Friday, March 29, 2024

The effects of Russian sanctions as portrayed in YouTube videos

Last month American provocateur Tucker Carlson visited a Russian grocery store. Because it was filled to the brim with food, Carlson claims that western sanctions placed on Russia aren't having an effect. "We've been told sanctions on Russia have had a devastating effect on its economy," writes Carlson. "We visited a grocery store in Moscow and found a very different situation."

Carlson's video is just one of many in a strange genre of "sanctions aren't working" videos produced by Westerners visiting or living in Russia. (Here is a good rebuttal to Carlson's video by Russian YouTuber NFKRZ.) In another video, Dutch-Canadian farmer Arend Feenstra, who has recently moved to Russia with his wife and nine children, walks through a hardware store full of tools. "Sanctions???" he quips.

Don't let the videos fool you. Sanctions have had a big effect on Russia. And by sanctions I'm referring not only to the official sanctions levied by coalition governments, but also self-sanctions imposed by Western companies. Self-sanctioning occurs when companies like Lego, Coke, or McDonald's choose to leave Russia, not because their government says they must, but because their customers and employees have pressured them to leave, or out of a general sense of solidarity with Ukraine. (Here is a list of companies that have left.)

While Carlson and Feenstra's videos of store shelves suggest prosperity, what they don't show is how many resources Russian businesses have been forced to sacrifice in order to re-order their affairs so as to provide Russians with full shelves. These businesses have had to go out and build new relationships with manufacturers in places like China or Turkey. The alternative products that have been introduced often aren't as good, or as familiar, or as useful to customers. 

Many of the "sanctions don't work" videos spotlight the contraband Western goods that are often found on Russian store shelves. This video, for instance, shows Coke being sold at Spar, a grocery store. Coke is banned in Russia, so the message here is presumably that the sanctions are a waste of time. But what they don't show is that the prices for these contraband goods will be higher than before. The Coke products in the video are no longer made in Russia but must be smuggled in via third-parties such as Poland, Afghanistan, and Kazakhstan, the extra shipping and handling costs being incorporated into their final price. Think of this as a sanctions-induced smuggling tax.

Put differently, coping with sanctions and self-sanctions is costly for Russia; in Carlson's videos we only see the final product, full shelves, but not all the hassle and resources that have gone into producing that state of affairs. Nor is the set of full shelves on display in his video necessarily as desirable as the set of full shelves that existed prior to sanctions.

A much more realistic illustration of the effect of sanction is provided in a recent video by Arend Feenstra, the Dutch-Canadian farmer, of a visit he makes to a Russian tractor dealership.

I watched it so you don't have to. What follows is a quick summary of the relevant bits. It starts out with an excited Feenstra driving out to is what he believes to be a Case/New Holland dealership. Since the Case and New Holland tractor brands are popular in Canada, Feenstra's previous home, he will get to see some brands that he is familiar with. Ah, nostalgia.

(A side note: As a Dutch-Canadian myself, I find it jarring that someone of my ilk has decided to emigrate to Vladimir Putin's Russia. But digging deeper, we learn that Feenstra is a bigot: he doesn't like the LGTBQ community. Given that Russia's regime considers the "international LGBT movement" to be a terrorist organization, I suppose there's a natural fit for folks like him in Russia.)

Unfortunately for Feenstra, when he arrives at the dealership he discovers that it no longer sells Case or New Holland tractors. Both brands of farm equipment are built by CNH, a UK-headquartered equipment manufacturer, and along with most other Western farm companies CNH pulled out of Russia in 2022, effectively ending all its Russian dealership relationships. 

The only new tractors that the dealership has available are Chinese-built YTOs, which the dealership was forced to turn to in 2022 to fill the sudden gap in its show room.We learn in the video that YTOs are a regression in terms of technology. Feenstra points out throughout that the Chinese tractors have less electronics than their western equivalents and more mechanical parts. Instead of electronic shifting, for instance, the YTOs use mechanical shifting. The fuel pumps are mechanical too. It's like stepping back in time.

A regression to mechanical components is a nuissance, but it's not awful. However, things get worse. Enter the triple mower problem.

A tractor with a triple mower

Prior to the sanctions, we learn that the dealership's most popular tractors were larger horsepower products like the New Holland 210. These larger tractors are particularly desired by farmers in the region for their ability to accept an attachment known as a triple mower, says the employee. A triple mower is designed to cut a wider swath of grass or crops compared to a single mower. This allows farmers to cover more ground in less time, improving overall efficiency during harvesting or haymaking operations.

