Payment systems’ changing role from economic growth to the new foreign policy lever

This paper analyzes governments’ usage of payment systems to achieve non-economic policy objectives. Payment systems are primarily thought to function to maximize economic growth. The U.S. dollar’s status as world reserve currency provides America a unique ability to use the payment system to achieve national objectives besides economic growth. America has increasingly relied on the payment system to achieve non-economic objectives, mostly in the realm of foreign policy but not exclusively. The paper analyzes the growing usage of payment systems as a tool for projecting international power and achieving domestic political goals, with a focus on the Western response to Russia’s recent invasion of Ukraine. The paper concludes by discussing the ramifications of increased reliance on the payment system for the projection of American foreign policy, including China’s development of an alternative payment system and the rise of cryptocurrency as a new payment system.

Payments are part of the economy’s backbone, essential for settling transactions and conducting trade. Increasing trade between nations further enhances the importance of international payment systems. Inherent tensions in payment systems exist between their role in facilitating trade and commerce and a government’s ability to use payment systems to achieve policy objectives. This tension exists both internally with respect to domestic social policies and commerce and internationally with respect to foreign policy and international trade. This paper analyzes the structural causes of these tensions, their tradeoffs, and how they have evolved in the given global financial system. The paper finds that the dollar’s status as the world reserve currency gives the United States unique leverage. The paper further finds that the U.S. is increasingly using payment systems as a tool for policy objectives, both domestically and internationally. This is particularly the case in response to Russia’s invasion of Ukraine. The paper discusses the implications of America’s usage of the payment system to project international power and considers the potential implications of the development of alternative payment systems as a consequence.

The paper is structured in six sections. Following the introduction, the second section provides background on the definition of money, payment systems, and the role and evolution of payment systems with a focus on the history of the pound and dollar as the global reserve currencies. The third section details the United States’ centrality in the current global payment system. The fourth section analyzes how America uses the payment system as a tool for achieving domestic and foreign policy objectives outside of, and sometimes in conflict with, maximizing economic growth. The fifth section explores the ramifications of these decisions, with particular attention to the current war between Russia and Ukraine. The final section considers potential threats to the U.S. centrality in global payments, particularly the rise of non-nation-backed cryptocurrency.

What is money?

Payment systems are methods to exchange money. Money is often defined as a medium of exchange (University of Minnesota 2016). Not every economist is satisfied with this definition; Friedman’s (1991) study of the role of the Fei (stone money) in the Pacific islands supports a different definition. In this paper, I will use Martin’s (2015) definition from his book “Money: The Unauthorized Biography—From Coinage to Cryptocurrencies,” which describes money as a system of debits and credits that allow for third-party acceptance without prior party consent. This definition is consistent with Friedman’s insights on the ability of the Fei to function as money even when the physical manifestation of money had been lost. Using this analysis helps frame money in a broader context and increases the centrality of the payment system as an inherent element of money. In both definitions, in order for money to exist, there must be a mechanism by which it can be exchanged. Thus, for money to exist, there must be a payment system.

In early times, the payment system was as simple as physical exchange. However, as Friedman shows, physical exchange was not necessary for money even in primitive societies, as long as a record system of debits and credits was established and mutually honored. This record-keeping function of the payment system is part of what makes money. It places the payment system as both a system by which money is moved and as a prerequisite for money to exist.

Payment systems

Payment systems are structures that facilitate payments. A payment is an exchange of value, usually money, between two or more parties. A payment can be thought of as having two distinct elements: the transmission of funds and the corresponding information. The transfer of funds is the actual movement of money between parties. The information necessary to complete this includes who is paying whom, how much, when, and through which accounts or intermediaries. The flow of information is separable from the flow of funds, an important foundational concept in understanding payment systems. Some payment systems are informational (SWIFT), whereas others combine information and flows of funds (ACH) (Stripe 2023).

Payment systems generally experience network economic effects (Deloitte 2019). Each additional member of a given payment system adds positive marginal value to existing members. This increases the economic value to size, promoting large-scale and universal acceptance as properties that users desire. Payments can also have network or agglomerative economic externalities, in which the addition of a new payment system provides positive value to direct competitors (Committee on Payments and Market Infrastructure 2016; Johansson and Quigley).

The rise and fall of British sterling as the center of global payments

Sparked by a confluence of British constitutional, agricultural, and commercial revolutions, the Industrial Revolution in the 18th century established British dominance in international finance (Davies 2002, 238). The pound sterling, which had been used for centuries within England, took on new prominence. Harrod (1952) identifies several reasons for sterling’s dominance, helping secure its position at the forefront of the payment system. The first was widespread British foreign trade and investment (Harrod 1952). Pounds were used as payments throughout the British Empire, which spanned the globe. The second was “absolute confidence in its stability,” (Harrod 1952, 1) helped by the British formalization of the gold standard in 1816 (Dick 2013). By the mid-1800s, Britain’s gold standard had “become the British Imperial Standard and, in the last quarter of the century, the International Gold Standard” (Davies 2002, 356). One estimate states that around 60% of world trade was settled in sterling between 1860 and 1914 (Eichengreen 2005, 4).

The onset of World War I was the “virtual end” of this Anglo-centric “system of national and international payments” (Davies 2002, 284). The British government took substantial debt during the war, devaluing the pound, and by 1919, exports of gold were prohibited, making convertibility into gold unfeasible. Fearful of a devalued pound, the Bank of England raised interest rates in the mid-1920s while Parliament brought back convertibility under the gold standard (Wang 2011, 30). With the onset of a financial crisis at the end of the decade, due to public panic withdraws, the Bank of England had a run on gold reserves and was forced to abandon the policy in 1931, and “willingness to hold the pound… was accordingly sharply reduced” (Wang 2011, 30). This opened the door for other currencies to take its place.

Differing opinions exist as to when this shift occurred. Some argue that the sterling’s importance continued well past World War I, with Paul Krugman characterizing it as having “surprising persistence,” (Krugman 1984, 274) and Catherine Schenck (2011) writing that only after the British entrance to the European Economic Community in 1971 was it “necessary for the U.K. government to be publicly explicit that sterling’s reserve role would be eliminated as soon as possible” (Schenck 2011, 6). By contrast, Chitu, Eichengreen, and Mehl (2012) argue that the dollar overtook sterling as the international leading currency as early as 1929, while others note the shrinking British share in global trade and industry.¹

Regardless of when the decline of the pound began, there is broad agreement that it is no longer the world reserve currency, nor does it play a central role in global trade. Today, central banks only hold 5% of their reserves in pounds (Arslanalp, Eichengreen, and Simpson-Bell 2022). The United Kingdom remains a major hub for global finance with London in particular, playing a central role in financial markets. Financial institutions in the U.K. play a large role in payments, processing more than 50% of all European inflows and outflows with the Americas and Asia-Pacific region (Swift 2015, 6). This is particularly interesting given the U.K.’s decision to not adopt the euro as its local currency, and the recent Brexit from the broader European Union.

