What exactly is the SWIFT banking system?

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Listener Jared Evans asks:

What is SWIFT banking system? How would countries remove Russia from it? What effect would that have?

The European Union announced on Wednesday that it will bar seven major Russian banks from using the SWIFT financial messaging system and may exclude more, depending on Russia’s future actions.

SWIFT, which stands for Society for Worldwide Interbank Financial Telecommunications, allows banks to transmit information about financial transactions between each other.

Russian banks including Bank Otkritie, Bank Rossiya, Novikombank and VTB Bank will be excluded from SWIFT from March 12.

Russia launched its full-scale invasion of Ukraine last week, causing at least 227 civilian deaths and prompting 1 million people to flee the country. In response, nations around the world have imposed sanctions against the country.

Investments in projects co-financed by the Russian Direct Investment Fund will also be banned and euro banknotes will not be supplied to Russia, according to the EU. RDIF is a sovereign wealth fund, although the US Treasury Department says it is “considered a fund two for President Vladimir Putin and is emblematic of Russia’s broader kleptocracy.”

The EU said the sanctions adopted against Russia, which include a ban on SWIFT, will lead to “massive and severe consequences” for the country.

How does SWIFT work?

Belgium-based SWIFT went into operation in 1977 and replaced telex machines, noisy typewriter-like devices that used telephone circuits to send text messages.

Now, over 11,000 financial institutions in over 200 countries and territories use SWIFT. Last year, an average of 42 million SWIFT messages were sent per day.

Banks in the SWIFT system have a code or number, consisting of 8 to 11 characters, which identifies them.

As the payment operations platform Modern Treasury explains: Let’s say you want to send a wire transfer via SWIFT to someone who lives in Tokyo. To make this payment, you will need a series of information, including the amount sent and the Japanese bank’s SWIFT code. Your bank will send this information and once the receiving bank has this information will deposit the money.

“Later, both institutions will settle the payment, which means they will adjust their account balances to reflect the transfer,” says Modern Treasury.

It’s not a system that frees up business, said Paolo Pasquariello, a professor of finance at the University of Michigan.

“It’s just a system through which financial institutions communicate,” explained Pasquariello.

However, he said SWIFT is important because when banks are transferring money to other banks, they need to communicate to the other party with certainty about the amounts being sent (along with other pertinent information).

SWIFT is used for 70% of transfers in Russia, according to Reuters.

“The fact that these [Russian] banks are now excluded from SWIFT means that these banks cannot use this near-instant communication device to talk to banks outside Russia,” said Pasquariello.

What effect will the SWIFT ban have?

Experts say transactions will become more difficult, but not impossible.

Randall Henning, a professor of international economic relations at American University, said this ban does not mean Russian banks are barred from “accessing international markets or doing business with Western banks.”

But what that will do, he explained, is increase the cost and increase the time involved in carrying out these transactions.

Pasquariello and Henning said banks can still answer the phone or send a fax, but that brings complications.

For example, “now you have to pick up the phone and someone with an Italian accent has to speak English to someone with a Russian accent,” Pasquariello said.

This turns what was “an almost frictionless transaction” into one with the potential for misunderstandings, errors and delays, he added.

Pasquariello said that before becoming a professor, he worked in finance, and every time he made a trade, his phone calls with brokers and dealers had to be recorded.

“Lawyers on both sides had to listen to my awkward phone conversations when I spoke English with an Italian accent,” he said.

Pasquariello said they were confirming information such as the price they had agreed upon.

“SWIFT ensures that this information is communicated quickly and accurately to both parties,” he noted.

Some banks will not be banned from SWIFT

Reuters reported that EU SWIFT sanctions will not apply to banks handling energy payments, a decision that has drawn backlash from government leaders such as Polish Prime Minister Mateusz Morawiecki.

“As Poland, we demand that all Russian entities, thanks to which Russia finances the war in Ukraine, be effectively and fully covered by sanctions,” Morawiecki said on Facebook.

Henning explained that Western Europe is not willing to do this now because of its dependence on Russian natural gas and oil.

“Once they have made energy policy changes and found alternative sources of energy, then they can start to reduce their dependence on Russian oil and gas,” said Henning.

More than 40% of the EU’s natural gas supply comes from Russia.

“The reality is that it is very difficult to overhaul a power system overnight. You just can’t,” Nikos Tsafos of the Center for Strategic and International Studies told Marketplace last week.

Pasquariello said the EU “doesn’t want to use all the financial weapons at its disposal” at once, although it may ban these banks from using SWIFT in the future.

Does Russia have a workaround for SWIFT?

This week, the Central Bank of Russia said it will replace SWIFT with its Financial Message Transfer System, or SPFS, established in 2014.

“It remains to be seen whether this is a solution to their problem or not. It is unlikely to reduce the cost of dealing with Western banks and other institutions,” said Henning.

Marketplace reported that China’s cross-border interbank payment system, also known as CIPS, is a potential alternative to the global SWIFT payment system.

“China’s CIPS connects participants inside and outside China to trade or invest, and then settles those transactions using Chinese yuan,” explained Jennifer Pak, Marketplace China correspondent.

However, Pak said that while “it’s feasible in theory,” it still isn’t in practice. This is partly because the Chinese currency is not as popular as other currencies. In January, only 3% of global payments on the SWIFT network were in Chinese yuan.

Other sanctions include freezing Russian central bank assets in the United States and banning technology exports to Russia.

We are already starting to see the effects of these sanctions. The value of the Russian ruble dropped to a record low as people in the country rushed to ATMs to withdraw cash.

Pasquariello pointed out that while some financial institutions can still technically do business with their Russian counterparts, even if they have been cut off from SWIFT, they may be reluctant to do so anyway.

“Whether over the phone or by fax,” he said.

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