Breaking down financial sanction ‘fatbergs’

Maximilian Hess established Enmetena Advisory, is a member of the Foreign Policy Research Institute, and wrote the book 'Economic War: Ukraine and the Worldwide Battle Amidst Russia and the Western Nations.'

The United States has the ability to impose sanctions on other countries because they control the US dollar, which is supported by many organizations such as the US Treasury and Atlantic clearing houses.

Working together, these factors create something called "weaponized interdependence," according to scholars Henry Farrell and Abe Newman. In their original paper, they explain that this term describes a situation where different countries are heavily reliant on each other, but at the same time are using their interdependence as a way to gain power or control over one another.

Uneven network arrangements offer room for "weaponized interdependence," where certain countries can use their interdependent relationships to pressure others. In particular, countries that have control over the central nodes in the worldwide interconnected systems that facilitate the movement of money, goods, and information are in a one-of-a-kind situation to enforce consequences on others. By having the appropriate home institutions, they can use these networks as weapons to collect information, limit economic and information streams, uncover and capitalize on weaknesses, require policy adjustments, and discourage actions that are not welcomed.

The ability to carry out, monitor and enforce sanctions depends heavily on the plumbing of financial networks. However, it's a complex system that involves a mix of public and private entities. To increase the success of sanctions and avoid negative impacts on the broader financial market, proper supervision and coordination are crucial.

If things had gone according to plan, these networks would have been redirected so that the Russian government, its cohort Belarus, and individuals linked to the Kremlin wouldn't get any new money, while allowing foreign currency reserves to flow out smoothly. If combined with a successful strategy to cut down on profits from oil and gas, this could potentially drain the financing for Russia's military efforts over time.

Nevertheless, though sanctions have become more crucial to Western leaders, it seems that no action has been taken yet. The financial blockages are increasing in the system, which is causing major issues. Without any attempt to resolve these blockages, the cash reserves meant to funnel towards the West are being retained by Russia. It is possible that if no action is taken, the entire system could collapse.

The contrast between the desires and actuality of policy is most evident when it comes to Euroclear.

The clearing house located in Belgium has been a major topic of discussion in regards to sanctions. This is due to the fact that it is earning a significant amount of profit from Russian assets that have been frozen. The European Union has officially approved the decision to allocate these profits towards funding Ukraine's reconstruction.

According to the Council (with their emphasis as shown below):

The Council made a decision stating that Central Securities Depositories (CSDs) that hold over €1 million of CBR's assets have to report any accumulated cash due to EU restrictive measures separately and should also keep any related earnings apart. Moreover, the CSDs are not allowed to get rid of any net profits that arise from this.

This choice clears the path for the Council to determine if there should be a fee taken from net profits to assist Ukraine with its restoration and rebuilding in the future. The funds may then be directed to the Ukraine Facility through the EU budget, which both the Council and the European Parliament provisionally agreed upon on February 6th, 2024.

Officials in Ukraine are optimistic that the action will lead to an influx of $4 billion annually into their financial reserves. However, the tax in Belgium has only been given clearance to affect about fifty percent of Euroclear's estimated windfall of €4.4 billion in 2023. This particular tax is set to target merely eighty percent of the company's overall net interest earnings for that year and is not expected to be applied retrospectively.

In the event that a new group effort is put in place to more effectively access the resources, the suggested legal measures by the European Commission involve granting Euroclear permission to keep a portion of the earnings. Specifically, they would be allowed to keep three percent to cover their own operational costs and an additional 10 percent to account for any legal disputes with Russia.

Nevertheless, the way Euroclear and EU policymakers handle issues related to sanctions has actually been quite weak.

On February 28th, 2022, Euroclear and Clearstream were instructed not to provide services to Russian clients or the National Settlements Depository (NSD) that was previously associated with Russia. This meant that certain bond holders in the Western regions affected by sanctions were able to receive payment while those in Russia were not allowed to. However, the success of this plan remains uncertain.

