Q9 Markets: Crime and Punishment

25th February 2021

Q9 Capital: www.q9capital.com

• Ukraine invasion sees investor flight to safety
• Crypto falls alongside equities
• How can Russia use crypto to evade sanctions?

Russia’s decision to invade Ukraine and bring war back to Europe has sent shockwaves through financial markets. While equities and crypto are down, gold, oil, base metals, agriculture commodities and currency market safe havens like the US dollar and the Japanese yen are trading higher. This doesn’t tell the whole story however as in typical ‘sell the rumour buy the fact’ fashion, ‘risk on’ assets caught a bid when the rumour became actual news.

Crypto was very much a ‘risk on’ asset, rallying yesterday but finishing the week lower with Bitcoin moving to $38k (down -5.4% over the week) and Ethereum to $2.6k (-9.8%). Most high beta DeFi and metaverse tokens posted double digit losses and $200bn was wiped from crypto markets overall. The current market cap of all cryptocurrencies currently sits at approximately $1.7tn.

Investors have long hailed Bitcoin as a better inflation hedge and haven asset than gold. However, recent price action like this week continues to suggest otherwise as the cryptocurrency has moved more or less in tandem with stocks. The fact that fiat safe havens are doing better than Bitcoin perhaps indicates that the crypto market as a whole is at the far end of the risk curve.

However, zooming out, gold hasn’t done much to protect investors over the long term and its rally as a hedge was short lived this week. In fact, the narrative around Bitcoin is not only as hard money vs devaluation, but also that it is censorship resistant. All decentralised crypto could/should be censorship resistant. This was in the news this week prior to the invasion when Canada said banks could shut down accounts of any funds associated with the trucker protest without fear of liability. This is the type of censorship that many Bitcoiners and crypto folks have in mind when thinking about what they like about crypto. It’s a sovereign individual currency and probably doesn’t endear them to govt’s and the pro-statist crowd. Folks are worried about a further state backlash.. state vs the people.

Vitalik Buterin on Twitter

How Russia Can Avoid Sanctions Using Crypto

Ironically, we are about to get a real live case study in how censorship resistant crypto is to the state run by one of the most autocratic states in the world. Russia has been weaning itself off USD for years, crypto is popular in Russia (17mn Russians are already crypto owners) and Russian companies and individuals now have many cryptocurrency tools at their disposal to evade sanctions — ‘All’ it needs is to find ways to trade without touching the dollar. Below we have a look at how the West could look to sanction Russia and what techniques they can use to soften the blow.

The Bank of Russia has stated it “will ensure the maintenance of financial stability and continuity of the operation of financial institutions, using all necessary tools. We have clear action plans for any scenario”

The West is Imposing Tough Financial Sanctions

Joe Biden said on Thursday he has authorized “strong sanctions” against Russia. Sanctions are some of the most powerful tools the US and European countries have to influence the behavior of nations they don’t consider allies — economists estimated that sanctions imposed by Western nations after the Crimea invasion in 2014 cost Russia $50 billion a year.

New sanctions aim to limit its ability to do business in dollars and other major international currencies, and include penalties on five Russian banks that represent an estimated $1tn in assets. A broad swath of Russian elites and their family members will also be targeted.

Another Financial Weapon is Banning Russia From SWIFT

One idea under discussion involves cutting off access to a messaging system called SWIFT. SWIFT delivers secure messages among more than 11,000 financial institutions and companies, in over 200 countries and territories. The message traffic (42mn a day on average last year) includes orders and confirmations for payments, trades and currency exchanges. A country cut off from SWIFT can suffer significant economic pain, as happened to Iran in 2012.

Cutting Russia off from SWIFT could have ramifications for other nations as well, since Russia is a key energy supplier to Europe and countries rely on the SWIFT system to pay for fuel. The US and EU have opted not to cut Russia off from SWIFT for now but could revisit the issue.

The Problem With All This Is… Declining Dollar Dependence

Sanctions will have less bite than they would have done ten years ago, mainly because the declining dependence on the dollar, the world’s reserve currency.

Putin can swap dollars for yuan or other currencies that have growing influence. The dollar’s share of Russia’s foreign-currency reserves has declined to 16% in 2021 from 46% in 2017. In comparison, the yuan’s share rose to 13%, from less than 3%. The dollar’s share in Russia’s export to China has declined from nearly 100% in 2013 to about 40% currently, according to UBS. Its import share also dropped from 90% to 60%.

Russia may now be testing grounds for Beijing’s push to internationalize the yuan.

Here’s How Russia Will Try to Evade Sanctions Using Digital Assets…

1. Crypto

In October, the Treasury warned that crypto could weaken US sanctions. Why?

Crypto can help individuals buy goods and services and invest in assets outside of Russia — all while avoiding banks or institutions that adhere to sanctions and could trace their transactions. Unlike fiat currencies, which move through third-party institutions that have the ability to track, freeze or block them, crypto can be sent from one person directly to another regardless of location, government sanctions or other restrictions.

Crypto holders can set up a web of wallets with different addresses across several exchanges, making it extremely difficult to track any activity and even harder to tie transactions back to a particular individual. They can also choose exchanges that are not based in jurisdictions imposing sanctions and therefore don’t necessarily have to adhere to regulations.

However, individuals would have to convince any services they are doing business with to accept digital payment, which could be difficult.

2. Stablecoins

Stablecoins, created by private enterprise and typically pegged to USD, are a convenient way for individuals to move assets around from wallet to wallet without the volatility of crypto markets. According to CoinDesk, at least one exchange reports they cannot meet increased demand for Tether (a USD denominated stablecoin), and are seeing higher exchange rate premiums and a liquidity crunch following the invasion. The total supply of stablecoins has soared to over $180bn, a 32% rise from mid-November 2021.

