Trump-proofing Canada means ending our dependence on SWIFT

It's time to stop staring into the headlights and respond to the fact that Canada is being eyed as a choice morsel by a much larger predator: our former ally the United States of America. In President Trump's very own words, he wants to use "economic force" to join Canada and the United States together. In anticipation of the U.S. turning its economic might against us, we need to locate all the ways in which our access points to various crucial financial networks are controlled by this predator, and switch those dependencies off, quickly, before they are used to hurt us. One of our most glaring dependencies is the SWIFT network.

Banking and payments run on networks. And network users tend to coalesce around a single dominant network, like SWIFT or the Visa and MasterCard networks. Which leaves whomever controls the dominant network, often the U.S, with tremendous power over all the network's other users. If Canada can reduce our exposure to some of these networks now, then we can't be exploited by the Trump regime down the road to weaken us economically, sap our strength, and threaten to take our resources or annex us.

I've already written about one point of failure: our dependency on the U.S.-controlled MasterCard and Visa card networks. Canada has enjoyed huge conveniences by being connected to the U.S. card networks. However, if Trump were to suddenly cut off our access, Canadian credit cards would be rendered ineffective in one stroke, throwing us into chaos.

The good news, I wrote back then, is that our MasterCard/Visa dependency can be solved by building a domestic credit card system, underpinned by Interac, our made-in-Canada interbank debit network. With a domestic fall-back in place, the threat of a Trump disconnection would no longer loom over our heads. Canada wouldn't be doing anything unique. All sorts of nations have their own indigenous credit card systems, including India, Indonesia, Brazil, France, and Japan.

The next chokepoint we need to address, and quickly, is Canada's dependence on the SWIFT network. Most Canadians don’t realize that SWIFT isn't just an international payment tool. It is deeply embedded in our domestic financial system, too.

What is the SWIFT network? Payments are really just synchronized updates of bank databases. A paying bank subtracts numbers from its database while the receiving bank credits its own. To initiate these updates, banks need to communicate with each other, which is where SWIFT comes in. Think of SWIFT as WhatsApp for bankers. It's a highly secure communications network that banks can use to coordinate bank-to-bank payments, otherwise known as wire transfers, between each other on behalf of their customers, using specialized financial languages like ISO 20022 or FIN.

The SWIFT network, owned by the Society for Worldwide Interbank Financial Telecommunication, a non-profit based in Belgium, has over the years become the global standard for banks to signal cross-border database updates. There is currently no alternative. Decades ago, everyone gravitated toward using the SWIFT network for international payments; so that's where a banker has gotta be.

Canada's SWIFT exposure is especially problematic. Many of the world's largest nations only rely on the SWIFT network for international payments; they do not use SWIFT for domestic payments. For security reasons, these nations have built their own bespoke messaging networks and require their banks to use the domestic network for making within-country wires. For example, India has the Structured Financial Messaging System (SFMS), the U.S. uses FedLine*, and Japan has the Zengin Data Telecommunication System.

Yet a group of smaller countries, including Canada, also rely on the SWIFT network for domestic payments. The UK, Australia, and South Africa are part of this group, too. (I wrote about this domestic reliance a few years ago, if you want more details.) What it boils down to is that if a Toronto-based customer of Royal Bank wants to wire $1 million to a Calgary-based customer of TD Bank, it is the SWIFT network that conducts the communications necessary to complete this within-Canada wire payment.

That is, our domestic payment system is fully reliant on a piece of Belgian infrastructure. And this domestic reliance is a huge weakness.

Cutting countries off from SWIFT has become one of the U.S.'s standard tools for disciplining enemies. Over the years North Korea, Iran, and Russia have all undergone it. Being de-SWIFTed isn't a killing blow, but it makes it much tougher for the offending nation's banks to interact with counterparties to make payments. Without SWIFT, bankers fall back on ad hoc networks of fax machines, email, and telex. Efficiency is replaced by clunky, error-prone workarounds.

In 2025, Canada suddenly finds itself in the same boat as North Korea, Iran, and Russia: we are all U.S. targets (or is Russia about to become a U.S. friend again?) And so Canada faces a genuine threat of being de-SWIFTed. Some of you are thinking: "But wait, JP. SWIFT is a European-based platform. As a liberal democracy, Europe is on Canada's side. They would never allow us to be cut off, right?"

Yes and no. The U.S. market is far bigger than the Canadian market. Given a U.S. ultimatum between disconnecting Canada's banking system and facing U.S. punishment, SWIFT and the Europeans may very well choose to take the path of least resistance and cut Canada off.

A potential European betrayal is precisely what happened to Iran when it was severed from SWIFT in 2018. Recall that the U.S., Europe and other partners had signed a nuclear deal with Iran in 2015 whereby Iran agreed to cease its efforts to get the bomb in exchange for a cessation of western sanctions. Trump reneged on the deal in 2018, enraging the Europeans, who wanted to continue honoring it. The U.S.'s 45th president began to pressure SWIFT to remove Iran from its network, threatening sanctions and travel bans on SWIFT execs. At the time, I thought SWIFT might resist Trump's pressure. Europe remained supportive of Iran, after all, and the EU's "blocking statute" makes it illegal for EU firms like SWIFT to comply with American sanction demands. But Europe caved and Iran was quietly unplugged from SWIFT.

In short, Canada, like Iran, can't rely on Europe to uphold its SWIFT access.

As I said earlier, a de-SWIFTing is doubly serious for Canada. Not only would it sever our banks from the sole communications network through which they can make foreign payments. We would also lose our ability to make local wire payments in Canadian dollars. Need to pay $500,000 by wire to close a house purchase? Too bad. It won't go through.

For those interested in visuals, the chart below illustrates our SWIFT dependence. Note how all arrows pass through the SWIFT network:

How a Canadian wire transfer works: When a Canadian bank (i.e. the "instructing agent") makes a wire payment to another Canadian bank (the "instructed agent") on behalf of a customer, it starts by initiating a PACS message. This message is sent to the SWIFT network, which notifies Lynx, Canada's high value payments system. All Canadian banks have accounts at the Bank of Canada, our nation's central bank. Lynx's role is to debit the central bank account of the first bank and credit the account of the second bank. A confirmation message then flows back from Lynx to SWIFT and on to the recipient bank. SWIFT is central to this entire flow. All arrow lead to or away from it. If SWIFT is no longer permitted to bridge Canadian banks and Lynx because of a Trump ban, then this entire payments flow ceases to function. Image source: Payments Canada

While we can't do much about losing access to SWIFT's international payments services, we do have options for mitigating the effects of lost access on local transactions. Canada must build its own proprietary domestic financial messaging network — urgently. For argument's sake I'll call it MapleFIN. Once built, the government could require domestic banks like BMO and TD Bank to support MapleFIN along with the existing SWIFT option, giving financial institutions two routes for passing on financial messages to other Canadian banks. Then if we are threatened with a de-SWIFTing, at least our domestic payments system won't be paralyzed; we can fall back on MapleFIN.

The oddest thing for me about the sudden emergence of the U.S. threat is that I've been looking to bad actors like Russia and Iran for inspiration on how Canada must harden itself. Like Canada, Russia was historically dependent on the SWIFT network for "almost all" domestic transactions. For many years it had no domestic financial messaging system. Then Russia unjustly invaded Crimea in 2014. It was only at that point that, realizing its vulnerability, the rogue nation belatedly built its own domestic messaging network: the Sistema peredachi finansovykh soobscheniy, or System for Transfer of Financial Messages (SPFS). When Russia's banks finally began to be de-SWIFTed in 2022, they were cut off from making cross-border payments, but at least they could fall back on SPFS for making domestic payments, saving its economy from all sorts of extra chaos.

