Understanding the Impact of Enhanced Due Diligence in Anti-Money Laundering Practices

Financial institutions across the globe are required to conduct various due diligence measures to comply with anti-money laundering regulations. Depending on the risk level associated with a customer or business relationship, organizations must perform one of three types of due diligence: 

• Simplified Due Diligence (SDD)
• Customer Due Diligence (CDD)
• Enhanced Due Diligence (EDD)

While CDD is often sufficient for low- and medium-risk customers, Enhanced Due Diligence (EDD) becomes essential when dealing with higher-risk clients or transactions. Failing to apply EDD when required can expose financial institutions to significant regulatory penalties, financial crime, and reputational damage.

This blog focuses on Enhanced Due Diligence (EDD), the most advanced process designed for higher-risk scenarios, and explores how businesses can leverage it to enhance their AML efforts.

What is Simplified Due Diligence (SDD)?

Simplified Due Diligence (SDD) is a risk-based approach applied to low-risk customers and transactions, allowing financial institutions to streamline their due diligence processes. Unlike CDD and EDD, SDD involves less scrutiny, but it still complies with AML/CTF regulations. 

SDD is commonly used in situations involving public companies listed on stock exchanges or customers in low-risk geographical regions.

Key aspects of SDD include:

• Allocating resources to higher-risk areas while simplifying processes in lower-risk situations.
• Adapting due diligence efforts based on risk levels.
• Maintaining regulatory adherence without overburdening systems in minimal-risk cases.

SDD is implemented by obligated entities, such as banks, under regulatory guidelines like the 4th and 5th Anti-Money Laundering Directives (AMLD) in the EU and Germany’s Geldwäschegesetz (GwG). 

SDD still requires ongoing monitoring and compliance with changing legal standards, ensuring that institutions manage low-risk customers effectively while staying compliant.

What is Customer Due Diligence (CDD)?

Customer Due Diligence (CDD) is a key process used by financial institutions to prevent money laundering and other financial crimes. It involves identifying and verifying the identities of individuals and legal entities before establishing a business relationship, ensuring that these customers do not present a risk to the institution.

A sound CDD program typically includes the following elements:

1. Verifying the customer’s identity, such as reviewing their passport or other valid identification.
2. Establishing guidelines to determine which customers may be accepted based on their risk levels.
3. Conducting continuous monitoring to detect any suspicious transactions or unusual activities based on the customer’s risk profile.

CDD is a standard procedure for assessing low- to medium-risk customers and forms the basis of anti-money laundering (AML) compliance programs.

What is Enhanced Due Diligence (EDD)?

Enhanced Due Diligence (EDD) is applied in situations with an increased risk of money laundering or terrorist financing. It requires financial institutions and regulated companies to take extra steps in verifying customers, their backgrounds, and the nature of their transactions. 

This section will help you understand the fundamentals of Enhanced Due Diligence (EDD) and its specific use cases in anti-money laundering.

EDD is a thorough investigative process that involves collecting detailed information about a customer’s background and activities. This includes verifying beneficial ownership, tracking the sources of funds, and examining the purpose of the business relationship:

• Obtaining specific and detailed information about the customer (e.g., full name, date of birth, identification).
• Verifying the customer’s beneficial owner, particularly when the customer is a legal entity.
• Determining the purpose and expected nature of the customer's business relationships.
• Analyzing the sources of funds and wealth to ensure the legitimacy of transactions.

EDD goes beyond verifying identification, it includes checks into the background of transactions, the source of funds, and the customer’s potential risk profile based on geographic, political, or sector-specific concerns.

What is the Difference Between CDD and EDD?

The key difference between Customer Due Diligence (CDD) and Enhanced Due Diligence (EDD) lies in the level of scrutiny required based on the customer’s risk profile.

When conducting CDD, financial institutions apply it to customers who present a normal level of risk. This includes verifying the customer’s identity, understanding their transaction patterns, and ensuring compliance with standard regulations.

However, EDD is employed when a customer poses a higher risk, such as politically exposed persons (PEPs) or those involved in high-risk industries (e.g., arms dealing or gambling). If a customer’s risk assessment reveals potential dangers, EDD becomes necessary, involving additional steps such as:

• Verifying the source of funds - Financial institutions must verify the legitimacy of the customer’s income or capital to ensure it isn't associated with illegal activities.
• Providing additional documents - This could include official records like registration documents, banking information, and information about third-party relationships, including other financial institutions or board members.

EDD often requires more detailed information, not just from the customer, but from third parties as well, making the process more extensive and thorough than CDD. Both CDD and EDD are essential components of a financial institution’s broader AML compliance strategy. 

CDD is employed at the beginning of a business relationship and for low-risk customers. In contrast, EDD is implemented when risk levels escalate, offering additional layers of protection.

Why is Enhanced Due Diligence Important?

Enhanced Due Diligence (EDD) is essential for preventing high-risk financial crimes, significant fines, and reputational harm. It protects financial institutions, particularly when handling high-risk customers like Politically Exposed Persons (PEPs) or clients involved in high-risk industries, such as arms dealing or gambling.

