De-risking: Show Me the Money

On the one hand, with trillions of dollars at stake, it’s no wonder that wealthy countries will take whatever steps are necessary to ensure that their financial sectors are protected from competitors. On the other hand, much of the wealth they seek to ‘protect’ is accumulated from international trade and the global nature of the financial system as a whole. So, while larger countries will typically adopt relatively non-aggressive foreign policies towards their equally powerful counterparts in order to preserve the peace among one another, when it comes to small countries, particularly economically developing ones, they have much less incentive to engage in fair play.

Reputational Attacks

By far the most common way for those in large countries to strike out against their smaller neighbours is to accuse them of being inherently suspicious and below board. Somerset Maugham once described the French Riviera as a ‘‘sunny place for shady people’’, but nowadays that phrase is more often used to impugn the reputations of small countries, often found in tropical locales in the Caribbean and the Pacific, as havens for criminal activity. After all, how could a small country compete with Wall Street or the City of London unless they were catering only to money launderers and other criminals?

If reputational attacks were the only arrow in the quiver of wealthy countries, however, then they could be largely disregarded. Unfortunately, financial industries and national governments are often so intertwined that, in most countries, it’s challenging to tell where one begins and the other ends. With the powerful governments of wealthy countries at their disposal, financial industries have a number of effective weapons to use against their competition in what they regard as upstart countries. One of these is the blacklist of ‘non-compliant’ countries published by the Financial Action Task Force (FATF), which is housed at the OECD, supposedly for the purpose of combatting money laundering. Another is the European Union’s global list of countries that have the audacity to levy insufficiently high enough taxes (the EU list of non-cooperative jurisdictions for tax purposes). Despite all of this, however, the most powerful weapon of all is the prospect of disconnecting a small country’s financial system from the rest of the international system. In this era of globalisation, this is effectively a ‘death penalty’ for a national economy.

One reason that this is possible is that banks in small countries are, themselves, account holders at banks in major countries. In order to facilitate deposits, international payments, and related services in major trading currencies, such as the US dollar and Euro, banks in other countries have accounts at a major bank in the US or EU. These are known as ‘correspondent accounts’ and are a major vulnerability for banks in small countries as, if they are unable to access such accounts, their own account holders are effectively barred from holding value or making transactions in major currencies. When correspondent accounts are closed by upstream banks, smaller banks rarely remain in business for much longer.

De-Risking – But for Whom?

When executives at correspondent banks perceive that they may come under fire politically for maintaining the correspondent accounts of banks in countries facing sanctions by multilateral institutions, they may react to that risk by closing the correspondent account. We call this drastic approach to mitigating political risk, ‘de-risking’. However, as a term which implies that all risk has been removed from the situation, it leaves a lot to be desired. In fact, in such situations there are three different parties who are facing risk in three different ways. The correspondent banks are facing political risk by maintaining the downstream relationship. The downstream banks also face risk, and existential risk at that, because without those correspondent accounts, they cannot function. This particular threat is not eliminated, but rather realised when de-risking occurs, and this risk trickles all the way down to the end account holder – the third party in the equation. There are many reasons why individuals choose to bank internationally or otherwise use financial services based in countries other than their own, but none of them matter if the financial institution they use is forced to close due to having been disconnected from the rest of the world. After all, what good is a tax optimisation strategy that reduces the amount one might otherwise have to send to a government treasury, if the money saved disappears in a bank failure?

De-risking is one of the biggest problems facing the Caribbean, in particular – where countries are extremely small and have little clout in the international system to defend themselves from spurious claims made by multilateral institutions. Ironically, excessive de-risking can be antithetical to its alleged purpose which is the elimination of the financing of terrorism and other atrocities. By pushing countries out of the international financial system, it becomes more difficult to catch criminals, not less. You may have heard the phrase ‘follow the money’; in an international financial system where every account is connected to its real world owner and every transaction is assiduously tracked, ‘following the money’ is not particularly difficult. It’s a lot harder to follow money, however, when it's being loaded into backpacks and briefcases in packs of $100 bills. If anything, one might expect that if a country’s financial institutions were involved in money laundering, the last thing multilateral institutions would want to do is sever connections and flows which are so easily monitored by law enforcement.