The United Kingdom’s experience as the nation-state with the global reserve currency is illustrative for several reasons. First, it shows the confluence of economic and military power in determining the global reserve currency. Although the U.K. itself was only responsible for 8.2% of world GDP in 1913, the broader British empire produced nearly 20% of world GDP (De Keersmaeker 2017, 90). The size and breadth of the British empire combined with its advanced financial center in London and its openness to trade created the necessary conditions for the centrality of the pound. The decline in the British empire and financial and economic turmoil after World War I created an opportunity for another nation’s currency to replace the pound. As we will see, the United States stepped right in.

Rise of the U.S. dollar as the international reserve currency and a medium of exchange

The United States dollar rose to replace the pound sterling due to a combination of economic, military, and structural reasons. America lacked a central bank for most of the 19th century and into the 20th. The establishment of the Federal Reserve System as America’s third central bank in 1913 increased liquidity in American financial markets (Eichengreen 2005, 8). Unlike the U.K., the U.S. maintained the dollar’s convertibility into gold for decades after WWI and its aftermath. This led “to a considerable expansion in the dollar’s role as a unit of account and means of payment for international transactions” as conventional thought at the time valued the linkage to gold (Eichengreen 2005, 9). America’s economy grew strongly during the first part of the 20^th century, particularly with respect to the new industrial sector. America’s share of global industry grew from 31% to 39% from 1900 to 1930 (Wang 2011, 31).

While America entered WWI in favor of the eventual winning side in 1917, the war was never fought on its soil. WWII followed a similar pattern with relatively little direct combat occurring in America. As a result, after each war, the U.S. economy was well positioned to expand. Multiple military victories further enhanced America’s geopolitical standing. While the same can be said for the U.K. in terms of military victory, the two wars, particularly the second, involved substantial physical degradation of U.K. territory and decreases in international holdings of land (Broadberry 1988). In contrast, America expanded its territorial holdings during and after both conflicts.

The dominance of the U.S. dollar following WWII was institutionalized in the 1944 Bretton-Woods agreement (Schenk 2011, 4). Under this system, the dollar was pegged to gold at $35 an ounce, and other countries pegged their currencies to the dollar (Mele 2012), cementing the dollar as the leading method of exchange. Ultimately, America abandoned this aspect of the agreement as President Nixon abandoned the gold standard in favor of free-floating exchanges in the early 1970s (Office of the Historian n.d.). However, by that time, convertibility into gold had ceased to be a primary concern for the stability and value of a currency (Authers 2021).

Floating exchange rates became the norm for most developed, free-market economies (IMF Staff, 2000). While advanced free-market countries agreed to allow their currencies to float freely (mostly, with notable government interventions periodically including the Plaza Accords of 1985) there was demand for one currency to function as the base for global trade. The dollar effectively fills that role (Bertaut, Beschwitz, and Curcuru 2021).

Globally, central banks hold 59% of reserves in U.S. dollars, though this figure has declined in recent years, compared to the next closest in euros at around 20% (Arslanalp, Eichengreen, and Simpson-Bell 2022). As a dominant currency’s store of value and its role as a unit of account “mutually reinforce” one another (Gopinath and Stein 2021, 6), the dollar also remains the primary method of exchange. According to SWIFT data, by value, the dollar accounts for 79.5% of payments in international trade, (Swift 2015, 8). Additionally, over the period from 1999 to 2019, the dollar accounted for 96% and 74% of trade invoicing in the Americas and Asia-Pacific regions, respectively (Bertaut, Beschwitz, and Curcuru 2021). Further reinforcing the demand for dollars, about one-half of the cross-border loans and international debt securities are denominated in the dollar, including transactions where neither the borrower nor the lender is based in the U.S. (Committee on the Global Financial System 2020). In support of the dollar’s global role in finance and the potential for shocks to the global market to affect the U.S. domestic financial system, the Federal Reserve implemented Central Bank Liquidity Swaps at the start of the financial crisis in 2007. The swap lines, which alleviate shortages of dollars in select foreign markets, were heavily used during the crisis and at times since then, including during the pandemic “dash for cash” in early 2020.²

The current global payment system runs through government-chartered banks. These banks are empowered by their governments with the ability to create and store money. Specifically, a system of fractional reserve banking, by which banks are able to leverage capital to create and offer money to consumers and businesses, coupled with deposit insurance provided by governments has created substantial confidence in banks to store, create, and transmit money. Banks are generally networked domestically to their nation’s central banks and internationally, both directly to each other, through networks of connected central banks and through networks of global banks. Broadly speaking, these form the correspondent banking system which dominates the current payment system.

Correspondent banking system

According to Boar, Rice, and von Peter (2020), the “bulk of payments flows through correspondent banks that operate a vast network of bank relationships” (1). Under this structure, one bank, the correspondent, holds deposits owned by another bank, the respondent, and provides those banks with payments services. The idea of banks facilitating interjurisdictional transactions dates to at least 14th-century Venice (Dunbar 1892). An international network of correspondent banks began to emerge in the late 1800s, following greater globalization and communication ability, and expanded into the 20thc entury (Boar, Rice, and von Peter 2020, 38). One study put the number of correspondent banking relationships in the 1930s at over 2,000—predominantly in New York and London (Merrett and Panza 2019).

Scholars have highlighted flaws and inefficiencies in this structure. For example, A. Abbadi, Zyoud, and S. Abbadi (2011) pointed out exchange rate volatility, foreign government blockage of fund transfers, and the possibility of correspondent banks assigning low priority to certain respondents. Likewise, there can also be time delays as a result of different operating hours, creating settlement risk and potential liquidity issues (Committee on Payments and Market Infrastructure 2022). Finally, differences and complexities in international anti-money laundering (AML) and know-your-customer (KYC) laws can cause delays in payment settlements and add expense to transactions (Agudejo and Iken 2017). There is evidence that correspondent banking relationship numbers have decreased recently, with the decrease often attributed in part to banks “de-risking” to reduce the potential exposure to fines for violating anti-money laundering and combatting the financing of terrorism rules (Boar, Rice, and von Peter 2020).³ As banks pull back, fintechs and decentralized instruments, like stablecoins, may also soon play a larger role in international settlements (Carstens 2020). Thus, while correspondent banking is and has been the main global payment system for the present and recent past, there are new technologies and other pressures for alternative systems to potentially take root.

Cross-border payment technologies and services

There are several technologies and services commonly used in international settlements over which the United States holds influence:

SWIFT

SWIFT, or the Society for Worldwide Interbank Financial Telecommunication, is a messaging network that initiates international payments. Founded in 1973, it is connected to over 11,000 institutions in over 200 countries and territories worldwide (Swift 2023b). Of the about $140 trillion transmitted across borders in 2020, around 90% was transmitted through SWIFT (The Economist 2021). The service is overseen by a select group of central banks (of which the Federal Reserve is one), as well as the European Central Bank (Swift 2023a). Despite that SWIFT is headquartered in Belgium and that “U.S. banks are only minority shareholders in the organization,” the United States holds substantial influence (Eichengreen 2022, 2). As former SWIFT executives Gottfied Leibbrandt and Natasha de Teran stated in an interview:

“The dollar plays a crucial role in payments, where it denominates close to half of all cross-border activity, as well as the lion’s share of securities and derivatives settlements and foreign exchange trades… [N]o bank can afford to lose access to the U.S. payment system. If overseas banks do not comply with U.S. sanctions, the U.S. can simply forbid its banks to process dollar transactions for them” (Farrell 2021).

