Are NATO’s sanctions against Russia tough enough?

And why is everyone on Twitter talking about SWIFT?

(Originally written on February 24, 2022, updated to reflect new developments on February 27, 2022)

*The views expressed in this post are my own and do not represent the views of my employer*

So it has begun. Early on the morning of February 23, 2022, Russian President Vladimir Putin ordered Russian troops to execute a “special military operation” in Ukraine. The Kremlin’s official spin is that it felt that the threat from “fascist” Ukraine was so dire that they were forced to invade the country to protect ethnic Russians in the Ukrainian regions of Luhansk and Donetsk and “de-nazify” a nation that has never attacked another sovereign state.

However, Putin—apparently fresh from an ayahuasca ceremony—immediately let the cat out of the bag about his true intentions in a wildly bizarre speech, which could charitably be called geo-political fan fiction. He cast himself as an anti-fascist liberator, taking up the mantle of the Soviet troops that fought back against Nazi Germany’s invasion of the USSR and then summarily did exactly what the Nazis did by invading a free democracy. Nothing says I want peace quite like a cruise missile.

In all seriousness, today has been incredibly heartbreaking to watch unfold. Ukrainian troops have been fighting valiantly against a much more powerful adversary and many have needlessly died as part of one man’s senile quest for power. More upsetting still is seeing Ukrainians forced from their homes by the violence. Refugees who only hours before lived in a peaceful nation.

It is incredible to watch the steadfast bravery of the Ukrainian people and President Vladimir Zelensky as well as that of Russian citizens who have taken to the streets in the thousands to protest the actions of their government in a country where protest is brutally criminalized. Social media has been consumed by the conflict as well as the world’s response.

As the day unfolded, so did the response of the international community. The United Kingdom, the European Union, and the United States—as well as other NATO partners--issued sanctions against Russian individuals and banks, hoping to deliver a decisive blow to Russia that would spawn a financial war of attrition. The United States targeted “80% of all banking assets in Russia” by sanctioning Russia’s two largest banks—Sberbank and VTB—as well as an extensive list of Russian owned enterprises and financial institutions and numerous individuals, including Russian oligarchs, family members, military leaders, and Putin’s inner circle. They also took aim at the ability of Russia’s state run enterprises to access debt and equity (to borrow and raise money in international markets).

Here is a comprehensive list of the specified targets:

Financial Institutions:

·       Sberbank

·       VTB

·       Otkritie

·       Sovcombank

·       Novikombank

·       Gazprombank

·       Russian Agricultural Bank

·       Alfa Bank

·       Credit Bank of Moscow

Russian State-Owned Entities:

·       Gazprom (The world’s largest natural gas company)

·       Gazprom Neft (One of Russia’s largest oil producers and refiners)

·       Transneft (Manages Russia’s network of petroleum-related pipelines)

·       Rostelecom (Russia’s largest telecommunications company)

·       RusHydro (A hydroelectricity company and one of Russia’s largest power companies)

·       Alrosa (The world’s largest diamond mining company, responsible for 90 percent of Russia’s diamond mining capacity, which accounts for 28 percent globally)

·       Sovcomflot (Russia’s largest maritime and freight shipping company)

·       Russian Railways (One of the world’s largest railroad companies)

Individuals:

·       Sergei Sergeevich Ivanov, son of Sergei Borisovich Ivanov

·       Andrey Patrushev, son of Nikolai Platonovich Patrushev

·       Ivan Igorevich Sechin, son of Igor Ivanovich Sechin

·       Alexander Aleksandrovich Vedyakhin

·       Andrey Sergeyevich Puchkov and Yuriy Alekseyevich Soloviev

But What Do These Sanctions Really Do?

So how do these sanctions work? Well in practice the sanctions can be broken down into 3 distinct types of restrictions:

1.     Correspondent and Payable-Through Account Sanctions

2.     Blocking Sanctions

3.     Debt & Equity Prohibitions

Correspondent and Payable Through Account Sanctions

For Sberbank—holding the largest share of savings in the Russian economy and the country’s main creditor—The US government has issued Correspondent and Payable Through Account Sanctions. If you’re not involved in the financial system, you likely have no idea what Correspondent Accounts or Payable Through Accounts are—don’t worry you’re not alone. Essentially, in order to transfer funds around the world, banks develop relationships with one another known as Correspondent Banking Relationships which essentially entail a bank acting as an extension of another bank for the purposes of funds transfer.