Iran, too, has its own domestic financial messaging system, having introduced SEPAM in 2013, so when Trump's 2018 de-SWIFTing hit, at least Iran's domestic payments still went through.

We need to do what Russia and Iran did and build domestic payments networks.

A recent design change by the European Union really drives home the point that no nation should be 100% reliant on SWIFT. Like Canada, the EU has always used SWIFT for all of its domestic financial messaging traffic. SWIFT is based in the EU, so you'd think that Europeans would be comfortable being wholly dependent on it. But they aren't. In 2023, European Central Bank modified the domestic payments system so that in addition to SWIFT, banks could also transmit payment messages via a non-SWIFT competitor, SIAnet. (I wrote two articles, here and here, on Europe's decision to reduce its SWIFT reliance).

I worry that many Canadians are still stuck in the early stages of coping with the loss of our privileged relationship with the U.S. There's plenty of anger and betrayal. Many are in denial and think things will return to normal once Trump's regime comes to an end, assuming it ever does. But if we want to safeguard our economy against the years of instability ahead, we can't just stew. We need to accept that things have changed and quickly move forward to mitigate the threat. Financial messaging systems are not irrelevant bits of financial arcanery. They are a vital part of Canada's plumbing through which a large chunk of the nation's commerce flows. If the plumbing seizes up, our financial lives go on pause. Let's fix this, now.

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*The Federal Reserve used to refer to its network as FedNet, but appears to have switched its nomenclature to FedLine.

The intensifying effort to isolate Russia's banks

Last week the U.S. government expanded the coverage of its Russian secondary sanctions program to encompass most of Russia's banks. It's a very big step, one that has been long-awaited by sanctions watchers, and will likely have significant repercussions for Russia and its trading partners. Here's a quick explainer.

Stepping back, we can think about the U.S.'s sanctions war on the Putin regime as an effort proceeding in two acts. The first involved a "casual" round of primary sanctions beginning as far back as 2014 when the Russians invaded Crimean. Then the heavy round began in December 2023, almost nine years later, with the arrival of secondary sanctions.

Pound for pound, U.S. secondary sanctions are far more impactful than primary sanctions. Primary sanctions cut off American entities from dealing with designated Russian targets but allow non-American actors to step into the breach and take their place. This merely shifts or displaces trade routes, creating a nuisance rather than reducing trade outright.

Secondary sanctions like those introduced last December aim to curb this displacement effect by extending prohibitions on dealing with Russia to non-U.S. actors, in particular foreign banks. The gist of secondary sanctions is: "If we can't deal with them, then neither can you!"

Why do non-American actors in third-party nations like China and Turkey bother complying with U.S. secondary sanctions on Russia? The U.S. wields an incredible amount of influence by threatening to cut third-parties off from the U.S. economy should their ties to Russia be maintained. The importance of accessing the U.S., in particular its financial system, far outweighs lost Russian business, prompting quick compliance.

So what exactly happened last week? Let's first re-explore what occurred in December 2023.

If you recall from my previous article, the December secondary sanctions targeted foreign banks. Their aim was to prevent bankers in places like India, Turkey, China and everywhere else from interacting with Russia, but only with respect to a narrow range of transaction types – those linked to the Russia's military-industrial complex.

More specifically, a Chinese or Turkish bank could continue to deal with Russian customers as long as the transaction in question involved goods like cars or dishwashers. The novelty is that they were now prohibited from conducting any transactions with Russia that involved weapons, military equipment, and dual-use goods, on pain of losing access to the crucial U.S. financial system.

In addition to a flat-out prohibition on military-industrial goods, the U.S. Treasury also compiled a blacklist of around 1,200 or so Russian individuals and entities that support Russia's military-industrial complex by working in allied sectors such technology, construction, aerospace or the manufacturing sectors. The December order stipulated that if caught dealing with any of these 1,200 or so names, a foreign bank could be cut off from the U.S. banking system. Russian individuals and businesses who were not on said military-industrial complex list, however, could still be served by foreign banks, even if they had been otherwise sanctioned. (Remember, primary sanctions only apply to U.S. actors.)

As I wrote back in February, anecdotal data from the first two months of secondary sanctions suggest that they are having an effect. Below I've updated the chart from an earlier tweet showing Turkish exports to Russia, which continues to trend downwards (note the 12-month moving average.)

In a recent article, The Bell assessed customs statistics and found that since the start of 2024, imports from some countries are down a third in some countries compared to 2023, notably Turkey (-33.8%) and Kazakhstan (-24.5%).

Source: The Bell

Which finally gets us to last week's announcement.

The scope of the secondary sanctions has been dramatically widened by adding around 3,000 or so additional names to the original 1,200 or so individuals and entities involved in Russia's military-industrial complex, for a total list that is now 4,500 long, according to FT. The reasoning for this extension is that now that Russian is a war economy, pretty much everyone is contributing to the war effort. 

The most important of the additions to the list are Russia's banks. The Treasury's press release drove home this point by specifically drawing attention to the branches of Russian bank in New Delhi, Beijing and Shanghai that are now are off limits.

Going forward, any bank in China or India that interacts with a Russian bank, say Sberbank, now risks losing its crucial connection to the U.S. This is huge! The majority of global trade is conducted by banks in one country interacting with banks in another on behalf of their respective customers. If Russian banks are cut off from this global network, that's tantamount to severing the entire Russian economy from the international economy. With their bankers now isolated, Russian firms won't be able to buy or sell stuff overseas, nor repatriate funds to pay their local employees.

I'm still trying to get my mind around the enormity of this. Russia has become the top destination for Chinese auto exports, for instance, and those purchases require getting a Russian bank and a Chinese bank to interact with each other. How on earth will Russia import Chinese cars without the intermediation of Russian banks? Or appliances, or smartphones?

There are two significant exemptions to the secondary sanctions coverage: agricultural products and  crude oil. What this means is that while a bank in India can no longer deal with a Russian bank like Sberbank, that prohibition ends if they want to conduct transactions with Sberbank that involve grain or oil. Since Russia's economy is so reliant on its oil exports, this exemption is a gaping hole in the sanctions wall that Ukraine's allies are trying to build.

How will Russia and its trading partners react?

A few sacrificial banks

To keep trade flowing between Russia and trading partners like China, it may be necessary for China to serve up a sacrificial bank or two to the U.S. sanctions regime. Who to sacrifice? A small bank with little to no U.S. business is a prime candidate. Such a bank may be able to afford being cut-off from the U.S. financial system in order to ensure that its mostly Russian-linked clientele can keep making bank-to-bank payments.

An example of a willing-to-be-sanctioned financial institution is the Bank of Kunlun, a small Chinese bank which continued to facilitate Iranian transactions even after secondary sanctions were levied on Iran in late 2011. The U.S. government reacted the following year as it had threatened that it would: it cut the Bank of Kunlun off from the U.S. financial system, a state of affairs that continues to this day. Kunlun remains the only bank in the world on the U.S.'s CAPTA (Correspondent Account or Payable-Through Account) list; a register of financial institutions which cannot get a U.S. bank connection.

An appearance on the CAPTA list hasn't stopped the Bank of Kunlun from doing business, however. According to the Atlantic Council, Kunlun has become one of the main connection for so-called Chinese "teapots" – small independent refineries – to buy oil from Iran. Apparently, one of its flagship products is "Yi Lu Tong," which means "Iran Connect." Of course, the Bank of Kunlun can't do a shred of U.S. business, which severely limits its clientele.

