The war in Ukraine threatens the global financial system

Fourteen years ago, Zoltan Poszar, an analyst at Credit Suisse, discovered the power of financial contagion. At the time, he was working at the Federal Reserve investigating the plumbing of the credit world.

When Lehman Brothers collapsed in 2008, he saw how unexamined interconnections in the market’s financial “pipes” could generate unexpected shocks, particularly in the triparty buyout business (where short-term loans are made against guarantees between several parties).

Now, however, Poszar wonders if a similar chain reaction could occur as a result of Western sanctions against Russian institutions. “We are dealing here with pipelines – financial and real”, he recently told customers. “If you block streams by doing [Russian] banks unable to receive and send payments, you have a problem [like] when a tri-party clearing bank failed to return the cash to the money market funds for fear of ending up with intraday exposure to Lehman.

Investors should take note of this. Fortunately, there are no signs of serious trouble in these financial pipes right now, let alone a Lehman Brothers-style shock. Yes, there are signs of stress in some corners of the market; the spread between the price of spot Bunds and derivatives, say, greatly expanded (apparently because investors grab securities that they can use as collateral in trades).

Shares of European banks sold off, amid fears over their loan exposures to Russia. There are concerns that some emerging market funds are dumping non-Russian assets to cover losses on frozen Russian holdings. And there’s also gossip among traders about whether dramatic swings in commodity prices or interest rates have caught some over-leveraged hedge funds on the wrong foot; memories of the 1998 collapse of the long-term capital management fund are rekindled.

Yet what is perhaps most remarkable about the markets this week is how smoothly they continued to operate in the face of unprecedented financial “shock and awe”.

This could be explained by the fact that the overall scale of Russian financial assets is relatively small compared to the global financial system as a whole. However, another important factor is that Western regulators and investors are more adept at dealing with shocks than they were before 2008 – precisely because they have had so much practice with the financial crisis, the Covid and a decade of quantitative easing. It has become almost normal for risk managers to imagine six (once) impossible things before breakfast, to paraphrase Lewis Carroll.

However, it would be dangerous to be too complacent. One of the reasons is that the full impact of the sanctions has not yet been felt in the system; the formal exclusion of seven Russian banks of the Swift messaging system does not go into effect until March 12. Another is that we simply don’t know how a Russian asset freeze will affect interconnected contracts.

The main point that investors should understand, notes Adam Tooze, professor at Columbia University, is that “the accumulation of reserves by Russia, like the accumulation of reserves by other oil and gas producers such as Norway or Saudi Arabia, is a source of financing in Western markets – [and] part of complex chains of transactions that can now be jeopardized by sanctions”.

It is difficult to accurately track the nature of these chains, as cross-border data on financial flows and counterparties are incomplete. Take, for example, the situation around US Treasuries. In the spring of 2018, it was widely reported, based on US Treasury data, that the Russian central bank had sold $81 billion of its $96 billion in Treasuries, ostensibly to avoid future sanctions. It seemed dramatic.

However, Benn Steil and Benjamin Della Rocca, economists at America’s Council on Foreign Relations, later did a forensic analysis from different national databases. From there, they decided that $38 billion of those Russian holdings simply disappeared from US records; Russia had apparently “moved [the bonds] outside the United States to protect against American seizure” – mainly to Belgium and the Cayman Islands. We don’t know if they’re still there, Steil told me.

Yet, while these flows are opaque, Poszar also scoured (various) obscure databases, aiming to track both the $450 billion in non-gold foreign exchange reserves on the bank’s books Russian central, and the estimated $500 billion in liquid investors apparently held by the Russian private sector.

This leaves him guessing that the Russian players have “just over 300 billion dollars [held] in short-term money market instrumentsoutside of Russia and “about $200 billion represents the lending of US dollars in the foreign exchange swap market.” How these contracts (and other interrelated derivatives transactions) will be treated in the face of sanctions is unclear; corn lawyers are scrambling right now to find answers.

Don’t get me wrong: in pointing out the risks of this financial pipeline, I’m not predicting a Lehman shock. Nor am I suggesting that these dangers are a reason for the West to roll back sanctions. Rather, what I mean is this: financial warfare, like real variety, creates unpredictable aftershocks and collateral damage. It would be naive to think that this will only affect Russian players.

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Don F. Davis