Know-your-customer (KYC) and customer due diligence (CDD) are essential components of a compliant anti-money laundering strategy. Together, they provide the information businesses need to make accurate anti-money laundering (AML) risk assessments and comply with AML reporting requirements.
Collecting identifying information and verifying customer identities are the foundation of KYC and CDD. However, financial institutions and other businesses subject to AML regulations may need to dig deeper into some customers’ financial histories to accurately assess risk.
Source of funds (SOF) and source of wealth (SOW) are among the most valuable checks for determining risk. They help regulated organizations better understand the risk profile presented by transactions and customers; they play a pivotal role in enhanced due diligence checks.
In this article, we’ll take a closer look at what SOF and SOW are, why they matter, and the circ*mstances in which they are required.
What is Source of Funds (SOF)?
Source of Funds (SOF) is the origin of the money involved in a transaction. It is the specific activity or event that generates the money a customer uses to conduct a transaction. Understanding the SOF enables financial institutions and other regulated entities to ensure that the funds do not result from illegal activity.
When a customer deposits a large sum of money, makes a significant investment, or purchases a high-value asset, the institution handling the transaction should verify the SOF. To do so, they ask the customer to provide evidence—bank statements, pay slips, or documents confirming the sale of an asset—that shows the funds come from a legitimate source.
Let’s say a customer wants to invest a large amount of money into a mutual fund. The financial institution managing the investment will need to check the SOF. They will ask the customer for proof, like bank statements or documents that show where the money came from, whether that’s the customer’s salary, a business sale, or a gift from a family member.
If the funds come from the customer’s business, the institution might ask for business financial statements or records of recent transactions showing the money was earned legally. If the money was a gift, the customer might need to provide a letter from the person who gave it.
Verifying the SOF aids in detecting, preventing, and reporting suspected money laundering. Money launderers often try to introduce their illicit funds into the financial system by disguising their origins in a process known as layering, which is the second stage of money laundering. As a result, verifying the SOF is a key process for detecting and preventing money laundering.
What is Source of Wealth (SOW)?
Source of Wealth (SOW) is about understanding a customer’s overall financial status. It looks at how customers accumulated their total wealth over time, including their past earnings, investments, inheritance, and any business dealings that have contributed to their current wealth.
For example, if a customer has a high net worth and wants to open a private banking account, the bank will look into the SOW. They might ask about the customer’s employment history, business ownership records, or inheritance documents. The goal is to build a profile showing the customer’s legitimate wealth.
Consider a customer with a net worth of several million dollars. The SOW check might reveal that the wealth was accumulated through a successful career as an executive, savvy stock market investments, and a substantial inheritance. The bank would then verify this information through employment records, investment statements, and inheritance paperwork.
Understanding SOW helps banks and businesses manage risk by ensuring their clients have lawfully acquired their wealth. It’s a vital part of due diligence, especially for high-net-worth individuals or those involved in complex financial transactions. By verifying SOW, institutions protect themselves from being used as a vehicle for financial crimes like money laundering or fraud.
Source of Funds vs. Source of Wealth
SOF and SOW help businesses understand the risk a customer or transaction presents, but they serve different purposes and address different questions.
SOF concerns the origin of the specific money used in a transaction. It answers the question, “Where did this money come from?”
In contrast, SOW deals with the broader question of how a customer accumulated their wealth. It answers the question, “How did this customer become wealthy?” SOW checks look at the customer’s financial history, including their career, business activities, investments, and other significant events that have contributed to their wealth over time.
The key differences between SOF and SOW can be summarized as follows:
- Scope: SOF is transaction-specific, while SOW is about the customer’s entire wealth.
- Purpose: SOF checks ensure that the funds for a particular transaction are not linked to illegal activities. SOW checks help to build a profile of the customer’s financial history and ensure their wealth is consistent with their background and income sources.
- Documentation: SOF verification might require bank statements, payment receipts, or loan agreements related to the transaction. SOW verification might require a broader range of documents, such as tax returns, business records, or proof of investment returns, to paint a picture of the customer’s financial journey.
Why Do SOF and SOW Matter?
In the United States, SOF checks are mandated by Section 312 of the USA PATRIOT Act for certain types of customers. This includes Politically Exposed Persons (PEPs)—individuals who are or have been entrusted with prominent public functions and may represent higher risks due to their position and the potential for corruption.
Enhanced due diligence (EDD) is required for these customers and others where a preliminary risk assessment suggests a higher risk of money laundering or terrorist financing. EDD is a more thorough process of investigation that goes beyond standard identity verification and KYC processes. It involves a deeper examination of a customer’s background, financial activities, and the risks they may pose.
It includes SOF and SOW checks to ensure the business fully understands the nature of the customer’s transactions and wealth and detects any potential red flags indicating illicit activities.
Additionally, collecting and verifying SOF and SOW is part of the Financial Action Task Force’s recommendations for combating anti-money laundering and terrorist financing.
SOW and SOF Checks with Alessa
Alessa is a modular anti-money laundering software platform with comprehensive customer due diligence and enhanced due diligence features, including SOW and SOF information gathering and verification.
Contact our AML experts today to learn how Alessa can streamline and optimize your business’s AML compliance processes.
