or a more sophisticated terrorist organization — could be willing to crash the system. That’s something that the Chinese, the Russians, the Indians, the Israelis, the Europeans, the U.S., and the South Americans all want to prevent.
At the end of the day, where we’re going to see the most dynamic elements of cyber cooperation is in the protection of those kinds of systems. We haven’t seen the full-on version yet, but we’ve seen glimmers of it begin to emerge — especially when you look at cooperation among central bank authorities. You look at cooperation among the major global banks, and you look at the types of agreements that the U.S. and China have started to articulate. They provide a hopeful note amid the doom and gloom of what worries us.
Juan Zarate is the chairman and co-founder of the Financial Integrity Network and the senior national security analyst for NBC News and MSNBC.