Western sanctions hit everyone apart from their intended targets

It was quite the downgrade.

On March 3, S&P Global cut Russia all the way down to CCC– from BB+ while still keeping it on credit watch negative. The Russian government’s capital controls, imposed to defend the rouble, may prohibit transfer of foreign currency debt service payments to international bondholders.

It is a reminder that cutting Russia off from the international financial system has painful consequences for those outside the country as well as those within. And these spread beyond owners of Russian bonds.

As oil and natural-gas prices rose in the second half of 2021 and in the first two months of this year, one popular macro hedge was to go long oil-exporting sovereigns by selling protection on baskets of their credit default swaps (CDS).

Russia was often one of a handful of names in those baskets.

Reason suggested that the sovereign creditworthiness of the oil exporting nations would benefit from rising dollar revenues. Now, with oil priced at over $117 a barrel on Thursday, one of the biggest exporters might default – as early as March 16 if Russia tries to pay interest in roubles on its Eurodollar bonds.

What is more, Russian bonds may not even be deliverable to CDS protection sellers to hold for workout recoveries. Probability of default now looks imminent. Loss given default could be high.

Another reason for all the rating agencies’ sharp downgrades is the coming disconnection on March 12 of seven large Russian banks from Swift at the same time as the Bank of Russia loses access to perhaps half its foreign exchange reserves, so reducing its capacity to act as a lender of last resort.

However, even while the Russian financial system and economy teeter on the brink, doubts still remain about the effectiveness of these moves on powerful and politically connected Russian individuals.

“There are plenty of ways to move money that don’t touch Swift,” says Mitch Thomas, head of solutions engineering North America at FinLync, a treasury technology company.

FinLync points out that the only way to stop money moving in and out of Russia is for every global bank to block every transaction to or from any Russian bank domiciled in any country.

Thomas tells Euromoney: “Blocking the messaging system is not as powerful as sanctions against entire Russian banking entities including their foreign subsidiaries.”

Even with those sanctions, the only people to escape the consequences of this war might be its initiators.

Sanctions and disconnecting Russian banks from Swift will have some effects. It is easy to say that Swift is only a messaging service and that disconnection makes payments more difficult and cumbersome rather than disabling them.

As S&P reminds us, after Barack Obama froze the assets of Iran’s government, central bank and financial institutions in 2012, Iran still managed to complete some transactions using third-party intermediaries. The US authorities eventually imposed heavy penalties on banks that facilitated them.

Today, most bank executives want to do more than follow the letter of the law and avoid penalties. They want to do the right thing.

Will sanctions work?

Mark Gazit, chief executive of ThetaRay, a provider of artificial intelligence technology to banks that screens for suspicious patterns within innocent-seeming payments traffic, has grave doubts.

Gazit tells Euromoney: “Swift was developed in 1973, at a time when banks used to identify customers by having them come into the branch with their passports. The thought was that you judged the individual, and then their transactions were OK. Swift is the equivalent of the fixed-line telephone system for banks. But we’re in a new world of digital payments technology – and the bad guys are masters of that world.”

Gazit uses the analogy of airport security. This used to depend on passport checks of travellers’ identities until terrorist activity raised the need to monitor every individual piece of carry-on and hold baggage through X-ray machines.

Think of checking every banking transaction as the equivalent of X-raying every bag.

Shell companies are easy to create, which makes sanctions easy to avoid.

Gazit says: “It is not just that it is easy to create fake identities. The whole process can be automated. Your computer can do it. Find a country not subject to US or EU controls where regulation is light.”

He doesn’t need to say it, but China is the obvious one. Traffic on China’s Cross-border Interbank Payment System (CIPS) rose far above normal volumes in the hours after the US imposed sanctions on Russian individuals and entities.

“You set up an account at a bank in a third country that is still connected to Swift in the name of a person or an entity that is not sanctioned,” Gazit says. “That becomes your gateway for payments. All you need is an internet connection to that account. Or you take over the savings account of some non-sanctioned individual. There are so many dormant accounts that the holder will not even notice.

“Also, remember, all the fintechs and non-bank payment services providers. You can set up thousands of accounts and move relatively small amounts between each of them that don’t, on their own, trigger any suspicions. Transfer just $1,000 at a time between 10,000 accounts and you’ve moved a lot of money.”

It seems obvious that, because he knew the invasion was coming while everyone else clung to the hope of a diplomatic solution, Vladimir Putin, as well as those close to him, will have had time to prepare for sanctions. And they have the know-how.

“Think of using a virtual private network to watch movies only available in the US when you are in Europe,” says Gazit. “It is not exactly uncommon or difficult. We need to understand that the bad guys are really good at cyber. They have artificial intelligence too. You can see them trialling new ideas for routing payments to avoid sanctions, just like corporations beta-testing a new online marketing strategy. They don’t abandon something if it doesn’t work the first time. They iterate. They fine tune.

"I almost hesitate to say it, but it is pretty impressive to watch.”

And then there’s crypto. Forget bitcoin. NFTs are the instruments to watch now.

Most of the work ThetaRay’s does for banks such as Santander, Mashreq and payments companies such as Payoneer is monitoring for signs of criminals and terrorists moving money. Its AI is moving almost to the point of intuition, spotting the mere presence of a pattern where there should be none: for example, the exact same sums of money entering and leaving accounts and perhaps being transferred at odd hours of the day for a bank’s time-zone.

Gazit recounts a favourite example from investigations into the proceeds of crime: a drug lord whose assets turned out to include a warehouse of paintings, all reproduction copies of high-value works of art. The drug lord knew they were fake. The sellers knew they were fake. He wasn’t buying art. He had been paying bribes to government officials. The paintings were delivered as a cover for money going the other way.

Who needs a warehouse? Today the fake painting is likely to be the NFT of a bored ape. There’s a growing financial system that bypasses Swift.

Gazit says: “I do think it is possible to improve Swift with additional security layers. But it is a member-owned cooperative. That makes it much harder to introduce new transaction monitoring software that an individual bank might more easily take.”

There is a danger here that cutting the entire banking system of a country off from Swift imposes pain on the general population, including many that oppose the war, while the rich and powerful that prosecuted the war are hardly touched.