In part, I’m recording this to celebrate the work we did in Kenya. But much more so I want to capture a snapshot of a scene in metamorphosis. I’m certain that in a few years it will be hard to believe, let alone remember, all the arcane things we had to do in order to make online commerce work back then.

The Challenge

Ecommerce players in emerging markets almost all are forced to accept cash. In part this is because of the dominance of cash as a payment method. But even more so because customers won’t part with hard-earned money until they can verify the merchant has made good on their half of the trade.

In Euro-merica, customers know they can dispute a charge if the merchant doesn’t deliver—both literally and figuratively. But in emerging markets, card adoption is still low. So customers there don’t have the same default-trusting posture as their American and European counterparts.

While our cash management challenge was far from unique, it was certainly revelatory. To solve it we had to reassemble the world around us, venturing into territory where there was little or no prior art. Through the process we learned how commerce, payments, trust, transport, and urbanism all interlocked in Nairobi in 2019.

And our specific experience of the problem, as a pre-seed grocery delivery startup, uncovered additional layers that few ever get to see.

Non-Deterministic Checkouts

As far as trust went, it was already bad enough that nobody had heard of us. Even worse, on-demand grocery suffered from the curse of non-deterministic checkouts. On grocery apps, the basket and price on the “Confirm Order” screen does not necessarily reflect what you’ll receive or what you’ll owe.

The non-deterministic checkout curse is especially strong in the beginning because most on demand grocery apps tend to start as guerrilla operations: they pick from established grocery stores rather than holding their own inventory. This model, often called hyperlocal, is a great hack for instantly getting the same breadth of product assortment as a legacy supermarket.

But hyperlocal is terrible for predictability because the on-demand app has no idea what’s in stock. So a lot of the time, on demand grocery checkout screens don’t really know for certain how much you’ll owe when you place your order. They have to add form fields like “What should we do if items are out of stock?”, which would seem absurd in any other ecommerce experience.

Here’s what ours looked like. Always tryhards, we even had an offer where we’d scour the supermarkets of Nairobi until we completed your basket.

Even as an on-demand platform gets bigger, the non-deterministic checkout problem never fully goes away. It isn’t something that on demand grocery apps scale out of, but more like a force of nature that they negotiate with all the way up.

Consider Instacart. It’s now a publicly traded company teeming with world-class engineers and operations researchers. It has tens of millions of deliveries under its belt. It still can’t tell you for certain how much a tomato will cost:

So not only were we operating in an environment with justifiably low trust in ecommerce, we were asking customers to entrust us with their most intimate purchase—their food. We were also pitching them on a product that didn’t know how much you owed until you we had completed shopping for you and you were on the hook to pay.

It made total sense then that customers wouldn’t pay until they saw the goods in person and on their doorstep. We didn’t take any of this personally. Quite the opposite: we were a team of excellence seekers who loved the challenge of winning over customers with such exacting standards.

But this added a complication to our entire business. Low baseline trust in ecommerce—worsened by the unique non-determinacy of grocery—and the state of the payments infrastructure we sat atop, all pointed towards one uncomfortable conclusion:

Our whole business had to build itself around payment upon delivery.

Kenyan Payments circa 2019

In the US when you check out on Instacart and they don’t know how much a tomato will cost, they place a pre-authorization on your credit card. For many reasons, this option was off the table for us.

First off, in 2019 Kenya, cards were still very new and penetration was very low. And the people who did have cards used them exclusively for making international purchases like Netflix or Amazon.

Plus, card numbers are seen as a much more sensitive piece of information than they are in the United States. In part it’s that cards in Africa are usually directly connected to your bank account, and consumer credit—at least as we know it in the US—is quite rare. So card charges in Africa represent a much more direct claim on your personal cash balance than they do in America.

Plus, from the consumer’s perspective, it’s not clear that the resolution process for disputing a charge will run as swiftly and favorably as we expect it to in the United States.

When we consulted our credit card processor, a leading player in the space, they advised against pre-authorization for all of these reasons.