Fedwire

Fedwire is a real-time gross settlement system whereby institutions that hold an account with a Federal Reserve bank can initiate transfers of funds between each other (Board of Governors 2021). The service has over 5,000 participants and is directly administered by the Federal Reserve, an agency of the U.S. government (Federal Reserve Banks 2023).

FedGlobal ACH Payments

The Federal Reserve also operates an automatic clearing house international (ACHi) as part of its broader ACH system. For years, ACHi connected the Federal Reserve with a select set of other central banks, mostly in major developed economies. FedGlobal ACH Payments had a European and G-7 focus but expanded to include Mexico given the large number of individual remittances sent between people in those countries (Federal Reserve Financial Services 2022, 12). In 2023, the Fed announced it would discontinue services to Europe and Canada, leaving only Mexico and Panama as recipient countries. Networking central banks allows banks in both countries to more effectively transact with each other even absent direct bilateral correspondent relationships. As the Federal Reserve states, “The services are intended to encourage the use of the ACH system for international payments by accelerating the clearing time and reducing the cost associated with these payments.”⁴ The Fed’s decision to reduce instead of expand ACHi services contradicts Congress’s instruction under the Dodd-Frank Act. Dodd-Frank’s Section 1073 states: “The Board of Governors shall work with the Federal Reserve banks and the Department of the Treasury to expand the use of the automated clearinghouse system and other payment mechanisms for remittance transfers to foreign countries, with a focus on countries that receive significant remittance transfers from the United States.”

CHIPS

Clearing House Interbank Payment System (CHIPS) is a netting agent for payments in dollars between parties, which clears and settles around $1.8 trillion in payments throughout the world each day (The Clearing House n.d.). CHIPS is the private sector counterpart to Fedwire, and together they are the “primary network for transferring and settling payments in U.S. dollars” (Modern Treasury n.d.). It is privately owned and operated by about 50 financial institutions including U.S. banks and U.S. branches of foreign banks (Eichengreen 2022). Given the ownership structure, the system is subject to U.S. regulations and laws. Additionally, CHIPS has been designated as a systemically important financial market utility as detailed under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (12 USC § 5463), giving the Federal Reserve heightened oversight and influence over CHIPS’s operations.

American treatment of global payments

During much of its leadership of global payments, the United States endeavored for stability largely agnostic of geopolitical or sociopolitical objectives. For one, countries typically considered adversaries were permitted access to payment technologies and services. One example is the SWIFT messaging system, enabling access to the largest network for cross-border payments, which for many years was kept open to countries with whom America was engaged in significant geopolitical tension and adversarial relations. Financial institutions in North Korea, a nation with whom the United States is still technically at war (Blakemore 2020), participated from 2001 to 2017 (Haggard 2014; Wagstaff 2017). Banks in Iran, designated a state sponsor of terrorism since 1984, were permitted to use SWIFT until 2012 (Milne 2022).⁵ The SWIFT network still includes several banks in Cuba, a nation that the United States has placed under economic embargo since 1962, a few years after its revolution.⁶ Sanctions involving global payment systems like SWIFT were very rare. As the Congressional Research Service wrote in studying America’s decisions not to use the payment system as a tool for foreign policy, “policymakers had been reluctant to do so given potential economic disruptions” (Congressional Research Service 2022, 1).

In addition to providing a more open payment infrastructure, the United States allowed other American payment corporations to operate in adversarial nations, thereby engaging adversaries into the American dominated payment system. For example, American Express opened an office in the Soviet Union in 1958, mostly to do business with foreign visitors to the USSR (Zubacheva 2020). Visa and Mastercard, two of the largest payment corporations in the world, expanded into the Soviet Union and started issuing cards through Soviet banks in 1988 (Associated Press 1988), as part of the USSR’s opening of increased economic activity with the West but before its collapse. The United States government could have blocked these expansions through various means, including Treasury’s Office of Foreign Assets Control’s (OAFC) power to prohibit transactions with individuals and countries.⁷ However, many economic sanctions during this time focused on restricting trade, such as a grain embargo implemented following the Soviet invasion of Afghanistan (Lescaze 1981), as opposed to restricting access to the payment systems. Allowing other nations to use American-based payment systems, coupled with sanctioning particular actors and actions, demonstrates an engagement strategy to bring adversarial nations into the U.S.-dominated global payment system.

Finally, the United States government directly assists many foreign countries in storing gold reserves, once the bedrock of the payment system under the gold standard and still an important mechanism for stability. The basement of the Federal Reserve Bank of New York is the world’s largest known depository of monetary gold, storing about 497,000 gold bars with a combined weight of about 6,000 tons as of 2019 (Federal Reserve Bank of New York n.d.). As of 2008, 48 central banks owned gold in the New York Fed (Mayerowitz 2008). Much of the reserves arrived following World War II, just as the dollar was becoming the world reserve currency and the United States was beginning to hold more influence over global payments (Federal Reserve Bank of New York n.d.). The Fed is private about who owns what and how much is in its vault. As former Fed Chairman Alan Greenspan stated: “When you deposit your funds in a bank, should that bank make your account balances available to whomever asks?” (Quoted in Burne 2017). However, this function of the New York Federal Reserve Bank and its widespread use serves as evidence that the United States early on sought stability in international financial and monetary systems, and by extension global payments.

The United States has incorporated payments into our foreign and social policy regimes with increasing frequency over time. This has been particularly the case with respect to foreign policy where America increasingly exerts its economic power in place of, or in combination with, its military engagement. The United States’ first Strategy on Countering Corruption highlights using AML laws as part of its tools to hold corrupt actors accountable (White House 2022, 25). Using access to financial markets and payment systems as a metaphor, it may be said that America is increasingly fighting its adversaries with bonds, not bombs.

Foreign policy

Although usage has increased as will be documented below, America has flexed its global economic power in financial markets in the past. In 1956, Egypt nationalized the Suez Canal, formerly controlled by Britain and France, and those two countries sent troops. President Eisenhower, wanting to prevent broader war in the region, threatened the unloading of considerable holdings of pound-sterling bonds onto global exchanges and directed the Treasury to bar the International Monetary Fund from offering any relief to Britain to strengthen its currency (Echevarria II 2017, 107). The move would devalue the sterling and cause a shortage of its reserves in Britain, dramatically impacting the country’s ability to conduct global payments. Ultimately Britain, as well as France, pulled out of Egypt (Bracken 2007).

