Blockchain and the future of sanctions
Decentralization was never supposed to be part of a war. But the invasion of Ukraine is unfolding as the first major cross-border conflict in the crypto era. This is having material impacts on the effectiveness of sanctions today, and raising critical questions about whether emerging financial instruments can be designed in a way that improves the strength of future sanctions.
In this short piece we look at two decentralized financial instruments – central bank digital currencies (CBDCs) and cryptocurrencies – to understand how their existence has impacted the sanctions process, how they might impact the process were they to be fully deployed in the future, and what this means for the design process going forward.
The underlying message is that blockchain has led to the development of new instruments that can democratize finance and make it more inclusive. But there will always be rogue actors. Many of them have already leveraged cryptocurrencies to evade taxes, pay for illicit products and launder money. If we are to build a new financial infrastructure that is resilient and stable and reflects the interests of the global community, it will need to include mechanisms that allow pullback when needed.
1. The SWIFT effect: if regulated intermediaries are removed, how do you discipline rogue actors?
A longstanding discussion in decentralized finance has been about the importance of transferring value without defaulting to existing correspondent banking relationships. This is attractive because the existing process is expensive, slow, and not especially inclusive. Blockchain networks allow members to transfer value in a way that cannot be censored by an intermediary like SWIFT because there are no intermediaries. This is attractive to many users of the financial system because it bypasses the problems with today’s correspondent networks.
But this more efficient peer-to-peer system is problematic in the situation of a rogue actor. This is because if such an actor made a payment using cryptocurrency, the only way to intercept it is via the exchanges where funds enter and exit the system. And even then, it only works if the wallet address can be reliably tied to a sanctioned entity, which is complicated in the best of circumstances.
The removal of targeted Russian banks from the SWIFT network has made global headlines, though its effectiveness has been questioned. This is because while SWIFT is the major channel for financial institutions to exchange authenticated messages, it is not the only channel. There are many banks, mostly in emerging economies, that are not members of SWIFT. They are still able to transact, though using costlier and slower methods.
The importance of network restrictions is that they complement sanctions. Sanctions do the actual work of disincentivizing actors from doing business with targeted Russian entities, while network restrictions make it more difficult to do so. In past episodes of removal – like Iran in 2012 – it was the combination of sanctions and network restrictions that resulted in Iran losing half its oil export revenue and an estimated 30% of its foreign trade.
The question for the future is – in the absence of centralized networks like SWIFT, what are the levers we have to support sanctions against rogue actors? A resilient payments infrastructure must have this functionality. Some regulators like the ECB are now fast tracking regulations on cryptocurrencies to address questions like this.
2. Can we prevent cryptocurrencies from circumventing future sanctions?
Today, the lack of payment infrastructure at both the wholesale and retail level will limit the success of rogue states in fully circumventing sanctions with cryptocurrency. But this infrastructure is coming. Once it is here and cryptocurrency is commonly used in payments, sanctions could lose their bite.
There is precedent for using cryptocurrency to break sanctions. North Korea and Iran have both used cryptocurrency in the face of financial restrictions. Russia is well placed to follow their lead. It is already the third largest country for bitcoin mining, and bitcoin has allowed Russian criminal operators to benefit greatly from ransomware as well as providing oligarchs with a way to move illegal funds.
Even so, in 2022, it is unlikely that switching to cryptocurrency for international payments will work either as a means of paying for imports at the national level, or paying for products at the individual level.
At the national level, the need to liaise with regulated financial institutions makes it unlikely that cryptocurrency could be substituted for other currencies in the financial settlement process. The high risk weighting of holding cryptocurrencies at regulated financial institutions means that few, if any, are set up to settle accounts in it yet. Even the Russian Central Bank had previously warned financial institutions against facilitating such transfers.