Let’s say I live in the United States and want to send funds to a family member living in Italy. I bank with Main Street Bank, which is a commercial bank in the United States. If my family member lived in the US this transfer would be easy because the US Central Bank (The Federal Reserve) processes transactions between US financial institutions. However, the Federal Reserve generally does not transfer funds for international banks and there are no Main Street Bank locations in Italy. My family member banks with a local Italian financial institution called Mamma Mia Bank. However, because they have an Italian bank account at Mamma Mia Bank—a bank that my bank does not have a direct relationship with—Main Street Bank needs to find a banking institution in the United States that has a correspondent banking relationship with Mamma Mia Bank to process the transaction. Let’s say Sierra Ridge Bank (another American Bank) has a correspondent banking relationship with Mamma Mia Bank. This would allow my bank to send funds from my account to Sierra Ridge and then from there to Mamma Mia Bank, where it can be credited to my friend’s account (To review: Main Street Bank > The Federal Reserve > Sierra Ridge Bank > Mamma Mia Bank).

The correspondent relationship allows banks to extend their services and provide customers access to different global financial markets, attracting new customers and expanding their potential footprint without brick-and-mortar expansion. In terms of the recently announced US sanctions, they essentially instruct all US financial institutions to sever ties with Russian banks with which they have these types of relationships, crippling the ability to transfer funds into and out of Russia. This type of sanction specifically targets Russian oligarchs and Putin’s closest inner circle because a great deal of their wealth is held offshore in cities across Europe, particularly in the United Kingdom and in the United States. Ironically, they move their funds to these places for safe-keeping, so they can launder them to disguise their source and have a stable place to use them. Now, theoretically, as the US and its partners enact similar sanctions, they won’t easily be able to get their money back.

Blocking Sanctions

Blocking Sanctions are a bit more straight-forward in the sense that they do what they sound like they do, block access to funds. More often referred to as freezing assets, we see that more of the financial institutions on the US list are designated as blocked entities, meaning that the financial assets that they currently hold in the United States and its partners are no-longer accessible to them. This also means that individuals in the United States cannot transact with these entities in any material way. This effectively depletes the wealth of the Russian state, as it cannot access assets accumulated and held internationally with many of its usual banking partners.

Debt & Equity Prohibitions

The final type of restrictions implemented by the United States are called Debt & Equity Prohibitions. These are easier to understand in a broad sense than in the nitty gritty. Essentially, major Russian banks and state-owned enterprises can no longer borrow in US and European markets to support the operation and expansion of their companies. This may sound kinda underwhelming after the first two restrictions, but it’s actually probably the most impactful of the three in the short-run. Following the announcement of these sanctions the Russian stock market tanked, losing 50% of its value. And for good reason, companies that can’t raise money in most of the major markets in which they operate probably aren’t going to do very well in the near future. Also, since these businesses are arms of the state, it directly hits the Russian war machine as well.

But will these sanctions be effective?

It is likely too early to say how impactful these sanctions will be on stopping Russia’s advance, mostly because Russia still has sufficient capital and military capabilities today and the effect of these sanctions is to hurt its financial system, its leaders, and the broader economy over the coming days, weeks, and months. My personal view is that eventually the economy will be devastated. As I want to discuss in another post later this week, the Russian state is a kleptocratic regime heavily dependent on natural resource wealth from the sale of oil and natural gas. The economy itself is not very modern or diversified and they are being sanctioned by some of the biggest customers. It’s not exactly a winning equation for Putin.

Many voices on social media criticized the intensity of the sanctions, specifically that they didn’t include Vladimir Putin himself and didn’t target the SWIFT system (Don’t worry I’ll get to that in a minute!) But I would like to make a point about sanction intensity. While it’s true that the West wants to portray a strong, united front to defend Ukraine from Russian aggression, there is some 3-dimensional chess involved. Sanctions can be tricky instruments—and as many have publicly noted—don’t always have the intended results. I think that Biden in particular is keeping the sanctioning of Putin himself and other, more drastic measures in his back pocket for points of leverage for if/when this turns into a protracted conflict. Sometimes if you dial up sanctions too aggressively, too quickly, it strengthens the resolve of the target because they know you’re already at your ceiling, it cannot possibly get worse. This is actually what happened with Saddam Hussein and Iraq during the First Gulf War. The United States and our allies invoked the full strength of sanctions and the regime became irrational. This measured approach shows discipline that I think is important with an adversary as erratic as Putin.

But Adam, what about SWIFT?

What is it? Why is everyone on Twitter talking about it? Should we take Russia out of it? Why don’t some European countries want to do that?

So SWIFT stands for Society for Worldwide Interbank Financial Telecommunication. It is essentially a messaging system that allows financial institutions to communicate with one another to facilitate transactions across the global financial system. To return to our example from earlier, SWIFT is the system that would be used by Main Street Bank to message Sierra Ridge Bank and tell them that I wanted to send money to Mamma Mia Bank. It’s not exactly instant messaging, but more directional in nature and is secure, with numerous built-in redundancies to protect from misuse or fraud.

