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, and 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 circumstances in which they are required.
What Is Source of Funds (SOF) in Anti-Money Laundering (AML)?
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 illicit funds into the financial system by disguising their origins through a process known as layering, which is the second stage of money laundering. For this reason, verifying the SOF is a key process for detecting and preventing money laundering.
What Is Source of Wealth (SOW) in AML Due Diligence?
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 confirming that their clients have lawfully acquired their wealth. It is a vital part of due diligence, particularly for high-net-worth individuals or customers involved in complex financial transactions. By verifying SOW, institutions reduce the risk of being used as a vehicle for financial crimes such as money laundering or fraud.
Source of Funds vs. Source of Wealth: Key Differences for AML Compliance
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 Source of Funds (SOF) and Source of Wealth (SOW) include:
- 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 for AML and Regulatory Compliance?
In the United States, Section 312 of the USA PATRIOT Act requires covered financial institutions to implement enhanced due diligence programs for certain types of high-risk accounts and customers, including documentation of source of funds and heightened scrutiny for Politically Exposed Persons (PEPs) and other foreign clients that pose elevated money-laundering or corruption risks. These enhanced due diligence obligations are designed to help prevent illicit activity in correspondent and private banking relationships and explicitly include verification of the source of funds where appropriate under Section 312’s risk-based requirements. FinCEN.gov+2Sanctions+2
In Canada, the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA) and its associated regulations require reporting entities to maintain comprehensive compliance programs, including risk-based know-your-client (KYC) measures and ongoing monitoring. While Canadian AML law and FINTRAC guidance do not contain a blanket statutory mandate for source-of-funds (SOF) checks for all clients, reporting entities are expected to adopt enhanced due diligence commensurate with assessed risk. Canadian AML expectations, shaped by risk assessments and FATF-aligned principles, can lead to SOF and source of wealth (SOW) information being collected for higher-risk customers or transactions as part of enhanced due diligence under a risk-based approach.
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.
As part of EDD, SOF and SOW checks help organizations fully understand the nature of a customer’s transactions and wealth. These checks also support the identification of potential red flags that may indicate illicit activity.
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’s AML Compliance Platform
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.
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