It is not recognized or communicated enough how the Russians have been trying to figure out ways to get around obstacles. Instead of just doing what they are told to do, they faced a problem where blocked pipes at EU clearing houses would stop their own creditors in Russia from getting their money. So the regulators from Russia decided to push harder in order to create payment systems within their own country. To further control the flow of hard currency out of Russia, they also added limitations through counter-sanctions.

Consequently, Euroclear and Clearstream receive fewer dollars and euros, resulting in Western creditors receiving less money. However, many Russian companies and even the state have been able to provide alternative "mirror" bonds to their domestic creditors using these domestic payment systems. This has allowed Russia's credit market to continue functioning smoothly without any negative impact.

On the other hand, creditors from the Western world are frequently caught in a state of uncertainty. They face difficulties in receiving their payment for the bonds, are unable to find effective solutions, and are often unable to dispose of their assets (even to traders in impartial lands who could retrieve the payment from Russia or Belarus).

What Counts As A Default?

The ramifications of regulatory obstacles have become even more difficult for those involved in the market. This is due to the way in which Euroclear has dealt with Russian-linked debt obligations affected by sanctions. Those who own the bonds are dependent on the clearing house to receive payments and to facilitate trading between each other within the secondary market.

Nobody planned these obstructions, and they happened without policymakers even realizing it. Usually, the people in charge of following rules, called compliance departments, are the ones causing these blockages. Instead of taking away money from those who are being sanctioned, the way that the sanctions were intended to work, these measures have actually ended up releasing those individuals and groups from any financial obligations they may have owed. Even when there aren't any sanctions being enforced, these same measures seem to benefit people who are in debt, but who might be located on the opposing side of a political battle.

Consider the situation of Russian Railways - a transport company owned by the state which has a significant role in Russia's efforts during the war. The International Swaps and Derivatives Association (ISDA) is a vital but often overlooked entity in enforcing sanctions. In April 2022, ISDA found that Russian Railways was in breach of payment obligations to international bondholders due to the sanctions imposed after the invasion.

The decision taken was a crucial move towards preparing for Russia's own national bankruptcy in June 2022. As a result, investors can now receive payment under credit default swaps for both Russia's government debt and those of its affected entities, such as Russian Railways. The sanctions directive also eliminated these protections as a means to issue debt after February 2022, and ISDA has since revised its guidelines.

However, Euroclear's handling of debts that have been impacted has been unclear. A bond from Russian Railways that was due in October 2023 has not been marked as in default, but rather as "matured," even though Western bondholders cannot receive their principal and interest payments due to sanctions from the West and counter-sanctions from the Kremlin. If a bond is marked as "matured" but not "In default," Euroclear cannot settle it, which means that it cannot be traded as freely.

Euroclear's stance impacts only the Western creditors since they can't get money from the sanctioned entity, nor can they sell their claims to others who can. This ultimately allows the Russian state-owned company, under sanctions, to keep money it isn't authorized to possess.

A similar problem has arisen with a bond from Evraz Steel, which was due to mature last March. The company is only under UK sanctions and not subject to US and EU sanctions. However, the compliance team at Euroclear has tried to comply with all potentially relevant sanctions regimes. As a result, all Western creditors, including those in the US and EU, are facing the costs of the Kremlin's countersanctions. These require Evraz's Russian subsidiaries to block payments abroad, leaving creditors unable to mitigate the situation. Additionally, the bond is not tradeable due to obstacles from European clearing houses.

In the case of Belarus' 2022 sovereign default, which occurred after the regime of President Alexander Lukashenko followed Moscow's lead by restricting foreign currency payments to Western creditors, the problem was taken to an extreme.

The Belarusian government decided not to repay their sovereign bonds that were supposed to be paid off by 2023. However, this situation is not considered a default by Euroclear, who instead refers to it as "matured". Even though there are sanctions in place, they do not explicitly prevent Belarus from making repayments. Additionally, the Belarusian Central Bank is not subject to the same level of sanctions as the Central Bank of Russia, meaning that bondholders could theoretically still receive payments.

