Taking but not confiscating: getting creative with Russian state assets

In the past two issues of Free Lunch, we dissected the striking productivity divergence between the US and the EU. This divergence shows no sign of reversing, with the latest numbers continuing the trend. My colleagues report the data and have collected comments from a wide range of experts.

Today we return to one of our regular topics: the vexed question of what to do with Russia’s foreign exchange reserves.

The question of how to fund Ukraine’s existential struggle as a free, western democracy remains what one can generously call a work in progress. But it is not, at least, in stasis. The EU has just agreed to top up its weapons fund (the Orwellian-sounding European Peace Facility) with €5bn for Ukraine’s defence, although it seems that may largely repackage aid given bilaterally. The US has scraped together a few hundred million of unspent change from previous allocations. That was what Denmark, one-hundredth the size or so, put up just last month.

There has even been movement on something we follow very closely here in Free Lunch: what to do with the blocked foreign exchange reserves of a Russia guilty of an illegal war of aggression. My Brussels colleagues report that the EU is planning to fast-track the seizure of profits made by securities depository Euroclear on cash balances that have ballooned because it is not allowed to pay out anything from the Central Bank of Russia’s deposit account. Between €2bn and €3bn could apparently be transferred to Kyiv by July.

But seizing Euroclear’s profits highlights the area where there is, in contrast, no movement at all: on using the CBR’s actual assets to compensate Ukraine for the destruction Russia has caused. The US was rumoured to push the G7 into making a move in this direction by the second anniversary of the full-scale invasion, but February 24 came and went. By all accounts, the EU G7 members remain steadfast in their opposition.

There has, however, been further analytical development since the last time I wrote about this. For those wanting to dive into the legal arguments, I recommend a recent report for the European parliament by law professor Philippa Webb. But in terms of policy innovation, the most important recent contribution is a short paper by Hugo Dixon, Lee Buchheit and Daleep Singh (let’s call them DBS) — respectively a journalist, the doyen of sovereign debt restructuring lawyers, and the Biden administration’s deputy national security adviser for international economics. (The paper came out before Singh returned to the administration, in the same job he had had at the start of Russia’s war in Ukraine.)

Read the whole thing — it’s not long (or read Dixon’s even shorter column on the idea). But here is the gist: they propose that the G7 (or a larger group of allies) issue a syndicated loan to Ukraine, which offers future reparations claims on Russia as security for the loan on a “limited recourse” basis (this means handing over the security would fully discharge the loan). There is no doubt Russia is obliged by international law to compensate Ukraine for the damage it has caused (see Webb’s report for details), and the UN General Assembly has said as much. There are, however, obvious doubts whether Russia will actually fulfil that obligation.

The DBS proposal has similarities with my suggestion a few months ago of a special-purpose vehicle funding Ukraine against those claims, or just purchasing the claims outright. (The differences matter for recorded public debt in Ukraine and its friends, and the DBS approach usefully highlights that syndication can be done on a “sharing” basis that takes care of possible complications around which country lends how much.)

The crucial contribution DBS make to the debate is to explore the legal possibility to “set off” — which I understand as simply the notion that if I owe you $100 and you owe me $100 that is due now but you have refused to pay, I can set off my debt to you against yours to me and be free of my obligation (as well as my claim on you).

Crucially, setting off is not confiscating. Confiscation involves a change in ownership (see the definitions in Webb’s report mentioned above). Setting off, in contrast, is just a netting procedure where the two parties involved have reciprocal claims on one another that cancel one another out.

This opens a route for Russian foreign exchange reserves to be transferred to Ukraine without any confiscation ever happening.

That matters. Most of the misgivings against efforts to mobilise the Russian state’s assets to help its victim have centred on the legality of confiscating a central bank’s reserves. This may, by now, be a mostly vicarious argument to camouflage more self-serving concerns by the governments that oppose it for other, political or commercial, reasons. (These reasons keep being strongly disproved, for example recently by Olena Halushka and Mark Sobel.) In any case, the prospects for mobilising Russia’s assets for Ukraine’s benefit without confiscation need to receive widespread and detailed attention.

How would it work? As DBS explain, setting off is possible if those counterparties on which the Russian state has a claim through its foreign exchange reserves are the very same that have claims on the Russian state. DBS suggest legislative or executive action to move the CBR’s assets from current depositories such as Euroclear to be deposited directly with western governments. I am worried about the complication that owning a security is a claim on the issuer of the security, not a claim on the depository. But most of all, we should recognise that by now, most of the securities the CBR owned on February 24 2022 have matured. The bulk of its blocked reserves are in the form of bank deposits — the single biggest share in a giga-deposit in Euroclear Bank. By my estimates, this deposit amounts to about €140bn.

