Fig 1
How the US and Europe’s Financial Systems Impact International Transactions and Sanctions Enforcement.
International sanctions are a widely used tool by Western nations to impose financial restrictions on countries like Iran, North Korea, and Russia. It is important to understand how these sanctions are enforced and how Western nations prevent nations from violating them. In general, countries have four main methods to impose sanctions, including diplomatic pressure, financial penalties, secondary sanctions such as the CAATSA, and the most influential method, which is blocking transactions that take place through their respective financial systems.
This article will focus on How & Why blocking a transaction is the most prevalent way to enforce sanctions. In the case of sanctions on Russia related to the cap on oil and gas prices, the Western world did not outright forbid trade with Russia. Instead, they imposed a diplomatic stance that Western financial institutions would not be used for trade settlement with Russia.
To gain a clear understanding of the enforcement of sanctions, it is essential to have an understanding of the complexities of international payment systems and the regulations that govern them.
The Supremacy of the Dollar, Euro, and Western Financial Systems in International Trade
The supremacy of the dollar, euro, and Western financial systems in international trade cannot be understated.
According to recent data, as of December 2021, the US dollar accounts for about 40.51% of global payments by value, while the Euro accounts for about 36.65%. This means that the majority of international payments are made in these two currencies
As per the Society for Worldwide Interbank Financial Telecommunication (SWIFT), in December 2020, almost 42% of the total value of cross-border transactions was settled through American financial systems, while nearly 34% were routed through European financial systems. It is important to note that this figure includes all currencies, and not just the US dollar or Euro. Furthermore, SWIFT’s 2018 report stated that approximately 47% of cross-border payments in US Dollars are cleared through European banks, whereas around 36% are cleared through US banks. These figures indicate the significant dominance of the American and European financial systems in cross-border transactions.
Additionally, the US and Europe are home to the world’s largest correspondent banks, payment systems, and clearinghouses. According to a report by the Financial Stability Board, as of 2018, there were an estimated 3,500 active correspondent banking relationships involving banks in over 200 countries. As of 2021, it is estimated that around 80% of cross-border transactions are settled using American or European settlement systems, clearing houses, and payment systems.
After delving into the dominance of the dollar, euro, and Western financial systems in cross-border payments, it is important to examine how international transactions between two nations are conducted through these financial systems.
How International Transactions Take Place Using Western Financial Systems
In order to understand how an international transaction between two parties takes place, it is important to look at the various steps involved.
A basic international transaction involves two parties: the sender and the recipient. The sender’s bank and the recipient’s bank may not have a direct relationship, so they use correspondent banks to facilitate the transaction. Correspondent banks are intermediary banks that have a relationship with both the sender’s bank and the recipient’s bank. The correspondent bank of the sender’s bank transfers the funds to the correspondent bank of the recipient’s bank, which then transfers the funds to the recipient’s bank.
Let’s say a business based in India needs to pay a supplier in Germany for goods it has purchased. The business has an account with the Bank of India, and the supplier has an account with Deutsche Bank in Germany. However, neither bank has a direct relationship with the other, so they will use a correspondent bank located in the US to facilitate the transaction.
- Initiation: The payment is initiated by the business in India. The Indian Bank creates a payment message using SWIFT. The payment message includes information such as the payment amount, currency, beneficiary bank information, and other details. (in this case, Euro).
- Correspondent banking: Because the payment involves different currencies and banks in different countries, the Bank of India and Deutsche Bank will use correspondent banking relationships to facilitate the transaction. In this case, the Bank of India will have a correspondent banking relationship with a bank in the US (JPMorgan Chase Bank, USA), which will hold accounts with the correspondent bank of Deutsche Bank (JP Morgan Chase, Germany). The correspondent banks will act as an intermediary, with the banks involved in the transaction holding accounts with the correspondent bank. These accounts are used to transfer funds between banks in different countries or currencies. All the banks involved in the transaction send payment messages to each other via the SWIFT messaging system. The payment message is encrypted and authenticated using SWIFT’s messaging protocols to ensure the security and integrity of the message.