EDD is essential for several reasons, each underscored by significant statistics and real-world examples highlighting the potential consequences of inadequate due diligence.

1. Mitigating Financial Crime Risks

A report by Elsevier estimates that developing countries lose around $1 trillion annually due to illicit financial flows to tax havens, severely hampering their ability to achieve sustainable development goals. EDD plays a key role in mitigating these risks by enabling institutions to detect and prevent suspicious financial activities before they escalate

2. Avoiding Hefty Fines and Legal Consequences

Failing to conduct proper EDD can lead to significant financial consequences. For example, a bank in the United Kingdom was fined $630 million by U.S. and U.K. regulators in 2022 for its failure to maintain an adequate anti-money laundering control framework, which included inadequate EDD practices.

It is estimated that in 2021 alone, financial institutions were penalized with fines totaling almost $1 billion for failing to comply with customer due diligence regulations. The costly consequences of neglecting EDD highlight that thorough due diligence is both a regulatory obligation and a way to avoid massive financial penalties.

3. Regulatory Compliance and Enhanced Scrutiny

As regulatory bodies worldwide impose stricter controls on financial institutions, the need for compliance continues to grow. The Financial Action Task Force (FATF) has implemented strict guidelines that require increased scrutiny of high-risk customers. Non-compliance can result in penalties and increased scrutiny from regulators, which can hinder business operations. 

According to Navex Global's 2023 Definitive Risk & Compliance Benchmark Report, 83% of risk and compliance professionals stated that ensuring their organization remained compliant with relevant laws, policies, and regulations was a key factor in their decision-making processes.

4. Improving Risk Awareness and Management

EDD enhances an organization’s understanding of potential risks associated with customers and transactions. Gathering comprehensive information allows businesses to identify red flags and suspicious activities effectively.

EDD also includes the assessment of third-party relationships, such as suppliers, distributors, and service providers. This becomes especially important when these third parties operate in high-risk industries or regions, requiring a thorough examination of their operations and financial practices to avoid indirect exposure to money laundering risks.

5. Strengthening Internal Controls

Implementing EDD helps strengthen internal AML controls. Enhancing the screening processes for PEPs and sanction lists enables organizations to better assess their exposure to high-risk individuals or entities.

Many jurisdictions have also adopted FATF recommendations into their local laws and regulations, requiring organizations to incorporate EDD with their anti-money laundering (AML) compliance programs. These regulations establish minimum standards for customer due diligence, record-keeping, and the reporting of suspicious transactions.

Case Study: Credit Suisse Group AG

A striking example highlighting the importance of Enhanced Due Diligence (EDD) is the Credit Suisse Group AG case from 2019. The bank was implicated in a major scandal where it raised over $1 billion for state-owned entities in Mozambique. 

The funds, intended for infrastructure projects, were instead misused as part of a hidden debt scheme involving bribery and corruption. Credit Suisse misled investors and failed to disclose the full extent of Mozambique’s indebtedness, concealing important information about the nation’s financial health.

If Credit Suisse properly adhered to EDD protocols like thoroughly investigating the source of funds, identifying beneficial ownership, and understanding the purpose and nature of the transactions, the bank could have mitigated the risks associated with the high-profile, high-risk deal. 

Neglecting these important EDD processes, Credit Suisse exposed itself to serious financial and reputational consequences, including $475 million in fines from regulatory bodies like the U.S. Securities and Exchange Commission (SEC) and the U.K. Financial Conduct Authority (FCA).

Who Needs Enhanced Due Diligence and When?

All financial institutions and regulated businesses are required to comply with AML regulations, including conducting EDD when necessary. EDD is required in several situations, including:

• New customers or those applying for new products or services.
• Existing customers whose risk profile has increased due to suspicious activity.
• Politically Exposed Persons (PEPs) or their close associates who have connections to government authorities and may be prone to corruption or money laundering.
• Customers are linked to high-risk sectors such as the arms trade, crypto exchanges, or gambling.
• Unusual transactions or customers involved in transactions that appear suspicious or lack a clear, legitimate purpose.
• False identification documents or discrepancies in the customer’s provided information.

These triggers demand additional scrutiny to ensure that the customer is not involved in any unlawful activities.

How to Conduct Enhanced Due Diligence (EDD)

Implementing EDD requires a strategic approach to minimize risk exposure. Here’s a step-by-step guide to setting up an effective EDD process:

Step 1: Employ a Risk-Based Approach

Organizations should follow a risk-based approach, as recommended by the Financial Action Task Force (FATF). This method allows financial institutions to allocate resources based on the level of risk posed by the customer. EDD is required in cases where higher risks are identified.

Step 2: Obtain Additional Identifying Information

Collecting extra information from high-risk customers is essential. This could include:

• For businesses: Corporate records, banking information, and board member identities.
• For individuals: Verification of relationships with other financial institutions and information about their personal wealth and political exposure.
• For Politically Exposed Persons (PEPs): The title and details of the current or former position held by the PEP. If the PEP is a close associate or family member, establish their identity, title, role, and the degree of their connection to the public office.