Euroclear Bank is a Belgian company with a banking licence, wholly owned by Euroclear, subject to Belgian and EU banking regulation and supervision. The European Central Bank should by now have direct power over it through its Single Supervision Mechanism; its assets are well above the €30bn threshold, and some of the “importance” criteria may well be fulfilled too. These powers include the withdrawal of a banking licence.

Suppose banks with deposits by the CBR, including Euroclear Bank, were made to split out a separate corporate entity to hold these deposits, together, of course, with all the cash with which those deposits are already backed (and which are the source of Euroclear’s extraordinary profits soon to be seized by Brussels). Could the ECB or other authorities instruct the banks to do so? Regulators I have spoken to think this is a stretch. But it is easy to make an argument that Euroclear’s huge balance sheet and its exposure to sanctions policy come with big risks to it and hence to a systemically important function in European and global securities markets.

Presumably, Euroclear itself would be delighted to be rid of these risks — and as a matter of industry practice, deposit portfolios can be shifted around corporate entities when banks get into trouble or undergo mergers, splits or acquisitions. If not by regulatory decision, then the EU (and others) could pass legislation requiring CBR deposits to be split off into new banking entities to insulate the financial system from risks. This would not in any way affect the safety of CBR assets, which would still be backed by hard cash, let alone amount to confiscation. If the separate entity has to be capitalised, note that Euroclear has by now earned about €5bn in net interest on its huge cash balances.

In this thought experiment, Russia’s €140bn deposit would now be held in a new entity still owned by Euroclear — call it Euroclear Bank 2 — which would have about €145bn (including accumulated interest earnings) on the asset side of its balance sheet. Suppose a consortium of governments (the G7, or the entire sanctioning coalition) offered to buy this entity from Euroclear for €1 plus an indemnity for Euroclear’s associated legal risks. Similar offers could be made for the (much smaller) entities holding CBR deposits around the west.

Let the new owners (western governments) rename the bank they have bought as the “Bank for the Reconstruction of Ukraine”. And at this point, the owners could tell the BRU to reinvest its assets in either a loan to Ukraine secured with limited recourse to the country’s claims on compensation from Russia (as DBS suggest) or an outright purchase of those claims. Either way, Ukraine would get an advance today on the compensation it is incontrovertibly owed by Russia, up to the amount of Russia’s reserves held in the west.

The BRU would now have a single obligation — the CBR’s €140bn deposit — and claims on €140bn-plus worth of war reparations payments owed by Russia. And that is how things could remain for a long time. If BRU was now seen as undercapitalised, the ECB could withdraw its banking licence — it’s not as if it was going to do any other banking business anyway. Instead of an unsecured, uninsured claim on a eurozone bank (that’s what a €140bn deposit is), the CBR’s asset would be an unsecured claim on a eurozone non-bank financial company. As a creditor to the company, Russia could try to force it into bankruptcy, but what would be the point? The immobilisation of Russia’s reserves, which the G7 has vowed will remain in place until it compensates Ukraine, means that either way, Russia could not cash in its claim.

Note that nothing in this process would in any way have touched on Russia’s legal title to its reserves. In particular, no confiscation would have taken place. At some point in the future a legal process would formally establish Russia’s obligations to Ukraine, which Ukraine would have transferred to the BRU. BRU could now set off Moscow’s debt to it against its debt to Moscow. And that would be the end of it.

What do Free Lunch readers think? Stretched, no doubt. But technically doable? Legally realistic? Politically feasible? Send us your thoughts.

Other readables

• Fiscal rules artificially create a perverse political trade-off between responsible public finances and sustained economic growth, I argue in my latest FT column.

• After the UK chancellor’s move last week to reform the UK’s “non-domiciled” system of taxation (or rather non-taxation), Simon Nixon has penned a devastating analysis of the aberration that the non-dom rules amount to. Among many highly quotable insights, this is perhaps my favourite: “A set of arrangements designed to meet the needs of domestic oligarchs in the 19th century proved perfectly suited to a new age of oligarchic capitalism.”

• Switzerland opens its first criminal investigation into violations of sanctions against Russia.

• Gillian Tett explains the sorry state of sovereign debt restructuring, and surveys an intriguing legislative change under way in New York.

• Malaysia is a big winner in the chips wars.

• Surge pricing struggles to cross from online to IRL.

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