Alas, the Chinese-made YTOs can't use a triple mower, the employee tells us. The dealer is in talks with the manufacturer to make changes to the frame to accommodate them, but there's no indication when this will occur. Feenstra is not impressed by any of this.

Feenstra checking out a YTO tractor

In the meantime, the dealer tells Feenstra that if he needs a new tractor with triple mower compatibility, he will have to import a Western one via the parallel market. This will involve buying a tractor in Europe and sending it through a third-party transit country, like Turkey, then moving it to Russia. But the whole process will be expensive, warns the employee, including paying VAT three times.

Russian farmers who bought New Holland or Case tractors prior to the sanctions are no better off, we learn, because they now face hurdles getting spare parts for their tractors. Prior to the self-sanctions they could rely on the Case/New Holland dealership for a steady supply of Case and New Holland parts, but with the dealer having lost its relationship with CNH, the only way to get parts is by smuggling them in. Alas, smuggling adds uncertainty and a higher price tag.

Another conversation between Feenstra and the employee centres around a piece of machinery known as a baler, which can be attached to the back of a tractor in order to convert a row of hay into a convenient bale. According to the employee there are a number of Russian companies that make balers, but they are "not very good". The video reveals that one Western-made baler brand is available for purchase, a German-made Kuhn. (Is Kuhn one of those rare European farm companies that has chosen not to self sanction?) But the Kuhn baler it is quite expensive, more than the cost of an entire tractor.

Stepping back, Feenstra's video is great illustration of the costs imposed on Russia by sanctions and self-sanctions. The dealership is struggling to fill the void left by departing Western brands. Its customers, Russian farmers, are stuck with the option of an inferior replacement for Western-made tractors, like the YTO, or a more expensive smuggled products. The dealership and its customers seem to be getting by, but they are clearly worse off than before.

Feenstra isn't the only western farmer in Russia to be producing "sanctions don't work" videos. An Australian family that has moved to Russia in order to start a farm also makes YouTube videos on the topic. "So, the sanctions really haven't been bad for Russia," says the family patriarch, John, standing in a Russian mall. "If they have done anything, they have been great for Russia."

But another video (see below) suggests the opposite. In it the Australians are paying a visit to a nearby John Deere tractor dealership. We learn from an employee that this particular dealership is part of a Russian dealership network that, prior to the sanctions, was the largest John Deere distributor in all of Europe. John Deere is a U.S. equipment manufacturer.

Near the start, John optimistically films a large sign boasting the dealership's many relationships with western manufacturers, including JCB, Pottinger, Väderstad and Haybuster. But as he learns later on, the sign is no longer meaningful. Along with most other farm product companies, John Deere and JCB exited Russia in 2022. The dealership has lost its dealer status and can no longer sell either John Deere or JCB products, nor most of the other brands that are advertised on its sign.

To fill the void, the dealership now offers Turkish-made Basak tractors and Chinese-made Noma tractors. An employee who shows the family around the dealership grouses to John about the quality of the Chinese tractors that he stocks, saying: "I don't know what we will do with it, because if I sit inside of the cabin and look down I can see the ground because there in a gap in the floor." The tractor is the technological equivalent of a first generation John Deere, he complains.

Interestingly, the owner of this particular network of Russian dealers, known as EkoNiva-Technika, is based in Germany and produces public financial statements. I dug through the numbers to get a better feel for how the dealership is doing. 

In 2021, prior to self-sanctions, the EkoNiva-Technika dealership network sold 403 tractors. Then Russia invaded Ukraine, and the dealership's sales fell to 263 tractors in 2022. In 2023 it sold just 131 tractors. That's a big fall.

The German parent blames the decline in tractor sales on a "significant drop in demand" for new agricultural machinery by Russian farmers, as well as the loss of its main suppliers, which were replaced by alternatives from China and Turkey whose "products fell far short of the previous sales figures." Meanwhile, the dealer's spare parts business saw a big jump in revenue thanks to an intensification in demand for Western parts and higher parts prices, no doubt due to having to resort to costly transshipment routes. Spare parts have gone from 24% of the dealership network's revenues prior to sanctions to 49% of revenues in 2023.

Back to John, the Australian farmer. When he does eventually buy a tractor, we find out that it's a used Japanese-made Yanmar tractor. All the controls are written in Japanese and he can't read the manual. Compounding matters, Yanmar has officially left Russia, so John will likely find that getting parts is a pain. Again, that's the nuissance of sanctions. Rather than getting the first-best, the only option is often second- or third-best.

