Policy experts can argue about the appropriateness of various sanctions policies. Some voice concerns that the U.S. overuses sanctions tools while others convey that the U.S. must increase targeted sanctions to hinder the financiers that enable terrorists and corrupt regimes. But there has never been the prospect that sanctioning could become a moot option against some states embracing new financial technologies. Until now.
Today, various regimes are trying to develop sanctions resistance through cryptocurrency technology.
Governments that get sanctioned by the U.S. always seek ways to evade the economic restrictions that cut them out of the financial system. They usually find paths of least resistance, through frontmen and front companies allowing them to do business, secure capital, and move funds around the globe. This brings about a cat and mouse game where the U.S. Department of Treasury works to uncover deceptive schemes and fine parties that facilitate sanctions evasion. This cat and mouse game now includes easy-to-acquire blockchain software.
Since the end of World War II, the U .S. dollar has been the world’s dominant reserve currency, and the vast majority of cross-border trade is conducted in dollars. This gives the U.S. immense financial—and political—leverage. Losing access to dollar-clearing and correspondent relationships with banks in New York would be a death sentence for most foreign financial institutions. The U.S. used this leverage to urge European Union regulators to oust Iran from the international financial messaging system known as SWIFT as part of nuclear sanctions in 2012. The next year, Iran decided to begin negotiating a nuclear deal to get out from under sanctions.
Emerging powers like China have been calling for an alternative international reserve currency for years. And in the midst of growing trade disputes between China and the United States, some Asia regulatory experts earlier this year proposed that a digital currency system would be the ideal way to develop this alternative.
It is no surprise that states like Russia, Venezuela, and Iran are looking to build blockchain technology to develop sanctions resistance for their financial sector. Officials in each country claim that state-based cryptocurrencies could eventually help blunt the effects of Washington’s financial coercion. But what has not been discussed much is that the main technological ingredient for these efforts is open-source; software that is freely available on the internet, not owned by any one entity, and for practical purposes, can not be prevented from being acquired by these states.
For example, Iran’s central bank announced in late August that it is planning a national cryptocurrency running on a Hyperledger Fabric private blockchain. Hyperledger Fabric is an open source software platform for enterprise blockchain systems. It is a product of the Hyperledger Consortium, a group of companies led by the San Francisco-based Linux Foundation, a non-profit that supports open-source technology projects. Hundreds of firms around the world are engaged with Hyperledger blockchain projects.The Iranian effort is not affiliated with the consortium and there is little the Linux Foundation or any one else could do to stop the regime in Iran from using Hyperledger.
There is certainly nothing wrong with any nation setting up more efficient, blockchain-based payment systems. In fact, governments developing financial processes with the greater auditability that blockchains allow is a positive step for transparency. What is problematic is that Russia, Iran and Venezuela state outright that they intend to use blockchain technology to get around sanctions. They seek to undermine one of the few nonviolent tools that the international community has to respond to governments that grossly violate human rights, sponsor terrorism, or do other malign activities. Thus, one potential step forward for transparency is accompanied by a step backwards that in some ways enables authoritarianism.
Russia is subject to U.S. and EU sanctions against many of its major banks and has slowly been integrating blockchain technology pilots into its financial system. Earlier this year, Sberbank—the largest bank in Russia—completed a $12 million corporate bond transaction, settling purchases using Hyperledger Fabric software. Current sanctions prohibit U.S. firms from providing debt or equity financing to Sberbank, but not software.
Venezuela was the first country to attempt to launch a national cryptocurrency several months ago, claiming to create the oil-backed petro token based on a public blockchain platform called NEM. The claim was plausible, because anyone with limited computing skills and resources can develop a token like the petro in a few easy steps. The accessibility of this open technology brings an opportunity; a way to conduct financial transactions outside of the current financial system
With conventional banking, financial authorities pressure sanctions targets by freezing their assets and blocking their transactions. But these sanctions resistance projects rely on software that allows for financial transactions impervious to third party interdiction.
Banning or sanctioning open source software would be an elusive and impractical goal. Open source code intrinsically is easy for anyone to replicate and share anywhere in the world. It also would be ill-advised on another count: Open source technology has tremendous societal benefits. Open source software platforms have driven the key business innovations of the past twenty years; mobile phones, transportation systems, and medical technology have advanced greatly from non-proprietary code.