In any case, the Bank of Kunlun, or something like it, could end up being the linchpin of Russian sanctions avoidance.

AML-dodging stablecoins

Another alternative option for Russian trade will be to turn to U.S. dollar stablecoins like USDC and Tether. Stablecoins are blockchain-based payments platforms that offer balances pegged to national currencies, usually the U.S. dollar. Unlike banks, which do due diligence on their customers, stablecoin issuers will allow anyone to use their platforms, no questions asked. This feature offers Russian firms a reliable non-bank payments option for settling purchases of Chinese or Turkish products.

Stablecoins are not a new route for Russians keen to evade the long-arm of U.S. sanctions. I wrote last year about how intermediaries linked to a sanctioned Russian oligarch purchased oil from Venezuela's sanctioned state-owned oil company using Tether stablecoins, or USDT. "No worries, no stress," says the Russian to his Venezuelan contact. "USDT works quick like SMS."

"...quick like SMS" [link]

More recently, a Russian sanctions evader describes how he uses Tether to "break up the connection" between buyers like Kalashnikov and sellers in Hong Kong, making it harder for US authorities to trace the transactions. "USDT is a key step in the chain." 

Turning to the U.S., what might its next steps be in the sanctions war?

Extend the secondary sanctions to oil

Sanctions are a cat and mouse game. As Russia inevitably finds ways to adapt to last week's actions, the U.S. will have to find alternatives to keep up the pressure on the Putin regime. A prime candidate for the next ratcheting up of secondary sanctions will be to extend their reach to Russia's oil industry.

The U.S., EU, and other coalition countries are currently trying to cap Russian oil prices at $60 in order to reduce Russia's revenue base, with mixed success. One option would be bring the rest of the world into the price cap effort in order to make it more effective. A simple upgrade to the secondary sanctions regime would allow for this. Foreign banks would still be able to conduct transactions with Russian banks that involve oil, but only if these banks have verified that those purchases have been made at a price of $60 or lower. Any international bank caught breaking the price cap would risk losing its financial connection to the U.S.

Locked up in escrow

Another way to tighten the noose on Russia would be to modify the secondary sanctions program to impede the ability of Russian oil exporters to repatriate or easily utilize the funds they receive for oil sold abroad. 

How would this work? As before, foreign banks in, say, India would still be allowed to conduct oil transactions with Russian banks at prices not exceeding $60, subject to a new sanctions feature stipulating that all oil proceeds must be confined to escrow accounts in the buying nation, in this case India. If Putin does wish to use the funds in Indian escrow accounts to make purchases, they can only be used to buy Indian products. If an Indian bank fails to keep oil proceeds "locked up" in India, and lets them escape by wiring them back to Russia or a third party like Dubai, then it could face the threat of losing its U.S. banking access.

If implemented, this locking restriction would dramatically reduce Putin's ability to repurpose oil revenues. Stuck in foreign banks with only a limited menu of local goods to buy (and likely earning sub-market interest rates), Russian resources would languish, illiquid and uncompensated.

This sort of restriction isn't a new idea. It was successfully tried out on Iran beginning in 2013 in the form of the notorious Section 504 of the Iran Threat Reduction and Syria Human Rights Act (TRA), once described as a bit of sanctions warfare that was "so well constructed and creative that in some respects it can be considered… beautiful." I wrote about it eleven years ago. It's time to dust it off.

The first round of U.S. secondary sanctions on Russia is working

Turkish banks halted transactions with Russian banks last month and are only slowly reintroducing payments for a narrow range of products that are on a so-called "green list," reports Ragip Soylu. This broad debanking of Russia by Turkey is part of the fallout from President Biden's first round of secondary sanctions, announced on December 22. 

Ukraine/sanctions watchers around the world are breathing a sigh of relief. At last the cavalry has arrived! While the Russian sanctions program has often been described by the press as the "world's strictest", in actuality it has been (till now) alarmingly light-touched due to its lack of the toughest tool of financial warfare: secondary sanctions.

Primary sanctions vs secondary sanctions

Secondary sanctions, especially when applied to foreign banks, are far more damaging than primary sanctions, which to date have been the dominant type of sanction levied against Russia. 

With primary sanctions, it is the "primary" layer – U.S. citizens and companies – that are cut off from dealing with the designated Russian target(s). However, primary sanction don't prevent non-U.S. individuals or non-U.S. companies, say a Turkish bank, from filling the void left by departing American counterparts, often acting as a re-router of the very U.S. goods that can no longer be moved directly to Russia by U.S. firms. So rather than reducing the amount of Russian trade, primary sanction often lead to little more than a displacement of trade from one route to another. That's a nuissance for the targeted country, but hardly a game changer.

Secondary sanctions are an effort to combat this displacement effect. They do so by extending the trade prohibitions placed on the primary layer, U.S. actors, to the second layer, that is, to non-U.S. actors. In the case of Biden's December order, foreign banks can no longer facilitate certain Russian transactions that have already been off bounds to Americans for several years.

So far, Biden's secondary sanctions appear to be working. In addition to halting all transactions with Russia for a month, Turkish banks have completely stopped opening accounts for Russian customers. According to Reuters, Turkish exports to Russia fell 39% year-on-year in January. In China, reports say that banks have "heightened scrutiny" of Russian transactions, in some cases going so far as to cut off Russian banks. UAE banks have also begun to restrict linkages to Russia.

Why comply with the U.S.?

Why do non-U.S. actors bother complying with U.S. secondary sanctions? After all, if you're a Turkish banker in Istanbul, Biden has no jurisdiction over you. America can't put you in jail, or fine you.

The way that the U.S. is able to sink a hook into non-U.S. actors is by threatening to take away access to the U.S. economy. Foreign banks, for instance, are told they will be exiled from the all-important U.S. banking system if they don't severe or constrict their Russian relationships. Since access to the Ne York correspondent banking system is so important relative to the small amounts of sanctioned Russian business they must give up, foreign banks are quick to fall into line.

Biden's secondary sanctions on foreign banks only apply to a narrow range of transaction types, specifically those that support Russia's military-industrial base. In short, any foreign bank that is found to be conducting transactions involving military goods destined for Russia can be penalized. Those foreign banks that deal in, say, Russian food imports needn't worry.

In addition to obviously prohibited military items, like missiles and fighter jets, the U.S. Treasury has provided a list of not-so obvious items, such as oscilloscopes and silicons wafers, that it deems fall under the category of military-industrial goods. I've appended this list below. The Treasury suggests that these additional items might be used for, among other things, the production of advanced precision-guided weapons.

Source: OFAC

That's quite an extensive list.

Turkish banks appear to have overcomplied by dropping any transaction that even has a whiff of Russia. This de-risking effect is a common by-product of various banking controls, both sanctions and anti-money laundering, whereby banks cease dealing not only with prohibited customers but certain legitimate customers that are superficially similar to prohibited customers that they are deemed too risky and expensive to touch.

According to reports, Turkish banks have reintroduced transactions for green-listed products such as agricultural products, which aren't actually targeted by the U.S. secondary sanctions.

Turkish financial institutions may be particularly sensitive to U.S. sanctions given the fact that an executive of Halkbank, a Turkish government-owned bank, was sentenced to 32-months in U.S. jail in 2018 for helping Iran evade U.S. sanctions and money laundering. One of his evasion routes was the notorious gold-for-gas trade, which I wrote about here. Halkbank itself was indicted in 2019 for sanctions evasion; the case against it is ongoing.