Enter M-Pesa.

M-Pesa is a mammoth payment network run by Kenyan telco Safaricom. Its customer base constitutes the majority of the adult population of Kenya. It is, without exaggeration, one of the most staggering accomplishments of human ingenuity in the last 50 years.

Years before the arrival of credit cards or even broadband internet, Kenya was the first country at its income band to crack cashless payments. In the years since M-Pesa’s launch in 2007, telcos around the world have created dozens of national mobile money networks by copying M-Pesa’s playbook. For those uninitiated to the magic of M-Pesa, let me give a very lossy compressed summary of its provenance and how it works:

SIM cards in Kenya (and markets like it) have historically been provisioned on pay as-you-go plans. Customers top up on minutes on their SIMs by purchasing scratchable airtime cards.

These cards are available at Kenya’s informal convenience stores, locally known as “dukas”. They’re Africa’s answer to New York’s bodegas or Japan’s konbini: small-scale community stores that sell fast moving consumer goods to clientele situated within a few hundred feet of their shops.

And like bodegas and konbini, dukas in the last couple decades have expanded into telephony services as mobile phones have become ubiquitous among their consumers.

What sets apart dukas from bodegas or konbini is the sheer density of their coverage. Because a duka can set up shop on a roadside without a permanent physical structure, there are more than 10x more dukas per capita in Kenya than there are konbini in Japan. These dukas became the primary channel through which they distributed airtime cards to consumers.1

For the telcos, building out a distribution network to reach these kiosks was a massive undertaking. But it was necessary to meet the customer where they were. They also added the ability to send minutes to other phone numbers, something that family members would often to do to gift each other airtime.

One Kenyan telco, Safaricom, realized that they they could repurpose the infrastructure they had built for distributing airtime into a giant payments network.

Here’s an extremely simplified walkthrough of how:

Imagine if a SIM could carry two separate balances: one for minutes, and one for money.

The same flows used to change cash into minutes could change cash into mobile money. The same accounting systems built to maintain a massive ledger of pay-go plans could now maintain a ledger of mobile money wallets. And the ground game they had developed to distribute top-up cards could be used to create a network of mobile money agents.2

You can think of these agents as human ATMs, or micro bank branches.3 You can hand them cash, and you’ll receive an SMS from Safaricom notifying you of your new M-Pesa balance. Or you request a withdrawal, and you’ll receive a debit notification SMS, after which they’ll hand you cash. Like ATMs, agents earn a small convenience fee whenever a customer withdraws.

The brilliance of M-Pesa is that it was an infrastructural breakthrough that required almost no net-new ingredients: just the existing human will and national-scale logistical competence. M-Pesa doesn’t even require a smartphone. It runs entirely through the SIM using an esoteric legacy protocol called USSD.

M-Pesa has been an astounding success. By the time we arrived in Kenya, its annual transaction volume was equal to half of Kenya’s GDP. And it had lifted a million Kenyans out of poverty.

M-Pesa’s APIs

M-Pesa was amazing, but its initial product left a gap that prevented its use in true internet-native commerce.

Namely, while you could send money to another mobile wallet (and later a merchant wallet), there was no way to programmatically attach metadata to the transaction. This prevented a merchant from conclusively reconciling M-Pesa Payment 123 with Order ABC.

After M-Pesa allowed customers to send money to merchant wallets, they added the ability to specify an “account number” for that merchant. The utility companies made great use of this to design bill payment workflows completed entirely over SMS and USSD. A customer would request to pay a certain amount to a utility via SMS or USD; the the utility would send back a token corresponding to the request; the customer would pay the merchant wallet for the utility and include the token as the account number. Still there was no way for the merchant to initiate a payment request from a customer, with the right amount, account, and metadata. So placing an order and paying for it were still totally disjointed.

In 2018, M-Pesa’s developer team opened beta access for a new API to issue payment requests to customers programmatically. Called STK Push, it allowed merchants to initiate a request to pop open the M-Pesa USSD confirmation screen on a customer’s phone. All the customer had to do was enter their PIN and the merchant would receive funds to their wallet instantly, to an account number they could specify. It was Kenya’s answer to the 3DS flow that European credit card users know so well.

