Ukraine is under attack. The world is responding with financial warfare. It's a new domain in multi-domain operations. Air. Land. Maritime. Space. Cyber. Finance. We explore how financial warfare happens: how SWIFT works and why Russia's been kicked off, how the US can enforce sanctions all over the globe, and what freezing Russia's central bank reserves means for Russia's economy. We conclude with a look at what each of us can do to support Ukraine. They're small acts, but they make a very real difference.
Hey friends -
The tone and focus of this letter are a departure from my normal letters. Ukraine is under attack.
First and foremost - my thoughts are with the people of Ukraine. Even as I write, they suffer under the tremendous weight of war not knowing if they and their loved ones will survive or if the country they hold so dear will remain independent. While the acts of heroism by Ukrainian President Volodymyr Zelensky and others are rightfully highlighted in the media, it is the unreported acts of patriotism by millions of ordinary citizens that I find most laudable. They fight for their country's right to sovereignty today and a better future for generations yet to come.
The world is not standing by as idle spectators. Alongside traditional support of armaments and intelligence, the US, EU, and other countries wage a new type of war - financial warfare. We've seen glimpses of the weaponry and destruction such modern war can wreak in recent engagements with Iran and North Korea. This is the first time it has been directed against a country as large and interconnected as Russia.
Financial warfare is not as dramatic as physical destruction and the effects often won't lead to front-page headlines, but the results are no less terrible. It can break the will of a people, impoverish millions, and directly cause untold suffering and death. It's the focus of this week's letter.
In this week's letter:
Total read time: 18 minutes, 7 seconds.
The aims of financial warfare are twofold: to impact an adversary's ability to finance war and to cripple the will of its people.
The US and its allies have deployed three main weapons:
For those curious about the history of these tools, I highly recommend Treasury's War. What author Juan Zarate documented in 2013 was a harbinger of warfare to come. Excerpts from his concluding chapter will help set the stage for our foray into how the tools are being used against Russia:
What made this type of financial warfare different from and more effective than traditional sanctions was that we harnessed the private sector's own interests and calculus to isolate rogue financial actors.
Power and influence now often lie outside the classic state structures... The state remains relevant, but more than ever before, the global power landscape is shared with other actors and networks.
[T]he nation that galvanizes the majority of these new global voices will enjoy more power and exert more influence than has ever before been possible. More than any other state and culture, America - enabled and accelerated by globalization and new technologies - still enjoys a comparative advantage in leveraging power and influence in ways that are commensurate with our enduring strategic security heritage and our prosperity... American power is more than what the government controls; it also encompasses those activities that shape local and geopolitical environments in line with American interests.
The Society for Worldwide Interbank Financial Telecommunications (SWIFT) is a global messaging system for payments. Rather, it's the global messaging system.
SWIFT is a member-owned cooperative. Shareholders elect a 25 person board. The board determines if new organizations may become shareholders. The board makeup is generally representative of the shareholders - global, multinational banks.
The co-op connects 11,000 banks globally so they can exchange the information necessary to complete payments. Message information can include unique SWIFT identification numbers for the banks involved in the transaction, beneficiary account information for the ultimate recipient, and confirmation that the receiving account can hold the intended currency. In short - lots of information that enables banks to verify to whom, via whom, and what is being sent. The actual movement of funds is conducted separately.
Cutting off a country from SWIFT is a significant hindrance. If you can't send the requisite payment information, you effectively can't send the payment. Russia's 291 banks that use the system average over 600,000 messages per day. It's not that those messages can't be sent via other means, it's that it is a massive pain to do so.
The ultimate decision to cut off a country does not rest with any government - it rests with the shareholders. What governments can do is convince the shareholders (banks) that it's in their best interest to follow in the policy footsteps of their parent governments.
What governments can do - and what helps convince the shareholders - is apply sanctions.
Sanctions are straightforward in theory and devilishly difficult in practice. Like with SWIFT, the goal is to make life difficult not to achieve 100% success.
Sanctions - like the ones enacted against Russian businesses and individuals - are a prohibition against sending money or goods. Sanctions can be applied generally - no movement of funds, period - or targeted to specific goods. There are quite literally "bad guy" lists maintained by governments. The US Treasury Office of Foreign Asset Control maintains the current sanctions list for the US. You can search the list or peruse the Russia-specific sanctions. Transaction senders, receivers, and intermediaries are screened against the list.
You can see how SWIFT comes into play. Sanctioned banks, like VTB Bank and Sberbank, are not allowed to receive payments. Banks that facilitate payments to or through the sanctioned entities will be fined by their parent countries. Removing the sanctioned banks from the messaging system helps protect the remaining members.