An unforgiving legal standard

An important element of any alleged crime is the mental state of the alleged criminal, or their "intent." This gets us to another reason for the rapidity and breadth of the debanking of Russian trade. Biden's secondary sanctions have a novel legal feature. The legal standard on which they rely, strict liability, does not require that the prosecution prove intent.

Up till now, U.S. secondary sanctions have not deployed this sort of a strict liability standard. To demonstrate that a foreign bank has engaged in evading secondary sanctions on Iran, for instance, U.S. prosecutors have been required to show that the foreign bank did so knowingly. If the banker conducted prohibited Iranian transactions unknowingly (i.e. inadvertently or unintentionally), then they couldn't be found guilty of sanctions evasion.

Under the strict liability standard set out in Biden's December 22 order, there is no onus on U.S. sanctions authority to show that a foreign bank has knowingly conducted transactions linked to Russia's military-industrial complex. Even an unintentional transaction can be punished. Because this strict liability standard makes it so much more likely that foreign banks run afoul of sanctions and get cut off from the U.S. banking system, bankers are rushing to comply.

What's next?

When the U.S government asked domestic entities to stop dealing with Russia a few years ago, many of these transactions were quickly displaced to third-parties like Turkey. By deputizing foreign banks to be equally vigilant, secondary sanctions will likely crimp the original displacement effect, resulting in a big and permanent decline in Russian trade.

To get an idea for what might happen to Russia's military-industrial goods trade, take a look at how Iran's oil exports were halved after Obama imposed secondary sanctions on Iran in 2012, leapt when they were lifted in 2016, and crumbled again when Trump reimposed them in 2018.

The lesson is that secondary sanctions on foreign financial institutions can be very effective.

Evasion efforts will begin very quickly. When secondary sanctions were first placed on Iran in 2012, Turkish bank Halkbank introduced a forged document scheme in an effort to disguise trade in sanctioned crude oil shipments as legitimate food transactions. The U.S. will have to step up its enforcement efforts to plug these holes. Without proper enforcement, the effect of the secondary sanctions will remain muted.

Using the secondary sanctions on Russia's military-industrial complex as a model, there are many more sectors of the Russian economy on which secondary sanctions might be placed. The next round could extend to Russian automobile imports, its central bank, or the diamond industry.

Secondary sanctions to strengthen the oil price cap 

Even more useful would be to use secondary sanctions to strengthen the most important piece of financial artillery heretofore deployed against Russia: the $60 oil price cap. 

The price cap endeavors to force Russia to accept a below-market price for the oil that it ships, thus hurting its ability to finance its invasion of Ukraine. The cap is currently underpinned at the primary level by threatening banks, insurers, shippers and other businesses located in the EU, U.S., and other G7 countries ("the Coalition") with penalties if they trade in Russian oil above $60. Because Russia has historically been dependent on Coalition service provides for shipping oil, it has been getting less revenue for its oil then it would otherwise receive. 

However, over time a growing chunk of Russia's oil exports has been diverted away from Coalition service providers to third-parties in jurisdictions like Turkey and UAE that are not subject to the cap. This has allowed Russia to sell at prices in excess of $60 and thus recover much of its forgone revenues. If the cap were to be applied not only at the primary Coalition layer, but also at the secondary layer by requiring foreign financial institutions to join in via the threat of secondary sanctions, then much more Russia oil would brought back under the $60 ceiling, and Russia's ability to finance its war against Ukraine would be significantly crimped.

It's time to impose Iran-calibre sanctions on Russia

Russia is sometimes described as the world's most sanctioned nation. And while that's true, the long list of sanctions that the G7 coalition has placed on Russia in response to its attack on Ukraine are surprisingly light compared to the fewer but far more-draconian sanctions placed on Iran over the last decade or so.

This ordering of sanctions precedence is a mistake. With its all-out invasion of Ukraine, Russia has moved past Iran into top slot at world's most dangerous nation. Vladimir Putin merits a sanctions program that is at least as onerous as Iran, if not more so, yet for some reason he is getting off lightly. It's time to apply Iran-calibre sanctions to Russia.

What makes a draconian sanctions program draconian?

What makes the Iranian sanctions program so draconian is that many of the sanctions are so-called secondary sanctions, a feature that has been mostly absent in the Russian sanctions program.

When the U.S. or EU levy primary sanctions on an entity, they are saying that American individuals, banks, and businesses (and European ones, too) can't continue to interact with the designated party. This hurts the target, but it leaves foreign individuals, banks, and businesses with free reign to fill the void left by departing American and European actors, thus undoing part of the damage.

Secondary sanctions prevent this vacuum from being occupied. The U.S. government tells individuals or businesses in other nations that they, too, cannot deal with a sanctioned entity, on pain of losing access to U.S. economy. It's either us, or them.

When applied to foreign financial institutions (i.e. banks) secondary sanctions are particularly potent. The U.S. tells foreign banks that if they continue to provide banking services to sanctioned Iranians, the banks' access to the all-important U.S. financial system will end. Since the U.S. financial system is so crucial, foreign banks quickly offboard all sanctioned Iranian individuals and businesses. The sanctioned Iranian entity finds that it has now been completely removed them from the global financial system. This financial shunning effect is much more powerful than the effects created by primary sanctions or secondary sanctions on non-banks.

Notice that I've limited my commentary on secondary sanctions to the U.S. Since it first began to use secondary sanctions in 1996, the U.S. Treasury has become a master of the art, whereas as far as I know they are a tool the EU has long resisted adopting.

The bank-focused secondary sanction placed on Iran over the last decade-and-a-half have been particularly devastating because they target a broad sector of Iranian society, most crucially the Iranian oil sector, the life blood of Iran's economy. Secondary sanctions prevent foreign banks from processing Iranian oil trades on pain of losing access to the U.S., and so most foreign banks have chosen to cease interacting with the Iranian oil companies.

The chart below illustrates the effectiveness of this approach. When President Obama placed the first round of bank-focused secondary sanctions on Iran's oil industry in 2012, the nation's oil exports immediately cratered from around 2 million barrels per day to 1 million barrels. When he removed them in 2016, they quickly rose back up. And when Trump reapplied the same secondary sanctions in 2018, they collapsed once again, almost to zero.

Source: CRS [pdf]

In short, U.S. secondary sanctions imposed huge body blows on the Iranian oil industry. These same forces have not been brought to bear on Russia's oil industry.

A dovish Russian sanctions program

While the Russian sanctions program is often portrayed as being strict, it is far lighter than other sanctions programs, including the one placed on Iran, because it is comprised almost entirely of primary sanctions. (For a good take on this, see Esfandyar Batmanghelidj here). While a small list of secondary sanctions have been placed on Russia, for the most part they have not been of the banking type.*

The second reason why the Russian sanctions program is dovish is that the oil component of the EU and U.S. sanctions campaign has been particularly lenient. Take a look at the above chart of Iran oil exports and you can see very real evidence of damage from sanctions. Scan the chart of Russian oil exports below, however, and it suggests business as usual.

Source: CREA

Sure, the EU and other coalition partners have cut Russian oil imports to almost nil, and that's great. But overall, this effort hasn't done much harm to Putin, since over time the coalition's respective share of Iranian oil exports has simply been taken up by nations like India and China. Both before and after the 2022 invasion of Ukraine, Russia reliably shipped around 1,000 kt/day of crude oil and crude oil products.