This power move was blunt, but effective. It was also aimed at allies and fellow NATO members, countries with which direct armed conflict would be highly unlikely. It was an economic response involving assets and currency valuations that would impact payment operations. It was not directed at access to payments infrastructure. It also only ever amounted to a threat, never an implemented action. This underscores an important aspect of economic warfare, long acknowledged in monetary policy, that mouths can move markets. Actions need not be taken that restrict access of impact payment systems in order to achieve intended geopolitical objectives, if threats are credible. The credibility of a threat for payment systems can be markets and economic actors, not just national governments.

Direct use of the financial system for foreign policy was undertaken by the United States against Iran. After hostages were taken in the Tehran U.S. Embassy in 1979 during the Islamic Revolution, President Carter signed an executive order under the International Emergency Economic Powers Act which froze all Iranian government assets, including bank accounts, in the United States (Walsh and Goshko 1979). The United States has periodically imposed sanctions since, including the Iran and Libya Sanctions Act of 1996, which, among other provisions, placed certain limitations on how much U.S. banks could issue loans or credit in these countries (50 USC. § 1701).⁸ In early decades, though, many sanctions targeted specific parts of Iran’s economy, especially targeting the Iranian oil industry. In 2006, however, a “series of ‘targeted financial measures’ were introduced to stop foreign banks undertaking financial transactions with Iran” (Milne 2022). This was part of a series of economic actions intended to impose American political objectives on the Iranian government. Knowlton (2006) quotes then U.S. Senator Evan Bayh (D-Ind.) as stating, “’Iran is a menace they have to deal with, through economic, political and cultural steps.’ But force ‘should not be an option at this point.’”

Several years later, Congress sought again to create tougher economic sanctions against Iran. The U.S. Comprehensive Iran Sanctions, Accountability, and Divestment Act of 2010 and the National Defense Authorization Act of 2011 effectively banned all U.S.-Iranian financial transactions, and given its immense global influence, “The EU, as a somewhat reluctant partner to U.S. financial sanctions, froze the assets of Iran’s central bank in January 2012. Other countries followed suit” (Milne 2022). The United States put pressure on large foreign banks — such as Credit Suisse and UBS of Switzerland — to stop doing business with Iranian banks, through both formal actions by the Treasury’s Office of Foreign Assets Control and informal actions, given that banks face reputational risks in dealing with Iranian institutions (Bracken 2007). By 2012, Iran was off the SWIFT messaging system. By denying Iran and its institutions access to the global banking system, the United States and its allies have essentially restricted the ability to conduct cross-border payments with Iranian actors. The pressure for economic sanctions began in financial markets and moved into payment systems and infrastructure.

The United States and its allies have similarly enacted financial warfare measures against North Korea. In 2017, the SWIFT messaging system removed North Korean financial institutions from its payments services due to increased provocations (Wagstaff 2017). Likewise, after the inhumane treatment of Otto Warmbier shined a spotlight on human rights abuses in the country, Congress passed the Otto Warmbier North Korea Sanctions Act of 2019. This law imposes punishment for any organization that conducts financial transactions, or payments, with them. In May 2022, OFAC issued sanctions against two banks, an individual, and a trading company under this law, officially for supporting the county’s weapons of mass destruction and ballistic missile programs (U.S. Department of the Treasury, 2022a). The United States is actively denying North Korean actors access to the global payments system.

The United States has long imposed economic sanctions on Cuba, following Fidel Castro’s Cuban Revolution, which triggered a trade embargo, but many of these sanctions have expanded to target the payments system. For example, under the Cuban Assets Control Regulations established by the Office of Foreign Assets Control, no actor subject to U.S. jurisdiction may engage in a financial transaction or payment with someone in the Cuban military, intelligence, or security service (31 CFR § 515.209). Given that many of the global banks and services that facilitate payments are subject to U.S. jurisdiction, this rule is wide reaching. Additionally, Cuban banks may not open correspondent accounts at U.S. banks, limiting payments between Cuba and the rest of the world through U.S. banks, though U.S. banks can operate correspondent accounts at Cuban banks (See note to 31 CFR § 515.584(a)).

Most recently, the United States has cut Russia’s access to payment systems as a first line of response to Russia’s invasion of Ukraine. Following Russia’s first invasion of Ukraine in Crimea, the U.S. and Europe implemented sanctions that included asset freezes and restrictions on loans for various banks and individuals but stopped short of removing Russian banks from SWIFT, though the idea was discussed at the time (Hutton and Wishart 2014). After the broader 2022 invasion, though, SWIFT, with the backing of the U.S., voted to remove seven major Russian banks from its system, and U.S. sanctions also restrict banks from doing business with most Russian entities, while freezing U.S. treasury securities and bank notes held by the Central Bank of Russia (Eichengreen 2022, 1). This move is significant and represents a major escalation of tactics:

“The exclusion of banks from SWIFT as part of Western economic sanctions also is not new…However, never before have banks of a comparable size and degree of connectedness with the global financial system such as Sberbank been banned from SWIFT” (Nolke 2022, 2).

However, it’s worth not overstating the policy action. SWIFT did not ban all Russian banks, and given that the banks were already subject to sanctions, some like Kolhatkar (2022) doubt that the move will have a crippling effect.

Social policy

The United States has used access to the payment system for domestic social policy objectives. An early example is the Interstate Wire Act of 1961 (18 U.S.C. § 1084).⁹ The law prohibits the use of wire communication in interstate commerce to facilitate gambling. Wire communication (as evident in terms like Fedwire) is a common mechanism through which payments are initiated. The law was the embodiment of a campaign in the United States, championed particularly by Robert F. Kennedy (Kennedy 1961), against gambling and organized crime. Gambling was targeted primarily as a source of significant income for organized crime at the time (Ferentzy and Turner 2009; Schwartz 2010).

Another expansion is the Bank Secrecy Act (31 USC § 5311),¹⁰ establishing the basis for modern anti-money laundering enforcement. The purpose of the BSA has evolved from its inception to root out organized crime in the 1960s to focusing on drug trafficking in the 1980s and 1990s and then to terrorism after the attacks of September 11, 2001 (Klein and Readling 2015). The original BSA law greatly increased the government’s ability to conduct oversight over banks, so much so that a case challenging it under the First, Fourth, and Fifth Amendments made it all the way to the Supreme Court. In a 6-3 opinion, the Supreme Court upheld the law’s Constitutionality (California Bankers Assn. v. Schultz, 416 U.S. 21 (1974)).¹¹

Another example is the prohibition of online poker enacted by Congress through the Unlawful Internet Gambling Enforcement Act (UIGEA) of 2006 (31 USC § 5363). UIGEA prohibits any person or business from knowingly accepting payments in participation of another person engaged in unlawful Internet gambling (Board of Governors 2017). Congress chose to use the payment system, including banks, to capture entities subject to American regulation given the global nature of online poker. Financial regulators, including the Federal Reserve, promulgated rules that effectively covered banks serving possible gamblers, gambling companies, and payment intermediaries facilitating transactions between those two parties. This included “system operator, merchant acquirer, third-party processor, or card issuer in a card system (including credit cards, debit cards, prepaid cards, and stored value cards).” (Board of Governors 2017). The onus was placed on the banks to “establish and implement written policies and procedures that are reasonably designed to identify and block or otherwise prevent or prohibit payments related to unlawful Internet gambling that are restricted by UIGEA” (Board of Governors 2017).