Expect this asset to come under a lot of regulatory scrutiny — particularly as they are backed by the same currencies of governments enforcing sanctions.

3. Privacy Coins

The features of privacy coins make it easy to use for untraceable transactions, illicit activities as well as for use on the dark web. Monero (one such example) is an open-source, privacy-oriented cryptocurrency that was launched in 2014. Its blockchain is opaque, which makes transaction details and the amount of every transaction anonymous by disguising the addresses used by participants.

4. Central Bank Digital Currency

The Russian gov is developing its own CBDC, a digital ruble that it hopes to use to trade directly with other countries willing to accept it without first converting it into dollars. Russia’s central bank says a digital ruble could make Russia less dependent on the US dollar and more resistant to foreign sanctions. It would let Russian entities conduct transactions outside the international banking system with any country willing to trade in digital currency.

Russia could find willing partners in other nations targeted by US sanctions, including Iran, that are also developing government-backed digital currencies. China, Russia’s largest trading partner in both imports and exports, has already launched its own CBDC. Xi Jinping recently described China’s relationship with Russia as having “no limits.”

5. Ransomware, Theft and Mining

Russian entities that are under sanctions could deploy their own evasion strategy, using ransomware attacks. North Korea, for instance, has used ransomware to steal cryptocurrency to fund its nuclear program.

Russia is already at the center of the growing ransomware industry. Last year, about 74% of global ransomware revenue, or more than $400mn worth of crypto, went to entities that are probably affiliated with Russia in some way, according to Chainalysis. Russia-based cybercriminal organization, Evil Corp, has been prolific in ransomware, and their leadership is believed to have ties to the Russian government.

Russia can also use Bitcoin mining for additional funds. Iran is already using revenue from Bitcoin mining to make up for the limitations on its ability to sell oil because of sanctions.

6. The Dark Web

Illegal funds have also flowed into Russia through a dark web marketplace called Hydra — which operates only in the Russian language. Hydra is by far the largest darknet market in the world, accounting for over 75% of darknet market revenue worldwide. It is powered by crypto and handled more than $1 billion in sales in 2020. The platform’s strict rules (sellers are allowed to liquidate crypto only through certain opaque exchanges) have made it difficult for researchers to follow the money. On its own, Hydra is not yet big enough to handle the volume of transactions that Russia would need to successfully evade sanctions.

How Can the West Counter This?

There are signs that the US is stepping up its monitoring of cryptocurrency activity. Last week, the Justice Department and the FBI announced they had created a new national crypto enforcement team. Blockchain compliance and data firms such as Chainalysis already offer a “know your transaction” (KYT) tool that alerts companies when blacklisted entities use their services.

The extent to which crypto can be traceable is visible from the recent arrest of two individuals related to the 2016 Bitfinex hack. The government was able to track the activity of certain wallets and as a result freeze the accounts as soon as they were converted into fiat currencies.

Public ledgers keep track of the movements of crypto from one wallet to another. In theory, this should let authorities track all crypto transactions and keep restricted entities from completing them. However, a designation of an illicit crypto wallet address is not foolproof. That designated actor can easily still open up a new wallet elsewhere.

Summary

Western sanctions against Russia will have huge economic consequences for the country and this is a major test case for crypto as an alternative system that exists outside the control of any state. Cryptocurrencies, dark web marketplaces, powerful ally nations, and other advanced digital techniques simply did not exist as tools for Russia ten years ago. Cumulatively, these could be a significant counterstrike against current and future sanctions.

Yet not much today is really paid for in crypto — this will have to change for it to effective as an alternative currency. Russians will have to find willing participants to swap goods and services for crypto with others who are happy to avoid the system (both internally and internationally). This event could be a catalyst to open up more and more channels for crypto to be used.

Western powers now realize that all this stuff can be tracked. Even though they don’t have control of crypto like the SWIFT network they are now getting comfortable monitoring and tracking it. If someone committed a crime using cash five years ago you’d never find them today — but the recent arrests following the Bitfinex hack in 2016 show centralized authorities are catching up. Similar tools can be used to track wallets and digital assets connected with sanctioned Russian players in a game of cat and mouse.

We are about to see a drama unfold that Dostoevsky could relate to.

In the News

• More than 75% of family offices see benefit in crypto, BNY Mellon
• Criminal whales hold over $25bn in crypto from multitude of illicit sources
• China tightens law to jail those found raising funds though crypto sales
• How crypto foe China is embracing NFTs, with strings attached
• Go-to-market in Web3: New mindsets, tactics, metrics
• Pantera says some crypto selling pressure has been tax related
• Terra raises $1bn for an emergency Bitcoin reserve
• New draft resolution aims to make crypto deregulation part of the Republican platform for next Congress
• OpenSea’s user activity tumbles by almost 20% after $3mn NFT heist
• FTX to roll out crypto service for games publishers
• How NFTs are creating social value

Legacy Markets

Oil futures rose +2.9% and the SPX fell -2.1% week-on-week. 10-year US treasury yields were unchanged, the US Dollar index rose +1.3% and the Gold & Silver index slipped -2.1%.

Crypto Markets

• BTC/USD dropped -5.4% and ETH/USD fell -9.8%. The total market cap of crypto universe is just north of $1.7tln and Bitcoin’s dominance rose above 42%
• SOL dropped -4.5% from last week’s levels. Among metaverse coins, GALA dropped -23.9%
• Annualised volatility in crypto markets remained unchanged: 65% for BTC and 80% for ETH

Flows

• Client pad skewed towards selling (2.2 x sellers vs buyers) on stronger volumes
• Two-way flow in ETH and sellers in BTC & SOL
• Mild buying activity in GALA