Open source software promotes collaboration among software developers, strengthens security by enabling crowdsourced fixes for bugs, and increases the pace of innovation as platforms iterate through wider use. U.S. policymakers should be careful not to respond to these efforts in a way that would indirectly jettison American developers from the open source software community. This would undermine U.S. technological competitiveness in the long run.
This does not mean that financial authorities are powerless against sanctions resistance strategies. For example, if Iran does launch a cryptocurrency, the same sanctions that target Iranian currency would apply to the digital rial.
Today, cryptocurrencies derive their value through supply and demand on cryptocurrency exchanges. Treasury’s sanction restrictions against Iran means that cryptocurrency exchanges under U.S. jurisdiction (including some foreign exchanges with U.S. financial connections) would not be permitted to trade the new token. This sanctions pressure should have a deflationary effect on the price of the “crypto-rial.”
So, although the U.S. might not technically be able to block cryptocurrency transactions, Iran’s new token would not fundamentally alter U.S. sanctions leverage. It also would not likely provide a boon to the Iranian economy. Digitizing a floundering fiat currency is not enough to make it attractive for foreign investors or creditors.
Sanctions evasion using cryptocurrencies is not likely to be a major threat for the short term. In the long run however, if a reliable blockchain-based system emerges that can support financial transactions on par with the SWIFT system, U.S. sanctions power could be diminished. Still, a true “blockchain SWIFT” is something that probably would take decades to unfold.
U.S. Adversaries Playing the Long Game
China and Russia are long-term planners. The Chinese government has invested more than $3 billion in blockchain technology projects in 2018. And a Russian intelligence official expressed earlier this year, “the internet belongs to Americans, but blockchain will belong to us.” And businesses in China and Russia are collaborating. In late 2017, large blockchain firms from both countries set up a joint $100 million cryptocurrency fund to invest in blockchain ventures. Both governments are working on establishing technical standards for distributed ledger technologies for their respective nations.
It is too early to say exactly how or if blockchain systems will take hold. No one can predict whether fully decentralized protocols like Bitcoin or Ethereum will become more relevant to global finance, or if cryptocurrencies will be insignificant in a few years. A middle path may be more likely, with banks embracing hybrid features of blockchain technology, embedded within current banking infrastructure.
What is clear is that the leaders in any new financial system of the future will be those who build its platforms.
So, the greatest sanctions risk is a long term one; that nation-states that desire to displace the U.S. dollar as a global trading currency might do so slowly, by creating a functioning parallel value-transfer system that does not move U.S. dollars or go through New York City. This would be an alternative to the SWIFT infrastructure that is essential to transferring funds today. Such a system would not respond to the current sanctions enforcement playbook.
The U.S. Should Not Rest on its Laurels
The best U.S. strategy against this may be counter-intuitive. It is not to try to stop the proliferation of these nations’ blockchain projects. That would be ineffective due to their reliance on open-source protocols. Rather, the U.S. should increase its own influence within blockchain-based finance by expanding American expertise in these new systems, just as U.S. adversaries are doing. Also, although it is unclear how a true “blockchain SWIFT” would work in practice, the U.S. should take the lead now in setting technical standards for blockchain protocols used for large-scale international commerce. Standards should include requiring layers for anti-money laundering and combating the financing of terrorism. The U.S. and its partners should dissuade nations from joining any blockchain banking platform that emerges without such standards.
Before the U.S. can do that, it first needs to do two things: One, the U.S. government should assess the status of blockchain technology development by key U.S. adversaries like Russia, China, Iran, and North Korea. Second, America should develop a National Digital Currency and Blockchain Strategic Plan that maps out ways to ensure that American firms, talent, and government agencies stay ahead of the potential cryptocurrency curve. Recently, U.S. Federal Reserve governor Lael Brainard expressed her confidence that the dollar will remain the world’s dominant reserve currency. Let’s hope such sentiments do not lead to complacency. If they do, the cat and mouse game could instead turn into the fable of the tortoise and the hare.