The structure of UIGEA is unique among criminal enforcement mechanisms in the United States. Banks have a series of obligations under BSA and AML regimes to identify and report suspicious or illegal activity to law enforcement. However, only for the type of unlawful internet gambling mentioned under UIGEA (online poker) are banks required to proactively block, prevent, and prohibit payment systems that fund these wagering systems. The law requires the Treasury Secretary and Governors of the Federal Reserve Board, in conjunction with the Attorney General, to establish a regulatory mechanism that identifies and blocks financial transactions to unlawful internet gambling (Congressional Research Service 2012).

While UIEGA is an example of Congress legislating social policy through the payment system, there are other examples depicting the growing use of payments in policy through non-legislative actions by the government. Take the case of WikiLeaks, a site which publishes datasets and other official materials that are typically considered restricted and sensitive. In 2010, the State Department sent a letter to Wikileaks stating that its operations were illegal in the United States, prompting PayPal, fearing its own legal exposure, to halt individuals from using its services to donate to the organization (BBC News 2010). Visa and Mastercard followed suit (Greenberg 2010). Similar examples include recent attempts to combat prostitution and human trafficking through the ability of the internet company Backpages to receive payments (Garcia 2015). Additional concerns regarding the use of the payment system to purchase guns involved in mass shootings have led some to call on payment companies to prevent their purchase (Sorkin 2018). Some of these decisions were later overturned (Shanley 2013), but they still show the influence the U.S. government can wield in halting payments services to organizations to which it objects. Further raising concern in some circles about the potential for these tools to suppress political dissent was Canada’s freezing of financial accounts of some organizers of a truckers’ protest in 2022. That action is alleged to have resulted in the suspension of some individuals whose only action was to make contributions to the trucker’s convoy (Evans 2022).

Using the payment system to fight illicit activities domestically has two main outcomes. One is that preventing these industries from using the financial system to transact payments makes them more difficult to occur, raising costs and increasing barriers to conduct business. The other is that the financial system can be used as a method to detect, track, and eventually capture and convict criminals (D’Antuono 2018). A metaphor helps explain this objective: Criminals are like fish in the ocean; they swim deep to avoid detection. Crime produces profits in the form of money. This money needs to be transmitted or used. Much as air from fish at the bottom of the ocean rises to the top, so does the money required for criminal activity. Detecting and following the money can allow law enforcement to go back and find the criminals responsible.

A final element of the detection system is that the illegal usage of money can be easier to prove and merit convictions for than the underlying crime itself. For example, former U.S. Speaker of the House Dennis Hastert is in jail for anti-money laundering violations involving illegal payments to a person he was accused of sexually molesting, not any crimes regarding sexual molestation (Tarm 2018). And perhaps the most famous American example of law enforcement pursuing financial crimes as opposed to other crimes involves the gangster Al Capone, who was convicted of tax evasion, not running the largest organized crime syndicate in the United States at the time (FBI n.d.).

A core tension exists between the two objectives of the BSA of making crime more difficult and making criminals easier to detect, capture, and convict. The first pushes criminals out of the formalized banking system by discouraging financial institutions from providing services. The second relies on the provision of financial services by institutions subject to these laws to provide the data necessary for law enforcement to use these tools (Gifford, Barr, and Klein 2018). This tension helps explain why current American law largely allows banks to provide financial services to those suspected of engaging in criminal activity but requires them to report that activity.

Despite legal permission to provide services to criminals, many banks attempt to avoid doing so. Over the past decade, a number of states have rebelled against federal criminalization of cannabis, establishing a series of state-licensed cannabis growth, manufacturing, and sales operations (Weisz and Rosenblum 2021). These state-based cannabis markets have grown sharply to an estimated $13.2 billion market in 2022 (Grand View Research, 2022). State and local governments have actively engaged and promoted these markets, earning substantial tax revenue directly from the cannabis industry which remains illegal under federal law (Klein 2019).

Cannabis companies require access to the payment system and have struggled at various levels with that access. A series of hodgepodge rulings from the U.S. government (Cole memorandum) and federal bank regulators (including differing rulings from various regional Federal Reserve Banks) have made access to the banking system expensive and difficult but not impossible for cannabis companies (Hudak and Klein 2019). American cannabis companies have even been able to access public capital markets, although they have had to go overseas, primarily to Canada for public offerings (Khan 2021).

The payment system is a powerful lever for policymakers to pull to achieve domestic and international objectives. The United States has particular power when it comes to payment systems given the dollar’s role as the global reserve currency and to a degree, control over access to the global payments system. American leaders have been more willing to use this leverage as a tool for foreign and social policy objectives. What does this mean?

To start, the payment tool is effective. While Russian sanctions did not stop its invasion of Ukraine, they were a particularly strong response among non-military countermeasures available. Schott (2023) argues that the “Sanctions have contributed to a sharp compression of Russian imports; forced Russia’s military and industry to source from more costly and inefficient suppliers at home and abroad; and slowly begun to put a squeeze on Russian government finances” (1).

Financial sanctions can also be more precisely targeted as opposed to traditional economic warfare such as a trade embargo, which can be more broad reaching and so less efficacious in targeting a country’s political and economic elite (Bracken 2007). In addition to targeting Russian banks and other financial facilitators, America has attempted to direct sanctions at Russian elites and policymakers. This has the explicit goal of economically targeting senior leaders and supporters of the Russian government and economy, whether or not they are government officials (Eisen, Blumenthal, and Lewis 2022).

It is worth noting, though, that some doubt the purported power of financial warfare. For example, despite all our actions against Iran, it still earned about $40 billion in payments for oil exports in 2021 (U.S. Energy Information Agency 2022; Demarais 2022; Northam 2020).

However, sanctions involving finance and payments are also more politically expedient than alternatives. According to a Washington Post poll, 67% of Americans supported increasing economic sanctions on Russia, while 72% opposed direct U.S. military action (Parker et al. 2022). According to Bracken (2007), “Most people think of financial warfare as a substitute for military action.” If people want to take substantive and punitive action, without traditional methods of conflict that potentially put troops in harm’s way, sanctioning a country’s banks to inhibit the ability to transmit payments is an attractive option.

Payment systems are also a tool for anti-corruption efforts more broadly than just bilateral foreign policy. Curbing illicit finance is the second of five core pillars of America’s Strategy on Countering Corruption. As the strategy states: “For the U.S. Government to effectively counter contemporary corruption, we must recognize the transnational dimensions of the challenge, and respond in a manner that is both systemic and tailored to local conditions. Doing so will require addressing vulnerabilities in the U.S. and international financial systems…” (White House 2021, 8). The U.S. Treasury Department used sanctions to implement this anti-corruption policy: “Over the course of 2022, Treasury took numerous actions to promote accountability for human rights abusers and corrupt actors across the world, including sanctions on dozens of individuals and entities” (U.S Department of the Treasury 2022d). As Under Secretary of Treasury Brian Nelson noted, this specifically involves using the financial system: “Treasury has made combatting corruption and serious human rights abuse a top priority, including through the use of financial sanctions and addressing vulnerabilities in the U.S. and international financial systems” (U.S. Department of the Treasury 2022d).