The US is particularly well-positioned to enforce sanctions and regularly does so. The US Dollar accounts for over 50% of all SWIFT transactions by value and volume. It's used in about 90% of all trade finance deals. If two banks need to exchange payments and do not have a direct correspondent relationship or access to dollars, they'll go through an intermediary bank in the US. That subjects the flow of money to US sanctions.
The biggest challenge with sanctions is determining the ultimate beneficiary owner. A brief explanation of how transactions are screened will help.
Sanctions are enforced as part of a financial institution's Anti-Money Laundering and Counter-Terrorism Financing program. There are two general elements to a program: know your customer and transactions screening.
The purpose of know your customer is to... well... know your customer. The output is a profile and a risk score. Inputs include understanding where a customer is from, what types of business they're involved with, and to/from who they make payments. Two key inputs for the risk score are the source of funds and source of wealth - where did they get this payment from and where did they get their money from more generally.
Banks screen customers against sanctions lists while building out their profiles. It's not enough just to screen the individual or entity. The bank has to screen everyone who has ownership or control over the funds. Individuals are simpler. Entities rapidly become complex.
Imagine you get your wealth from a trust that has trustees that vote on behalf of an LLC that is in turn owned by an off-shore LLC controlled by your uncle. Your uncle is the ultimate beneficiary owner of the funds. The bank has to trace ownership and control all the way up the ladder to your uncle. Such labyrinthian structures are common among those who expect to be sanctioned.
The risk score informs the degree to which transactions are surveilled. The results of transactions surveillance feedback into the risk score. If a customer says they're a local flower pot company and the bank finds them sending a lot of payments to an auto company abroad, the bank's going to have some questions. The goal is to keep the profile and risk score current with the actual risk the customer poses.
Transactions screening includes comparing sender and receiver against the sanctions list. This is again part of where SWIFT comes into play - banks send the necessary sender, receiver, and intermediary details over SWIFT so their correspondent bank can screen against sanctions. Together, sanctions and cutting parties out of SWIFT can limit most transactions.
But there's one type of entity against whom sanctions don't have their usual effect - central banks. Sanctions and SWIFT help but they're incomplete. You need one more tool.
The US and its allies froze the reserves of Russia's central bank.
Reserves play a major role in how a central bank manages the strength or weakness of its currency. Remember that 90% of global trade is conducted in dollars. Every time a Russian company wants to purchase goods or services globally, they have to sell rubles and buy dollars before they can make payments. Without any offsetting buyer demand for rubles, that will reduce the value of the ruble. Russia's central bank typically sells reserves to buy rubles and acts as that buyer demand.
The price of the ruble has bounced around a bit in 2021, but it generally fluctuated around 74 rubles to the dollar.
Russia's central bank has slowly been building up its reserves since the 2014 annexation of Crimea. As of February 18th, the bank had $643 billion in reserves. Just a reminder of the hegemony of the US dollar - even Russia's central bank expresses its reserves in USD.
As of January, $132 billion was in gold stored in Russia. That's fully under their control. It's the other 75% of reserves totaling $500 billion where this gets interesting:
The exception here is China. About $90 billion or so of the total foreign securities and amounts sitting with foreign counterparties is linked to China. Let's assume those are released to Russia. At best, that leaves them with $90 billion from the Chinese and $132 billion in gold. That's $420 billion of reserves - 65% - gone overnight. (Shoutout to Lorcan Roche Kelly for the research!)
To note - Russia has another $200 billion in their National Wealth Fund that is supposed to back a public pension scheme, but it could be repurposed to bolster central bank reserves. The fund's disclosures are poor and I'm unable to determine where those funds are stored. It'll nonetheless have similar challenges to the central bank - it's also sanctioned.
What this all means is that the Russian central bank has a lot less money to support the price of the ruble.
With the reserve-freeze announcement, the price crashed overnight to 100+ rubles to the dollar. That means that Russian companies - both those allowed to trade and the sanctioned ones that somehow get around the restrictions - will have to sell 33% more rubles to acquire goods and services priced in US dollars than they did just a few days ago. Imagine waking up tomorrow and finding out everything was 33% more expensive. That just happened to an entire country.
The central bank of Russia has taken dramatic actions to try to limit the fallout, but there's not a lot they can do. As of the time of writing:
Even selling more government debt to raise funds isn't an option - the US and its allies sanctioned new debt purchases and trading. Unless China or another major player makes significant sums of money available to Russia, there's only one viable way out - print more money. That's a death spiral. It'll allow current debts to be paid, but it'll concurrently increase the supply and thus further tank the price. As citizens and businesses expect further printing, they'll demand even more rubles for future debts in anticipation of future money printing. It's a remarkably effective way to wreck an economy.
