Monday, June 17, 2024

The intensifying effort to isolate Russia's banks

Last week the U.S. government expanded the coverage of its Russian secondary sanctions program to encompass most of Russia's banks. It's a very big step, one that has been long-awaited by sanctions watchers, and will likely have significant repercussions for Russia and its trading partners. Here's a quick explainer.

Stepping back, we can think about the U.S.'s sanctions war on the Putin regime as an effort proceeding in two acts. The first involved a "casual" round of primary sanctions beginning as far back as 2014 when the Russians invaded Crimean. Then the heavy round began in December 2023, almost nine years later, with the arrival of secondary sanctions.

Pound for pound, U.S. secondary sanctions are far more impactful than primary sanctions. Primary sanctions cut off American entities from dealing with designated Russian targets but allow non-American actors to step into the breach and take their place. This merely shifts or displaces trade routes, creating a nuisance rather than reducing trade outright.

Secondary sanctions like those introduced last December aim to curb this displacement effect by extending prohibitions on dealing with Russia to non-U.S. actors, in particular foreign banks. The gist of secondary sanctions is: "If we can't deal with them, then neither can you!"

Why do non-American actors in third-party nations like China and Turkey bother complying with U.S. secondary sanctions on Russia? The U.S. wields an incredible amount of influence by threatening to cut third-parties off from the U.S. economy should their ties to Russia be maintained. The importance of accessing the U.S., in particular its financial system, far outweighs lost Russian business, prompting quick compliance.

So what exactly happened last week? Let's first re-explore what occurred in December 2023.

If you recall from my previous article, the December secondary sanctions targeted foreign banks. Their aim was to prevent bankers in places like India, Turkey, China and everywhere else from interacting with Russia, but only with respect to a narrow range of transaction types  those linked to the Russia's military-industrial complex.

More specifically, a Chinese or Turkish bank could continue to deal with Russian customers as long as the transaction in question involved goods like cars or dishwashers. The novelty is that they were now prohibited from conducting any transactions with Russia that involved weapons, military equipment, and dual-use goods, on pain of losing access to the crucial U.S. financial system.

In addition to a flat-out prohibition on military-industrial goods, the U.S. Treasury also compiled a blacklist of around 1,200 or so Russian individuals and entities that support Russia's military-industrial complex by working in allied sectors such technology, construction, aerospace or the manufacturing sectors. The December order stipulated that if caught dealing with any of these 1,200 or so names, a foreign bank could be cut off from the U.S. banking system. Russian individuals and businesses who were not on said military-industrial complex list, however, could still be served by foreign banks, even if they had been otherwise sanctioned. (Remember, primary sanctions only apply to U.S. actors.)

As I wrote back in February, anecdotal data from the first two months of secondary sanctions suggest that they are having an effect. Below I've updated the chart from an earlier tweet showing Turkish exports to Russia, which continues to trend downwards (note the 12-month moving average.)

In a recent article, The Bell assessed customs statistics and found that since the start of 2024, imports from some countries are down a third in some countries compared to 2023, notably Turkey (-33.8%) and Kazakhstan (-24.5%).

Source: The Bell

Which finally gets us to last week's announcement.

The scope of the secondary sanctions has been dramatically widened by adding around 3,000 or so additional names to the original 1,200 or so individuals and entities involved in Russia's military-industrial complex, for a total list that is now 4,500 long, according to FT. The reasoning for this extension is that now that Russian is a war economy, pretty much everyone is contributing to the war effort. 

The most important of the additions to the list are Russia's banks. The Treasury's press release drove home this point by specifically drawing attention to the branches of Russian bank in New Delhi, Beijing and Shanghai that are now are off limits.

Going forward, any bank in China or India that interacts with a Russian bank, say Sberbank, now risks losing its crucial connection to the U.S. This is huge! The majority of global trade is conducted by banks in one country interacting with banks in another on behalf of their respective customers. If Russian banks are cut off from this global network, that's tantamount to severing the entire Russian economy from the international economy. With their bankers now isolated, Russian firms won't be able to buy or sell stuff overseas, nor repatriate funds to pay their local employees.

I'm still trying to get my mind around the enormity of this. Russia has become the top destination for Chinese auto exports, for instance, and those purchases require getting a Russian bank and a Chinese bank to interact with each other. How on earth will Russia import Chinese cars without the intermediation of Russian banks? Or appliances, or smartphones?