John and his new Japanese tractor

Given all the anecdotes I've assembled, what is the bigger picture?

Prior to being sanctioned, Russia's farming sector had evolved towards a particular pattern of specialization and trade comprised of middlemen dealerships, their relationships with Western manufacturers, and the farmers they served. The sanctions (and self-sanctions) immediately upended that pattern, forcing dealers and farmers to undergo a massive and costly recalculation event.

The new pattern of specialization and trade that the Russian farm sector has arrived at doesn't appear to be as good as the initial pattern. 

To begin with, the alternative brands that have filled the void seem to be a downgrade. The Chinese YTOs that the first dealer is selling won't accept a triple mower while the tractors the second dealer stocks have holes in the floors. Spare parts that were once widely available thanks to dealerships' stable relationships with their western suppliers are harder to come by. Dealership resources are now being diverted to smuggling in contraband parts, which means higher prices for farmers. Finally, as suggested by the dealership's financials, farmers are refurbishing old tractors rather than investing in new tractors. This slowdown in capital investment will presumably hurt crop yields in the long term.

In sum, contrary to Tucker's video and many other "sanctions aren't working" videos on YouTube, the videos made by expatriate Canadian and Australian farmers suggest that the opposite: sanction are having an effect. And it isn't a good one.

Monday, March 18, 2024

How PayPal can use stablecoins to avoid AML requirements and make big profits

There's a new financial loophole in town: stablecoins. Stablecoins are dollar, yen, or pound-based payments platforms that are built using crypto database technology.

Financial institutions are always looking for loopholes to game the system. Typically this has meant avoiding capital requirements or liquidity ratios in one jurisdiction in favor of a looser standards elsewhere. The new stablecoin loophole allows for a different set of financial standards to be avoided, society's anti-money laundering regulations.

I'll explain this new loophole using PayPal as my example.

PayPal now offers its customers two sorts of regulated platforms for making U.S. dollar payments. The first type will be familiar to most of us. It is a traditional PayPal account with a U.S. dollar balance, and includes PayPal's flagship platform as well as PayPal-owned platforms Xoom and Venmo. These all have strict anti-money laundering controls.

The second type is PayPal's newer stablecoin platform, PayPal USD, which has loose anti-money laundering controls. PayPal USD is built on one of the world's most popular crypto databases, Ethereum. Dollars held on crypto databases are typically known as stablecoins, the most well-known of which are Tether and USDC.

What do I mean by fewer anti-money laundering controls?

If I want to transfer you $5,000 on PayPal's traditional platform, PayPal will first have to grant both of us permission to do so. It does so by obliging us go through an account-opening process. PayPal will carry out due diligence on both of us by collecting our IDs and verifying them, then running our information against various regulatory blacklists, like sanctions lists. Only after we have passed a gamut of checks will PayPal allow us to use its platform to make our $5,000 transfer.

Contrast this to how a payment is made via PayPal's new stablecoin platform.

First, we both have to set up an Ethereum wallet. No ID check is required for this. That now allows us to access PayPal's stablecoin platform. Next, I have to fund my wallet with $5,000. I can get these these funds from a third-party who already holds money on PayPal's stablecoin platform, say from a friend, or from someone who buys goods from me, or from a decentralized exchange. Again, no ID is required for this transaction to occur. Once I have the funds, PayPal will process my $5,000 transfer to you.

Can you spot the difference? In the transaction made via PayPal's legacy platform, PayPal has diligently got to know everyone involved. In the second transaction, PayPal makes no effort to gather information on us. And lacking our names, physical addresses, email addresses, or phone numbers, it can't do a full cross-check against various regulatory black lists.  

More concretely, PayPal's legacy platform does its best to stop someone like Vladimir Putin, who is sanctioned, from ever being able to sign up and make payments. But if Putin wanted to use PayPal's new stablecoin platform, PayPal makes almost no effort to stop him from jumping on.

One of the biggest expenses of running a legacy financial platform is anti-money laundering compliance. Programmers must be deployed to set up onboarding and screening processes. Compliance officers must be hired. If a transaction is suspicious, that may trigger a halt, and the transaction will have to be painstakingly investigated by one of these officers. The platform is hurt by lost customer goodwill  no one likes a delay.

That's where the stablecoin loophole begins.

PayPal can reduce its costs of getting to know its customer by nudging customers off its traditional platform and onto its PayPal USD stablecoin platform. Now it can onboard them without asking for ID. Since it no longer collects personal information about its user base, fewer transactions trigger flags for being suspicious, and only rarely do they register hits on sanctions blacklists. That means fewer halts, delays, and costly investigations. PayPal can now fire a large chunk of its compliance staff. The reduction in costs leads to a big rise in earnings. Its share price goes to the moon.

