Iranian Oil, the Petrodollar, and the Hong Kong Exception

a nice reminder that payment rails matter

A very brief (actually) update on something of interest.

The Economist has recently run an excellent deep dive into the complex web of oil shippers, military leaders, offshore shell companies, and multinational banks involved in the international sale of Iranian oil. I highly encourage everyone to read it; it’s very interesting, but we won’t cover it all here. That the Iranian oil industry is doing so well is surprising enough (although those familiar with Chinese oil import policy will be less shocked—China buys up roughly 95% of Iranian crude exports), the real Easter egg is how much of the trade is being done in dollars—while precise data isn’t available, the report suggests that it’s a lot.

Hard times, hard currency

The obvious thing to do if you’re Iran is export oil to China (fact check: true) and have China pay you in yuan. What you obviously wouldn’t want to do is get paid in dollars (sanctions). From China’s perspective, you’d probably want to buy oil from Iran (fact check: true) and pay in yuan (to internationalize the yuan and protect yourself from crippling energy import sanctions from Washington). And yet, the two countries only manage a small amount of bilateral yuan-denominated trade for the shadow oil market. Why?

This is a problem we’ve talked about before: once you get yuan, you have to do something with them. Given that China has a (mostly) closed capital account, you can’t invest a whole lot with yuan. You can import stuff from China, though, which is what Iran does: “recycles [the yuan] within China . . . [but] there is only so much Iran can buy from China.” Right, China is a massive net exporter, sure, but Iran can only absorb so much of that. And cross-border yuan-denominated payments are complicated to boot.

So, Iran—in an incredible moment of irony—asks for China to pay it in dollars. And it works!

CHAT me up

Law firm sanctions memoranda the world over are pockmarked with parenthetical caveats and footnotes about the “Hong Kong exception,” a small loophole where dollar payments aren’t ultimately (at least necessarily) cleared at the New York Fed. Here’s The Economist (emphasis mine):

The territory [Hong Kong] is home to the only sizeable dollar-clearing system outside America. USD CHATS, powered by accounts that banks fund with dollars, allows members to transact with each other in greenbacks without involving institutions in America. All international banks with decent business in Asia, including nine of China’s ten largest, use it. Neither they nor HSBC, which runs the system, are required to report transactions to Uncle Sam.

Under a deal with America, Hong Kong banks must still check that payments they route through CHATS comply with American sanctions, even though Hong Kong does not enforce them. But the fact that America cannot monitor transactions gives room for manoeuvre, says David Asher of the Hudson Institute, a think-tank. Last year the system processed an average of $60bn in payments a day, a volume that makes dubious transactions hard to spot.

Readers of this site will be familiar with this central concept: it is not the dollar (whatever exactly we mean by that) per se that triggers US sanctions jurisdiction; rather, it is the involvement of a US entity, which usually means the payments rails themselves are the triggering hook. From an earlier note:

At their core, the strength of US (and, to a lesser extent European) sanctions rest on the centrality of correspondent banking relationships and payments systems. In other words, to use dollars, you’ve gotta have an account at the Fed, or bank with someone who has an account at the Fed, or bank with someone who banks with someone (and so on, you get it) who has an account at the Fed. That’s the magic behind the legal force of sanctions: US legal jurisdiction covers US entities and ultimately, if you have to clear payments through the New York Fed, you’re dealing with a US entity. This is a source of frequent misunderstanding: while sanctions are targeted at foreign institutions, they actually apply to American ones only. But the vast majority of payments go through the Clearing House Interbank Payments System (CHIPS), which is comprised of American institutions or foreign institutions with a US bank branch (and therefore still subject to US law).

Most, but not all. The Hong Kong Monetary Authority’s (HKMA) USD CHATS system is, of course, the exception to this rule. It’s run by HSBC and Hong Kong Interbank Clearing Limited, and is a US dollar real-time gross settlement system. Banks with offshore dollars (eurodollars, confusingly named, given that they’re not limited to Europe) can fund clearing accounts with USD CHATS and transact daily via Hong Kong. For a primer on the Asian eurodollar market and its workings, I highly suggest this primer at Conks. Now, to be fair, as The Economist noted, the HKMA does at least on paper say that it complies with US sanctions (diplomatically), but the recent investigation shows that in practice enforcement might be light (not that that’s a Hong Kong-specific thing; the report also listed plenty of Western banks, including American ones, also potentially involved). (It goes without saying that none of the banks potentially associated with sanctions violations would have been doing so intentionally—sanctions are very easily to violate without knowing when you’re processing billions of dollars of transactions a day from companies with convincing provenance.)

Another important note: there is a reason that you don’t typically do dollar clearing without involving, directly or indirectly, the Fed: emergency liquidity. When payment system liquidity dries up in the US, the Fed can step in with liquidity and put out the flames. In Europe, standing swap lines from the Fed to the ECB, Bank of England, and Swiss National Bank provide similar (albeit intermediated) protection. Not so for the HKMA (notwithstanding its access to the FIMA Repo facility).

It’s the plumbing (again)

Why do I mention all this? To (perhaps pedantically) drive home a point: it’s the payment rails and the plumbing of the financial system, not the dollar itself, that lead to sanctions risk and geopolitical strategizing. This is well-timed, as Mr. Putin has hosted a BRICS gabfest about the imperialism of the dollar, which apparently didn’t woo the attendees all that much.

The upshot for me is that even with dollar centrality and legacy payment systems, those willing to take some liquidity risk can make offshore real-time gross settlement systems work. In a (potentially) brave new world of cross-border wholesale CBDC payments or dollar-denominated stablecoins, it’s not hard to imagine making the web more complex.

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This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.