Nevertheless, as de-risking seems to be the response of choice to the perceived risks of terror financing and money laundering on the part of banks in larger countries, we must ask what our other two stakeholders can do to minimise or mitigate their own risks. What can financial institutions in small countries do to defend themselves from being cut off? And what can individuals do to hedge against the possibility that financial institutions in their preferred jurisdictions might disappear? In both cases, one answer might be increased use of cryptocurrencies.

Cryptocurrencies as a Solution

While many of the most talked-about cryptocurrencies (Bitcoin, Ethereum etc) are infamous for their price volatility, there also exists a different, much less volatile category of cryptocurrencies, called stablecoins. These cryptocurrencies are designed to track a particular currency or asset with a price that never varies, similar to an index fund or a pegged currency, whilst retaining the inherent advantages of cryptocurrencies – that is to say, their decentralised and immutable nature. Stablecoins might be a viable way for international financial institutions in small countries to survive being de-risked by their correspondent banks because they would provide an alternative means to holding a balance in major currencies (such as the US dollar, the Pound Sterling, the Euro, and others) whilst being resistant to politically-motivated interference. The use of stablecoins might not be as convenient for individual account holders as a correspondent account, particularly when making international transactions, but as a guarantee of a store of value, they may be equally suitable.

Stablecoins may also help mitigate any harmful effects of another method of control being pushed by policy makers who want to centralise every aspect of our lives; the ‘war on cash’. As countries seek to reduce the amount of cash in circulation, perhaps even with the hope of someday eliminating it altogether, people are being pushed to use credit and debit cards for purchases – so that their every financial move, however small, may be tracked. While different cryptocurrencies are built with privacy as a greater or lesser focus, those cryptocurrencies which are appropriately designed will easily resist that sort of tracking.

This raises another question, however. In a world where stablecoins make it easy to hold a balance of the equivalent to various major currencies, without recourse to banks in one's country of residence, does one still need a bank account at an institution in a second country at all? Could the rise of stablecoins mean that rather than trusting banks on distant shores, savvy investors might be able to be their own offshore bank, as it were? In fact, in the long run, it may be reasonable to ask whether stablecoins represent as much of a threat to international financial institutions as de-risking does.

That’s not to say, however, that stablecoins are the only cryptocurrencies that internationally-minded investors should consider. Despite the name, cryptocurrencies are far more than just a medium of exchange; they represent a whole, new category of asset class. The volatility of Bitcoin and related cryptocurrencies indicates growing pains, true; but for all but the most conservative investors, they are increasingly considered a normal and sensible addition to a diversified portfolio. Indeed, cryptocurrencies, with their many useful characteristics, and in particular, their resistance to political currents and instability, could be an important tool in the individual’s personal approach to de-risking.

All aspects of the international financial system, and indeed business in general, are to greater or lesser extents predicated on financial risk and return. For institutions and individuals, cryptocurrency, which may have once been considered a risky area, is becoming an increasingly safe bet. While, in the short term, the price of cryptocurrencies continues to fluctuate, as digital assets and fintech become ever more commonplace, and governments and international institutions begin to further incorporate digital finance into regulation and policy, we can only expect cryptocurrencies to become an increasingly formalised aspect of the financial system.

Such a change would certainly agitate the status quo thus presenting a risk for the economic giants that dominate the current system. For smaller, less economically powerful states, such as those in the Caribbean however, the potential of cryptocurrencies is to offer myriad opportunities for greater financial inclusion and growth.

Adella Toulon-Foerster
Adella Toulon-Foerster LLB (hons), LLM, is an early adopter of cryptocurrencies and the founder of the St. Lucian based Nakamoto Group which works closely with regional Caribbean and North American law firms and advisory groups. The group focuses on multi-jurisdictional corporate governance, regulatory compliance and clarity for tech and cryptocurrency based projects and platforms. Ms Toulon-Foerster can be contacted at: adel.la