Compliance Risks in Crowdfunding: A Growing Threat in the Digital Finance World

Crowdfunding is a growing digital finance tool, it allows for compliance risks including money laundering, terrorist financing, and fraud. The article "Compliance Risks for Crowdfunding: A Neglected Aspect of Money Laundering, Terrorist Financing, and Fraud" by Fabian Teichmann, Sonia Ruxandra Boticiu, and Bruno S. Sergi explores the significant risks associated with crowdfunding platforms (CFPs). It examines the new EU regulations designed to make sure minimum regulatory standards and defend contributors. The article emphasizes the significance of robust anti-money laundering systems, thorough customer due diligence, and awareness to mitigate these risks effectively.

Crowdfunding first emerged as a solution to the reduced willingness of the banks’ lending money after the 2008 financial crisis, addressing the capital needs of Small and Medium-sized Enterprises (SME) and startups. It requires soliciting funds from multiple individuals, often through internet-based platforms. However, the rapid growth of this financial method has outpaced the development of proper due diligence practices and anti- fraud guarantees, making it new opening for illegal activity.

The article talks about 7 different types of crowd funding:

Peer-to-Peer Lending: Loans from a crowd of investors with an expectation of repayment with interest.
Equity Crowdfunding: Investors receive a share of ownership or profits.
Donation-Based: Contributors donate without expecting financial returns.
Rewards-Based: Donors receive non-financial rewards.
Profit-Sharing/Revenue-Sharing: Businesses share future profits or revenues in exchange for current financing.
Debt-Securities: Investment in debt securities with an expectation of interest repayment.
Hybrid Models: Combining elements from multiple types.

Why is there a compliance risk in crowd funding and does it have to do with money laundering and terrorist funding?

It is because crowdfunding platforms are ideal for criminals due to their lack of stringent anti-money laundering (AML) systems and customer due diligence (CDD) practices. The absence of adequate regulation monitoring facilities and the exploitations of these platforms for laundering money and financing terrorism. For example, a fraudster can create a fake campaign to either clean money they acquired illegally, or terrorists can use the anonymous donations to fund their activities. The article talks about many kinds of frauds:

Campaign Fraud: Misleading investors about the project's nature or outcome.
Investor Fraud: Investors canceling their donations to sabotage a project.
Equity Crowdfunding Fraud: Promising shares in a non-existent company.
Platform Fraud: Fraudulent platforms soliciting donations.
Misuse of Funds: Diverting donated money for personal gain.

European Union Crowdfunding Regulation and Mitigating Compliance Risks

The EU introduced the Regulation on European Crowdfunding Service Providers for Businesses (ECSPR) to standardize rules across member states and enhance investor protection. Key provisions include:

Due Diligence: Platforms must conduct thorough checks on projects and their owners.
Credit Risk Assessment: Obligatory risk assessments for projects.
Pre-Contractual Reflection Period: A four-day period allowing investors to withdraw offers.
Suitability Tests: Assessing the financial situation and experience of non-specialist investors to ensure they understand the risks involved.

To mitigate risks associated with crowdfunding, the following measures are recommended:

Enhanced AML Systems: Implement robust anti-money laundering and CDD practices.
Legal and Regulatory Compliance: Adhere to EU regulations and national laws to ensure proper oversight.
Investor Protection Mechanisms: Establish clear guidelines for due diligence, risk assessments, and transparency.
Awareness and Education: Educate investors and platform operators about the risks and legal obligations associated with crowdfunding.
Technology and Monitoring: Utilize advanced technology to monitor transactions and detect suspicious activities.

For more on this topic, see Journal of Financial Crime, 25. July 2022 (Fabian Teichmann, Sonia Ruxandra Boticiu, Bruno S. Sergi). https://www.emerald.com/insight/content/doi/10.1108/JFC-05-2022-0116/full/html.