Underlying this leniency, G7 businesses are still allowed to engage in the Russian oil trade, as long as this doesn't involve bringing the stuff back to the EU. For instance, foreign buyers of Russian oil (say like Indian refiners) are allowed to hire European insurers and shipping companies to import Russian oil.

There is a limitation on this. European insurers and shippers can only be used by an Indian refiner, or some other foreign buyer, if the purchase price of Russian oil is set at $60 or below. This is what is known as the G7 oil price cap.

Because the insurance and shipping industries of the UK, EU, and U.S. have a large share of the market, Russia has had little choice but to rely on coalition intermediaries for selling at least some of its oil at $60. This has come at a cost to Russia; it must sell at below-market prices. And that certainly makes Russia worse off than a world in which there was no oil price cap.

But the very fact that these purchases are occurring at all, compared to a world in which Iran-calibre sanctions would prevent them from ever taking place, illustrates how weak the oil price cap is. 

Russia's oil export income is the life-blood of Putin's war economy. These funds gets funneled directly to the front-line in the form of weapons and supplies. It's time to get serious about Russian sanctions, remove the dovish oil price cap, and apply to Russia the same calibre of secondary sanctions that so effectively crimped Iranian oil exports.

We may have to deescalate sanctions on Iran in order to escalate them on Russia

What has prevented the U.S. and its allies from applying draconian Iran-style sanctions to Russia? One of their main worries is that taking a major oil exporter out of the market will have major macroeconomic impact. 

Russia currently exports around 4 million barrels of crude oil per day, as well as a large amount of refined products such as gasoline. Assuming that half of this were to be removed by secondary sanctions, world oil prices would probably rise. Voters in the EU and US would get angry. Neutral countries dependent on oil imports – China, India, Brazil – would push back against the colation, because they'd have to scramble to replace a major supplier. Secondary sanctions aren't just a nuisance for these neutral parties. Due to their extraterritorial  nature, secondary sanctions impinge on the sovereignty of neutral nations. This creates hostility, understandably so, the negative blowback eventually flowing back to the U.S.

So if the EU, U.S. and the rest of the coalition are going to get serious about sanctioning the Russia's oil industry, and thus removing a few million barrels of oil per day from the world market, they may need to counterbalance that in order to soften the blow. One way to do so would be to free up more Iranian oil exports, which means softening the sanctions on Iran.

That doesn't mean not applying sanctions to Iran. A version of the $60 price cap on Iranian oil probably makes a lot of sense. However, a fully armed financial battleship – i.e. bank-focused secondary sanctions directed at a major crude oil exporter's oil industry – may be something that has to be reserved for one country only: Russia.

Now, I could be wrong about the world being unable to bear draconian sanctions on two major oil exporters. Maybe I'm creating a false dichotomy, and in actuality the choice is less stark and the coalition can actually apply draconian oil sanctions on both Iran and Russia. If so, I stand corrected.

Either way, Russia's oil industry has skated through the invasion and resulting sanctions remarkably unscathed, as the Iranian counterexample illustrates. It's time to cut off Russia's main source of revenues by putting the same set of secondary sanctions that Iran has faced on Russia's oil patch. 

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* There are a few bank-focused secondary sanctions placed on Russia. Notably, Section 226 of CAATSA (2017) requires foreign financial institutions, or FFIs, to avoid certain sanctioned Russians or sectors on pain of losing access to the U.S. banking system. (See here, for example.) However, the U.S. must not be enforcing Section 226 very tightly because I haven't found a single case of a bank being punished under 226.

This December, another round of secondary sanctions was imposed on FFIs. Any foreign bank that facilitates transactions involving Russia’s military-industrial base may be cut off from the U.S. financial system. Additionally, any bank that conducts transactions for specially designated nationals who operate in Russia's technology, defense and related materiel, construction, aerospace or manufacturing sectors may face punishment. Note that both rounds of secondary sanctions leave the Russian oil industry untouched.

Is gold safe from sanctions?

As Russia is progressively cut off from U.S. and European payments systems thanks to an ever tightening wave of sanctions, the idea of using gold as a sanctions buster is being discussed. Russia has some $130 billion worth of the yellow metal. Might these gold bars be packed into planes and used to buy vital goods & services from other countries? To complete this monetary circuit, why doesn't Russia start accepting gold bars as payment for Russian oil and gas exports?

Gold seems like an ideal way to evade sanctions. Thanks to its high value-to-weight ratio, it is good at condensing value. This makes transport easier. Gold is also a bearer instrument. Unlike a dollar, it can't be frozen at the click of a button.

But that doesn't mean that gold can't be stopped by sanctions. Here's how a putative Russian gold payments rail gets shut down.

As of now, the only sanctions that have been announced by the U.S. are primary banking sanctions. That is, the U.S. government has decreed that U.S. financial institutions cannot provide banking services to named Russian banks (like Sberbank), certain individuals (like Putin), and Russia's central bank.

But there is harsher type of sanction that remains to be implemented: secondary sanctions. With secondary sanctions, the U.S. government announces that U.S. banks must cut off not just named Russian entities; they must also stop doing business with any foreign bank (Indian, Chinese, etc) that provides banking services to named Russian entities.

Think of secondary sanctions as a strategy of the friend of my enemy is my enemy. Foreign banks cannot afford to be enemies of the U.S. banking system. That would mean no more access to the massive U.S. economy. And so they will comply and cut off designated Russian entities. Where primary sanctions sever Russian entities from access to the U.S., secondary sanctions attempt to remove them from the global banking system.

To close Russia's gold window, a few additional steps must be taken.

The wording of secondary sanctions must extend to non-banks and into markets like gold. The U.S. might simply say something to the effect that "any foreign individual, corporation, or institution that facilitates gold transactions with designated Russian entities will be shut off from the U.S. banking system." If a foreign buyer of Russian crude oil, say an Indian refiner, had previously accepted Russian gold as payment, they may not be so willing anymore. Touching Russian gold could jeopardize their entire refining business, which will inevitably have a U.S. nexus (say a U.S. parts supplier or technical consultant.)

To enforce sanctions, the U.S. would have to rely on whistle-blowers, snitches, and intelligence gathering. The sanctions would not entirely close the gold window. There would be rule breakers. But the sanctions would do a sufficient job.

The best example of the yellow metal being shut down comes from Iran in the early half of the 2010s.

In 2010, a harsh round of U.S. secondary sanctions came into effect. As these were tightened over the ensuing years, Iranian trade plummeted, as did the Iranian rial. Iran's difficulties were compounded in March 2012 when a set of Iranian banks were banned from SWIFT, a global financial messaging network.

The sanctions did not make it illegal for foreign entities to deal with Iran using gold. And so a gold window emerged. This was most apparent in Turkey with the so-called "gold-for-gas" market. (I wrote about this market here and here). In brief, Turkey relies on Iranian natural gas. A quid pro quo was achieved between the two nations by sending gold bars back to Iran. No need for U.S. dollar correspondent banking accounts. No need for SWIFT.

In July 2012, the U.S. began to close the gold loophole. First it issued an executive order extending sanctions to sales of gold to Iranian Government entities (EO 13622). It was still possible for Turkish institutions to sell gold to Iranian individuals, however, so in January 2013 additional legislation was passed sanctioning the sale of gold to any Iranian entity. (See Benjamin Fraser Scott's Halkbank and OFAC: a sanctions evasion case study for an account of the closure of Iran's gold-for-gas trade.)

And thus Iran's gold loophole was cutoff. 