When the payment succeeded, you’d receive a webhook with the payment metadata including transaction id, customer phone number, and amount. STK Push was nothing short of revolutionary. For the first time, Kenyans could complete a purchase entirely on the web, using the dominant cashless payment method.

Here was the workflow, in a nutshell:

We were proudly one of the first production deployments of STK Push.

As an early adopter, we had a front row seat to watch the proverbial cement dry.

Cement Drying Problems

My friends and I invoke “cement drying” as a reference to the opening of Disneyland, where Disney was building so maniacally to the last minute that it had to bring in helicopters to dry the cement, still wet, as the first guests streamed into the park.

Many of STK push’s cement drying problems were the kind you’d expect from new API infrastructure rolled out by a legacy telco. For example, developers trying to access the M-Pesa API credentials were subject to an agonizing yak shave, especially if they were developing on Macbooks.

Here’s a snippet from our internal documentation, meant to onboard our developers to getting set up on the M-Pesa APIs, written by Ishuah Kariuiki, our founding engineer:

In order to access the M-PESA Organization Portal you have to install an M-PESA certificate on the specific computer that you intend to use. The certificate is valid for two years and can only be installed on computers running Windows 7.

…

If the computer you intend to use does not run Windows 7, you can create a VM on VirtualBox and install Windows 7.

1. Using the Admin email (in NUMI’s case, *********@numi.tech), send a blank email to M-PESABusiness@safaricom.co.ke. That same email should respond with the password. Alternatively you can call Safaricom Business on 0722002222 with a whitelisted number. (This password is updated every week)

2. On the Windows 7 computer, run Internet Explorer and open the url: https://vmtke.ca.vodafone.com/certsrv. There should be a login prompt. Enter the username and password from the email/call in step 1.

3. Fill in the name, email and company field with valid entries that you used to register your till number and submit.

4. If the request is successful you will be redirected to a page with the title ’Certificate Pending’. You’ll wait 24-48 hours. Please call after 24 hours to ensure your request is on the queue.

Note that at this time, Windows 7 was a decade old, and the last version of IE had been released 6 years prior. Once you got the credentials, and got working in production, you were confronted with another challenge: STK Push didn’t always send webhooks upon payment completion.

The first M-Pesa app developers, us among them, discovered this through awkward production incidents. Typically a customer would find themselves gated from accessing value on an app because M-Pesa’s webhooks had not fired for the transaction that they just completed.

Eventually developers began to realize they needed to reconcile payments multiple ways. This included the proactively query about a specific payment via the M-Pesa transaction status API. And if that failed, they would need to wait for the data dump cron job on the VPN-gated FTP server that they could set up with Safaricom’s developer team.

To the Safaricom API team’s great credit, they were pushing the limits of their own infrastructure trying to deliver a Stripe-like experience. And through the resourcefulness of Silicon Savannah engineers, working both their command lines and their rolodexes, online-native payments began to emerge in Nairobi.

Upgrades

It wasn’t just the M-Pesa developers who had to scrape the rust off their payment rails. We discovered that many customers’ SIMs were on older versions of firmware that were backwards incompatible with STK Push.

And neither the merchant nor the customer would receive an error message if an STK push request was issued to an old SIM. Instead the customer would just be waiting, as the driver awkwardly tried to debug what the problem might be.

We eventually found out from Safaricom customer support that subscribers with old SIMware needed to punch in a series of USSD commands to receive an over the air upgrade to their SIMs.

So we created the first payment loading screen that I’ve ever seen, which provided the USSD sequence to install an OTA upgrade on their SIMs.

We took pride in shipping error copy so actionable that it drove our customers to the frontiers of the latest payments infrastructure. Error screens like this are relatively rare in the history of user interfaces, because they only make sense in settings that are changing rapidly.