There are two significant exemptions to the secondary sanctions coverage: agricultural products and  crude oil. What this means is that while a bank in India can no longer deal with a Russian bank like Sberbank, that prohibition ends if they want to conduct transactions with Sberbank that involve grain or oil. Since Russia's economy is so reliant on its oil exports, this exemption is a gaping hole in the sanctions wall that Ukraine's allies are trying to build.

How will Russia and its trading partners react?

A few sacrificial banks

To keep trade flowing between Russia and trading partners like China, it may be necessary for China to serve up a sacrificial bank or two to the U.S. sanctions regime. Who to sacrifice? A small bank with little to no U.S. business is a prime candidate. Such a bank may be able to afford being cut-off from the U.S. financial system in order to ensure that its mostly Russian-linked clientele can keep making bank-to-bank payments.

An example of a willing-to-be-sanctioned financial institution is the Bank of Kunlun, a small Chinese bank which continued to facilitate Iranian transactions even after secondary sanctions were levied on Iran in late 2011. The U.S. government reacted the following year as it had threatened that it would: it cut the Bank of Kunlun off from the U.S. financial system, a state of affairs that continues to this day. Kunlun remains the only bank in the world on the U.S.'s CAPTA (Correspondent Account or Payable-Through Account) list; a register of financial institutions which cannot get a U.S. bank connection.

An appearance on the CAPTA list hasn't stopped the Bank of Kunlun from doing business, however. According to the Atlantic Council, Kunlun has become one of the main connection for so-called Chinese "teapots" small independent refineries  to buy oil from Iran. Apparently, one of its flagship products is "Yi Lu Tong," which means "Iran Connect." Of course, the Bank of Kunlun can't do a shred of U.S. business, which severely limits its clientele.

In any case, the Bank of Kunlun, or something like it, could end up being the linchpin of Russian sanctions avoidance.

AML-dodging stablecoins

Another alternative option for Russian trade will be to turn to U.S. dollar stablecoins like USDC and Tether. Stablecoins are blockchain-based payments platforms that offer balances pegged to national currencies, usually the U.S. dollar. Unlike banks, which do due diligence on their customers, stablecoin issuers will allow anyone to use their platforms, no questions asked. This feature offers Russian firms a reliable non-bank payments option for settling purchases of Chinese or Turkish products.

Stablecoins are not a new route for Russians keen to evade the long-arm of U.S. sanctions. I wrote last year about how intermediaries linked to a sanctioned Russian oligarch purchased oil from Venezuela's sanctioned state-owned oil company using Tether stablecoins, or USDT. "No worries, no stress," says the Russian to his Venezuelan contact. "USDT works quick like SMS."

"...quick like SMS" [link]

More recently, a Russian sanctions evader describes how he uses Tether to "break up the connection" between buyers like Kalashnikov and sellers in Hong Kong, making it harder for US authorities to trace the transactions. "USDT is a key step in the chain." 

Turning to the U.S., what might its next steps be in the sanctions war?

Extend the secondary sanctions to oil

Sanctions are a cat and mouse game. As Russia inevitably finds ways to adapt to last week's actions, the U.S. will have to find alternatives to keep up the pressure on the Putin regime. A prime candidate for the next ratcheting up of secondary sanctions will be to extend their reach to Russia's oil industry.

The U.S., EU, and other coalition countries are currently trying to cap Russian oil prices at $60 in order to reduce Russia's revenue base, with mixed success. One option would be bring the rest of the world into the price cap effort in order to make it more effective. A simple upgrade to the secondary sanctions regime would allow for this. Foreign banks would still be able to conduct transactions with Russian banks that involve oil, but only if these banks have verified that those purchases have been made at a price of $60 or lower. Any international bank caught breaking the price cap would risk losing its financial connection to the U.S.

Locked up in escrow

Another way to tighten the noose on Russia would be to modify the secondary sanctions program to impede the ability of Russian oil exporters to repatriate or easily utilize the funds they receive for oil sold abroad. 

How would this work? As before, foreign banks in, say, India would still be allowed to conduct oil transactions with Russian banks at prices not exceeding $60, subject to a new sanctions feature stipulating that all oil proceeds must be confined to escrow accounts in the buying nation, in this case India. If Putin does wish to use the funds in Indian escrow accounts to make purchases, they can only be used to buy Indian products. If an Indian bank fails to keep oil proceeds "locked up" in India, and lets them escape by wiring them back to Russia or a third party like Dubai, then it could face the threat of losing its U.S. banking access.