Russia's gold hasn't been sanctioned yet. But it is eminently sanctionable. 

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PS: Yes, this applies to bitcoin. (Bitcoin is traceable, which makes it arguably worse than gold.)
PPS: Sanctions could put an end to a nascent Russian gold payments rail. But just because sanctions can do damage doesn't mean that the target will change its course of action.

Bitcoin and sanctions

I recently watched a video with Alex Gladstein on the importance of financial privacy. In general I agree. We should be working on expanding the scope for transacting privately, although I am conscious of the tradeoffs. Anonymity helps good people evade bad rules, but we need to be wary of how it abets bad people evading good rules. (See for instance my recent post on the good & bad of using prepaid debit cards to donate anonymously).

In the above list, Gladstein intimates that bitcoin has a positive role to play in evading U.S. sanctions. I have two quick points to make.

I mean, there are U.S. sanctions that I agree with and those that I don't agree with, and I'm sure the same goes for Gladstein. I hope that the sanctions that I agree with are in fact the morally justified ones, and the ones I don't agree with are the immoral ones. By my reckon sanctions on the apartheid regime in South Africa were justified, and same with the ones on North Korea and Zimbabwe government officials. Those on Cuba and the recent ones on Iran are not.

One (admittedly-blunt) sorting mechanism for determining the morality of U.S. sanctions is how much international consensus there is on levying them. If plenty of nation's support sanctioning a regime then the odds that the target is a genuinely bad actor are higher than if just the U.S. thinks so.

Trump's recent round of Iran sanctions has almost no international buy-in. America's European allies are furious that the U.S. left the Iran nuclear deal, a carefully negotiated agreement to control Iran's access to nuclear technology. The Chinese and Russian are upset too. On the other hand, Obama's earlier round of Iran sanctions had broad support. Even Russia and China were on board.

So if consensus is a reasonable hurdle for judging sanctions, then Trump's Iran sanction don't pass muster, but Obama's passed the smell test.

All of which is to say that if bitcoin is indeed an effective tool for evading the current round of Iranian sanctions, then it had a negative role to play as spoiler to the previous round of "good" sanctions. Bitcoin might have delayed (or prevented) the 2015 Iran nuclear deal that did eventually emerge. Which would have been unfortunate.

If we do care about the morality of sanctions, bitcoin doesn't really solve anything. We need to get the sanctions correct at the outset. Don't like Trump's Iran sanctions? Try to convince your neighbours about it. Tell your American friends. Go to a protest. Dial up your government representative. Yep, it's an incredibly blunt tool. But it's the best we got.

The second point I want to make concerns how useful bitcoin actually is as a sanctions buster. In his presentation Gladstein mentions Ziya Sadr, an Iranian who can't use Visa or PayPal but can use bitcoin.

I CAN'T use Apple pay/PayPal/Visa/Master or anything like them

I'm from Iran

I CAN use Bitcoin

What do you have to say?!

— Ziya Sadr (@Ziya_Sadr) July 5, 2019

Sure, Bitcoin may give some tech-savvy Iranian freelancers a means to connect to external buyers. But it hasn't helped where it really counts. It hasn't allowed Asian refiners to keep buying Iranian oil or European manufacturers to keep their factories running. Pretty much every foreign company has stopped dealing with Iran. As a result, the nation's oil exports have cratered and its economy has gone into a tailspin. This has had a tremendously negative effect on regular Iranians.

Let's not just single out bitcoin for being ineffectual. The euro, the world's second largest currency, has also been a useless sanctions buster.

Last month I wrote a post about why U.S. sanctions are so effective. Let me give a brief recap. A foreign company--say a European refiner--currently has to choose between continuing to buy crude oil from Iran or no longer accessing U.S. markets. This means not only being shut off from U.S. energy exports, but also doing without U.S refining technology, expertise, and financial access. Any refining executive who ignores the sanctions could be blacklisted from entering the U.S. for travel, or sending their kids to U.S. schools, or getting U.S. medical care.

Source: BBC

And so given an explicit choice between the US and Iran, most companies have chosen the US, since it has much more to offer. In our globally interconnected world, the population of willing-to-be-sanctioned companies is pretty much non-existent.

Having some sort of alternative money like euros or bitcoin doesn't provide much of a work-around.

Say that our European refiner decides to do a bit of business with Iran under the table in euros (or bitcoin) rather than dollars. All sorts of people will touch this transaction, not just the payment side but also the movement of crude. A banker, a bitcoin exchange, or a freighter captain could rat the refiner out to the US Justice department. And so the refiner would be fined or even worse blacklisted, which would means losing all access to US resources. The risk is simply too high.

In sum, the case for bitcoin as a sanctions buster is not clear-cut. Genuine evil leaders probably should be sanctioned, the less ways to short-circuit the blockade the better. And given the way that U.S. sanctions are structured, bitcoin may not provide much help anyways.

Is the strength of U.S. sanctions due to U.S. dollar hegemony?

I often hear the idea that the U.S. dollar is the means by which the U.S. implements sanctions. And since the U.S. dollar pervades all corners of the globe, the U.S. government's sanctions are uniquely powerful. For instance, Reuters reports that Russian resource giant Rosneft is shifting all its contracts over to euros in order to "shield its transactions from U.S. sanctions."

Another version of this idea was recently floated by David Marcus, the head of the Libra payments project:

"The future in five years, if we don’t have a good answer, is basically China re-wiring” a large part of the world “with a digital renminbi running on their controlled blockchain,” Marcus said. He warned about the prospect of “having a whole part of the world completely blocked from U.S. sanctions and protected from U.S. sanctions and having a new digital reserve currency” with no alternative."

The shared assumption of both the Rosneft and David Marcus quotes is that the U.S dollar is the primary pathway for projecting U.S. sanctions. By going out of their way to adopt a different currency, euros or renminbi, a nation or corporation can sidestep the sanctions threat.

But that's not quite right. Sure, the U.S. dollar is the world's reserve currency. However, the U.S.'s ability to apply strong and effective sanctions has very little to do with the U.S. dollar itself.

To see why, we need to visit how sanctions work. If the U.S. doesn't like a particular company, say Rosneft, and wants to cripple it, it starts with primary sanctions. The government tells U.S. companies to stop dealing with Rosneft on threat of fine.

But the real story begins with secondary sanctions. Here, the U.S. government tells Americans that on top of breaking ties with Rosneft, they must stop doing business with all other foreign entities (European, Canadian, Japanese, etc) that does business with Rosneft.

A foreign company now has a choice. If it is a European refiner, it will have to choose between continuing to buy crude oil from Rosneft or no longer accessing U.S. markets. This means being shut off from U.S. energy exports, doing without Texan oil & gas technology, forgoing U.S. repairs and refinery parts, being exempt from Silicon Valley tech expertise, being excluded from purchasing American assets, and having its existing U.S. subsidiaries threatened. There are also financial repercussions. It will lose access to New York's capital markets and the dollar payments system.

Given a choice between Rosneft or America, which will our refiner choose?

As I wrote a while back at Bullionstar, their are additional costs to being blacklisted by the U.S. government. Blacklisted executives would have to face the possibility of "no longer being able to send their kids to Ivy league schools, travel to Las Vegas for holiday, or seek medical care at Johns Hopkins or the Mayo Clinic." They wouldn't be able to visit the U.S. for business purposes, or explore U.S. job opportunities. I doubt that Russia has enough good job opportunities, universities, vacation spots, and high end hospitals to compensate.

This impressive list of penalties is why the U.S. government's secondary sanctions are so powerful. Almost every foreign company will prefer to give up Rosneft and keep doing business with America.

