What SWIFT Really Is

Let’s begin with what SWIFT actually is. This is important as reporting across various media outlets has been remarkably inconsistent. Some have referred to it as an international “payments system”, and others a global “interbank messaging system”.

So which is it, and what’s the difference?

SWIFT is an interbank messaging system. Not an international payments system.

The difference here is extremely important. If it were a payment system, that would imply that banks use SWIFT to transfer money across the globe. They do not.

Instead, banks use SWIFT to send a message to other banks detailing the particulars of specific transfers of money. Information is what travels across the SWIFT network, not money. Since the details of a transfer ultimately lead to the transfer itself, it is easy to see how SWIFT is so easily misunderstood as a payment system.

Now that we know that SWIFT is really just, quite literally, a network that allows the easy sending and receiving of standardized messages, we can see why it isn’t as critical as everyone is making it out to be.

SWIFT In, Or SWIFT Out? Does It Matter?

Firstly, removing Russian banks from SWIFT does not impede their ability to transfer or receive money, particularly USDs.

It makes it that much more difficult for them to do so, but at the end of a day, details of a transfer can be done over other messaging systems, or even the phone and email.

Jamie Dimon, the CEO of JPMorgan, makes the exact same point here.

Second, only a handful of Russian banks have been removed from SWIFT. Important ones, like Sberbank and Gazprombank remain on the network, ostensibly to allow Europeans and other countries to keep paying for their imports of Russian oil and gas.

All of which only reinforces the point – how nuclear can the SWIFT ban be if 1) it only disables a mode of communication between banks, and 2) it doesn’t apply to the entire Russian banking system?

The way the ban is currently implemented is the same as someone saying that they built a roof over your house, but out of porous material that has holes in it.

Not nuclear at all.

The US Treasury Has The Right Idea

Now here’s what’s important, and how to make financial sanctions really nuclear. Note that financial nuclear war is similar to real life nuclear war in that both are internecine in the extreme.

What Western allies need to do to really cut Russia out of the international financial system is ban their domestic banks from having a correspondent relationship with their Russian counterparts.

As a matter of fact, the US Treasury has already taken such a step. From their press release on the 24th:

“By cutting off Russia’s two largest banks — which combined make up more than half of the total banking system in Russia by asset value — from processing payments through the U.S. financial system” (emphasis ours)

But just how would they achieve this “cutting off” from processing payments in the US financial system?

Here’s an elaboration from the same press release:

“Within 30 days, OFAC is requiring all U.S. financial institutions to close any Sberbank correspondent or payable-through accounts and to reject any future transactions involving Sberbank or its foreign financial institution subsidiaries. Payments that Sberbank attempts to process in U.S. dollars for its clients — with examples ranging from to technology to transportation — will be disrupted and rejected once the payment hits a U.S. financial institution.” (emphasis ours)

It’s the correspondent relationships between banks that really matter, not SWIFT, and not political posturing or sanctioning oligarchs.

What Is Correspondent Banking?

But what exactly is a correspondent relationship?

Here’s a simple example to illustrate.

Imagine that you have 2 bank accounts. One is a basic savings account with a US bank, and the second a multi currency account, say, with a British bank in London.

What happens when you transfer USDs from your US savings account to your multi currency British account?

Quite simply, your US bank transfers the amount of USDs you sent to another US bank, not your British bank. What makes this other US bank special is that it has a correspondent relationship with your British bank.

This means that your British bank has an agreement with this other US bank for it to hold USDs on the British bank’s behalf.

Your British bank cannot directly hold USDs unless it does so through a correspondent bank, or a US subsidiary that has access to the US interbank payments system (a la Fedwire).

Why can’t your British bank hold USDs directly?

Simply because it is a British bank that is chartered in the UK, and thus can only settle transactions using UK bank reserves, which are obviously denominated in GBP.

Since it cannot settle transactions in USDs, it needs to find a bank which can do so on its behalf. And the only banks which can settle transactions in USDs are American banks, and foreign banks with US subsidiaries.

This “acting on behalf of foreign banks” is the correspondent relationship.

It is important to note that correspondent banking chains need not be 1 to 1 as portrayed in the above example. They could stretch out into a long chain where a bank has a correspondent relationship with another bank which then uses yet another correspondent bank in order to access USDs.

This tends to be the case for smaller banks, especially smaller banks in developing or third world countries. Which is a big part of the reason why swapping in and out of USDs is so expensive for them.

As you can see, correspondent banking is how money really moves around the world, which is really based on an understanding of what bank reserves really are, and the role they play in the financial system.

The Real Financial Nuke

Consequently, the real nuclear option has nothing to do with SWIFT.

It has to do with sanctions banning all banks with access to the US interbank payment system from having correspondent relationships with Russian banks.

If one wants to make it even more “nuclear”, throw in sanctions cutting Russian banks from accessing the European interbank system as well, so that they can’t make or receive payments in Euros.

Obviously, this won’t be easy to enforce in practice, since correspondent banking chains can be long, with counterparties far down the chain difficult, if not impossible to identify.

It is, after all, quite possible that banks in the chain who know that they are directly linked to a Russian bank still choose to act on their behalf.

Naturally, such a move comes with severe second order effects.

Russian banks being unable to transact in USDs necessarily means that Russian businesses cannot make payments to trading partners all across the globe. While some, if not many, businesses in Russia will default, non-Russian ones all around the world will too.

Of course, imposing such a ban also means that payments for Russia’s oil and gas exports can no longer be made, which would drive energy prices across the globe even higher. This could even lead to disasters in some parts of Europe which are struggling with record high natural gas and electricity prices.

Whether or not Western allies will ever impose such sanctions is unclear. Although, from how sanctions have been developed and sold to the public so far, it seems unlikely that the US or EU will choose to do so.

That being said, they might not have to, simply because of how severely misunderstood the SWIFT ban was. Russian banks are reportedly already facing runs on USD deposits, with the economic situation in Russia looking more uncertain with each passing day.

Whether or not the banking panic in Russia levels out soon, and its economy isn’t too adversely affected by it remains to be seen, but it does give us an important reminder:

What is true is not necessarily as important as what people believe to be true.

At the end of the day, it’s paradigm that truly matters. People rushing for the exit based on rumor or false belief is just as destructive as them doing so based on fact.

If this misunderstanding of SWIFT sanctions contributes to a quicker end to Russian belligerence and destruction in Ukraine, without the need to deploy the true financial nuke, all the better.