Here’s what our M-Pesa flow looked like once it considered the cement drying challenges, and of course the inevitable insufficient funds errors:

The nature of the problem made it so that our flow of goods and money looked very different from any ecommerce that we, two internet-native US-raised founders recently transplanted from San Francisco, had ever seen.

While STK Push was a big improvement, we still saw about 20% of our orders paid in cash. In a game where we wanted to maximize our growth, increase word of mouth and create local network effects, we couldn’t ignore this 20%. The lore has it that Flipkart became ascendent in India because they accepted cash on delivery.

Like Safaricom did with M-Pesa, we had to meet our customers where they were.

The Cash Management Status Quo

Our competitors were on-demand platforms live in multiple countries, with billions in funding. We naturally assumed they had figured out the best practices in managing cash. Our riders, who delivered for all the platforms, told us how they did it.

Every platform let riders hold the cash that they picked up over the course of a week, and then required them to come back into the head office. There they’d drop it off and reconcile it with someone in finance.

Contractors on on-demand platforms everywhere have to worry about timeliness of payouts. At its core this is a working capital problem. Typically it’s the case that the contractors are waiting on the platforms to pay them out.

That’s because the platforms are getting paid by the customers via card. After a few days, the funds settle from the platform’s payment processor into the platform’s bank account, where they will leave at the end of the pay period to be transferred into the contractor’s bank account.

The story gets messier in markets where the platforms accept cash. The money flows in two directions: from platform to contractor for cashless payments, or from contractor back to platform for cash payments.

Who carries working capital for whom becomes a bit of a question of political economy. Riders liked getting paid in cash because it allowed them to get their wages up front and use the float to cover their fuel and maintenance costs. The platforms prefer to get paid up front, and ideally to skip handling cash entirely.

For the platforms, handling cash introduces so much more headache surface area. It comes with a unique set of operational challenges:

1. Finance managers and riders disagreements on exactly how much cash is owed, how much cash traded hands, or whether certain bills are too damaged to be accepted at a bank

2. A bank teller and finance manager disagree on the same

Each problem has a solution. But they add process to your flow of funds. And as you add process, you increase the number of potential failure points.

One way to sidestep these thorny questions of institutional design is to deflate the stakes. So we tried that first.

We required all riders to drop off their cash with us at the end of each shift. This reduced the magnitude of each cash headache and allowed us to defer implementing a more robust balance tracking system.

Marchetti’s Motorcycles Strike Back

While our daily cash remittance policy made cash management problems smaller, it clashed with the urban layout of Nairobi.

In Marchetti’s Motorcycles, my friend Osarumen Osamuyi excellently breaks down how the speed of transport shapes the spatial development of Africa’s megacities. As the mileage that a person can travel in an hour grows, the city will naturally expand outward from the center to reach that limit.

We began to feel these forces we reached order volumes that 1) allowed us to batch multiple orders in the same trip and 2) made deliveries to Nairobi’s peripheral exurbs more and more frequent. For most our time, we picked from a single grocery store and dispatched across all of Nairobi.

Here’s what how our order density played out geospatially:

Much of our order volume clustered around a few affluent districts. And then the rest was spread across the city, in smaller clumps of neighborhoods where Nairobi’s young professional families flocked.

An aside: our team came up with some novel storage solutions as a result of this batching which—like the payment workflow created—we were surprised to see others hadn’t tried before.4

The riders began batching their orders so that their routes would go in order from the Carrefour at Junction Mall (our primary shopping site), all the way out to last stops in the exurbs. At the end of their shift, they’d try to plan their last deliveries to be along their way home.

This was the natural way to sequence deliveries. Having to come back to our office to drop off cash created a huge pain for the riders.

Consider this illustrative delivery route. The rider departs from Carrefour Junction (1), making multiple drop offs until the last customer at Stop 2. Rather than go home directly to Stop 4, they’d have to backtrack to our headquarters at Stop 3 to drop off their cash.

