IV Origin and Modern Uses of IFT Systems
- Mohammed El Qorchi, Samuel Maimbo, and John Wilson
- Published Date:
- August 2003
IFT systems are ancient and well rooted in the cultures of various countries. Despite the different terminology ascribed to them—fei-ch’ien (China), hui kuan (Hong Kong), hundi (India), hawala (Middle East), padala (Philippines), and phei kwan (Thailand)—the growth of informal funds transfer systems is primarily entrenched in the monetary facilitation of trade between distant regions. Before the advent of paper money, traders historically used gold and other precious metals for payments. However, insecurity along many trade routes led to developing alternatives that did not require the physical movement of gold and precious metals. This process occurred at different times in the various regions of the world and gave birth to instruments that are similar to, or work on the same basis as, IFT systems.
China. The history of funds transfer systems can be dated back to the Tang Dynasty (618-907).9 With the prospering economic activity during the Tang Dynasty, the need for a system to transfer funds, including tax revenues, became acute, which prompted the emergence of China’s ancient remittance system. The creation of the fei-ch’ien (flying money) system seemingly goes back to this time, when business people and government attempted to reduce the inconvenience of carrying currency and facilitate the transfer of funds. Later, by the middle of the Ming Dynasty (1368-1644), with the dwindling circulation of paper money, the government resorted to the remittance system for fund transfers. This practice continued during the Ch’ing Dynasty (1644-1911). In the early part of the eighteenth century, cotton trade played a key role in the development of fund transfers. One of the several networks of cotton dyestuff stores decided to add money transfers to its goods transfer functions. Subsequently, by the end of the century, other dyestuff stores entered the business and created a China-wide network.10 The fei-ch’ien system, widely used in the tea trade throughout Southeast Asia during this period, was reinvigorated by money changers, gold dealers, and trading companies, who not only wanted to facilitate their trade but also resented using financial intermediaries controlled by the non-Chinese. The system was “exported” to other countries by the Chinese living abroad, and a broad remittance network was established, which covered most of China and even extended to some major cities in Japan, Russia, and Southeast Asia.
South Asia. In the 1950s and 1960s, the main method of payment in the Indian subcontinent was through the hundi (see Box 4.1), chiti,11 or hawala,12 which was a draft drawn on a trading associate. Import credit from the “money bazaars” generally took the form of loans against hawalas or hundis. These were simple drafts drawn on correspondent traders in India, the Islamic Republic of Iran, and Pakistan by traders and foreign exchange dealers from the neighboring countries, including Afghanistan. In addition, because currency export from India and Pakistan was illegal, there was a considerable differential between official and hundi exchange rates, which increased the hundi’s popularity. Hawala was also used extensively in trade with the Islamic Republic of Iran as well as in domestic trade.13 Furthermore, after the partition of India and Pakistan in 1947, virtually no payment connected with trade with India and Pakistan was transacted through banks.
Box 4.1.Hundi in India
The hundi is an old system that was used in India before the advent of modern-day banking. The existing literature on this topic contends that the hundi had been in vogue in India from time immemorial. In India, no traces could be found of the existence of paper money in early times, nor is there any reference to negotiable instruments as such in Hindu and Muslim texts. However, bills of exchange have been popular from very remote times. The hundi developed in India with a strong body of rules, usage, and customs, which the legislature or courts of the country could not but recognize and give effect to. In the beginning, the hundis were likely issued by “brokers” for the purpose of debt collection. They took diverse forms, sometimes bills of exchange and other promissory notes, while being subject to local usage. These indigenous bills of exchange acquired such a high level of credibility that to dishonor a hundi was a rare event. They were freely circulated among Indian bankers for financing internal trade and were gradually integrated into the activities of the emerging modern banking system. The redrafted bill tried to reconcile and assimilate the Indian and European Law. The legislature did not abolish the numerous local customs and usages relating to hundis. Because the Indian commercial community was accustomed to using hundis, it was treated as if it were a bill of exchange in some Indian courts. Recently, when political and other corruption scandals erupted, hundi acquired a different perception, which led to its prohibition. Hundi is now illegal in India.