If implemented, this locking restriction would dramatically reduce Putin's ability to repurpose oil revenues. Stuck in foreign banks with only a limited menu of local goods to buy (and likely earning sub-market interest rates), Russian resources would languish, illiquid and uncompensated.

This sort of restriction isn't a new idea. It was successfully tried out on Iran beginning in 2013 in the form of the notorious Section 504 of the Iran Threat Reduction and Syria Human Rights Act (TRA), once described as a bit of sanctions warfare that was "so well constructed and creative that in some respects it can be considered… beautiful." I wrote about it eleven years ago. It's time to dust it off.


  1. JP this is admittedly not a comment on this topic but you really ought to put out another blog on your latest view on Bitcoin and it's future trajectory. You had a blog in 2014ish and then doubled down in 2017 when it 10xed. I think you generally remained a skeptic for a while but then it's only fair to take into account the events that have occurred since.


      ... and next off-topic comment will be deleted.

    2. Have read that one but I guess you'd agree a lot of water has flown under the bridge since early 2022.

  2. I remember when we debated back in December whether the secondary sanctions would bite. I predicted that the businessmen of Russia/China/Europe etc. would find ways to circumvent these sanctions - you described them as powerful and took the opposite view.
    The fact that the treasury has had to resort to this uprecedented step (at least now we can agree that Russia is the most sanctioned country?) proves my point that the first round of secondary sanctions has not had the intended effect.
    The table you post as evidence that they have worked is highly misleading - and you know it! It omitts China (?!?) and it while includes certain central Asian destinations that have become intermediaries, it does not reflect the fact that new intermediaries are constantly springing up/and closing down (Robin Brooks has been screaming about this forever).
    Let's see how this, frankly, desperate (I mean, the US Treasury secretary is litteraly bullying Chinese banks -LoL) step will play out, but my suspicions is that a lot of exports/Imports will get relabelled agricultural/energy - after all, the Chinese are masters at faking trade collateral data. Alternatively, many transactions will be done in cash/gold etc.

    1. " least now we can agree that Russia is the most sanctioned country?"

      Nope, that's still Iran. Russia is still allowed to export oil, but Iran's oil industry has been sanctioned. At some point, one hopes the full brunt of Iran-calibre sanctions are levied on Russia.

      "The fact that the treasury has had to resort to this uprecedented step... proves my point that the first round of secondary sanctions has not had the intended effect."

      It could mean that the first round did not have the intended effect, or it could mean that it did have the intended effect, and using that as a model the decision was made to really push the advantage by extending their reach.

      "The table you post as evidence that they have worked is highly misleading - and you know it! It omits China (?!?)"

      Go read the article by The Bell from which I snipped the table. It does a deep dive into the Chinese data.

    2. Ad Iran:
      given that oil exports have been sharply rising recently and that the Biden administration even allowed access to 16 billion in frozen reserves, it is hard to see how it is more sanctioned. Heck, there are even direct flights from Vienna to Teheran, whereas I have to go through Istanbul/Dubai to go to Moscow…Russia is the most sanctioned country on earth

      I saw the Bell article when it came out. I remember thinking that an author that analyzes Chines trade data for the first quarter without discussing the distortions caused by shifts in the lunar year holidays cannot be qualified for the task. Robin Brooks has clearly laid out that the 1 st quarter drop is due to the holiday (Dragon year!!!) not due to sanctions- public inowledge

    3. I think Robin is overstating the New Year influence. Recall that the secondary sanctions imposed in December targeted goods linked to Russia's military-industrial complex, not goods-in-general. In this series of tweets I map out how this specific category of Chinese exports has collapsed so far in 2024. There may be a few lunar effects on the data, but the changes are far too big to support this.

  3. Hmm... due to crap like FACTA and other such USA crap like these so called 'sanctions' it is increasingly looking like having only one financial institution in any country deal with the USA financial system is the prudent course of action.

    At least from the perspective of international merchants and traders.

    Such an finicial institution would simply make an internal account for any USA entity recieving money in that country and require any USA entity to get an account if they are sending money into the country.
    It would be the USA entity's responsibility to wire in or out any money and then transfer money domestically in the country.

    This pretty much kills any covenience USA correspondence banking has.

  4. And there it is:

    "July 10 (Reuters) - Payment issues between Russia and China, caused by U.S. sanctions, pose serious issues for Russian imports of Chinese cars that have supplied the domestic market over the last two years, the head of Russia's car dealers' association told Reuters."