What do sanctions mean for the future of decentralized finance?

Decentralized finance (DeFi) has emerged as somewhat of a double-edged sword. While this technology can foster greater financial inclusion and bring unprecedented efficiency benefits, it has also been criticised as a tool for rogue actors – and in the case of the invasion of Ukraine – the evasion of sanctions.

With blockchain in the midst of updating global finance, now is the time to examine how DeFi instruments might impact the sanction process. This is a thought experiment since many of these instruments are still developing and may change design as they go forward. By considering the consequences, we as an industry can begin to envision the framework we need to build to make sure DeFi contributes to a resilient and sustainable digital financial ecosystem.

SWIFT’s removal of Russian banks from its network was heralded as an important step in the ramping up of financial sanctions, but its effectiveness has been questioned. SWIFT is a major channel for financial institutions to exchange authenticated messages, but it is not the only channel. Many banks – particularly in emerging economies that are not members of SWIFT – are still able to transact, albeit using costlier and slower methods.

Network restrictions and sanctions are complimentary forces. Sanctions do the actual work of disincentivising actors from doing business with targeted Russian entities, while network restrictions make it more difficult to do so. Iran’s removal from SWIFT in 2012 combined with sanctions, for example, led the country to lose almost half of its oil export revenues and 30% of foreign trade.

The question for the future is: in the absence of centralised networks like SWIFT, what levers do we have to support sanctions against rogue actors? This is where blockchain enters the mix.

Blockchain networks allow members to transfer value in a way that cannot be censored by an intermediary like SWIFT. However, blockchain’s decentralized nature makes it more difficult to intercept payments between rogue actors. A future framework must consider how this important activity could be replicated for blockchain based value transfers. Regulators across the board are subsequently fast-tracking regulation on cryptocurrencies to tackle exactly these problems.

The notion of using cryptocurrencies to break sanctions is not new. North Korea and Iran have both used cryptocurrencies in the face of financial restrictions, and Russia is well placed to follow their lead being the third-largest country in the world for Bitcoin mining.

Even so, in 2022, it is unlikely that cryptocurrencies offer Russian institutions a primary means of evading the sanction process.

At a national level, the need to liaise with regulated financial institutions makes it unlikely that cryptocurrency could be substituted for other currencies in the financial settlement process. The high-risk weighting of holding cryptocurrencies at regulated financial institutions means that few, if any, are set up to settle accounts in it yet. Even the Russian Central Bank had previously warned financial institutions against facilitating such transfers.

If we anticipate a future where cryptocurrency is a commonly used payment method, network design must consider how sanctions could be applied. Although regulated exchanges are currently limiting transactions with known sanctioned entities, some will inevitably slip through the net, with no guarantee that every wallet address attached to a sanctioned user has been included.

The industry must therefore search for alternative solutions, such as the auditing of wallets held by authorised entities. Such a programme could be informed by the Authorized Economic Operators programme, in which wallet holders agree to provide attestations that link their legal identities to their wallets in exchange for benefits such as the ability to make large corporate transactions.

Most countries are only in the exploration phase when it comes to central bank digital currencies (CBDCs). However, any future where CBDCs are widely used must take into account two design considerations in relation to the declining use of physical cash and the freezing of Russian central bank assets.

The first is that a CBDC could reduce the burden of physical cash in times of crisis. If currency was token-based instead of paper, Ukrainian and Russian citizens would not need to line up and queue at ATMs to withdraw money but could instead access their holdings seamlessly and instantly. In this case, a CBDC would need to be available offline whether the electricity was on or off, given Russia’s history of hacking Ukraine’s electrical grid.

The second is the potential for a CBDC to optimise the process of freezing rogue state assets, since the issuer retains control over the currency at all times. In this sense, were reserves held by the Russian Central Bank denominated in CBDC US dollars, the US Federal Reserve could freeze those assets and technically prevent them from being spent. This means that access to CBDC networks is controlled, making the process of sanctioning a rogue actor both faster and wider reaching.

The invasion of Ukraine is indicative of what major conflicts are likely to look like from now on, meaning it is more important than ever to consider the application of blockchain technology.

Cryptocurrencies are making sanctions less effective, and while these alternatives to fiat currency are unlikely to mitigate the impact of sanctions entirely, future regulation must consider how a government might restrict certain types of actors and transactions.

This same technology can also play a central role in the post-conflict rebuilding process. When recovery begins, there will need to be transfers to citizens to aid in rebuilding, and CBDCs would be a way to do this in a targeted and efficient way.

With ordinary citizens being caught up in the Ukraine conflict, governments and corporates alike must strongly consider the humanitarian implications of today’s technology decision-making. Only this way will the global community be able to guarantee not only the future efficacy of sanctions, but also that citizens have safe and secure access to their assets.