At the individual level, while consumers are allowed to make retail purchases with cryptocurrency, it is not easy to buy common staples like bread with it. Most online marketplaces that accept bitcoin are not set up for those items and most physical marketplaces are not set up to accept bitcoin. The early indications of a surge in ruble/crypto transactions in Russia is more likely citizens hedging against devaluation than payments for products.
If we anticipate a future where cryptocurrency is a common method of payment, network design needs to consider how sanctions could be applied. Under today’s architecture, regulated exchanges are already limiting transactions with known sanctioned entities. But we cannot guarantee that every wallet address attached to a sanctioned entity has been included. This would be complex to roll out and difficult to enforce.
One design consideration for a future scenario might be the auditing of wallets held by authorized entities. Such a program could be informed by the Authorized Economic Operators program. Here, entities on a network volunteer additional identifying information to access expedited customs clearance. Wallet holders might agree to provide attestations that link their legal identities to their wallets in exchange for certain benefits like making large transactions at the corporate level.
3. What about central bank digital currencies?
Today, neither is operational at scale. In anticipation of a future where CBDCs do exist, there are two design considerations that have direct relevance for challenges we are seeing today with the spike in demand for physical cash and immobilization of Russian central bank assets.
The first is that a token-based CBDC could reduce the burden of physical cash in times of crisis. Both Ukrainian and Russian citizens are lining up at ATMs to withdraw money. This is a clunky way to access one’s assets. If citizens’ holdings of sovereign-issued currency were token-based instead of paper, they would not need to visit ATMs or banks to control their deposits. Holders of CBDC could have confidence that their holdings were secure and accessible. Designed properly this might also dampen the threat of bank runs.
One feature that needs additional research is offline access. In order to truly reduce stress on the cash system, a CBDC would need to be available offline. This is not technically trivial, but there is work being done today to move this forward. If CBDC were to be used in Ukraine in today’s crisis, it would increase the resiliency of the overall payments infrastructure and provide people with the confidence that they could access and transfers easier whether the electricity was on or not. This is an important requirement given Russia’s history of hacking Ukraine’s electrical grid.
The second application to the current conflict is that CBDC could optimize the process of freezing rogue state assets. The decision to immobilize the assets of the Central Bank of Russia has been a key tool in the sanctions process. The US (along with the EU, UK, Japan and Canada for their currencies) has frozen Russian central bank assets held in the US or by US institutions. The execution of this sanction depends on financial institutions complying, which they appear to be doing.
The optimization provided by CBDC is that the issuer retains control over their currency at all times, with the governance of the network providing the tools needed to enforce sanctions. In this sense, were reserves held by the Russian Central Bank denominated in CBDC US dollars, the US Federal Reserve would have the capacity to freeze those assets and technically prevent them from being spent. This programmability means that access to CBDC networks is controlled; access can be given and it can also be revoked. This means that the issuer could limit how it is spent by different types of holders, which would make the process of sanctioning a rogue actor both faster and more far reaching.
4. The bottom line
The invasion of Ukraine is indicative of what major conflicts are likely to look like from now on. This makes it particularly important to consider how blockchain has been and might be used.
We can see that traditional sanctions are becoming less effective. Cryptocurrencies and decentralized finance can be used to transfer value in the face of official limits on bank transfers. Today, these alternatives to fiat currency transfers are unlikely to fully replace the value lost from sanctions. However, in the future if there are no changes, sanctions will have less bite. New regulations must consider how a government might restrict certain types of transactions and actors.
There are also examples of how new financial instruments under development could be used for humanitarian impact. Cryptocurrency is already being used to fund relief efforts for Ukraine, $52 million at last count. And when recovery begins, there will need to be transfers to citizens to aid in rebuilding. CBDCs would be a way to do this in a targeted and efficient way.
The situation in Ukraine continues to change daily, and ordinary citizens in Ukraine and Russia are being caught up. It is incumbent on us to make technology decisions today that take the humanitarian implications of events like this into account. This will ensure that the global community is empowered to enact more efficient future sanctions and to ensure that their citizens have access to safe and accessible deposits.