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May 31, 2017

B inary options are a risky business and one that arguably does not lend itself to money laundering because of the risk of losing everything, unless of course the launderer owns and manipulates the process end to end (e.g., owning a roulette table, fixing the wheel and placing the bets).

For fraudsters, binary options are another story and an attractive business to be in where they can defraud millions of investors (victims) into believing that they can hit the jackpot and drain them of their hard-earned funds and credit lines.

Where fraud occurs, money laundering soon follows and as anti-money laundering (AML) professionals we must be alert to the predicate offenses (e.g., binary options fraud). This article is designed to raise awareness of the subject and provide indicators (red flags) and examples to assist comprehension.

Introduction

The binary options industry is a multibillion dollar market that has grown over the last decade and now employs thousands of people, many of whom work in a sales capacity. Although legitimate companies exist, many of the activities carried out by some companies in this field are either fraudulent or in violation of investment industry regulations for numerous jurisdictions in which they solicit business.

The Canadian Securities Administrators and various provincial securities regulators in Canada have published numerous alerts about binary options and maintain a blacklist to advise citizens of binary options groups or so-called “brokers” who are believed to be engaged in fraudulent practices. The Canadian Anti-Fraud Centre has echoed these warnings on notifications that they issue to the public.

In January 2017, the EUROPOL Binary Options Summit was hosted in the Netherlands to facilitate a discussion between 20 countries on how to combat fraud in the binary options industry. One suggested outcome from this summit was to prosecute everyone involved in binary options fraud, including those who work in call centers and other salespersons (i.e., not just the organizers). Binary options are such a hot topic that it may soon lead to urgent regulation across a number of countries. Some countries including the U.S., Cyprus, Japan and South Africa already have some form of regulation in place for binary options, but more needs to be done. 1

What are options?

Options are a type of highly leveraged derivative investment. This means that they derive their value from that of an underlying investment’s price—commonly a stock, commodity, or currency in the global capital markets. They are essentially a contract where the holder buys the right to purchase or dispose of the underlying asset at a predetermined price (referred to as the strike price) over the life of the option—it will typically range up to a year from the contract issuance date depending on the asset.

A call option locks in the price to buy an asset over a set period of time. For example, if a Canadian purchasing a retirement home in Florida wants to buy U.S. dollars with their Canadian dollars at a current exchange rate of $1.25 CAD/USD, it would cost them $125,000 to purchase $100,000 USD for a condominium down payment in Fort Lauderdale.

However, if their condominium does not close for another six months, the rate could move to $1.35 CAD/USD and it would cost them $135,000 CAD to purchase the same $100,000 USD and negatively affect their budget by $10,000.

Let us say that they want to buy an option for $0.03 CAD per U.S. dollar to lock in the exchange rate of $1.25 CAD/USD. They would effectively be paying $128,000 CAD for their down payment, but they will not risk being pushed outside of their regular budget. This reduces their risk and use of options. This is referred to as ‘hedging.’ This is why many derivatives, including options, were created and today are offered through all of the major brokerages.

A “put option” locks in the price to sell an asset over a set period of time. For instance, suppose someone retiring from XYZ Corp withdraws their employee stock option plan (ESOP) totaling $100,000 CAD in XYZ shares, but they are not allowed to sell the shares for another year or they pay a penalty. Currently, they hold 1,000 shares and XYZ trades at $100 CAD per share. If the markets go down and XYZ shares drop to $80 per share over the next 12 months, then the retiree’s life savings will be reduced by $20,000 dollars.

However, suppose that they purchase a put option locking in the sell price of $100 for the next year and pay a premium of $3 per share. They will reduce their life savings by $3,000 for the year (likely less than the value of dividends paid on the shares), but they no longer have any investment risk of the ESOP requirement to hold the shares for another year. This is another way to reduce risk through the use of options and is also known as ‘hedging.’

Options can also be used to speculate. In the first example, suppose the call option is not used to secure an exchange rate for a down payment, and instead the option purchaser pays $3,000 to lock in $100,000 USD for the next six months at $1.25 CAD/USD. If the rate moves to $1.35 CAD/USD, they can borrow money from the bank to buy $100,000 USD at $1.25 with their option, immediately sell at $1.35 in the open market and make a $10,000 gain for a return on investment of more than 200 percent. However, if the exchange rate goes down and stays under $1.25, their options are worthless and they lose 100 percent. This shows the high risk nature of the investment.

Suppose that the purchaser of a put option on XYZ stock at $100 per share is a speculator and owns no XYZ stock. They pay $3,000 to lock in that price on 1,000 shares and the price falls to $80 per share. They can immediately borrow money to buy 1,000 shares for $80,000 (market price), sell them for $100,000 by exercising the put options and make a gain of $20,000 for a return on investment of nearly 700 percent. However, if the price of XYZ shares goes up to over $100, they lose everything because their options are worthless.

How the fraud works?

A binary option is essentially a call or a put option and it is referred to as binary because there are two outcomes—win or lose—depending on whether the underlying asset performs the way you want it to relative to the strike price in your option.

The binary options industry is a massive network of online trading platforms (in some cases fraudulent ones) that claim to open accounts for investors wanting to trade options on various assets (mostly foreign exchange rates or major stock indices).

