Anti-money laundering (AML)

Anti-money laundering is a system of laws, regulations, and procedures that prevents criminals from making illegally obtained money look legitimate. Money laundering happens when criminals take profits from illegal activities and run them through the financial system to hide where the money originally came from.

For hedge funds, AML requirements create significant compliance responsibilities. These obligations affect how hedge funds interact with investors throughout their entire relationship—from the initial screening process through ongoing monitoring and reporting activities.

Several major federal laws govern AML requirements today. The Bank Secrecy ActFederal law requiring financial institutions to assist U.S. government agencies in detecting and preventing money laundering., which was later expanded by the USA PATRIOT Act of 2001, provides the foundation. The Anti-Money Laundering Act of 2020 and the Corporate Transparency Act Corporate Transparency Act (CTA) The Corporate Transparency Act is U.S. legislation that requires certain entities to report information about their beneficial owners to the government. As of March 2025, only foreign companies registered to do business in the United States must comply with these reporting requirements. Domestic U.S. companies, including most hedge fund vehicles, are now exempt from these rules. added new requirements. Together, these laws require traditional financial institutions like banks and broker-dealers to maintain comprehensive AML programs.

Hedge fund advisers face a different regulatory environment than traditional financial institutions. While banks and broker-dealers must have AML programs, hedge fund advisers have historically not been legally required to implement the same mandatory programs. However, this situation is changing.

In September 2024, FinCEN FinCEN FinCEN (Financial Crimes Enforcement Network) is a bureau within the U.S. Department of the Treasury responsible for collecting, analyzing, and disseminating financial intelligence to combat money laundering, terrorist financing, and other financial crimes, with evolving authority over hedge funds and investment advisers. issued a final rule requiring registered investment advisers to establish AML programs and report suspicious activity. This rule was originally scheduled to take effect on January 1, 2026. However, in July 2025, Treasury announced it would postpone the effective date until January 1, 2028, and reconsider the rule's scope through future rulemaking.

Even without current legal mandates, many hedge fund advisers have voluntarily created comprehensive AML programs. Two main business reasons drive this voluntary adoption.

First, large institutional investors increasingly expect hedge fund advisers to implement best practices across all compliance areas, including AML. Institutional investors like pension funds and endowments often require their investment managers to demonstrate strong compliance programs. The potential reputation damage and economic consequences of AML violations that become public can be severe for advisers and their funds.

Second, hedge funds conduct business with various counterparties that frequently require AML representations. Prime brokers, swap dealers, and banks often require hedge funds to demonstrate that they have sufficient AML programs. Without adequate AML programs, funds may struggle to provide these required representations. This limitation could restrict their business relationships and operational capabilities.

Effective AML programs typically include four fundamental components that provide comprehensive coverage of money laundering risks. Each component addresses a different aspect of AML compliance, and together they create a robust framework.

Advisers must adopt internal AML policies, procedures, and controls. These are typically included in the adviser's compliance manual. All employees are responsible for following these policies. The policies establish clear guidelines for how the firm identifies and responds to potential money laundering risks.

An AML Compliance Officer must be appointed to coordinate the program and serve as the primary contact for potential AML issues. This role is often filled by the chief compliance officer (CCO)The person responsible for overseeing a firm's compliance with applicable laws and regulations., CFO, COO, or CAO. While the AML Compliance Officer can delegate day-to-day duties to internal staff or outside administrators, this delegation does not eliminate the officer's or the firm's ultimate responsibility for the program.

AML programs must include periodic training for relevant employees. Many advisers integrate this training into their annual compliance training programs. This ensures employees understand their obligations and can identify potential red flags that might indicate money laundering activity.

Programs require independent annual reviews to ensure proper functioning. These reviews must be conducted by independent parties such as outside accountants, counsel, compliance consultants, or firm officers other than the AML Compliance Officer. The independence requirement ensures objective evaluation of the program's effectiveness.

The operational foundation of most AML programs centers on Know Your Customer (KYC) Know your customer (KYC) Know your customer (KYC) refers to the process and requirements for identifying and verifying the identity of clients, assessing their risk profiles, and monitoring their transactions to prevent money laundering, terrorism financing, and other financial crimes. policies, often called "Know Your Investor" policies in the hedge fund context. These policies require obtaining sufficient information about prospective investors before accepting their capital.

The information gathering enables the hedge fund to assess the investor's background, identity, and the source of their investment money. This due diligence information serves as the basis for determining whether potential investors should be permitted to invest or whether they should be subject to enhanced due diligence procedures.

