From SWIFT To Forex Reserves, Choice Of Russia Sanctions Bring Decades-Old Fears To Life

The sanctions used against Russia have driven home the dominance of developed markets on payment systems. Will it force a change?

<div class="paragraphs"><p>A shadow of man is cast on the ground. (Photographer: Seong Joon Cho/Bloomberg)</p></div>
A shadow of man is cast on the ground. (Photographer: Seong Joon Cho/Bloomberg)

Almost as far back as 2002-03, Reserve Bank of India veterans remember discussions on a key vulnerability in payment systems. It wasn't a technology glitch that the central bankers were worried about, but the outsized control that developed economies had on crucial parts of the payment infrastructure. A feature more than a bug.

During those years and later, India -- like many emerging economies -- noted the dominance of the SWIFT messaging system, as also that of card networks like Visa and Mastercard, and debated ways to minimise the risk from it.

That dominance has now been weaponised to impose sanctions on Russia, which invaded Ukraine last week. Access of crucial Russian financial institutions to the SWIFT network has been curbed, alongside a decision to effectively freeze a part of the Russian central bank's reserves and curb operations of large Russian lenders in the U.S.

The chosen mix of sanctions amid the war with Ukraine, justified as it may be, could have far-reaching implications.

"The decision of Western countries to remove several Russian banks from the SWIFT system and of the U.S. to sanction several large Russian banks including Sberbank and VTB Bank and expand sanctions on the Russian central bank will have widespread implications," said Sanjeev Prasad of Kotak Institutional Equities in a note dated Feb. 28. In the short term, there will be implications on global inflation, investment and trade. In the medium term, there will be implications for geopolitics and strategic alliances, Prasad wrote.

Weaponising Payments

"Almost 20 years ago in 2002-03, we debated whether to use SWIFT within India or not," recalls former RBI Deputy Governor R Gandhi.

At the time, advisors to the Reserve Bank were emphatic that India must have its own system, at least for internal use, Gandhi said. "This was one of the concerns—that if some geopolitical issues come up, payments, even domestically should not come to a halt."

In the initial years, India did not permit the use of SWIFT internally and even talked about trying to popularise an indigenous messaging system for international payments but the idea wasn't pursued, said Gandhi.

Some safeguards, however, were put in place such as asking SWIFT to set up a separate local network and data storage for operations in India, said G Padmanabhan, former executive director of the RBI.

For international transactions, though, there was little choice but to use SWIFT, which has the widest coverage with connections to over 11,000 institutions across 200 countries and territories.

A number of countries have tried to set up parallel systems to SWIFT. China's CIPS and Russia's SPFS are among those. But none has managed to break the dominance of SWIFT.

Payments infrastructure has a natural tendency to be a monopoly, said Gandhi. And so, instead of trying to build an alternative, the focus shifted towards the governance structure of SWIFT.

SWIFT's current governance structure is such that each nation’s usage of messaging services determines its shareholding and number of directors on the board. This gives a wide set of nations representation but the developed economies, by virtue of larger usage, still have control.

"There has been continuous thinking on these issues and it will accelerate after the recent events," said Padmanabhan. "Perhaps, Asian countries could come together to promote a separate network."

SWIFT is not the only payment infrastructure that has become a weapon.

Calls have grown for Visa and Mastercard to restrict operations in Russia. Both, according to Reuters, have blocked the Russian financial institutions under sanctions from their network. This, in effect, will mean that cards issued by the sanctioned banks on the Mastercard and Visa network may not work.

Again, the risk of such actions were part of the deliberations at the Reserve Bank when the local Rupay network was first proposed when YV Reddy was governor, said Padmanabhan. "The idea behind Rupay was that we shouldn't be too dependent on overseas systems. Just in case, any country to country problem crops up, it could end up impacting local payments."

Popularising Rupay, however, has been an uphill task.

Its share in volumes of card transactions, which was at 18.2% in FY19, had risen to 23.8% in FY21. Share of value of transactions has gone from 9.8% in FY19 to 16.2% in FY21, based on data available from the National Payments Corporation of India and the RBI.

Part of the problem lay in the government's decision to cut the merchant discount rate chargeable on Rupay transactions to zero. This left banks with little incentive to push cards on this network. In December, the government said that it would reimburse banks for low-value Rupay transactions to incentivise banks.

Perhaps the closest one will come to challenging the dominance of some of these legacy global payment systems is through central bank digital currencies, said Navin Surya, chairman emeritus of Payment Council Of India. Both the retail and wholesale versions of CBDCs, if introduced widely, will make transaction and settlement easier and faster. "It might be better to take that route rather than build a legacy institution to beat another legacy institution."

With the introduction of CBDCs, the dependency can be reduced over a period of time, provided there is focus and coordination, said Surya. "Else the reality is that cryptocurrencies will win."

The Reserve Currency Threat

Alongside the use of payment systems as a weapon, the U.S. and the European Union have taken steps to freeze a part of the Russian central bank foreign exchange reserves.

Here, too, the risks of holding a large part of a nation's reserves in one currency haven't escaped notice. While central banks, including the RBI, have diversified reserves over the years, there is a limit to this strategy.

Diversification of forex reserves has been continuously debated, said Gandhi. In particular, at the time of U.S. sanctions against Iran, when India continued to do business with that country, there were concerns that the country with the reserve currency "may turn against our interests", Gandhi said.

Since then, diversification has been an important principle of reserve management, irrespective of returns, said Gandhi.

The reserves held in dollars are mostly in the form of U.S. treasuries or cash holdings within the U.S. either with large banks or regional federal reserve banks like the Federal Reserve Bank of New York. This gives the U.S. powers to freeze those asset or prevent their liquidation.

"But you can only limit the damage in this regard given the dollar remains the reserve currency," said Gandhi.

About 59% of global forex reserves were held in dollars in 2020—the lowest in 25 years, according to the IMF. The share of the U.S. currency has fallen from over 70% in the late 90s. India uses a mix of dollars, euro, pound sterling, Japanese yen, among other, but does not disclose the precise share.

"While you can diversify into Euro and some other large currencies, there are limits to diversification," said Padmanabhan.

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