For now, PayPal's stablecoin platform remains quite small. Only $150 million worth of value is held on the platform, as the chart at the top of this post shows. The company's legacy platforms are much larger, with around $40 billion worth of balances held. Given the compliance cost difference, though, I suspect PayPal would love it if its stablecoin platform were to grow at the expense of its legacy platform.

I've used PayPal as my example, but the same calculus works for the financial industry in general. If every single bank in the financial system were to convert over to a stablecoin platform for the delivery of financial services, and no longer use their legacy platforms, the industry's total anti-money laundering compliance costs would plummet.

So far I've just explained this all from the perspective of financial institutions, but what about from the viewpoint of the rest of us? Society has set itself the noble goal of preventing bad actors from using the financial system. A large part of this effort is delegated to financial institutions by requiring them to incur the expense of performing due diligence on their platform users. This requires a big outlay of resources. Many of these costs are ultimately passed on to us, the users.

If institutions like PayPal switch onto infrastructure that doesn't vet users, then resources are no longer being deployed for the purposes we have intended, and the broader goals we have set out are being subverted. Is that what we want? I'd suggest not.

Some followup thoughts:

1. PayPal's stablecoin platform employs fewer anti-money laundering controls than its regular platform. On the other hand, its stablecoin platform has stricter standards in other areas, including the safety of its customer funds. I wrote about this here: "It's the PayPal dollars hosted on crypto databases that are the safer of the two, if not along every dimension, at least in terms of the degree to which customers are protected by: 1) the quality of underlying assets; 2) their seniority (or ranking relative to other creditors); and 3) transparency."

2. The pseudonymity of stablecoins is something I've been writing about for a while. In a 2019 post, I worried that at some point this loophole would lead to "hyper-stablecoinization," a process by which every bank account gets converted into a stablecoin. I'm surprised that almost five years later, this loophole still hasn't been closed.

3. The typical riposte to this post will be: "But JP, stablecoins are implemented on blockchains, and blockchains are transparent. This prevents bad actors from using them, and so stablecoins should be exempt from standard anti-money laundering rules." I don't buy this. Bad actors are using stablecoin platforms, despite their pseudo-traceability. "Its convenient, it's quick," say a pair of sanctions breakers about payments made via Tether, the largest stablecoin platform. Society has deputized financial institutions to perform the crucial task of vetting all their users. By not doing so, stablecoin platforms are shirkers. Trying to outsource the policing task to the public or to the government by using a semi-transparent database technology doesn't cut it.

Wednesday, March 13, 2024

Have the sanctions on Russia failed?

I very much enjoy economist Robin Brooks's tweets, especially his charts showing how sanctions imposed on Russia have affected regional trade patterns. While direct trade between Europe and Russia has collapsed thanks to Russia's invasion of Ukraine and subsequent sanctions, the chart below shows a suspicious-looking countervailing boom in European trade with Kyrgyzstan.

A big chunk of these European goods are presumably being on-shipped from Kyrgyzstan to Russia.

Now, you can look at this chart and arrive at two contradictory conclusions. The first is that the EU's sanctions are not working because they are being avoided via third-party nations like Kyrgyzstan. (This is Steve Hanke's take on Robin's charts.) Or you can see the charts as evidence that the sanctions are working, for the following reasons.

Sure, prohibited goods are filtering through to Russia  that was always going to be the case. But consider all the extra nuisances and frictions that now exist thanks to sanctions. For instance, instead of JCB tractors being shipped directly from factories in Europe to Russia, they have to be transferred to a third-party country, like Armenia, then perhaps re-routed to yet another country for the sake of obfuscation, say UAE, prior to those tractors finally entering Russia. (One of Robin's charts illustrates the rise of the EU-Armenia-UAE-Russia nexus).

These new roundabout trade routes introduce all sorts of additional costs including taxes, customs fees, shipping, insurance, and warehousing, not to mention extra palms to grease. There is also the extra risk of getting caught somewhere along this chain. A dealer involved in moving tractors to Russia via a third-party country, for instance, might be blacklisted by JCB (which has voluntarily chosen to exit Russia), losing their dealer status.

These combined costs get built into the final sticker price that Russian must pay for contraband American and European imports. Think of this extra wedge as a "sanctions tax." This sanctions tax leaves Russians with less in their pocket. And that means fewer resources for Putin to wage war than if the sanctions had never been levied.  