Each of the three financial warfare weapons is powerful. The combination is greater than the sum of the parts.
Removing Russian banks from SWIFT makes doing business internationally painfully difficult. You can't send money if you can't send information about where that money's supposed to go.
That pain is compounded by sanctions. Even if you can find a way to send the payment messages, none of the banks you want to send payments to will accept it. They'll be fined and possibly lose their banking licenses if they do. At this point, global trade is largely frozen.
Any trade that remains permitted - like oil and gas - or that does manage to sneak through will be done on massively disadvantaged terms. Everything will start 30%+ more expensive than it used to be and get more expensive over time. The country's businesses and people are quite literally getting poorer by the day.
It's a highly effective form of war. It concurrently undermines the ability to wage war and hits the population - especially the financiers - right in the pocketbook. But financial warfare is not a panacea. It comes with drawbacks.
Any discussion of financial warfare has to acknowledge two uncomfortable truths:
Financial warfare only works because of globalization. Countries, businesses, and individuals are more interconnected - and interdependent - than they've ever been before. Finance is at the very core of global trade.
Each time we weaponize the tools used to conduct global trade, we create new reasons for actors to develop alternative tools - new networks to communicate and new forms of money that aren't governed by potential adversaries. Russia launched the System for Transfer of Financial Messages (SFPS) in 2014 in response to the US threatening to disconnect Russia from SWIFT. It allows Russian banks to communicate domestically without involving SWIFT and handled 20% of all domestic Russian financial messaging as of December 2021.
China launched The Cross-Border Interbank Payment System (CIPS) in 2015. While it has faced significant technical setbacks and is only minimally used today, it's the foundation for a parallel messaging network to SWIFT. It uses the same standards as SWIFT - members on either network can message one another - but it's used only for cross-border renminbi trade deals. Both China and Russia recognize its potential. After a December 2021 meeting between the two nations, Putin's foreign policy advisor stated:
"... particular attention was paid to the need to intensify efforts to form an independent financial infrastructure to service trade operations between Russia and China. We mean creating an infrastructure that cannot be influenced by third countries."
Such steps are being pursued by our allies as well. In response to the US pressuring SWIFT to cut off Iran in the wake of withdrawing from the nuclear agreement, Europe launched INSTEX. Its explicit purpose is to "facilitate non-USD and non-SWIFT transactions with Iran to avoid breaking US sanctions."
Part of the rationale for building these systems is redundancy - you don't want control of your financial future in the hands of another country. But the very real collateral damage when these systems are weaponized should not be minimized.
Cutting off a country from global trade and wrecking its currency will indiscriminately hurt its populace. Russia imported $238 billion of goods in 2019. Packaged medications were the second-largest imported good. Even if shipments aren't formally cut off, Russian citizens whose wealth is denominated in increasingly less-valuable rubles will struggle to afford to pay. The resulting suffering and death won't be as widely reported as those from combat, but they're no less real.
Like any weapons, those used in financial warfare are horrible. A holistic picture that includes both how they work as well as their consequences helps us keep in mind the costs of using them.
There's one more weapon to discuss. It's one available to all of us and, unlike what we've discussed so far, it's highly targeted. It's something we can do to help.
Stop patronizing businesses that benefit Russia's kleptocrats.
I'm going to tell you two stories, one personal and one not, about a kleptocrat named Vladimir Potanin. The conclusions of both are the same - they're stories of greed overcoming decency, of a willingness to be ignorant of horrible truths rather than forfeit potential profits. My story comes from the world of business. The latter is from the world of non-profits.
In a past life, I was responsible for partnerships, joint ventures, and similar engagements on behalf of a large, multinational technology company. I continue to hold the company and my many former coworkers in high regard. The story that follows is the exception, not the rule.
I was approached by an internal team to consider an engagement with Nornickel, a Russian nickel and palladium mining company located in Siberia. Both Nornickel and its largest owner, Vladimir Potanin, have disturbing histories. A quick perusal of Wikipedia will give you the basics.
Potanin was the architect of Russia's loan-for-shares program in the mid-90s. The program was graft incarnate - billions of dollars of state-owned businesses were sold off to corrupt government insiders for fractions of their true values. Potanin served as First Deputy Prime Minister for a few months and took Nornickel as his prize. He controls at least 35% of it today.