Residents of jurisdictions around the globe are solicited online through pop-up ads, fake news stories, fake testimonials, and mailing campaigns. Boiler rooms are often used to follow up on leads generated through these online channels and make unsolicited cold calls with information mined from other sources. It is a form of mass marketing fraud and it is prolific.

Companies position themselves as large, sophisticated, reputable and regulated financial firms that help clients make astronomical returns on money and tout the excessive returns in speculative examples, such as the ones mentioned above. They fail to explain the inherently high risk and volatility that comes with such investments, and in some extreme cases, even claim that the investments are “risk free.”

At this point, the binary options brokers may have committed a predicate offense in many jurisdictions, but especially in Canada. In order to solicit a resident of any Canadian provincial jurisdiction for investment/advisory purposes, a company needs to be registered with that provincial securities regulator. Binary options brokers offering accounts to Canadian residents have likely broken this law, as no binary options brokers are registered with any securities jurisdiction in Canada. In Canada, securities are regulated on a provincial level, which classify binary options as ‘exotic options’ and view them as akin to gambling.

Some of these firms are permitted to operate in the U.S. if they are registered with the National Futures Association (NFA), and the rules vary between different countries, which commonly have a national securities regulator.

Many binary options companies list Canadian contact information and claim to be registered to conduct their activities in Canada, which is almost undoubtedly a false statement, and may constitute another violation of securities legislation in the provinces.

While these violations of securities laws in and of themselves are predicate offenses, the crimes committed by these firms are often more egregious. In many cases brokers allegedly falsify online balances and account statements, marking the prices of options held by their clients to arbitrary values. No actual trading may take place and clients are simply told that the trades have been executed based on their instructions.

As with many investment frauds, the binary options platforms will rig the first few ‘investments’ to show massive paper gains in the client’s account. They then attempt to press clients for additional assets and convince them, based on the previous performance that they can get rich quick. Clients who move significant portions of their investment portfolios to these brokers lose tens or hundreds of thousands, which makes it a particularly devastating type of fraud perpetrated on victims living in hope.

In some cases, trades are continually rigged so that the investor eventually loses their whole investment and thinks that they have gambled away their savings, rather than having been defrauded. In some cases, people attempt to withdraw their account balances only to be told subsequently that the brokerage cannot release the funds. The brokerage will then cease contact with them, absconding with the money. In other cases, one operation will own several binary options platforms, and once they have acquired credit card information they will start charging the client’s card on other sites without the client’s knowledge.

These firms almost exclusively operate offshore relative to the jurisdiction where they are soliciting clients. This often protects them from asset seizure and criminal prosecution. In a large number of cases, money from these frauds is traced back to Israel, where the boiler rooms and core operations of the schemes are based.

When dealing with clients they will often claim to be affiliated with either the same jurisdiction of the person’s residence or other jurisdictions traditionally affiliated with offshore investments (Caribbean, Cyprus, Seychelles, etc.). The grievances raised to regulators in Israel over these schemes have become so significant that the Knesset (Israeli Parliament) is finally discussing legislation to declare binary options illegal.

Red flags

Arguably, any binary options firm bold enough to establish themselves in North America should be heavily scrutinized and prohibited if they are dealing with Canadian clients or if they are not registered with the NFA in the U.S.

AML investigators might be able to detect outbound transactions to binary options firms’ banks in the form of wire transactions or credit card payments sent from client accounts. These can be detected by researching the name of the payee or the addresses listed on the wires. If you find a match to any websites that offer online trading services, especially in “options” or “forex,” then it is likely a binary options platform. Other red flags of binary options fraud AML professionals should be wary of are:

• Wire transactions or credit card payments sent by potential victims, where the payee is a company with the word “binary,” “option,” or “trader” in the name
• Transactions involving a company listed at the same address or phone number as several other companies containing the same keywords in the names
• Transactions with companies that have websites offering online “trading,” “options,” or “forex” services, but are not linked to a reputable financial institution
• The website domain information is registered to an Israeli address, or a person in Israel, despite the fact that the company claims to operate from another jurisdiction
• Transactions with companies included on a watch list of binary options, published by securities regulators in any jurisdiction

Conclusion

The binary options industry has proven lucrative for a number of reasons, but primarily because of the protection afforded by the jurisdictions from which it operates. It will be interesting to see the effects of future laws addressing the high instances of fraud in this industry. Given the profitability of this industry, and the fact that much of its presence is online, it may just transition to new jurisdictions or exploit loopholes that commonly exist in developing legislation.

Law enforcement will be required to collaborate closely with securities regulators and other countries if they hope to recover the money of victims and bring the responsible parties to justice. Regulators will also need to continue educating the investing public to mitigate the harmful effects of this industry. Financial institutions from many jurisdictions can assist in these endeavours by identifying the relevant activity, talking to their clients and reporting what they know to the appropriate regulatory authorities.

Michael Burgess, manager AML FIU, Bank of Montreal, Toronto, Ontario, Canada, [email protected]

Contributor: Peter Warrack, CAMS, CFE, CBP, director enterprise AML, Bank of Montreal, Toronto, Ontario, Canada, [email protected]

Disclaimer: The opinions expressed by the authors are held individually and should not be taken to reflect the policies, guidelines, procedures and risk appetite of their employer.

1. “The Legality of Binary Options in Canada,” Binary Options Canada, https://www.binaryoptionscanada.net/legal/