This all serves as an indication the U.S. may continue its current trajectory toward greater utilization of payments in policy. As Weiss’ (2022) recent paper analyzing the impact of U.S. sanctions against Russia for Ukraine concluded, “the threat to the U.S. dollar’s reserve currency status is relatively limited” (2). However, there are reasons for pause.

First, excessive policy actions could undermine the dominion of the dollar in foreign exchange markets. As Krugman (1984) wrote, “Here there is again a situation where the dollar is used because it is used, and its place could be taken by the mark or yen” (272). In other words, the dollar’s reserve currency status is not an absolute given, so if fewer countries are settling payments in dollars because of U.S. sanctions, the dollar may become less stored worldwide, opening the door for other currencies or possibly even financial technologies or digital assets to take its place. This would reduce the leverage the U.S. wields over global payments, while also reducing the strength of the dollar worldwide.¹² While this may not preclude the U.S. from targeting payments in sanctions packages in the future, it may lead to more caution or more of a desire to use this power sparingly.

The targeting of existing settlement services may also trigger the proliferation of new ones. CIPS, or the Cross-Border Interbank Payment System, was established in 2015 in China to clear and settle payments in renminbi, utilizing a network of around 1,300 institutions around the globe (Eichengreen 2022). The service is surely growing rapidly, possibly growing by 75% in transaction value in 2021 alone (Eichengreen, 2022).¹³ However, it is still new, its volume is small compared to U.S. clearinghouses such as CHIPS, and “China’s government is astute enough not to challenge SWIFT until the CIPS has matured, but no doubt one day the challenge will come” (Prasad 2017, 116). If alternatives like CIPS develop, over which the U.S. has minimal involvement, it would reason that it might be harder for the U.S. to effectively sanction the payment systems of countries that use them. There is even speculation that Russia received renminbi through CIPS for coal and oil exports to China in 2022 after many of its banks left SWIFT (Eichengreen 2022). If this is true, the U.S. may be less inclined to push for the removal of banks from services like SWIFT in the future.

In the next several years and decades, the U.S. will need to critically evaluate how it should utilize its influence over the payment system for policy objectives, particularly in the foreign policy arena where such control is most delicate.

The future of U.S. centrality in the global payment system

While the current financial payment system relies on U.S. dollars and a correspondent banking system that largely requires access to America’s financial system at some level, the future global payment system may not. Future alternative systems are actively being promoted by other nation-states, such as China. The introduction and global interest in non-governmental-issued cryptocurrency is another potential threat to America’s hegemonic state in the global payment system. A close examination of each illustrates the potential for replacement systems and the difficulty each faces in dislodging the status quo.

The People’s Bank of China (PBOC) launched its Cross-Border Interbank Payments System (CIPS) in 2015 (Reuters 2022). The PBOC supervises CIPS, a similar structure to the Federal Reserve and CHIPS. CIPS is a real-time gross settlement system as opposed to a netting system like CHIPS (Eichengreen 2022), making it move faster and have several structural advantages as is common with newer real-time payment systems. By 2022, CIPS expanded to 1,280 participating institutions in 103 countries, which while impressive is still far from SWIFT’s 11,000 plus institutions in more than 200 countries (Jin 2022). CIPS serves as both a messaging and settlement system as opposed to SWIFT, which is only a messaging system (Eichengreen 2022, 4). CIPS settles in Chinese renminbi, not in U.S. dollars.

China promoted its counterpart CIPS system in response to America’s decision to remove Russian actors from the SWIFT system. Chinese media proposed greater integration between CIPS and Russia’s internal payment system in direct response to America’s sanctioning of Russia (Gaur 2022). This position was echoed by Russian state-owned media (U.S.-China Economic and Security Review Commission 2022). Evidence of greater usage of Chinese payments by Russian companies has been found, as by “July 2022 Russia was responsible for 3.9 percent of all payments using RMB outside of China, compared to less than 1 percent in January 2022. Russian businesses and financial institutions may be exploring opportunities to use RMB in their international transactions after international sanctions curtailed Russian banks’ access to U.S. dollars and euros.” (U.S.-China Economic and Security Review Commission 2022).

As Eichengreen (2022) states, “China is making strides in fostering cross-border use of the renminbi and building a renminbi-based interbank payments system that can serve as an alternative to SWIFT and Western clearinghouses. However, these remain somewhat limited alternatives—for the moment” (1). Major limiting factors include the requirement for settlement in renminbi and limited global adoption of the system. Global adoption of the CIPS system could grow to reduce this problem, although it is not clear whether G7 nations would actively encourage their financial institutions to join or withhold membership. Regardless of CIPS participation, national banks are still subject to their own country’s sanctions regimes and could not use CIPS to evade sanctions. Further, to the extent that CIPS is promoted as a method to more deeply engage with Russian actors as a means to avoid sanctions, banks in G7 countries and their national regulators may be more hesitant to engage the CIPS system.

Settlement in renminbi requires either pricing the transaction in renminbi or the creation of exchange rate risk between buyer and seller. This exchange rate risk comes from the potential for fluctuations between the value in the currency of settlement and the RMB between settlement and payment. While the RMB remains loosely tied to the value of the dollar, the currency does float somewhat against the dollar. The PBOC actively manages the RMB value against the dollar, allowing for fluctuations of up to two percent on a daily basis in 2021 (Cheng 2021). This highlights the inherent difficulty in having a global payment system that does not transact in the global world reserve currency.

Moreover, there are additional preconditions for China’s renminbi to replace the dollar as the dominant currency. Among these preconditions are that China’s capital markets would need to be opened up and expanded, with the possible adverse consequences for its financial stability (Wei 2023) and its current account surplus (Pettis 2022). Further, although the U.S. has exploited its control over the dollar payments system, there is reason to doubt China’s commitment to the rule of law, which makes foreign investors more uneasy about holding Chinese financial assets (McDowell 2022).

Cryptocurrency

The publication of “Bitcoin: A Peer-to-Peer Electronic Cash System” on October 31, 2008, under the pseudonym Satoshi Nakamoto (2008) has led to the creation of a slate of non-governmental-backed cryptocurrency. These forms of digital currency have exploded in usage and value. In less than 15 years since their creation, the two largest cryptocurrencies, Bitcoin and Ethereum, carry market capitalizations of over $800 billion jointly with transaction volumes in the tens of billions daily.¹⁴

In addition to cryptocurrencies whose valuation is meant to fluctuate, another form of non-governmental backed cryptocurrencies are stablecoins. Stablecoins are meant to keep their value constant, often pegged to the U.S. dollar at parity. The largest stablecoins currently are Tether and U.S. Dollar Coin, with a combined market value greater than $100 billion.¹⁵ Stablecoins are used primarily for facilitating trades between cryptocurrencies and other government-backed currencies, or directly between cryptos. However, it is possible that stablecoins can be used for broader sets of payments given their greater levels of value stability compared to other forms of crypto and their ability to operate on nonbank payment rails, often on blockchains (Yadav, da Ponte, and Kim 2023, 54).