Before Potanin's purchase, Nornickel was part of the Gulag system, Russia's forced-labor camps started under Lenin. While current working conditions are less publicly known, the environmental track record is well documented. The company generates 2% of the world's sulfur-dioxide emissions - the main contributor to acid rains - an amount over three times greater than the next largest single emitter. This is in addition to multiple open-pit mines, numerous oil spills, and other similar environmental catastrophes. In short, Nornickel is a larger contributor to global environmental degradation than most countries.
This is not the type of company you do business with.
I successfully shut down efforts to work with Potanin and Nornickel. For a time.
I left my role and the company in late 2019 to launch a startup. You can imagine my surprise when the following announcement was released in February 2020:
Atomyze tokenization platform, developed using Hyperledger Fabric blockchain technology, launched in test mode. PJSC MMC Norilsk Nickel, the world's largest producer of palladium and high-grade nickel and a major producer of platinum and copper, will be the first issuer of tokens in the project and the first industrial company to tokenize its assets on the platform.
"Nornickel is interested in this project because it will enable the Company to popularize palladium and other metals by transitioning to digital trading methods," noted Vladimir Potanin... "The joint efforts among Atomyze, IBM and Nornickel have made it possible to develop a truly powerful and unique industry solution."
Atomyze is a new channel through which Potanin can sell palladium. It's gained legitimacy through association with a well-respected company. Neither is appropriate given the background.
If there was any doubt on where Potanin, Nornickel, and Atomyze fit in the Russian state apparatus, a recent announcement made it explicit:
The Bank of Russia, the main state authority governing monetary policies, granted the relevant permissions for the Atomyze tokenization service to be listed as the first company for digital asset management.
The very same Bank of Russia that the US and its allies just sanctioned.
You might be tempted at this point to pin my story on faceless executives at a "big company" and write it off as a situation you'll likely never find yourself in. My second story is likely to bring this much closer to home.
It's not all that difficult to launder money. Somewhere on the order of 2-5% of global GDP - roughly $1-2 trillion - is laundered annually according to the UN. The real challenge is laundering large sums of money.
Art is one of the few places you can do so.
The main mechanism to wash dirty money so it appears clean is anonymously purchase expensive art at auction using dirty money, legitimately sell the piece to unsuspecting buyers, and walk away with clean money. Until recently, there weren't even meaningful rules to try to avoid - only starting in 2020 did regulations require buyers and dealers to conduct due diligence on sellers.
There's a second mechanism for laundering. It takes more time and effort but it can be far more profitable. And it comes with the added benefit of rebranding the seller a "patron of the arts."
Join a museum board.
How do you join a museum board? Simple. "Donate" a lot of money and buy yourself a seat. Don't worry - you'll make it back soon enough. Let me explain:
If you're rich enough, you can pull this off at a tremendous scale. You could even stand up a foundation to do it for you. From the Vladimir Potanin Foundation:
The development of museums is one of the priorities of the Vladimir Potanin Foundation and an important part of its strategy...
Potanin is a trustee of the Guggenheim, a premier art museum in New York. In 2005, his foundation backed an exhibition of Russian art at the museum. Vladimir Putin spoke at the opening.
This is not an isolated incident. The New York Times profiled this "soft power" in a 2019 expose. A sampling from that piece and elsewhere:
The list goes on.
Stop supporting the organizations.
The Guggenheim, Lincoln Center, The Met, Carnegie Hall, and many other museums are complicit in helping kleptocrats wash their images and their money. That only works if we patronize the museums.
Carnegie Hall announced that Russian conductor Valery Gergiev and pianist Denis Matsuev will no longer perform. Both are longtime Putin supporters. The Metropolitan Opera announced that it is suspending ties to Russian artists and institutions allied with Putin. It's a good start.
Imagine the response if patrons refused to attend until the organizations swore off accepting money from known adversaries. There's already momentum. It's about continuing to push it forward.
In the grand scale of the atrocities underway in Ukraine, these are small measures. But they matter.
Potanin and Nornickel are effectively un-sanctionable. They control 14% of the world's nickel supply and a much greater proportion of the high-quality Class 1 nickel required for car batteries. They also control 41% of the world's palladium supply. 85% of palladium is used in catalytic converters in car exhausts - it converts pollutants into carbon dioxide and water vapor. Sanction Potanin or Nornickel and the auto industry will grind to a halt - it won't happen.
Yet we as individuals can make a difference. We can demand the Guggenheim remove Potanin from the board. We can stop spending money at museums he uses to enrich his coffers. We can play a small but meaningful role in this new age of financial warfare.
And if you ever have the chance to do business with Potanin - don't. You won't regret it.
Given the weightiness of the topic, there's no cocktail or cocktail talk this week. Instead, I'm highlighting other aspects of this new-age war where "the global power landscape is shared with other actors and networks."