So when I see Robin's charts of various transshipment routes, they suggest to me that sanctions are effective courtesy of the sand-in-the-gears effect I just explained.

Now, this doesn't mean that I think the coalition's existing sanctions program is sufficient. We are in a sanctions war with Putin, and that necessitates constantly opening up new economic fronts in order to throw Putin off guard and make it harder for him fund his war. The transshipment points illustrated in Robin's charts are a sign to me that existing sanctions are working, but they also seem like a great target for future sanctions.

And in fact, the coalition has already taking two steps to pressure transshipment to Russia.

The U.S. Treasury recently imposed secondary sanctions on any foreign financial institution that facilitates transactions involving Russia's military/industrial complex. (I wrote about this here). What this means, for example, is that banks in transshipment points like Kyrgyzstan will have to be more careful when they deal with Russian entities. Any trade involving the military-industrial sector that passes through Kyrgyzstan will likely grind to a halt. Other non-military trade transiting through Kyrgyzstan, say JCB tractors, will probably continue to make it through, but thanks to heightened sanctions risk, banks will pass on this risk to Russians in the form of a higher sanctions tax.

The second step is the EU's new and very provocative "no-Russia clause." It requires EU exporters to contractually prohibit their trading partners from re-exporting certain restricted goods to Russia. If caught, fines must be paid or the contract voided. That adds more sand in the gears.

One hopes that the coalition of nations arrayed against Russia continues to increase its pressure on transshipment points. For instance, the EU could widen the range of goods subject to the no-Russia clause, the current list being somewhat limited. For now, though, my guess is that Robin's charts will show that the coalition's sanctions program is doing a better job in 2024 than it did in 2023, with the EU's no-Russia clause and the U.S.'s secondary sanctions being the proximate cause of that improvement.

Tuesday, March 5, 2024

It's time to get rid of "crypto"

Call me a pedant, but I'm not a fan of the word "crypto". It may have been a serviceable category back in 2011 when there was only one type of crypto thingy  bitcoin. But it's ceased to be a meaningful term and, if anything, it causes a regression in understanding.

Source: Fidelity

Case in point is the above diagram from Fidelity, which suggests that clients should conservatively invest 40% of their wealth in "equity," 59% in "fixed income", and the other 1% in "crypto."

These categories are nonsensical because in many cases, crypto *is* equity. (And in other cases, crypto *is* fixed income.) Fidelity's buckets are not mutually exclusive.

For instance, take MKR tokens, which are inscribed on the Ethereum blockchain and are a top-100 asset listed on CoinGecko. MKR may sound like it deserves to fall in the crypto bucket, but hold on a sec. As a MKR holder, you enjoy a right to the earnings of MakerDAO, which is effectively an offshore bank. You enjoy buybacks, voting control, and a residual claim on assets after creditors in case of windup or bankruptcy. Guess what, folks. That's equity! Yep, buying MKR shares is economically equivalent to buying shares in Bank of America.

Likewise with Dai tokens, the payments instrument aka stablecoin  that MakerDAO issues to customers on the Ethereum blockchain and the 25th largest asset on CoinGecko. Sounds like crypto, no? But along with being pegged to the U.S. dollar, Dai pays interest of 5%. That puts it firmly into the fixed income bucket, very much like an uninsured interest-yielding account at the Bank of America.

What exactly is crypto, then?

The word "crypto" describes a database technology, not an asset class. Various asset classes  equity, bonds, options, and savings accounts (or various combinations of these)  can be recorded and stored on crypto databases, much like how MKR shares are served up on Ethereum, one of the most popular crypto database. These crypto databases fall in the same bucket as an Azure SQL database or an Oracle databases, both of which record assets but neither of which belongs itself to an asset class.

So now you can see why Fidelity counseling its customers to invest 99% in equity + fixed income and 1% in crypto is absurd. It's a category mistake, like if Fidelity advised folks to hold 99% in equity + fixed income and 1% in assets stored on Oracle databases.  

Telling customers to invest 1% of their wealth in generic assets stored in Oracle databases isn't just a category mistake; it's downright reckless. All sorts of wild financial stuff appears on Oracle databases, including sports bets and zero day options. Conservative investors have no business touching these. As for crypto databases, they are particularly notorious for holding financial fluff like ponzis and digital chain letters (i.e. litecoin, dogecoin, floki inu and their various ancestors and cousins); none of which Fidelity should be hocking to serious customers.

Crypto doesn't refer to an asset class, it describes the database technology on which assets appear. Better yet, let's just get rid of the word altogether. It's beyond repair.