How Effective Are Payment System Sanctions Really?
The war in Ukraine underscores the importance and complexity of managing the international flow of money.
This newsletter has time and time again claimed that overhauling the payment system with new technology is not only a matter of efficiency and economic potency, but of vital geopolitical importance. I have dedicated most of my attention to the rivalry between the US and China, but since last week it is another actor that triggered a real-life experiment to test the hypothesis. The world’s response to Russia’s invasion of Ukraine makes clear why the movement of money is not simply an industry like any other.
On credit cards and payment apps
In the 20th century America has been the main engine for building the global financial system and as such has most levers to pull when it comes to sanctioning misbehaving actors. First of all, it runs the world’s largest credit card networks. Companies such as Visa and Mastercard quickly disabled Russian-issued cards from being able to pay outside of the country’s borders. Inside the country, their networks remain up and running, also because there are Russian native alternatives. Hence, the impact would be negligent. Just hours ago some financial institutions have been blocked altogether in accordance to the sanctions.
Increasingly, IT-giants are also playing a strategic role – think Apple Pay and Google Pay. At the moment their impact is limited too, as they are simply an additional layer on the credit card system and users can always go back to the original plastic if needed. But in case the world in the future pivots towards pure payment apps like most of East- and Southeast-Asia did, data goliaths would become crucial gatekeeprs too.
The potency of SWIFT
But currently even more interesting is the SWIFT lever. SWIFT is a worldwide interbank messaging system that allows more than 11,000 member banks in more than 200 countries to transfer funds among each other. It is a society chartered in Brussels and the measures taken by SWIFT are usually agreed upon between the EU and the US.
It should be noted that no fund transfer occurs through the SWIFT network; it is rather a highly secured messaging service between financial institutions. Yet this messaging service cannot simply be replicated or circumvented. What makes SWIFT so powerful are three major assets:
1. A secured, offline network
2. A store and routing system between financial institutions
3. An XML reference model with formats for messaging types
Due to the potency of SWIFT it has been the major focus of the world’s financial sanctions so far. But it was a sanction that was not levied easily by the Western allies, which shows the heft an exclusion from SWIFT holds for both sides. First, disconnecting a country from SWIFT also means that you have no way to pay that country for its exports. The cost of cutting Iran off the network in 2018 was there, but limited. With Russia the situation is different. It accounts for a third of the EU’s gas supplies and Russia in general is a major trading partner, including oil and steel.
Second, as powerful as SWIFT is, it is not omnipotent. Russia has been working on an alternative to channel money to banks outside of the country since the Crimea invasion in 2014. The network called SPFS, which has reached about 20% of SWIFT’s volume and has connected international banks as well, could keep funding coming in. This is also a reason China has for some time been working on its own interbank messaging system as well named CIPS. The long-term danger of using SWIFT sanctions is that it might kick the CIPS roll out into high gear.
Still, the US, EU, and UK have decided to unplug Russian banks – at least some 70% of them – from the SWIFT-network. It shows the stakes and their resolve. Yet they have flanked the SWIFT-decoupling with other financial sanctions, most notably by blocking the Russian central bank from accessing a 630bn USD rainy fund. It had been accumulating foreign currency reserves so that it could soften the plunge of the ruble, which it now can’t. And of course, the preeminence of the dollar is a mighty weapon too. Even those banks that technically can trade with sanctioned individuals or companies will evade them out of fear they might be barred from dollar-denominated payment and settlement.
The compound result has been devastating. The ruble collapsed. The country’s banks have been hit hard. According to the ECB Sberbank Europe AG is likely to fail. And those imports still possible will be punishingly expensive. It is crystal clear that control over payment systems must be a major strategic priority for every country that wants to be a fully-fledged superpower.
What if international payment was run on decentralized ledgers?
Considering last year’s stellar rise of decentralized finance (DeFi) and the decentralized paradigm born with blockchain technology in 2008, the following question forces itself: What if crypto-purists had their way and there was no central authority in charge of the global payment system? What if there were no banks running the network and states had no power to disconnect wallets of a certain country?
This was the utopia envisioned by so many crypto-enthusiasts and cypherpunks. But if they haven’t understood so far that states have legitimate reasons to manage the flow of money, they must understand it in the light of current events. This feeds back to the basic discussion led by the cypherpunks in the 1980s and 90s about how much you can trust governments. There is no question that state influence should yield to the free market wherever possible and that wherever technology can help to bolster the free market, it should. But the movement of money is so crucial that it is also connected to the most basic duty of a state: to keep its citizens safe.
It is just another confirmation that the future of finance cannot do away with banks (aspiration of bitcoin) nor with traditional organizations (aspiration of DAOs). Blockchain technology will transform banking on multiple fields, but financial institutions will be instrumental in it. DeFi will still play a crucial role, but its full potential will only be realized in case of an integration with the existing banking system. Why and how? You will read both answers in next month’s edition of The New Frontier.
Some readers of The New Frontier are decision makers that are and will be among those deciding on whether and how to levy financial sanctions. For those that are not, there are ways to help the war-struck population too. There are even possibilities for donations in cryptocurrencies which arrive and help quickly. The Unchain Fund is an initiative that raises money for humanitarian help and is supported by big names in the blockchain community. Wallet addresses can be found on its website. In total Cointelegraph estimates that Ukrainian government, military, and charities have received about 37 million USD in cryptocurrency donations so far, mainly via bitcoin, Ether, and Tether.