- Clearing & Settlement: The payment request is submitted to a clearing & settlement system, which allows banks to exchange payment instructions and transfer funds securely. The clearing system will verify that the payment details are correct and will transmit the payment request to the correspondent banks, who will forward it to Deutsche Bank in Germany. The payment is settled by transferring funds between the Bank of India’s account with its correspondent bank in the US, and Deutsche Bank’s account with the same correspondent bank in Germany. Settlement can occur through the use of a payment system such as CHIPS or TARGET2.
- Confirmation: The German supplier’s bank receives the payment message via SWIFT and processes the payment. The payment is credited to Deutsche Bank. Once the payment has been settled, Deutsche Bank will confirm receipt of the payment to the supplier in Germany. The German supplier’s bank’s correspondent bank sends a confirmation message back to the US bank via SWIFT, indicating that the payment has been received and processed. The US bank receives the confirmation message via SWIFT and sends a confirmation message back to the Bank of India via SWIFT, completing the payment process. This may be done through SWIFT message authentication codes (MACs), such as an MT103 or MT202 message.
- Account update: The business’s and supplier’s accounts are updated to reflect the payment transaction.
If the payment is denominated in a currency other than Euro (in this case) the banks involved will convert the payment at the prevailing exchange rate.
However, it’s important to note that SWIFT is only responsible for relaying messages between the parties involved in a transaction, and doesn’t actually facilitate the transfer of funds. For that, payment systems and clearing houses like CHIPS and Target2 come into play. These systems are responsible for settling the transaction by transferring the agreed-upon funds from the sender’s account to the recipient’s account. The use of these payment systems is what enables international transactions to take place efficiently and securely. By leveraging correspondent banking relationships, these systems ensure that the payment settlement is executed reliably and in accordance with the agreed-upon terms. Overall, the combination of messaging systems like SWIFT and payment systems/clearing houses like CHIPS and Target2 is what makes international transactions possible in today’s global economy.
Note: It’s also worth noting that this is a simplified example, and there are many technical details and protocols involved in the messaging, payment, clearing, and settlement systems. The actual flow of funds can be complex and may involve multiple banks, currencies, and payment systems, depending on the specifics of the transaction.
Blocking Transactions as the Most Prominent Way to Implement Sanctions
According to the statistics presented at the beginning of this article, it is evident that the majority of global transactions are conducted through Western financial systems and correspondent banks located in both the United States and Europe.
The banking systems of the sanctioned countries, individuals, or entities are isolated from the international financial system, making it difficult or impossible for them to conduct international transactions.
In the case of transactions that are subject to sanctions, correspondent banks play a crucial role in enabling international payments. Correspondent banks act as intermediaries, holding accounts for banks involved in the transaction. These accounts are used to transfer funds between banks in different countries and currencies. Thus, if a correspondent bank is located in the United States, any transaction passing through that correspondent bank is subject to US regulations, including sanctions. As a result, the United States has significant control over the international financial system and is able to implement economic sanctions effectively.
The US and its allies have several mechanisms and methods in place for blocking or preventing US Dollar or Euro transactions that are subject to economic sanctions, even if those transactions do not involve US or European-based banks or correspondent banks.
There exist three primary methods through which the US or its allies can prevent a transaction.
- Block access to correspondent banks – The correspondent bank holds accounts in various currencies and countries, which makes cross-border transactions smoother. By blocking access to correspondent banks, the US and its allies can prevent transactions from occurring.
- Block access to payment systems – In addition to correspondent banks, payment systems also play a significant role in facilitating international transactions. Payment systems like SWIFT, TARGET2, and CHIPS allow banks to securely exchange payment instructions and transfer funds. By blocking access to these payment systems, the US and its allies can prevent transactions from occurring, which makes it challenging for sanctioned countries or entities to do business internationally. The US has significant control over the SWIFT network, which it can use to block or reject US dollar transactions that are subject to sanctions. This has been seen in the case of Russia, where the US leveraged its influence over the SWIFT network to oust Russia from SWIFT.
