The SWIFT System and Russian Sanctions

How financial information flows internationally and the geopolitical implications of SWIFT sanctions

How did we get here?  

The ongoing conflict in Ukraine has been the most significant coordinated military action involving international superpowers since the Iraq War. The conflict has resulted in not only a dire humanitarian crisis but also harsh sanctions on Russian citizens and businesses imposed by the G7 nations and the United States.

In March 2022, the US and European Union removed 7 Russian bank’s access to the SWIFT network. The SWIFT network is a global financial messaging system that facilitates cross-border transactions between financial institutions like banks. 

In May 2022, Western officials blocked Sberbank’s access to SWIFT as the invasion intensified and casualties increased. Sberbank is the largest lender in Russia (it’s partially owned by the government and a large natural gas company called Gazprom) and facilitates a significant portion of the country’s financial activity domestically and internationally.

Immediately after these sanctions were introduced, credit card companies stopped permitting Russian transactions, and depositors initiated a bank run on Sberbank leading to a massive redemption of over one trillion rubles.

While we have seen coordinated restrictions of access to SWIFT before, this is the first time SWIFT sanctions have been imposed on a world superpower. Let’s explore the importance of the SWIFT network, the implementation of sanctions, and the geopolitical implications of the ban. 

What is SWIFT? 

SWIFT, short for the Society for Worldwide Interbank Financial Telecommunication, is a secure peer-to-peer messaging system that enables financial institutions to exchange standardized financial messages, such as payment instructions and securities trading, among other transactions. SWIFT is governed as a Belgian cooperative society but the US and G7 countries have significant influence on the network. 

The SWIFT system offers a standardized format for financial messages and is used by more than 11,000 financial institutions in over 200 countries. The SWIFT network processes millions of financial messages every day. 

Before the implementation of the SWIFT system in the 1970s, banks lacked a uniform and automated system for exchanging financial information, and instead relied on slower and error-prone methods like Telex. Telex used a network of teleprinters to transmit messages between banks. 

SWIFT messages 

Parsing SWIFT messages is usually automated through computer algorithms. However, those algorithms sometimes fail to complete the translations, and experts who understand the SWIFT coding are needed. Understanding the syntax standards is crucial for designing software that can accurately interpret these messages, particularly in complex corporate action messages, which are initiated by publicly traded companies and can include dividend payments, mergers, and stock splits. I sometimes analyze the “raw” MT564 message when drilling into problems with corporate actions. 

Though these messages are not easy to read at first, using a less structured system like telex or secured email would be sub-optimal due to the unacceptable risks of human error in data formatting and transmission. By building on top of SWIFT's structured messaging system, fintech companies can ensure accuracy, reliability, and efficiency in processing financial information.

Nostro and vostro accounting 

Importantly, the SWIFT network doesn’t move money. What it is actually doing is sending information that updates ledgers in specific accounts at both the participating entities in a given trade. To complete international movements of money, banks use nostro (ours) and vostro (yours) accounts which are pools of liquidity that are reconciled by the banks so ledgers balance and the flow of transactions runs smoothly.  

Let's say a customer in the United States wants to wire $10,000 to a supplier in Italy. The customer's bank in the United States will first debit the customer's account for $10,000 and then initiate a transfer to its corresponding bank in Italy, which has a nostro account in the United States bank. 

The corresponding bank in Italy will receive the $10,000 transfer and credit it to its nostro account held in the United States bank. The corresponding bank in Italy will then debit the same amount from its vostro account held in Italy on behalf of the beneficiary, the supplier.

The supplier's bank in Italy will then credit the supplier's account with the $10,000 transfer received from the corresponding bank in Italy.

In this way, the vostro and nostro accounts facilitate the transfer of funds between banks in different countries and ensure that the funds are credited to the correct accounts. Banks bunch (sometimes called netting) payment details together and transfer the information in packages over the SWIFT network. Eventually, the bunched transactions clear through the bank system and the funds are moved to the accounts.

What does a SWIFT message cost? 

SWIFT transactions can cost corporate entities anywhere between $40-150 per batch of transactions and around $20 for individual transactions. 

The cost source of the transaction is not derived from the energy it takes to send the messages. That’s nearly free. The cost comes from the work that must be done by SWIFT employees to ensure that the messages are in compliance and sent properly. 

With as much as $2 trillion USD laundered each year and less than 10% of associated crimes caught, the price of getting these investigations wrong and allowing illegal transactions is enormous. Banks can face fines if they fail to complete the proper investigation and identify criminal activity. 

This investigative work can increase latency. To mitigate this, SWIFT has created new solutions including SWIFT gpi (global payments initiative). Gpi is SWIFT’s attempt at modernizing global bank payments through the use of APIs that allows you to see payments and track transactions. 

Banks effectuate the SWIFT sanctions by referencing a list of banned individuals and entities distributed by the US Office of Foreign Asset Controls (OFAC). In order to comply with the OFAC restrictions, banks have to know who their customers are. Banks complete Know Your Customer and Anti-Money Laundering checks before opening accounts and moving money, and they are responsible for building an internal database that identifies the Ultimate Beneficial Owner of funds. This work is challenging and thankless, and it requires a small army of professionals with various skills to complete it properly.  

What options does Russia have post-sanctions? 

The decision to remove Russia from the SWIFT network has precedence. Most recently, Venezuela had its access removed in 2019 due to the country’s political and economic crises. The option to block Russia from the SWIFT network was on the table in 2014 when Crimea was annexed.