Just like Russian Railways and Evraz, the creditors of Belarus from Russia are receiving their payments using NSD, which completely bypasses Euroclear. Sadly, Western creditors do not have this option and cannot reduce the impact of the damage. Euroclear's labelling system ensures that the bond will not be marked 'defaulted' unless the debtor allows it. This premise helps Belarus keep more of its borrowed dollars out of the creditors' reach - for now.

Euroclear has taken a peculiar stance. It wrote a letter to owners of Belarus' 2023 Eurobonds who have experienced difficulties in selling their claims as a result of Euroclear's actions. In the letter, it contends that Belarus' default should be viewed in a distinct manner compared to Lebanon, Sri Lanka, Venezuela, and Zambia.

These independent countries have acknowledged they cannot make payments and have, therefore, accepted failure to make payments, even if they did not explicitly say it was a 'default.' Belarus, on the other hand, has not admitted difficulty making payments and instead proposed different ways to pay.

Euroclear cannot make a decision on whether or not an Event of Default has occurred in relation to the 2023 Notes, as Euroclear is not involved in the contractual documentation and does not have the power of a court to make such a decision.

However, determining whether a country is in default is not up to its rulers, but rather for its lenders to decide. Even the World Bank, an influential creditor among others, believes that Belarus is in a state of default. Rating agencies such as S&P, Moody's, and Fitch share this view. Euroclear's stance seems to align solely with the opinions of Belarus and Russia.

Euroclear might have to deal with additional plumbing problems as it is currently facing numerous legal suits in Russia. This is a matter of concern for the clearing house, as mentioned in its yearly report.

In 2023, there were a range of political groups arguing about the results of sanctions being enforced. Most of the legal proceedings took place in Russian courts and the cases were primarily about accessing assets that had been frozen in Euroclear's records. The folks bringing these lawsuits hoped to get their money back. Despite Euroclear's best efforts and a lot of money spent on lawyers and fighting back, the likelihood of getting any favorable outcomes from Russian courts seemed slim because Russia didn't accept the global sanctions. Nonetheless, Euroclear will remain determined to protect against all legal challenges.

Even though the majority of these legal actions are being lodged in Russia, they have the potential to generate rulings against Russia that Russian plaintiffs may attempt to implement in Western jurisdictions.

Although Russia has invaded Ukraine and is currently engaged in an economic battle with the Western world, there has not been much dialogue about how effective the bilateral investment treaties and other international economic agreements are. Many of these agreements with Russia have been in place since the late Soviet era. The Kremlin is more proactive in this area than others, having passed legislation in 2022 to address issues of "actions by unfriendly nations" (such as sanctions) and how Russian countersanctions should be handled in legal disputes.

These circumstances have resulted in a scenario where individuals from the West, who possess Russian bonds, experience a notable disadvantage compared to their Russian equivalents. Meanwhile, the individuals who borrowed money have succeeded in putting off their debts to Western investors. If left unresolved, this issue could potentially damage Euroclear's role in the fundamental operations of the worldwide financial system.

In its yearly report, it was stated in a melancholic manner:

Euroclear is dealing with a lot of difficulty when it comes to handling the numerous sanctions and countermeasures that Russia has put in place to try and lessen the effects of the sanctions. In order to manage any potential issues and risks associated with these countermeasures, Euroclear is dedicating a lot of time, money, and resources. They are also keeping open communication with both clients and other interested parties.

The prevailing policymakers in the West may not be pleased with this result. Although Euroclear has been criticized for its excessively large earnings, there has not been enough effort to overcome the broader issues in enforcing sanctions. While it is necessary to implement modifications to sanctions that specifically hinder Russia's military capabilities and limit the country's profits from oil sales, ensuring that the financial system supporting the effectiveness of sanctions stays intact is equally significant, although it may not gain media attention.

There is a lack of skilled plumbers available currently. In the Russian language, which has a tendency to combine words, the term for plumbers - Santekhniki - also encompasses the fields of sanctions technicians and sanitation technicians.

Therefore, to modify a statement: Let all Sanctions Technicians from across the globe unite and come together, saying: Santekhniki vseh stran, soyedinyaites!