Fraudulent activity in the busy Iranian trade finance market is dampening down enthusiasm and ramping up due diligence procedures. International authorities are working with Iranian banks to counter the grafters who are harming Tehran's reputation as a good place for banks to do business.

Frauds are multiplying in what has been one of trade finance banks' busiest markets of recent years. The scams, which involve financial arbitrage on non-existent Iranian import deals, have attracted the attention of the International Chamber of Commerce (ICC), whose International Maritime Bureau (IMB) crime unit recently issued a warning bulletin which talked of "spiking levels" of fraudulent transactions.

The IMB and banks canvassed by Gulf States Newsletter (GSN) said the majority of these "deals" originated in Dubai.

The ICC said an IMB investigation on behalf of local banks indicated that "roughly two-thirds of such transactions" on the secondary trade finance - or forfaiting - market were fraudulent. It noted that "the schemes are being perpetrated in pursuit of low interest rate financing, the illegal transfer of local currency into hard currency outside Iran, and other questionable activities."

GSN was told by the IMB's Barking, London-based Director Pottengal Mukundan that the Bureau first became aware of the scams "about eight months ago". As the IMB has monitored more deals, "patterns have emerged more clearly", said Mukundan - noting that there are now "large numbers" of such transactions. "In each case, we are generally looking at sums in the low hundreds of thousands of dollars," he said.

Commercial banks confirmed that the IMB warning carried substance. "It's getting Iran a bad name - one 'bad' deal we heard of was worth a couple of million dollars," said the head of trade finance with a Japanese bank which has been active in trading Iranian bank paper.

The London office of another major trade finance bank said on 7 June that a Chinese bank was recently offered six Iranian trade finance deals in the secondary market, five of which were fictitious. "The ship never docked, or the vessel wasn't big enough to hold the cargo specified," said that bank's head of forfaiting.

He stressed that although "an awful lot of genuine deals" were still on offer to banks, "it is becoming far more difficult to find deals that we want to do". He added: "Every participant in the market is now quite conscious of the problems, and it has driven some players out of the market for the time being.

Dubai origination

Both the IMB and the secondary market banks underlined that Dubai was where much of the rot started. "Iranian companies seeking lower external interest rates appear to be using shell companies based in Dubai and elsewhere," said the IMB statement: "Employing shell companies makes it easier to structure their financial requirements under the guise of genuine trade finance transactions."

It highlighted that a typical scam involved 360-day letters of credit (L/Cs) opened in Iran - "under the advice of a bank in a Middle Eastern commercial centre" - in favour of a beneficiary linked to the buyer in a seemingly genuine trade deal. The transaction is then offered to other trade finance banks around the world for negotiation and discounting. However the "traded" goods underpinning the finance, and the vessels said to be shipping them, are often either non-existent, or the cargoes stated on the bills of lading are never actually loaded, or the invoices over-valued.

The London-based banker corroborated the Dubai connection. "The problem is with the Dubai entities," he said: "A company in Dubai is generally the beneficiary, and there are a small handful of international banks in Dubai which are providing the advice.

Profit margins are a strong driver of the process, the IMB said: "These transactions are attractive to the banks in the secondary market, because they can charge more for the Iranian risk than for transactions with other similar countries."

This factor has been amplified by upward pressure on trade finance rates for Iran, at a time when global rates are heading the other way. "The past couple of months have seen an uptick in Iranian pricing," said a banker with a major Middle East trade bank (who was sceptical of any direct connection related to worries over fraudulent paper). He attributed the rise mainly to an over-supply of Iranian bank paper and foreign banks' limits becoming full, as higher oil prices have boosted hard currency reserves and widened Iran's ability to import. Other relevant factors might include the coming Iranian elections, and unfavourable sovereign risk perceptions in recent months connected to nuclear issues.

Arbitrage or capital flight?

Where the IMB and commercial banks appear to differ is in their analysis of the motivation for the scams. Both agree that the interest rates offered by banks in Iran on dollar-based L/C transactions will be somewhere over 10%, and that the rates outside Iran are considerably lower - providing Iranian companies with the opportunity to arbitrage the difference by refinancing their L/Cs outside the Islamic Republic.

This technique has been used for many years for bona fide trade deals. "Iranian interest rates are in their mid-teens, but you can get 3% in Dubai, and 2.50-2.75% elsewhere in the secondary market," said the London banker. "Once the Iranian company has re-financed, it will place the dollars as a collateral deposit with the L/C issuing bank, having taken 7-10% in the middle."

The IMB, by contrast, contends that the activity is a "form of money laundering". Mukundan stressed that the money left Iran, and was received outside in foreign currency. "The illegal export of the currency is the scam. What appears at the moment is capital flight out of Iran. This is one of the ways that capital can go," he told GSN.

According to the London banker, "nobody has lost anything yet". Only in the case of a new embargo on Iran, including currency restrictions, would the danger of a non- repayment occur. "That's the real worry," he underlined.

Due diligence drive

However, reputational risk is another element for banks to consider, against the current general background of heightened regulatory concerns.

"Banks are now very aware of the problems with Iran - we know that some banks in the Middle East and Europe are now checking the details of transactions before they re-finance the deals," Mukundan said.

He contended that other secondary market players, by contrast, will always be willing to pick up any Iranian risk, given the country's excellent trade repayments record. "In the secondary market, there are banks which don't check at all. They believe that other banks have done the checks, and concentrate on the buying and selling arrangement," he observed. Mukundan added that the advisory bank "will rely on the client's history - and will go ahead if it appears to be OK."

The London banker agreed that diligence levels vary. "People have become more vigilant in checking now. If the current conditions continue to prevail, more people will quit the market. We are probably over the top in terms of protecting ourselves, but any link with fraud can be disastrous for banks. All deals are easily checkable by going to the IMB, which can verify authenticity of any transaction."

"This is a pure and simple due diligence issue," said the Japanese bank executive: "There are many ways to be more careful with your counterparty and to be certain on what you are financing - and that the goods are moving from the specified place to the destination." His bank used the IMB, while reserving the right to independently verify the transaction, and to apply the guidelines from the International Forfaiting Association (IFA), which provide recourse to the primary forfaiter in case of a fraud.

"Trades are getting done - we bought one last week - but if we can't do it under the IFA guidelines we won't do it," this banker stressed.

Mukundan revealed that "certain trading company names" were recurring regularly as a result of the IMB's monitoring, "as applicants, or as beneficiaries, or as issuers of false bills of lading". Rather than approaching these companies - "which might allow them to improve their fraudulent techniques" - the IMB passes the details to banks.

"The Iranian banks in Iran and in London are very concerned, and do not want to be a party to any of this. The Central Bank [Bank Markazi Jomhouri Islami Iran] is also looking at this," Mukundan said.

One of the bankers expressed stronger sentiments: "The Iranian banks in London are badgering their head offices to do something - and not be party to this arbitrage. But it seems to be falling on deaf ears. Markazi needs to send a circular out, pushing for more due diligence."

This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.