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Chinese crime syndicates are operating underground banks to launder the proceeds of fentanyl sales. But, as Miles Kellerman explains, their practices, and the risks they pose, are far from new…

One way of thinking about finance is to imagine it as an endless web of information assembly lines. Every transaction starts as a signal: some person wants to buy some thing. This is the raw material of demand. That material must, in turn, eventually make its way to whomever is in a position to supply. Sometimes this is easy. When you buy mangos at a farmers market, for example, you have direct communication with the supplier, handing over cash with one hand while receiving mangos with the other. But such direct interaction is rare. For most transactions, buyer demand must first travel along informational conveyor belts, where intermediaries shape, mold, and redirect that raw material before it reaches suppliers.

Take residential real estate. If a couple wants to purchase a beachfront bungalow in Santa Barbara, they probably aren’t going to just show up at the front door with a duffle-bag full of cash. That would be weird. Rather, they are much more likely to express their demand through a realtor. This information then makes its way down the assembly line, where it passes through a series of intermediaries: the seller’s realtor, title company, mortgage advisor, attorney, and, finally, the bank.

But buyers and sellers are not the only ones interested in this process. There is also the inquisitive eye of the state. Every stage of the information assembly line contains clues — about unpaid taxes, money laundering, terrorist financing, and all sorts of other shenanigans. The state would love to patrol every assembly line looking for these clues, like a mustached inspector peering over the shoulder of nervous factory workers. But this is expensive. And many of us would prefer that our information is assembled by intermediaries in private.

The state’s solution to this problem has been to outsource surveillance. It requires that certain intermediaries on the information assembly line look for signs of suspicion and report those suspicions to regulators. These are what is referred to as Anti-Money Laundering, or AML, obligations. At the risk of abusing the analogy, intermediaries with AML obligations are like factory produce inspectors. They spend all day staring at fruit as it travels across the conveyor belt, sorting out the rotten apples and tossing them into separate bins.

But what if, somewhere along the production line, the informational conveyor belt just…disappears? The Financial Times has reported that Chinese crime syndicates are capable of performing such sorcery. These syndicates, the FT writes, are using a “new” network to launder the proceeds of fentanyl sales, one that “…minimizes the movement of funds across borders.” The money simply disappears in one place and reappears in another, as if governed by quantum physics. But this is not magic. Nor is it new. It is instead an alternative conveyor belt of information, one that has operated outside the confines of the state for over a thousand years. And it goes by a simple yet ominous name: underground banking.

Imagine, for a moment, that you are a textile merchant somewhere along the 6,000 kilometer stretch of the ancient Silk Road. Every business has risks. But your risks are a bit more extreme. Large stretches of your trade routes are located in harsh desert climates where water is sparse. Nor is there any guarantee of security. Nomadic raiders could strike your caravans at any moment. And, even if you survive the trip, you could arrive to your destination only to find that it has been sacked by Attila the Hun (or, later, the roaming armies of Genghis Khan).

The last thing you want to do, in such a dangerous environment, is carry cash on you. Credit cards would be a great alternative. “No!” you might explain to Chase customer service after having your card stolen by Hun raiders, “I definitely did not order horse archers.” But it’s about 600 – 1,900 years too early for that. In this pre-electricity era, you need an alternative system. Specifically, one that allows you to manage your payments, settle outstanding balances, and avoid the perils of carrying money across the Persian desert. Enter Hawala.

Hawala is an Arabic term roughly meaning “to change” or “to transfer.” It refers to a system in which networks of brokers (hawaladars) facilitate the movement of value from one geographic location to another. Nobody really knows when Hawala was first used. But there is evidence from the 6th century that Muhammed, the founder of Islam, was familiar with at least some version. Similar systems, with equally ancient roots, have existed in India (Hundi), Thailand (phoe kuan), and China, whose term Fei-Chien translates to flying money. And they have collectively come to be referred to as different varieties of “underground banking.”

Here’s how a Hawala transaction might have worked on the Silk Road. Say you are a merchant in Iran who wants to import Aleppo pepper from Syria. Rather than drag heavy coins across the desert, you provide the necessary money (in whatever form was used at the time) to your local broker. In return, the broker would issue what was, in effect, a bill of exchange — a written order to pay an equivalent amount of money to the supplier at a later date. Once you arrive to Aleppo, you present that document to a Syrian broker, who honors the bill of exchange by issuing the money to the supplier in local currency. Each broker charges a commission for their services and settles their balances through repeated business.

