Several countries, led by the United States, have imposed a slew of economic sanctions against Russia following its attack on Ukraine last month. The measures thus far include exclusion of systemically important state-owned Russian financial institutions out of the correspondent banking system, exclusion of certain Russian banks from SWIFT, denying Russia access to international capital markets, and freezing of the Russian central bank’s reserves of around $630 billion. While the impact on the Russian people and economy has been swift, India too is searching for options to secure its imports from its longstanding and significant defence and trading partner.
These disruptions have triggered a debate about central bank digital currencies and specifically whether they can provide an alternative payment channel that can bypass such sanctions. To understand these issues, we need to look at the current payments system, how sanctions work within this system, how a CBDC-based new payments system will be different, and finally, how effective can sanctions be in the new system.
Sanctions In The Current System
The current global financial and payments system is dominated by the dollar, as both the leading reserve currency in the world and the principal currency in which a majority of international transactions are conducted. Additionally, all dollar transactions must necessarily go through the U.S. financial system.
In the current sanctions against Russia, U.S. banks are required to close correspondent accounts of—or stop processing transactions involving—the sanctioned Russian banks. This renders Russian banks unable to handle billions of dollars worth of transactions on behalf of their clients. Barring access to SWIFT is another tool that renders sanctioned entities unable to communicate or transact with other member institutions, impacting both individual and corporate cross-border transactions. Unlike CHIPS and U.S. banks, which must comply with U.S. laws, SWIFT is subject only to Belgian and EU laws. Thus, Russian banks have been excluded in the current instance under EU regulations, although the U.S. and other countries are also known to exercise influence over SWIFT through its governing body.
Previous Go-Arounds
Countries have of course sought to work around sanctions through contracts or arrangements that are not denominated in dollars. Examples include the ‘rupee-rial’ mechanism introduced by India in 2012; the Russia-China swap agreement of 2014; Russia’s National Payment Card System to process domestic card payments; alternative financial messaging systems like Russia’s System for Transfer of Financial Messages; or China’s Cross-border Interbank Payment System. These are however ad-hoc or limited in their reach.
CBDC-Based Payment Architecture
Will a CBDC-based cross-border payments arrangement be immune to sanctions? Let us first try to understand what such an arrangement could look like and how it could be different from the current system. Some recent experiments by groups of countries have looked at the feasibility of alternative designs for cross-border CBDCs. These experiments include project Dunbar by Australia, Malaysia, Singapore, and South Africa; project mBridge by Hong Kong, United Arab Emirates, Thailand, and China; and project Jasper-Ubin by Canada and Singapore. The objective of these experiments is to test alternative prototypes of multi-country CBDC-based arrangements within a digital sandbox.
All these different prototypes, however, can be classified into two broad categories, depending on whether they work based on country-specific CBDCs that are issued by corresponding central banks, or a universal CBDC issued by a global multilateral institution.
The first case, with country-specific CBDCs, could work in one of two ways. In the first arrangement, the central banks allow these currencies to be transmitted and exchanged only within their jurisdictions. To enable the cross-border transfer of funds, central banks would have to agree to allow intermediaries (like commercial banks for example) from different countries to hold an account with them denominated in the local CBDC. Entities that need to make payments to other countries can do so using these accounts.
In the second arrangement, the central banks allow these currencies to be transmitted and exchanged even beyond their jurisdiction. This works by enabling intermediaries in any country to hold an account with their central banks, but they can hold CBDCs of different countries in that account. Again, any entity can make payments to other countries using the CBDCs of those countries in these accounts.
Universal CBDCs, on the other hand, are not denominated in any local currency, but backed by a basket of currencies, and accepted by all participating central banks. Converting local currencies into this universal CBDC will be based on an exchange rate either fixed by the central banks or on a CBDC exchange. Payments can be made by converting the local currencies of the payer into the universal CBDC and again into the local currency of the beneficiary.
CBDCs And Sanctions
The critical difference between the current international payment arrangements and the CBDC-based one is that the latter cuts down on the crucial role of intermediaries, particularly correspondent banks. In the country-specific CBDC model, this role is effectively transferred to the central banks. In the case of a universal CBDC, it is the multilateral institution issuing the currency that plays this role. The importance of SWIFT is also diminished with a CBDC-based cross-border payments system. Not surprisingly, SWIFT is looking for other roles in a CBDC-based system.
As discussed earlier, past episodes of primary sanctions have targeted individuals or countries mainly by cutting off their access to correspondent banks and SWIFT. This will clearly not work in a CBDC-based payments system that works outside these legacy financial market infrastructures.
However, with a country-specific CBDC, the sanctions might target the central bank, which acts as the correspondent bank, thereby achieving its objective. How feasible is such a step? Here, it is important to keep in mind that the current sanctions have, in fact, targeted the Russian central bank. This means that such a step is definitely possible. However, it will be difficult to implement this repeatedly as the international monetary and financial system is dependent on the cooperation of major central banks.
Next, in the case of a universal CBDC, the sanctions will have to target the multilateral institution that issues these currencies. This will be even more politically difficult than targeting individual central banks, as this would be the equivalent of starting an economic war with all the participating countries.
Secondary sanctions will also be more difficult with the CBDC-based arrangements, compared to the correspondent banking system, for similar reasons.
To sum up, countries are yet to figure out the details of a CBDC-based cross-border payment system. However, the fact that it is still a clean slate offers an opportunity to countries that are looking for alternatives – a payments infrastructure that will be less susceptible to sanctions than the current one. Even though sanctions will still be possible with a CBDC-based payments system, it will definitely be more difficult. This may provide additional impetus to some countries to push for a change in the global payments architecture towards a CBDC-based arrangement.
Sabyasachi Kar is the Reserve Bank of India Chair Professor at the Institute of Economic Growth. Priyadarshini D. is an associate fellow with Carnegie India's Technology and Society Program.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.
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