Now, Rosneft might nudge and wink at its European customers and say "hey, let's just deal in euros. That way we can get around the sanctions. We'll keep doing business together and you won't lose access to the U.S."

But using euros doesn't change the economic calculus facing our refiner. Even if it does business with Rosneft in euros rather than dollars, it is still doing business with Rosneft. And the moment that the U.S. justice department catches a whiff of this (say one of its bankers rats it out), the European company will be blacklisted. And that means losing the entire list of goodies that is associated with access to America. The risk is simply too high.

Fancy payment options like bitcoin or gold don't solve this either. Say that Total, a big European refiner, buys Rosneft oil with bitcoin. Total execs hopes that a bitcoin payment might prevent its bankers from tattling on it to U.S. authorities. But it's very difficult to camouflage the opposite side of that trade--massive movements of crude oil back to Europe. There are just too many bodies involved in that sort of operation. A large law-abiding organization like Total can't take the risk of being discovered. And so, bitcoin or not, it will disconnect Rosneft.

To summarize, what makes American secondary sanctions so effective isn't U.S. dollar hegemony. It is the impressive amount of technology, wealth, goods, services, and experience generated by American companies and individuals. When firms are threatened with losing access to this treasure trove, they will make whatever sacrifices are necessary to keep it.

As for Libra, in an effort to sell his new payments system to American regulators, David Marcus conjured up a world "completely blocked from U.S. sanctions" thanks to a new digital renminbi. But even if firms have the ability to make transactions in digital renminbi, this doesn't change the fact that America's home-grown economic bounty is massive, and foreigners value that bounty above any other, U.S. dollar or not. There are other reasons for regulators to welcome Libra. But bolstering U.S. sanctions isn't one of them.

Europe's SWIFT problem

SWIFT headquarters in Belgium (source)

German foreign minister Heiko Maas recently penned an article in which he said that "it’s essential that we strengthen European autonomy by establishing payment channels that are independent of the US, creating a European Monetary Fund and building up an independent Swift system."

So what exactly is Maas's quibble with SWIFT, the Society for Worldwide Interbank Financial Telecommunication? SWIFT is a proprietary messaging system that banks can use communicate information about cross border payments. This November, U.S. President Trump has threatened to impose sanctions on SWIFT if it doesn't remove a set of Iranian banks from the SWIFT directory.

For Heiko Maas, this is a problem. Iran and Germany remain signatories to the same nuclear deal that Trump reneged on earlier this year. The deal committed Iran to cutting back its uranium enrichment program and allowing foreign inspectors access to nuclear sites, in return obligating signatories like Germany to normalize economic relations with Iran, including allowing the unrestricted sale of oil. If Iran is bumped from SWIFT, it could prevent Germany from meeting its side of the deal, potentially scuppering the whole thing. So a fully functioning SWIFT, one that can't be manipulated by foreign bullies, is key to Germany meeting its current foreign policy goals.

SWIFT is vital because it is a universal standard. If I want to send you $10,000 from my bank in Canada to your bank in Singapore to pay for services rendered, bank employees will use SWIFT terminals and codes to communicate how to manipulate the various bank ledgers involved in the transaction. If a bank has been banished from SWIFT, then it can no longer use what is effectively a universal banker's language for making money smoothly flow across borders.

It would be as-if you were at a party but unlike all the other party-goers were prohibited from using words to communicate. Sure, you could get your points across through hand gestures and stick drawings, but people would find conversing with you to be tiring and might prefer to avoid you. Without access to SWIFT, Iranian banks will be in the same situation as the mute party-goer. Sure, they can always use other types of communication like email, telex or fax to convey banking instructions, but these would be cumbersome since they would require counterparties to learn a new and clunky process, and they wouldn't necessarily be secure.

It seems odd that Maas is complaining about SWIFT's independence given that it is located in Belgium, which is home territory. But Trump, who is on the other side of the Atlantic, can still influence the network. The way that he plans to bend SWIFT to his will is by threatening members of its board with potential asset expropriations, criminal charges, travel bans, as well as punishing the companies they work for by restricting them from conducting business in the U.S.

How credible is this threat? As I pointed out here...

If SWIFT doesn't comply with US requirements that Iranian banks be cut off from its network, SWIFT board members (such as Yawar Shah) will face asset freezes & travel bans, and the banks that employ them (Citigroup) will be cut from the payments system: https://t.co/tVntv3USzs pic.twitter.com/XAiLOKPdtk

— JP Koning (@jp_koning) June 6, 2018

...SWIFT's board is made up of executives from twenty-five of the world's largest banks, including two Americans: Citigroup's Yawar Shah and J.P Morgan's Emma Loftus. No matter how erratic and silly he is, I really can't imagine Trump following up on his threat. Would he ban all twenty-five banks, including Citigroup and J.P. Morgan, from doing business in the U.S.? Not a chance, that would decimate the global banking system and the U.S. along with it. Requiring U.S. banks do stop using SWIFT would be equally foolish. Would he risk ridicule by putting two American bank executives—Shah and Loftus—under house arrest for non-compliance? I doubt it.     

No, the SWIFT board is TBTP, or too-big-to-be-punished. But even if Trump's threat is not a credible one, surely SWIFT will fall in line anyways. Large international businesses generally comply with the requests of governments, especially the American one. But there's a kicker. European law prohibits European businesses from complying with foreign sanctions unless the have secured EU permission to do so. This leaves SWIFT in an awfully tight place. Which of the two jurisdictions' laws will it choose to break? Assuming it can't get EU permission to comply with U.S. sanctions, then it can either illegally comply with U.S. law, or it can legally contravene U.S. laws. Either way, something has to give.  

Europe can win this battle, a point that Axel Hellman makes for Al-Monitor. After all, SWIFT is located in Belgium, not New York, and jurisdiction over SWIFT surely trumps lack of jurisdiction. Indeed, on its website SWIFT says that its policy is to defer to the EU on these matters:

"Whilst sanctions are imposed independently in different jurisdictions around the world, SWIFT cannot arbitrarily choose which jurisdiction’s sanction regime to follow. Being incorporated under Belgian law it must instead comply with related EU regulation, as confirmed by the Belgian government."

Consider too that SWIFT itself is supposed to be committed to a policy of non-censorship. Chairman Yawar Shah once said that “neutrality is in SWIFT’s DNA.” So from an ideological perspective it would seem that SWIFT would be aligned with Europe's more inclusive stance.

Of course, SWIFT's stated commitment to neutrality conflicts with the fact that it has banned Iran from the network before. In early 2012, U.S. pressure on SWIFT grew in the form of proposed legislation that would punish the messaging provider should it fail to ban Iranian users. SWIFT prevaricated, noting in early February that it would await the "right multilateral legal framework" before acting. In March 2012, the EU Council passed a resolution prohibiting financial messaging providers from servicing Iranian banks, upon which SWIFT disconnected them. It was only in 2015, after passage of the nuclear deal, that SWIFT reconnected Iran. (I get this timeline from the very readable Routledge Global Institutions book on SWIFT, by Suzan Scott and Markos Zachariadis).

The takeaway here is that SWIFT only severed Iranian banks in response to European regulations, in turn a product of a conversation between American and European leaders. SWIFT will seemingly compromise its neutrality if there is a sufficient level of global agreement on the issue followed up by a European directive, not an American one.

