If there's one thing I know, it's never to mess with mother nature, mother in-laws and, mother freaking Ukrainians.
Skinny Pete, The Italian Job
Financial Warfare
Things have evolved quickly. One of the great things about working for the Fed was that you learned to think about the financial system from the plumbing out. I know more about SWIFT 103 and 202 messages than I care to admit.
We’ve gone from discussing whether to allow Russia to use the SWIFT messaging system to full blocking sanctions against the Russian central bank, the Russian sovereign wealth fund, and its banking system.
This raises two immediate, related-but-distinct issues:
FX Settlement Risk (also know as Herstatt risk)
Demand for USD as Russian central bank reserves that are traditionally lend out need to be replaced.
FX settlement risk occurs due to timing differences between the different currency legs of a transaction. It occurred most notably with the failure of Herstatt Bank.
That day, a number of banks had released payment of Deutsche Marks (DEM) to Herstatt in Frankfurt in exchange for US dollars (USD) that were to be delivered in New York. The bank was closed at 16:30 German time, which was 10:30 New York time. Because of time zone differences, Herstatt ceased operations between the times of the respective payments. The counterparty banks did not receive their USD payments.
In the developed western markets has mostly been eliminated by the creation and use of CLS Bank. CLS Bank eliminates the risk by simultaneously settling transactions in the two currencies. Unfortunately, the Russian central bank, and by default the ruble, is not a CLS settlement bank.
Now RUB is a relatively minor currency exposure, and likely highly margined by the correspondent banks, but the move in the ruble has been severe enough that there are likely unsecured exposures. And if you are a Russian firm, your incentive to perform here is limited, so there will likely be some losses.
The bigger issue that has been highlighted over the weekend is the demand for USD in clearing. Zoltan Pozer of Credit Suisse, a former Fed collegue, the author of the famous shadow banking system papers, and one of the most all-around knowledgeable people on the plumbing of the financial system highlighted this risk with this note over the weekend. It has received a lot of attention for alluding to Lehman weekend causing a number of people to wonder if there was a systemic risk arising.
Adam Toose has written Chartbook #89 Russia's financial meltdown and the global dollar system that explains developments is great depth. I HIGHLY recommend reading it - I will not cover all the great stuff in there but just highlight this key point:
The crucial point that this highlights is that Russia’s reserve accumulation, like reserve accumulation by other oil and gas producers such as Norway or Saudi Arabia, is a source of funding in Western markets. The reserves do not simply sit idly in central banks accounts, they are lent out. With sanctions, the funding provided by Russia’s petro- and gas-dollars is in jeopardy. And that impacts not only the Russians.
If you sanction Russia and thus block hundreds of billions of dollars in the global balance sheet, you have to ask yourself: what happens to the other side of the balance sheet? Reserves are Russia’s assets, they are someone else’s liabilities, who in turn has balanced that liability with an asset and so on. Those chains can be ramified and complicated.
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All told, Pozsar estimates that Russia may be responsible for providing in the order of $300 billion in funding to short-term money markets. If that funding disappears overnight it may deliver a serious shock to the Western financial system.
Now, just to be clear, while there may be hickups, this is something the Fed, the ECB and other central banks are well-prepared to handle. The Fed can inject reserves as needed, and there are swap lines in place with the major central banks to handle these developments.
More
Here is a nice list that the FT has compiled of all sanctions in place.
The neutral Swiss get on board with sanctions
There has been talk about Russia using a Chinese alternative to the SWIFT messaging system called CLIPS. Lillian Li has a nice short tweet stream.