The Know Your Investor process typically occurs during the subscription process, when potential investors complete detailed questionnaires and provide supporting documentation. This information helps the fund understand who the investor is and whether their investment capital comes from legitimate sources.

Many advisers implement enhanced due diligence procedures for certain categories of high-risk investors. Enhanced due diligence involves more extensive background checks and documentation requirements than standard procedures. These enhanced procedures apply to investors who present higher potential risks for money laundering activities.

High-risk categories include investors located outside Financial Action Task Force (FATF) member jurisdictions. The FATF is an international body that establishes global standards for combating money laundering, so investors from non-member countries may face additional scrutiny.

Enhanced due diligence also applies to:

• Non-U.S. private investment companies
• Senior foreign political figures or politically exposed personsIndividuals who hold prominent public positions and may present higher corruption risks.
• Any investor resident in or organized under the laws of non-cooperative jurisdictions or FATF-designated high-risk jurisdictions subject to calls for action
• Investors whose subscription funds originate from or are routed through accounts maintained at prohibited foreign shell banksBanks that have no physical presence in any country and are not affiliated with a regulated financial group., offshore banks, or banks organized under the laws of non-cooperative jurisdictions
• Investors subject to special measures under various sections of the BSA/PATRIOT Act
• Foreign banks subject to enhanced due diligence requirements
• Investors located in jurisdictions subject to FinCEN advisories

Depending on their investment strategies, some advisers implement enhanced procedures for certain investments, particularly private investments. These procedures help ensure that funds avoid investing in or engaging with business partners that may have histories of violating OFAC sanctions OFAC sanctions OFAC (Office of Foreign Assets Control) sanctions are economic and trade restrictions imposed by the U.S. government against targeted countries, regimes, individuals, and entities, requiring hedge funds to implement compliance programs to screen investors and avoid prohibited transactions. programs or engaging in money laundering activities.

When hedge funds consider private investments, they need adequate due diligence on these opportunities to gain sufficient knowledge about the investment and better assess the legitimacy of companies and prospective transactions. This investment-level screening helps prevent the fund from inadvertently becoming involved with entities that could expose the fund to money laundering risks.

All U.S. persons must comply with OFAC Sanctions Programs, which impose economic and trade sanctions against particular countries, jurisdictions, individuals, and entities. These programs include OFAC Lists such as the Specially Designated Nationals ListA list maintained by OFAC of individuals and entities whose assets are blocked and with whom U.S. persons are prohibited from dealing. and the Sectoral Sanctions Identification ListOFAC list of entities subject to sectoral sanctions that restrict certain activities but do not block assets..

Hedge fund advisers and their funds may not accept investments from OFAC-sanctioned parties. This prohibition requires screening investor names against OFAC Lists both when relationships begin and periodically thereafter as the lists are updated.

Recent developments underscore the need for managers to remain attentive to OFAC risks when directing fund investments. Presidential Executive Orders have prohibited U.S. persons from investing in publicly traded securities of designated companies and securities providing investment exposure to such securities. This expansion broadens the scope of investment-related sanctions compliance beyond just investor screening to include investment screening.

The postponed AML rule for registered investment advisers would introduce several new requirements for hedge fund managers when it eventually takes effect in 2028. These would include:

• Mandatory filing of suspicious activity reportsReports filed with FinCEN when financial institutions detect potential money laundering or other suspicious activities. with FinCEN
• Expanded voluntary information sharing under Section 314(b) of the PATRIOT Act
• Requirements to file Currency Transaction Reports for transactions involving more than $10,000 in currency
• Recordkeeping and travel ruleRequirements to transmit certain information about fund transfers between financial institutions. requirements
• Maintaining RIA ultimate responsibility for effective AML programs even when functions are delegated to third-party administrators

Additionally, the regulatory landscape for beneficial ownership reporting has evolved significantly. The Corporate Transparency Act, which required certain entities to report beneficial ownership information BOI reporting Beneficial ownership information (BOI) reporting refers to disclosure requirements under the Corporate Transparency Act that require certain foreign entities registered to do business in the United States to identify and report the natural persons who ultimately own or control the entity to FinCEN. As of March 26, 2025, U.S. hedge funds and other domestic entities are exempt from these requirements. to FinCEN, had its domestic reporting requirements suspended in March 2025 following regulatory review. Currently, only foreign entities registered to do business in the United States remain subject to these reporting requirements.