Cryptocurrencies have their own payment systems, ranging from direct exchange electronically (or even physically in passing of thumb drives) to digital wallets, trading platforms, and exchanges. Cryptocurrencies have challenged existing regulatory structures by not naturally falling into any of the prior categories established by existing legal frameworks (Massad and Jackson, 2022).

Cryptocurrencies challenge an assumption, often unstated, that money needs to be issued and/or backed by a nation-state. As described earlier, a key property of money is that it can be accepted by third parties without prior party consent (Martin 2015). Crypto’s reliance on a distributed ledger for electronic record keeping, built on blockchains that are purported to be immutable and transparent, could give it the ability to achieve this status without the need for a national government to stand behind the asset.

However, there are several challenges that cryptocurrencies face to be viable alternative to payment systems. Blockchain systems, particularly open permissible ones, are significantly slower than existing payment rails. Bitcoin, running on such a blockchain, can handle seven transactions per second. For comparison traditional payment network Mastercard can handle 5,000 while Visa can handle 24,000 (Rodrigues 2022). Attempts to handle payment speed by altering aspects of the settlement process are ongoing, with movement on both a Lightning Network for Bitcoin (Rodrigues, 2022) and a variety of approaches on the Ethereum blockchain.¹⁶

Another difficulty in adopting cryptocurrencies on the Bitcoin or Ethereum blockchains is their lack of privacy. All transactions recorded on these blockchains show the amount transferred, and the blockchain address of the payer and recipient and these are visible to anyone who downloads the relevant blockchain. The blockchain does not contain the name and sender, but this so-called pseudonymity is of limited value, as oftentimes it is possible to determine identities — especially if the identity of one person is already known. Indeed, there are firms that specialize in identifying crypto transactors, and this work has led to criminal prosecution in cases where the participants thought they could transact anonymously (U.S. Internal Revenue Service 2022). Although law enforcement agencies may appreciate this ability to identify the participants in transactions, such a lack of privacy could be of concern to many individuals and almost all businesses — especially financial firms that are active in financial markets. Moreover, such a lack of transparency could significantly reduce the value of cryptocurrency as a means of avoiding sanctions.

There are methods of obscuring the relationship between the payer and the payee, such as protocols called “tumblers” or “mixers.” However, recent experience with these protocols highlights another obstacle to the adoption of cryptocurrency as a method of payment: the strong opposition of the U.S. Treasury. In August 2022, the U.S. Treasury (2022b) sanctioned the virtual currency mixer Tornado for its use to launder more than $7 billion worth of cryptocurrency. Tornado is only a piece of code on a blockchain and so cannot itself be sanctioned. However, the Treasury’s press release states, “All transactions by U.S. persons or within (or transiting) the United States” are prohibited unless authorized by an agency of the U.S. Treasury. Moreover, the Treasury (2022c) is also trying to control the on-ramps from dollars and crypto as well as the off-ramps from crypto to dollars by imposing fines on virtual currency exchanges. For example, Bittrex recently paid fines for alleged violations of the Bank Secrecy Act’s (BSA’s) anti-money laundering (AML) and suspicious activity report (SAR) reporting requirements. Such actions further inhibit the transition from dollars to crypto. The Treasury’s actions with regard to Tornado and Bittrex suggest that it is likely to respond aggressively against any future attempt to use cryptocurrency to avoid sanctions.

Cryptocurrency usage has been found to be correlated with corruption levels within a country. An IMF analysis states, “We find that crypto-asset usage is significantly and positively associated with higher perception of corruption and more intensive capital controls” (Alnasaa et al. 2022). Other research has shown increasing usage of cryptocurrency by transnational crime groups, including MS-13 a large crime organization in the United States and Latin America (Farah and Richardson 2023). MS-13 and other transnational gangs have been linked to corruption in both their home and host countries, which a National Defense University paper highlights as “driving multiple types of corruption that President Joe Biden in December 2021 vowed to fight as a core U.S. strategic interest” (Farah and Richardson 2022).

Tax treatment is another core problem cryptocurrencies face in wider-scale adoption. National currency used for payment purposes is typically exempt from capital gains taxation. When a national currency appreciates, it typically does not require its citizens to consider that increase in wealth for tax purposes (capital gains specifically, but other types of wealth taxes). There are exceptions to this when the currency is used as a financial asset (e.g., trading in foreign exchange markets) although very few retail investors trade currency.

The introduction of cryptocurrency begged the question of whether national governments would treat this as a form of money for payment and be exempt from taxation, or as a financial asset. Most nations, notably the United States, Japan, and most European nations, consider all forms of crypto as financial assets subject to capital gains taxation.¹⁷ The level of taxation varies between countries and presents its own impediment to the adoption of crypto for payments. A second problem involves the cost of record keeping for merchants who choose to accept crypto. In order to track their profit or loss from the change in value of the crypto they received, they have to keep clear records on the time of the transaction and the valuation of the crypto they received in terms of their home currency. To the extent merchants then use that crypto to fund their own business operations (whether directly or by converting it to fiat currency), they have to again record the change in valuation and are subject to applicable taxation.

A notable exception to this system is in El Salvador, which legally declared Bitcoin to be legal tender and required all merchants to accept it (Quirk 2021). El Salvador had previously abandoned its own national currency in 2001 and adopted the U.S. dollar as its official currency (Swiston 2011). The lack of having its own national currency may have played a role in El Salvador’s decision to adopt Bitcoin as legal currency as there was no national competition for that privileged position. In addition, El Salvador relies heavily on international remittances, one in every four Salvadorans lives abroad, and its proportion of GDP reliant on remittances is the second highest in the Western Hemisphere (Quirk 2021). Advocates of Bitcoin adoption argue that crypto could be an alternative to the expensive international remittance options available to retail consumers, particularly those sending from the United States.¹⁸ However, despite El Salvador’s push to incent digital payments, Bitcoin is not widely used as a medium of exchange, and remittances via Chivo (a national Bitcoin wallet) have been decreasing over time (Alvarez, Argente, and Patten 2023). It should be noted that MS-13, one of the gangs whose usage of cryptocurrency has been highlighted, poses what some have described as “an existential threat” to the El Salvador government, with corruption between the gang and government being a major source of the problem (Farah and Richardson 2022).

Another problem with most cryptocurrencies is that their value is rather unstable relative to fiat currencies, which makes them less desirable as a payment mechanism (Wellisz 2022). Major cryptocurrencies have experienced sharp swings in value, with Bitcoin prices moving more than 57% over a three-month period starting on March 29, 2022, and Ethereum prices moving more than 67% over the same period.¹⁹ Additionally, Bitcoin’s price has, at times, changed as much as 7.6% over the course of a day, with an average daily fluctuation of four percent in 2021.²⁰ By contrast, national fiat currencies rarely move more than one percent per day relative to each other, particularly for developed nations.

