Financial services organizations must navigate through a complex regulatory environment to ensure compliance and uphold customer security. This includes adhering to the Customer Due Diligence (CDD) Requirements for Financial Institutions (the CDD Rule), which began enforcement in May 2018.
The Financial Crimes Enforcement Network (FinCEN) introduced this rule as a way to improve transparency in the industry and combat money laundering and financing for terrorist organizations.
While the CDD Rule includes a certain level of due diligence procedures that apply to all customers signing up for new services, those deemed to have the highest risk are subject to enhanced due diligence (EDD).
What is Enhanced Due Diligence?
Enhanced due diligence (EDD) is a type of customer due diligence (CDD) that supports a company’s anti-money laundering (AML) and Know Your Customer (KYC) programs.
In general, the CDD process is used to verify that customers are who they claim to be and are using the company’s services for legitimate purposes. The goal is to establish a risk profile for each customer, ensuring that organizations are not allowing criminal entities and bad actors to use their offerings in service of illicit activities.
There are a few different levels of CDD, including standard, simplified, and enhanced. As the name might suggest, enhanced is the highest level of due diligence, which is applied to customers who have been flagged as high risk and require additional investigation into their transactions and verification of how their funds are sourced.
Which Customers Does EDD Apply to?
Again, EDD is conditionally applied to customers who meet a certain risk threshold. There are a few key factors that can qualify a customer for EDD compared to standard or simplified due diligence. This includes:
- The majority of the entity’s clients come from a foreign nation
- The customer is a high-net-worth individual or a politically exposed person (PEP)
- The customer’s business is largely cash-based
- The entity has a complex ownership structure
- The entity/individual’s transaction patterns are irregular and don’t reflect their known business or personal activities
- The business operates in “high-risk” industries like precious metals, real estate, casinos, etc.
If a customer meets any of the above criteria, they’ll need to face a more stringent verification process to ensure the bank or financial institution fully understands who their customers are and the types of risks they may pose to the organization.
What’s Involved in Enhanced Due Diligence?
When a customer qualifies for EDD based on the nature of their business, where they’re located, or other criteria, the organization will need to collect additional information to get a more comprehensive idea of who they are and how they generate their funds. Through the EDD process, the organization is hoping to identify potential risks that they would not be able to gather through standard due diligence alone.
From these findings, the organization needs to document the perceived risks and determine if they’re worth having a relationship with. In other words, given the available information, can the organization mitigate the risks the customer poses, or not?
At this point, the institution will already have collected some basic information about the customer, such as their name, address, date of birth, and purpose for opening the account. Then, the EDD process will require institutions to expand their scope and collect additional details such as:
- Source of wealth or funds
- Explanation of business activities for corporate customers
- List of beneficial owners who control or benefit from the entity
- Additional identity verification
- Risk-specific documentation
To clarify, there is no universal checklist that financial institutions use to complete EDD. The details they’ll need to collect should be tailored to address specific risks, so it will depend on the individual customer’s risk profile, geographic location, and business activities.
Benefits of Enhanced Due Diligence
Putting greater scrutiny on high-risk clients through enhanced due diligence provides financial institutions with the following benefits:
1. Stronger Support of AML/CTF Efforts
The primary reason for EDD is to detect and prevent organizations from having relationships with customers who are involved in risky or criminal activity. It helps to minimize their unknown involvement in illicit operations and exposure to fraudulent activities, supporting anti-money laundering (AML) and counter-terrorism financing (CTF) programs.
This provides an additional benefit of limiting criminal enterprises’ access to financial services, which helps to hamstring their organizations and produce positive ripple effects throughout society.
2. Adherence to Industry Regulations
Implementing EDD procedures doesn’t just result in better risk mitigation for financial institutions, but it also supports compliance with industry standards like AML and CTF guidelines. In turn, organizations can avoid the costly fines and legal penalties that result from non-compliance.
3. Enhanced Monitoring
Some customers who are subject to EDD will be deemed too risky and denied services. The other portion will be allowed to access the institution’s offerings, but this doesn’t mean having a relationship with them is completely risk-free.
When organizations have a clear understanding of who their high-risk customers are, it allows for better monitoring of transactions and behaviors to more quickly spot potentially fraudulent activities. This allows for early intervention to minimize potential losses or further risk exposure.
4. Strengthened Reputation
Institutions’ reputations can be severely damaged if they are found to be involved with criminal enterprises, even unknowingly. If it is eventually discovered that a criminal organization or bad actor was able to use the institutions’ services to support their activities, it could reflect badly on the organization.
On the other hand, EDD helps to showcase that the organization has the proper measures in place to detect and prevent unethical activities and behaviors, strengthening its public image and relationships with legitimate customers.