Middle East. In the Arab world, hawala as an IFT system helped to facilitate trade not only within the same areas but also between regions and fiefdoms. Historical accounts refer to instances where hawala-type instruments were widespread in the Middle East centuries ago.14 Some observers note that hawala developed more than a century ago when immigrant South Asian communities in East Africa and Southeast Asia used it as a means of settling accounts. Others observe that the hawala system dates to Arabic traders who established it as a means of avoiding the endemic robbery of caravans. But the precise antecedents of hawala in the Middle East have not been well documented.
Europe. Operating on similar principles as the modern-day informal hawala, a bill of exchange is an obligation in the form of a payment order addressed to the person responsible for honoring the payment. The bill of exchange requires that a person make payment to another individual on an agreed-upon future date. The bill in its present form was widely used in fourteenth-century Italy. This remittance trade was pioneered by the money exchange dealers who used to display their different moneys on the banco (bench) in Italian cities. In Western Europe, the practice of making bills payable to order and transferring them by endorsement originated at the close of the sixteenth or the start of the seventeenth century. The use of bills of exchange later extended into France and then into England, where they contributed to the development of British commerce.15 Though initially confined to international trade, their use subsequently extended to domestic bills between traders and, finally, to personal transactions.16 The development of bills of exchange is considered to be one of the cornerstones of the remarkable expansion of banking activity in Europe.
North and South America. In North and South America, the Black Market Peso Exchange (BMPE) is often mentioned in the same context as hawala, with the implication that it is comparable in operation and purposes, often as an important route to launder drug money. The loose association of the BMPE with the hawala remittance system needs careful review, not only because the primary use of the BMPE is money laundering but also because the accounting sequence of the BMPE, as generally portrayed, can differ substantially from that of the informal hawala system as discussed in this paper. Compared with the prototype informal hawala system transaction and settlement process, there are notable differences with some of the transactions attributed to the BMPE. Sometimes what is described as BMPE is a sequence of asset (financial) transactions, starting with a trafficker’s hoard of cash that has to be sold leading to those funds being laundered through formal financial institutions, such as commercial banks. In the process, the BMPE may be used to finance the importing of goods for South American traders with limited access to foreign currency. The complete combination of transactions need not necessarily include or exclude the basic fundamental characteristics of the system as detailed in this paper. In cases where the BMPE broker uses both formal and informal funds transfer mechanisms, the similarity between and the relationship of the formal system and the informal hawala system may be more tenuous.
Migrant worker remittances. Large migrant-labor communities often find this system particularly suited to their needs.17 Compared with formal banking channels, the informal hawala system is often not only less expensive but also can be a more accessible and convenient option for the remittance of funds. Also, the service is available 24 hours a day, every day of the year. The network has a wide coverage, which serves far-flung locations, including remote villages in Pakistan or Bangladesh, whereas banks may not handle such a small transaction or reach those remote areas within a reasonable time. Seldom do dealers fail to effect payment.18 Sometimes, from the remitter’s perspective, default risk can be eliminated through the “confirmation-before-payment” process, where the remitter pays the hawala dealer the value of the funds remitted after the recipient has confirmed receipt of the money.
Humanitarian, emergency, and relief aid in conflict-torn countries. Informal systems are particularly well suited and often the only option in countries at war or emerging from war. In cases such as Afghanistan and Somalia, where the formal financial system is not operating, the majority of aid organizations have used the informal financial sector for international or domestic remittance services for humanitarian, emergency, and relief operations. For most organizations, except the larger ones, the cost and logistical capacity required for the physical transfer of cash is too high. Oftentimes, staff members carry cash when flying into the country for operational duties, but the amounts involved are usually small and meant for overhead expenses, not program needs. For program requirements, the informal hawala system may often be the only option.
Personal investments and expenditures. Often, hawala systems can be used to transfer funds for legitimate personal investments and expenditures such as travel, medical care, or college tuition fees. Sometimes, as discussed in the previous section, it is simply a matter of convenience that funds are transferred though the informal channel rather than the banking sector; but hawala transfers are also used to avoid or evade exchange and capital controls and other economic restrictions.