- Use of Programs like FinCEN & TFTP – The US government can monitor international transactions that do not involve the US financial system by using its legal and regulatory authority to require US banks and financial institutions to report certain types of transactions or activity that could be related to criminal or illicit activities.
The implementation of economic sanctions involves a complex process, which includes various steps and actors.
The Office of Foreign Assets Control (OFAC), which is part of the US Department of the Treasury, is responsible for administering and enforcing US economic sanctions. OFAC is tasked with implementing and enforcing economic sanctions by issuing and enforcing regulations, identifying and designating targets, and enforcing penalties for violations of sanctions. It maintains a list of individuals and entities that are subject to sanctions, and it administers and enforces various sanctions programs. If a transaction involves a party that is on the OFAC’s sanctions list, the US government can block the transaction and freeze any assets related to it. OFAC often works together with FinCEN and other US and foreign government agencies to investigate and prosecute sanctions violations.
The US Treasury’s Financial Crimes Enforcement Network (FinCEN) serves as a financial intelligence unit and collects, analyzes, and disseminates information related to financial transactions that may be linked to illicit activities, including those targeted by OFAC sanctions. It has established working relationships with its foreign counterparts and shares information with them on a regular basis to help combat money laundering and other illicit activity. OFAC works closely with FinCEN to enforce its economic sanctions programs.
FinCEN receives data from financial institutions in the US and abroad that may be indicative of money laundering, sanctions violations, or other financial crimes. FinCEN collects and analyzes this data to identify potential patterns or trends that may indicate illicit activity.
In addition to working with US government agencies such as the Department of Justice (DOJ), the Federal Bureau of Investigation (FBI), the Drug Enforcement Administration (DEA), the U.S. Secret Service(USSS), and the Internal Revenue Service (IRS), FinCEN also has a number of working relationships with its foreign counterparts. These relationships include the Egmont Group, Financial Action Task Force (FATF), Joint Financial Intelligence Unit (JFIU), and Financial Intelligence Unit Network for Latin America and the Caribbean (RIAFIL).
As of September 2021, FinCEN has established working relationships with over 100 foreign counterparts, including financial intelligence units (FIUs) in other countries.
FinCEN’s analysis helps support OFAC’s efforts to identify and block transactions that violate US sanctions.
Conclusion
Fig 2
It is possible for someone to skip US or European correspondent banks in an international transaction. It might be accomplished using non-Western payment systems that do not involve US or European correspondent banks or using non-Western currencies, and cryptocurrencies. For example, two parties in Asia could use the Japanese yen or the Chinese renminbi and use the Chinese payment system CIPS (Cross-Border Interbank Payment System) or the Russian payment system SPFS (System for Transfer of Financial Messages) to settle the payment. Cryptocurrencies operate independently of the traditional banking system, and transactions can be made without the need for a correspondent bank. However, cryptocurrencies are still a relatively new technology and may not be widely accepted for international transactions.
Although it is possible for someone to skip US or European correspondent banks in an international transaction doing so will be challenging given the significant control that the United States and Europe hold over the global financial system, it can also be challenging to completely avoid their correspondent banks and payment systems and doing so can be difficult and may involve additional costs and time.
For example, a bank may need to establish new correspondent banking relationships, which can be time-consuming and may require compliance with additional regulations. Additionally, there may be a lack of trust or familiarity with alternative systems or banks outside of the established networks.
In conclusion, the global financial system is under the control of Western powers, with the United States and its European allies holding significant influence over international transactions. Due to the location of correspondent banks and the use of payment systems like CHIPS, Fedwire, and Target2, it is challenging to bypass economic sanctions imposed by the West. As the statistics show, a large majority of cross-border transactions are settled through American or European systems, making it challenging to conduct international trade without relying on these systems. Therefore, it is clear that bypassing them is not an easy feat. The US and its allies can use their financial influence to pressure nations into complying with their foreign policy objectives, making it essential for nations to consider the impact of sanctions on their economy and trade.
–BY ASHISH K NARWAL