Step 3: Examine the Source of Funds and Identify the Ultimate Beneficial Ownership (UBO)

Understanding the source of funds and the ultimate beneficial ownership is key in determining whether transactions are legitimate. Suspicious discrepancies may lead to requests for additional documents like bank statements, property ownership records, and income reports.

Step 4: Implement Transaction Monitoring

Ongoing monitoring of customer transactions is essential. This involves reviewing:

• The nature and purpose of transactions.
• Parties involved and the duration of business relationships. For crypto transactions, monitoring for red flags like multiple high-value transactions in a short period and transferring cryptocurrency immediately to multiple Virtual Asset Service Providers (VASPs) is important.

Step 5: Employ Adverse Media and Negative Checking

Regularly check media sources for any adverse information or negative news associated with the customer. Advanced tools such as Luci Copilot can be helpful for institutions because of their ability to conduct adverse media research on the customer’s profile. This research builds a fuller profile and helps assess risks.

Step 6: Conduct On-Site Visits

For businesses, verifying the customer’s physical address is a good way to confirm their legitimacy. On-site visits can reveal more information about the customer’s operations, especially in high-risk sectors. 

Alternatively, financial institutions can leverage the use of AI tools like Luci Plugin in their compliance procedures for address checks and business verification 

Step 7: Implement Ongoing Monitoring

AML transaction monitoring has evolved, making ongoing monitoring essential to keep customer profiles updated, especially as risks change. Ongoing EDD requires regular screening against sanctions lists and keeping up with any changes in the customer's status.

Monitoring sensitive customers can be demanding and require significant resources. To manage this effectively, creating a specific monitoring approach for each sensitive customer ensures complete oversight. Platforms like Lucinity equipped with transaction monitoring and detection technology can help reduce caseloads by 50%.

How Lucinity Can Help with Enhanced Due Diligence in AML Processes

Lucinity offers a suite of AI-powered tools designed to help financial institutions streamline Enhanced Due Diligence (EDD), ensuring compliance with Anti-Money Laundering (AML) regulations while minimizing the risk of financial crime.

1. Case Management - Lucinity’s Case Manager plays an important role in EDD by offering a unified platform to consolidate all customer-related data and third-party alerts. This enables compliance teams to efficiently view and analyze information, identifying potential risks linked to sensitive customers such as Politically Exposed Persons (PEPs) or individuals involved in suspicious transactions.

The Case Manager oversees a detailed review of customer behavior, ensuring that institutions can conduct the in-depth investigations required under EDD without missing important details.

2. Luci Copilot - The Luci AI Copilot enhances EDD efforts by automating key processes such as data gathering, summarizing case information, and monitoring transactions for anomalies. 

With Luci, compliance teams receive detailed insights and risk indicators that enable faster decision-making. Its ability to visualize money flows and assess the source of funds is useful for identifying suspicious activity in high-risk sectors like arms dealing or cryptocurrency transactions. 

Luci copilot plugin’s adverse media screening further supports EDD by cross-referencing customer data with negative news sources, helping organizations identify red flags early on.

3. Customer 360 - Customer 360 offers a comprehensive view of a customer’s interactions across different data sources, allowing for a more holistic assessment of their risk profile. This tool is essential in EDD processes, as it ensures that all relevant information, such as past transactions, connections to high-risk sectors, and potential links to PEPs, are continuously monitored. 

Summing Up

Enhanced Due Diligence (EDD) plays an important role in preventing financial crimes and ensuring compliance with Anti-Money Laundering regulations. Through automation, risk-based assessments, and ongoing monitoring, EDD helps companies protect themselves from high-risk activities. 

1. EDD is essential for high-risk customers and transactions, preventing financial, legal, and reputational risks in situations like dealing with PEPs or high-risk industries.
2. Non-compliance with EDD can result in hefty fines, with financial institutions facing nearly $1 billion in penalties in 2021 alone.
3. The Credit Suisse case demonstrates the risks of neglecting EDD, leading to a $475 million fine and reputational damage.
4. EDD strengthens regulatory compliance by enhancing internal controls and aligning with FATF guidelines to avoid regulatory penalties.
5. Lucinity’s AI-powered tools simplify EDD, automating data collection and monitoring, and reducing compliance workloads by up to 50%.
6. Ongoing monitoring is key to EDD, ensuring that customer profiles and risks are continuously updated to comply with AML regulations.

To learn more about how Lucinity can enhance your EDD compliance operations, visit Lucinity’s website.

FAQs

1. What is Enhanced Due Diligence in AML?
   
   Enhanced Due Diligence (EDD) refers to additional checks and procedures required for high-risk customers or transactions to prevent money laundering and financial crime.
2. When is Enhanced Due Diligence required?
   
   EDD is required in situations where a customer poses a higher risk, such as politically exposed persons (PEPs), unusual transactions, or involvement in high-risk industries.
3. How is EDD different from CDD in Anti-Money Laundering?
   
   Customer Due Diligence (CDD) involves basic customer verification, while EDD includes a deeper investigation into a customer’s background, source of funds, and potential risks.
4. Why is Enhanced Due Diligence important in financial services?
   
   EDD is essential for reducing risks related to money laundering and terrorist financing, helping financial institutions avoid legal penalties, fines, and reputational damage.