Many people are calling on the US and its European partners to remove Russia from the SWIFT system after Ukrainian authorities requested it as part of the actions it was seeking from its western allies. The functional impact of this would be that it would be extremely difficult to send transactions to or from any bank outside Russia, complicating the country’s ability to transact in international funds. But it is important to note that the sanctions that are currently in place achieve many of the same goals. We’re already calling for the closing of correspondent accounts and payable-through accounts and freezing Russian assets abroad, so also shutting down the bank messaging system is not completely a new lever. There are also concerns on a humanitarian level—the current sanctions regimes have specific exemptions for specific types of transactions—i.e. food and medicine, COVID-19 relief supplies, etc. To shut down SWIFT we need to be comfortable with forcing Russia to possibly go without those things.

There’s also the small inconvenience that no country or group of countries controls the SWIFT system (it is controlled by its member institutions) and there has only ever been one successful attempt to remove a country from the system. In 2012, the US and its allies successfully pushed to have Iranian banks removed from SWIFT, however, the effort took several months and required a demonstration that Iran was attempting to circumvent sanctions. In 2014, when Russia invaded Crimea, SWIFT actually refused to remove it from the system. It is possible that the United States could pass additional sanctions attempting to unilaterally take Russia off SWIFT, but this has never been attempted. It’s perceived that the EU can exert considerable pressure on SWIFT because of its headquarters in Belgium (which is what occurred in the case of Iran), but it’s not clear that the removal of Russia would occur in a timely manner.

Another unfortunate truth is that following the attempt to have them removed from SWIFT, Russia launched their own SWIFT alternative known as SPFS which acts as a back-up and can facilitate transactions between Russian financial institutions. So even if we removed them from the SWIFT system, they wouldn’t be completely without alternatives.

With these drawbacks in mind, I still believe that removing Russia from SWIFT will eventually have to be on the table given Putin’s unrepentant aggression. Maybe the impact on the broader economy will create greater unrest at home that will lower morale and increase demonstrations among Russian citizens.

The question from many has been, why are certain European countries, particularly Italy and Germany (key NATO allies) against the idea of removing Russia from SWIFT? And the simplest answer is that both nations, in addition to Hungary and Cyprus, have significant banking relationships with Russia that serve to create problems for their financial institutions if Russia is removed from SWIFT. Banks in Germany and Cyprus were both caught up in the Global Laundromat scheme, which revealed that as bankers to many high-net-worth Russian individuals and businesses they facilitated large-scale money laundering of diverted government funds. Furthermore, both Italy and Germany receive significant oil and gas supplies from Russia and therefore stand to be more negatively impacted by a complete removal of Russia from SWIFT.

But what should we do?

Because only some of these issues are my bread and butter and I don’t have the information that world leaders do it’s not for me to say, but I do think that the impact of these sanctions can’t be measured in hours or days and that’s longer than Ukraine may have. As I write, Russia is encircling Kiev and it is unclear how far they will go in their push westward. Ukrainians have shown they are strong but we have to support them, that might not mean ground troops, but it has to mean logistical support and funding, working with our allies to help the Ukrainian cause survive. We cannot flinch in the face of a war criminal.

May god bless the heroes of Ukraine…

UPDATED on February 27, 2022

Since this post was originally published, significant developments have occurred in regard to western sanctions against Russia. Specifically, on Friday, the United States, the United Kingdom, and the European Union sanctioned Russian President Vladimir Putin directly, as well as Russian Foreign Minister Sergei Lavrov.

What does this do exactly?

Well it is not something that is done often, that’s for certain. The effectiveness depends on the allies’ intelligence about where Putin and Lavrov’s funds are held. It has been speculated that Putin stores much of his wealth in the West and leaks such as the Pandora Papers in 2020 have detailed an intricate architecture of legal frameworks and straw-man or straw-woman account holders for shell corporations that many claim are storing funds on behalf of Putin. If the US and its allies know more about the location of these funds via classified intelligence, the direct sanctions against Putin and Lavrov could turn out to be impactful. The US and UK have already signaled an intention to seize Russian oligarch-owned property and assets in the west, so Putin’s assets may end up comprising a portion of those seizures.

On Saturday, the EU, US, UK, and Canada agreed to remove several Russian banks from the SWIFT system. It is clear that the allies are attempting to slowly ratchet up sanctions intensity to bring Putin to heel and impede the Russian advance. These financial sanctions were also released in tandem with technology sanctions limiting Russia’s ability to import certain high-tech goods to support the development and maintenance of their armed forces and society. This included sanctions on the import of aircraft parts.

There is significant discussion among US officials about taking additional sanctions measures against Russia’s central bank (which holds currency reserves around the world), essentially limiting the government from functioning by drastically reducing its liquid cash on hand and potentially sending the Ruble into freefall (This has already been the worst week for the Russian stock market on record). However, the exact measures to be undertaken have not yet been publicly specified.

These new sanctions measures have been accompanied by significant military support to Ukraine from governments throughout Europe and in the United States—and although fighting is fierce and Ukraine is still a significant under-dog—Russia has yet to conquer and hold any Ukrainian city.

May god bless the heroes of Ukraine…