If Heiko Maas wants an "independent SWIFT," the above analysis would seem to illustrate that he already has it. Thanks to its European backstop, SWIFT is already independent enough to say no to U.S. bullying. As long as they are willing, European officials can force a showdown over SWIFT that they are destined to win, thus helping to preserve the Iranian nuclear deal.

But maybe European officials don't want to go down this potentially contentious path. Perhaps they would prefer to preserve the peace and grant SWIFT an exemption that allows the organization to comply with U.S. sanctions, thus cutting Iran off from the messaging network, while trying to cobble together some sort of alternative messaging system in order to salvage the nuclear deal. Maybe this alternative is what Maas is referring to when he talks of a building an "independent SWIFT."

An alternative messaging service would have to be capable of providing bankers with sufficient usability so that Iranian oil sales can proceed fluidly. In a recent paper, Esfandyar Batmanghelidj and Axel Hellman give some clues into what this system would look like. During the previous SWIFT ban, several European banks were able to maintain their relationships with Iranian financial institutions by using "ad hoc messaging systems." These ad hoc solutions could be revived, note Batmanghelidj and Hellman.

Using this ad hoc system, so-called gateway banks—those that have both access to the ECB's large value payments system Target2 and limited exposure to the U.S. financial system—would conduct euro transactions on behalf of buyers and sellers of Iranian oil. Since presumably only a few gateways would be necessary to conduct this trade, it would be relatively painless for them to learn the new messaging language and the set of processes involved. For instance, instead of using SWIFT bank identifier codes to indicate account numbers, Batmanghelidj and Hellman point to the possibility of using IBAN numbers, an entirely different international standard.

This independent ad-hoc system would probably work, on the condition that the European monetary authorities continue providing gateway banks that serve Iranian clients with access to the ECB's Target2 payments system. This is a point I stressed in my previous blog post. It isn't access to SWIFT that is the lynchpin of the nuclear deal, it is access to European central banks. But as long as folks like Heiko Maas get their way, I don't see why this sponsorship wouldn't be forthcoming. In response, Trump could always try to sanction the European central bank(s) that allow this ad-hoc system to continue. But an escalation of U.S. bullying from the mere corporate level (i.e. SWIFT) to the level of a friendly sovereign nation would constitute an even more nutty policy. I just don't see it happening.

At stake here is something far larger than just Iran. As I recently wrote for the Sound Money project, financial inclusion is a principle worth fighting for. If one bully can unilaterally ban Iran from the global payments system, who is to say the next victim won't be Canada, or Qatar, or Russia, or  China? Europe needs to stand up to the U.S. on this battle, either by forcing a SWIFT showdown or by sponsoring an ad hoc alternative—not because Iran is an angel—but because we need censorship resistant financial utilities.

The €300 million cash withdrawal

The eyes of the world are on one of history's largest cash withdrawals ever. Earlier this week, the Central Bank of Iran ordered its European banker, Hamburg-based Europaeisch-Iranische Handelsbank AG, to process a €300 million cash withdrawal. Germany's central bank, the Bundesbank, is being asked to provide the notes. If the transaction is approved, these euros will be counted up, stacked, and sent via plane back to Iran. German authorities are still reviewing the details of the request.

Iran claims that it needs the cash for Iranian citizens who require banknotes while travelling abroad, given their inability to use credit cards, says Bild. Not surprisingly, U.S. authorities are dead set against the €300 million cash transfer and are lobbying German lawmakers to put a stop to it. They claim the funds will be used to fund terrorism.

The picture below illustrates $1 billion in U.S. dollars, so you can imagine that €300 million in euro 100 notes would be about a third of that. That's a lot of paper.

One Billion Dollar Art Piece by Michael Marcovici (source)

The fate of this transaction is important not only for Iran but the rest of the world. It gives us a key data point for answering the following question: just how resistant is the global payments system to U.S. censorship? If a payments system is censorship resistant, third-parties do not have the power to delete a user or prevent them from accessing the system. If the U.S. can unilaterally cut off any nation from making cross border payments, then the global payments system isn't censorship resistant.

We already know that the global payments system is highly susceptible to U.S.-led censorship. From 2010-2015, Barack Obama successfully severed Iran from the world's banks, driving the nation's economy into the ground and eventually forcing its leaders to negotiate limits to their nuclear plans.

The global payments system's susceptibility to U.S. censorship stems from the fact that an incredibly large chunk of international trade is priced in and conducted using U.S. dollars. To make U.S. dollar payments on behalf of clients, a foreign bank must be able to keep a correspondent account with a large U.S. bank. This reliance on U.S. correspondents allows U.S. authorities to use their banks as hostages. International banks can either comply with U.S. requests to cease doing business with Iran, or have their access to U.S. correspondent banks cut off. Dropping Iranian customers is generally the cheaper of the two options.

Following in Obama's footsteps, Donald Trump has decided to inaugurate the next round of Iranian payments censorship. But this time around Europe has not gone along in declaring Iran to be a banking pariah. (I wrote about this here). Europe is responsible for managing the world's second-most important currency: the euro. Its reluctance to sign on to the U.S.'s new censorship drive is a sign that the global payments system may be a little more resistant to censorship than the first round of Iran sanctions might have implied. If a nation is prohibited from using one end of the global payments system, the U.S. dollar end, but not the other (albeit smaller) end, then they haven't really been cutoff.   

Digital euros flow through pipes operated by the European Central Bank, the ECB. This financial piping system is otherwise known as Target2, the ECB's large value payments system. Any bank that is connected to Target2 can route euro-based payments on behalf of its customers to the customers of any other bank that is connected to those same pipes. While a Target2 connection might not be as good as being connected to the US-based financial pipes, it's a close second.

In addition to facilitating digital euro transfers, the ECB also makes euro cash available to member banks when they need it. The way this works is that European commercial banks like Deutsche Bank or Santander or Europaeisch-Iranische Handelsbank have accounts at the ECB. They can ask the ECB to convert balances held in these accounts into euro cash to meet their customer's withdrawal requests.

The ECB can censor a bank—and its customers—by cutting of said bank's access to Target2. It can also censor a bank by refusing to allow the conversion of that bank's ECB account balances into cash. Europaeisch-Iranische Handelsbank's request to withdraw €300 million on behalf of Iran's central bank is a litmus test of the ECB's willingness to continue providing the second of these services: cash withdrawals. Will it comply with U.S. demands and censor Europaeisch-Iranische Handelsbank, and thus Iran, or will it treat Europaeisch-Iranische Handelsbank like any other bank and process the withdrawal? If Europe can successfully resist U.S. pressure, and the cash is sent, then the world's payments systems will be significantly more resistant to censorship than it was before.   

It may be tempting to belittle the topic of censorship resistance as only being relevant to a small group of international pariahs like North Korea or Iran. Only the "bad" guys will ever be cutoff from the global payments system, not us. But nations like Turkey, Russia, and China could one day become tomorrow's pariahs, and thus targets of U.S. monetary sanctions. Heck, in Trump's America, even traditional allies like Canada, South Korea, and UK should probably be worried about being targeted by the U.S. for censorship from the global payments system.

There are sound political and moral reasons for both censoring Iran and not censoring it. Moral or not, my guess is that most nations will breathe a sigh of relief if German authorities see it fit to let the €300 million cash withdrawal go through. It would be a sign to all of us that we don't live in a unipolar monetary world where a single American censor can prevent entire nations from making the most basic of cross-border payments. Instead, we'd be living in a bipolar monetary world where censorship needn't mean being completely cutoff from the global payments system.

The sooner the Bundesbank prints up and dispatches the €300 million, the better for us all.