With this simple maneuver, currency has been exchanged across borders. But rather than physically moving money from one place to the next, the brokers have received and distributed local currency from their respective pots. The only true transfer is one of information…

… Trust is also essential to contemporary Hawala systems. But today’s networks are more focused on facilitating cross-border payments and currency conversions rather than international trade. Remittances are one important example. If a worker in Belgium wants to send money to their family in Pakistan, they can do so through their local Hawala broker. But unlike their ancient predecessors, there is no need for these brokers to issue a bill of exchange. They can simply pick up the phone or text their foreign counterparts that the money has been deposited.

But how can the worker be sure that the person picking up the money is actually their family member? One common solution: secret codes. Hawala brokers will often require each party to express these pre-agreed codes, which could be as simple as reciting the same verse from the Quran. Another option, observed in a Chinese context, is to present a sugar cube with a specially imprinted symbol — and swallow it once the transaction is complete.

You might be thinking that, aside from the secret sugar cubes, this all sounds pretty familiar. And you would be correct. Hawala is, in essence, the earliest known form of trade finance. It is also a predecessor to “modern” payment institutions and foreign exchange providers…

… Wise [an “above-ground payment system] implies that Hawala is informal because it is not regulated by the state. This is the same logic often applied to characterize such networks as “underground” banking systems. There is a historical irony here. Hawala, Hundi, and similar networks operated for hundreds of years before ‘states’ were a thing. And in some situations, such as the British Raj, sovereigns endorsed their use as indigenous forms of payment. Thus ‘formality’ is probably better thought of as a spectrum here, one which depends on both the state’s desire to regulate and the market’s desire to be regulated.

Nevertheless, Wise is correct that hawaladars are largely unregulated. In fact, they are outlawed in many countries, something Wise — a competing service — is keen to emphasize. And the reason is simple: Hawaladars often maintain fewer records of the transactions they facilitate for their clients. They disrupt, in other words, the informational assembly lines of the ‘formal’ financial system, undermining the capacity of the state or its intermediaries to perform surveillance. And this is music to the ears of a particular clientele. Namely: human traffickers, terrorists, and other actors with nefarious motives to move their money in the dark…

[Kellerman describes how Hawala works and gives examples from the Underground Silk Road…]

Here we see both the benefits and limitations of Hawala as a mechanism for financial crime. Like their ancient predecessors, Chinese brokers can move money from one place to another without a trace, sidestepping the informational assembly line of the state-controlled financial system. But additional steps are needed to actually launder the cash. And these steps often involve re-entering the assembly line by interacting with regulated intermediaries. The Chinese businesses buying Mexican products for the cartel, for instance, would have done so through banks with standard obligations to perform AML checks. Thus Hawala can obscure the movement of cash but cannot protect that cash once it enters the ‘formal’ economy.

And there is another caveat: a big one. Chinese underground banks move money through alternative conveyor belts of information which rely on the use of ‘encrypted’ WeChat texts. But are these really so secure? It is commonly understood that the Chinese state surveils WeChat and other messaging services. This has led some to speculate that certain Chinese government officials must be participating in these underground networks. Perhaps we will never know.

What we can say for certain is that the use of app-based communication is a deep security vulnerability for underground banking. These networks are attractive to drug cartels and other bad actors because they disrupt transactional audit trails. Phrased differently: they disassemble information. But communication can undermine these benefits by creating another type of paper trail, one that reassembles how cash moves from one pot to another. Criminals should take note. And so too should any public officials that may be assisting them. To paraphrase the great Lester Freeman, if you follow the cash, you’ll find the money brokers. But if you start to follow the texts, you don’t know where it might take you…

The advantages– and risks– to criminals of underground banking: “The (Dis)assembly of Information,” from @Miles_Kellerman. Eminently worth reading in full.

* “Deep Throat” in All the President’s Men (though it’s not clear that the real deep throat ever actually said that…)

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As we think about transnational transactions, we might recall that it was on this date in 1790 that an act of Congress, passed at the urging of Treasury Secretary Alexander Hamilton, created the United States Revenue Cutter Service– an armed maritime customs enforcement agency aimed at enforcing tariffs by reducing smuggling… which later became the U.S. Coast Guard.

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