This variability in value exacerbates the problems created by the taxation of cryptocurrency, both in terms of accurately measuring the value exchanged for tax purposes and in terms of creating potentially larger tax liabilities. However, the variability in value creates a more fundamental problem for using cryptocurrency in transactions. Stability in valuation is highly desirable in a payment system, as instability creates settlement and value risk between parties. Price has a component of time; two parties agree on both a price and time for a transaction. If the valuation of the payment changes during any delay in settlement, then one party can lose value. Given variance, neither party may know whether it is the one who could lose value, and hence both may be more cautious in the face of settlement risk. This type of risk increases uncertainty, which creates a series of other problems and frictions.

Crypto stablecoins have been created to address this risk. As mentioned above, stablecoins have exploded in size recently with the two largest stablecoin entities being within the top five market capitalizations of all crypto in June of 2023. Stablecoins grew by more than 500% from September 2020 to 2021 (Liao and Caramichael 2022).

Stablecoins offer several solutions to the problems discussed above. Fixing value solves both the risks created by price instability and concerns regarding taxation. Stablecoins pegged to the U.S. dollar seem particularly useful for global commerce in dollar-denominated assets. Thus, the dollar’s position as the global reserve currency is one reason why stablecoins choose to peg to the U.S. dollar.

Although stablecoins solve some problems, they create others, with arguably the most important problem being that of maintaining stability versus the fiat currency to which it is denominated (Bullmann et al. 2019). Stablecoins denominated in a fiat currency come in several forms: algorithmic, cryptocurrency-backed, and fiat-backed. Algorithmic stablecoins seek to manipulate the outstanding supply of the stablecoin to stabilize its value. The problem here, as demonstrated by the collapse of the stablecoin Terra, is that if demand falls to near zero, so will the value of the stablecoin.²¹ Cryptocurrency-backed stablecoins such as DAI rely on overcollateralization by cryptocurrencies (such as Bitcoin). Among the problems with this type of backing is the volatility of the other cryptocurrencies that can be used as collateral. The lower the collateral requirements, the greater the risk that the stablecoin will become undercollateralized. Alternatively, higher collateral requirements impose a greater cost to those seeking to obtain new stablecoins.²² The third option is to have the stablecoin collateralized by off-chain assets. The current largest of these stablecoins is Tether. Among the current issues with Tether are the questions of whether it actually holds assets at least equal to the value of the outstanding Tether and whether those assets are of sufficiently high quality and liquidity.²³ Reports have shown Tether holding billions in gold, an asset whose value fluctuates against the dollar. Even when stablecoins are attempting to hold assets in stable assets, there are risks. The second largest stablecoin, USDC, had $3.3 billion in uninsured deposits at Silicon Valley Bank (Howcroft and Jaiswal 2023). Had U.S. regulators not invoked a systemic risk exception, Circle would have had substantial exposure to losses on those bank deposits.

An additional problem arises when a U.S. dollar denominated stablecoin is used to evade U.S. sanctions, as the Treasury can still issue sanctions as it did Tornado Cash. Such sanctions could impair the stablecoin’s ability to obtain the high quality, liquid assets to back the cryptocurrency. On the other hand, if the fiat-backed stablecoin were denominated in and held assets denominated in something other than the U.S. dollar, that stablecoin would face the same problems as other fiat currencies replacing the dollar. Along with these problems with using stablecoins to avoid U.S. sanctions, there are other public policy reasons why the authorities may seek to regulate or limit the expansion of stablecoins. Financial stability concerns include “run risk,” whereby in the face of trouble (real or perceived) stablecoin holders are incentivized to be the first to redeem at par before any asset valuation or liquidity problems are realized (Quarles 2021). Other concerns exist regarding the impact of stablecoins on the broader banking system (Liao and Caramichael 2022).

Some have proposed improved regulation of stablecoins as a method to solve these problems (Jackson, Massad, and Awrey 2022). Questions remain over national and international regulation of stablecoins, what their optimal relationship is to the banking system, and the overall stability of the structure of the asset (G7 Working Group on Stablecoins, 2019). Whether stablecoins should be privately or publicly issued, potentially in the form of a central bank digital currency (CBDC), adds another layer to this debate. Digital currency is regularly issued by banks (credit and debit cards), but most nations have so far only offered physical currency that is a direct liability of the central bank, what is commonly called cash. Over 100 nations are exploring issuing a CBDC, representing 98% of global GDP.²⁴ China in particular has leaned into a CBDC, piloting such a currency in circulation. Some have speculated that China’s movement toward a CBDC is part of a broader push to replace the dollar (Orcutt 2023). Others have argued that China is responding more to internal pressure to bring payments back under government control after the unplanned migration from the banking system to Chinese tech firms AliPay and WeChat (Klein 2022).

The payment system is an important policy tool for the United States government. The balance between using a payment system to promote economic growth and commerce and using the payment system as a tool to project political power is shifting toward the latter. This is true both domestically and internationally for the United States.

The dollar’s position as the world reserve currency and the U.S.’s unique position within the payment and settlement system provide America the unique ability to project foreign policy through the payment system. That policy has increasingly been to use access to the payment system as a weapon, placing greater restrictions on unfriendly nations as a consequence for the policies. It is critical that the U.S. delineates clear lines setting forth when they will use payment system access as a weapon; as it should have, Russia’s invasion of a sovereign nation has revealed one such line. Similarly, the fight against corruption must delineate what level of corrupt action tolerates what type of response in terms of limiting access to the payment system for individuals, corporations, or even nations.

Russia’s invasion of Ukraine led to a major escalation in how America responds with payments as a tool for foreign policy. As former White House National Security Advisor for Russia Fiona Hill recently stated, “In the 21st century, these are economic and financial wars. We’re all-in on the financial and economic side.”²⁵ Greater international coordination among America, the European Union member states, Japan, and other allies has amplified the power of payments as a tool to inflict economic harm in response to military action.

In the longer run, China’s alternative payment network and cryptocurrencies are both alternatives to the existing bank-centric, dollar-denominated payment system. If either were to take off, they would reduce the ability of the United States to exercise political power through the payment system. However, both have substantial structural and operational issues that could preclude either or both from being a legitimate alternative to the current system. It is too soon to tell. Additionally, any replacement for the dollar would need to overcome the strong network effects arising from the dollar’s current dominance. That said, if the dollar were to lose its dominant position, its replacement would likely benefit from becoming the dominant network, making it even more difficult for the dollar to ever regain its preeminent status in the global payments system.

The more that America uses the payment lever for policy, the greater the incentives to develop alternative systems. This is true both domestically and internationally. Significant legal, economic, technological, and other challenges confront alternative systems. Payments are inherently economies of scale, displaying significant network effects. This can deter new entrants and make alternative systems more difficult. In addition, nations have incentives to keep their own currency with favorable status, including the value of seigniorage for state-issued currency and the economic value and stability of their financial system. Nevertheless, although displacement of the dollar in the short-to-medium-term remains unlikely, it would have very large consequences if it were to occur. Thus, we should not regard sanctions as a cost-free way of signaling our disagreement with another country’s policies.