Circumventing capital and exchange controls. Countries facing shortages of foreign exchange reserves have often imposed capital controls and created tax barriers for imports. Individuals and businesses seek alternative means to make international funds transfers through the reverse hawala route from countries under exchange controls to other, usually more developed, economies, without any documentary requirements. The incentive to use informal mechanisms to externalize funds is even higher if the capital controls exist in a country where there is an exchange rate risk because of political and economic uncertainties.19
Customs, excise, and income tax evasion. Importers sometimes resort to making part of payments to an overseas exporter through IFTs, particularly when customs, excise, and income taxes are high. To avoid paying customs duties, importers request the overseas exporter to “underinvoice” the goods. The difference between the actual price and the invoiced amount is then remitted to the overseas exporter through the medium of hawala. Similarly, when a government grants subsidies based on export receipts to encourage exports, exporters could “over-invoice” to maximize their gains.
Smuggling. Recent literature attributes the growth of the present hawala network, in part, to gold trading and smuggling operations in South Asia in the 1960s and 1970s. To avoid gold import restrictions, traders and smugglers used boats to ship gold from places such as the Gulf Cooperation Council (GCC) countries to South Asia. To remit funds back to their countries of origin or purchase more gold, traders and smugglers (importers) found a solution in the growing population of South Asian nationals working in the GCC countries. To settle their liabilities, hawaladars, in Dubai, for instance, would finance gold exports to their counterparts and clients in South Asia. The remitting workers received better rates because hawaladars charged higher fees from smugglers who made substantial profits from the gold trade. Thus, the smuggling activities benefited from, and enhanced, the existing systems of funds transfers used by expatriates in the Middle East, Southeast Asia, the United Kingdom, and even in North America. This network, it is argued, formed the base for the large-scale hawala operations that exist to this day.
Box 4.2.Terrorism Financed by Informal Hawala: A Hypothetical Example
Setting: Robert lives in country A; Michelle lives in country B. They decide to carry out an action in country A.
The operation: Michelle pays a hawaladar $1,000 in country B (HB) to have the equivalent delivered to Robert in country A. HB contacts a hawaladar in country A (HA) via phone or fax to arrange the payment. Robert receives the $1,000 equivalent in short order. Neither HA nor HB is privy to the reasons behind the transaction.
Technical traces: One phone call or fax between HB and HA.
Institutional involvement: None, except, perhaps, HA withdraws $ 1,000 equivalent from his local account.
Institutional records: None.
International transaction: None.
Effect of money-transfer reporting requirements: Probably none.
Money laundering activities. Both the formal banking sector and the IFT systems are vulnerable to abuse. The number and variety of methods used to launder the proceeds of criminal and illegal activities and finance terrorist acts continue to become more complex with time. The methods are diverse and can employ both banking and nonbanking channels, including exchange bureaus, check-cashing services, insurers, brokers, and nonfinancial traders. The methods through which IFTs and the formal banking sector can contribute to the placing and layering of funds in the money laundering process are similar, although, as discussed below, the informal transfer systems have peculiarities, which make them particularly vulnerable to abuse.
- First, neither system necessarily involves the physical transfer of funds from one jurisdiction to another. Instead, they depend on a series of accounting debits and credits between the accounts of a network of individuals, companies, accountants, lawyers, and intermediaries. The major potential for using an IFT system for money laundering lies in the fact that the proceeds can be moved away from the place where the crime was committed to destinations where the transaction can either appear legitimate or from where it can be later brought back to the country through a variety of legitimate routes for the integration process.
- Second, in the same way that banking secrecy laws may facilitate money laundering, the potential anonymity of an IFT system can render it susceptible to processing criminal proceeds in ways that disguise their association with criminal activities such as drug trafficking, prostitution, corruption, and tax evasion.
For criminals, laundering money through the formal financial systems in the early stages of the laundering process has the disadvantage of leaving behind a paper trail that can be traced during an investigation by law enforcement agencies. IFT systems, however, can minimize detection risk because they require little or no documentation. In instances where hawaladars maintain records, law enforcements officials cannot generally access them.
Terrorist financing. The anonymous transfer of funds through the IFT systems has also raised concerns about their potential use as a conduit for terrorist funds. Because there is no requirement for identification documents or source of funds, an IFT dealer can initiate or facilitate a multiplicity of transfers, which conceal the ultimate origin of the funds through their network in different jurisdictions. The recipient of funds can use them to carry out a terrorist act. Once the transaction is completed, all customer identification documents, codes, or references are most likely destroyed, except, perhaps, those required for settlement purposes. Box 4.2 illustrates how, for example, an IFT system can be used for terrorist financing.