Russia is a much larger and more complex country than other nations that have been removed from the SWIFT network including Iran, Venezuela, and North Korea. Not to mention, Russia possesses a massive amount of nuclear weapons.

In response to the need for trade with a well-capitalized counterparty and to reduce exposure to the US, Putin has strengthened his relationship with China. And, knowing that a SWIFT ban was a measure that could be used against China, Chinese technologists have a proprietary payments network called CIPS or the Cross-Border Interbank Payment System.

Zooming out, China is executing a neo-colonialist strategy by building infrastructure around the world and asking to be paid back in Yuan. China aims to establish the Yuan as the reserve currency for many of these countries and create separate information exchange rails to silo this information. 

Additionally, the Chinese government has implemented stringent laws for the movement of money for its citizens and corporations, and may seek to export these restrictions to international Yuan users.

In the realm of internal payments, Russia has developed its own system called Mir meaning “the world” or “peace.” Sberbank has issued millions of Mir debit and credit cards that can facilitate payments without touching SWIFT. Furthermore, Russia has created its own SWIFT competitor, the System for Transfer of Financial Messages (SPFS), which handled 20% of all domestic transfers in 2022.

https://econofact.org/swift-sanction-on-russia-how-it-works-and-likely-impacts 

Sanctions and the industrial chain

In general, sanctions are often most effective when implemented against countries situated in the middle or end of the industrial chain. The industrial chain refers to the economic path that natural resources take to become goods, which ultimately contribute to a country's gross domestic product (GDP).

GDP is a measure of a country's economic output and productivity, calculated by adding up the value of all goods and services produced within a defined period. Economists often adjust for inflation and other factors when calculating GDP.

China, for instance, sits in the middle-to-end of the industrial chain, importing raw materials and adding value before exporting the finished products or selling them domestically. Russia, on the other hand, is at the beginning of the industrial chain, supplying natural resources and commodities that cannot easily be substituted. As a result, the Russian economy has an increased level of resilience because their trading partners cannot easily create the goods.

Have the sanctions been successful? 

Although it is difficult to measure, there are a few key indicators to examine when trying to understand if the US policy has been successful. 

You can track any changes in the target country’s strategic initiatives. Russian leadership seems committed to their campaign in Ukraine. This signals that the sanctions have not yet been effective when measured on this vector. 

One could watch for any political strife among the citizenry. Although Russian banks destabilized initially, Russian citizens have not called for the resignation of Putin and have largely ignored the war. Bank runs have become less frequent. 

We could also look at the economic impact sanctions have on the country. Russia has certainly been worse-off since the beginning of the war, but because the country produces raw materials, it has been able to sustain a subsistence level of economic activity. Russian leadership has been happy to hold onto the physical resources that Europe and other trading partners desperately need and only trade when the terms benefit Russia. 

In early March of this year Sberbank reported its earnings for 2022. This was the first time in a year that the bank disclosed its earnings due to limitations on public disclosures from Russian officials. Russian politicians attempted to prop up the stability of the banks by limiting disclosures. The bank saw an 80% drop in net profit for 2022 and called it the most difficult year in its history. Sanctions are clearly impacting the profitability of the Russian banks and affecting their ability to lend. 

International compliance with sanctions is another vector worth examining when looking at the efficacy of sanctions. Although European countries have limited trading with Russia, we have seen quite a bit of economic activity between India, China, and Russia. 

What are the geopolitical implications?

The world is changing. As the US’s global share of GDP decreases, other countries are finding that they want to transact in currencies other than the US dollar. Currencies like China’s and India’s are becoming more stable as these nations increase their productive output, strengthen their militaries, and bolster their influence on the world stage.

This past week, France bought 65,000 tons of liquid natural gas from China and settled the transaction in Yuan rather than USD. This was China’s first trade ever executed with Yuan as the final settlement currency. This is the first real-world instance of the petroyuan and it should be rather alarming for US foreign policy analysts. 

This trade is largely symbolic. The Chinese Yuan accounts for only a small percentage of the energy market while the US dollar remains the dominant currency. Global oil is still priced in USD, and is hedged and traded at US based exchanges. However, this Yuan trade signifies that there are trading partners that are willing to circumvent US dollar settlement to trade in other currencies. 

When thinking through this topic, I often turn to Jason Lowery’s assessment of the SWIFT ban and his view on complex, emergent political phenomena. Jason is a US Space Force officer & astronautical engineer who advises officials on strategy in the digital age. 

In his analysis of the modern financial system, he emphasizes the importance of not forcefully exiling nations from the existing monetary network through sanctions. He warns that the monetary system relies on the user's perception of its reliability, and authorities misusing their power can scare users away leading to a devaluation of the network. Because switching costs to jump over to a new system are cheap and getting cheaper, the US and Western powers should be careful when setting a precedent for banning nations from the current systems. 

Lowery identifies four major risks to the US monetary system and its technological infrastructure (including SWIFT): loss of ability to measure value, transfer value, store value, and loss of users. The SWIFT ban on Russia increases the probability of these risks, and Lowery argues that it may have contributed to the ongoing banking crisis and erosion of trust in the current monetary system.

Thinking longer term, using a SWIFT ban dulls this political weapon and detracts from the West’s ability to power project. All nations with interests divergent from that of the West’s are now obligated to consider alternatives to the SWIFT system to protect against a denial of service if it is ever leveled against them.