In Nairobi’s ever-present traffic, this could easily add 45 minutes or more of driving time to a rider’s day. And these were 45 physically and cognitively expensive minutes, as the rider spent them either weaving between cars or enduring the micro-vibrations of their motorcycle engine’s as they drove on a freeway.

Our riders and my cofounder Harrison (who himself became a boda rider), devised a solution that worked beautifully.

Our Final Cash Management Workflow

If the customer informed the rider that they’d be paying in cash, the rider would open their rider app and record a cash payment for that order. We’d have it marked in our system that the rider owed the value of that order in cash. That much put us at parity with the other platforms.

But rather than having the riders come back to the office, they would remit that cash back to us via the same STK Push rails we had built for our customers.

After their last delivery, they’d ride just a couple hundred feet to the nearest M-Pesa agent. They’d load up their M-Pesa wallet with the cash they’d collected on that shift. And then they’d use our rider app to initiate an STK Push request to our till number. Using the metadata on the transaction, we’d know this was a rider remitting cash back to us. After verifying the payment, we’d deduct the value of the STK push transfer from the balance of the rider’s cash account.

This meant that from the rider’s perspective, every single M-Pesa agent was effectively a NUMI cash remittance agent as well. Suddenly NUMI went from 1 cash drop-off site to hundreds of thousands of them.

Here’s the final workflow visualized:

When Geoff Charles was running his Fintech World Tour before he started at Ramp, we got dinner one night in Nairobi. I told him about our policy of accepting cash, and he said “that must be an operational nightmare.” I was surprised that in his travels he hadn’t come across a better solution than the ones we had encountered from the other platforms in Nairobi. I checked with friends in Latin America and Southeast Asia, and they similarly hadn’t heard of any examples.

I’ve wondered why we were, to our knowledge, the first people to arrive at this cash management workflow. We were a creative and determined team, but that was far from unique. Simply due to their size, the platforms in other markets had many more creative and determined people building them.

The key ingredient in our solution was the magic of Nairobi. Nairobi has always been an early adopter city, and we happened to be there when new infrastructure unlocked. It’s not clear to me that there was another payment ecosystem like ours in 2019, where there was a ubiquitous mobile money service that had unrolled a payments request API for merchants.

And what about our local competitors? Why didn’t they come up with this solution? My guess is their scale and maturity focused them on running their existing processes well rather than inventing new ones. Our solution turned out to be very technically involved. It’s unlikely that the local on-demand platforms, themselves branches of companies based in Europe and SF, had the engineering resources available to build something similar.

When we launched, most our competitors hadn’t even implemented STK push yet in their native checkout flows. Their wisdom and restraint—holding off on adopting unproven infrastructure—was the opposite of our boundless, earnest naivety.

Ultimately, our Kenyan on-demand dreams didn’t pan out. But it was a joy to build at the frontier of the possible, and in our small way, help inch that frontier forward.

Made it this far? Let’s be friends on X (nee: Twitter)

• Part I: The Birth of Russia’s Market Economy

• Part II: Russian Bandits and the Rule of Law

• Part III: The Mechanics of Soviet Banking

• Interlude: Soviet Barter And International Trade

• Part IV: Russian Banking’s Birth By Mutiny

The final days of the Soviet ruble zone read much more like heist than history.

The Soviet ruble fell because Russia was unable to propose a bargain enticing enough to keep the other former Soviet republics in the currency union. But how the Soviet ruble fell looked less like a series of failed roundtable talks, and more like a cyberattack or bank robbery followed by a titanic game of musical chairs where each player was a national-economy.

In a paragraph, here’s what happened:

The post-Soviet republics exploited inadequate access controls on the Soviet payment settlement network to rampantly issue new ruble stock to themselves as a way of kickstarting their budding market economies. They debased the Soviet Ruble so aggressively, that even Russia abandoned it. In fact, Russia abandoned its own currency before several other post-Soviet republics. So for a while many post-Soviets used a currency with no institutional backing. As each country successfully deplatformed from the ruble zone, their dead ruble stock would secrete out into the remaining economies, accelerating inflation.

This ended when Tajikistan issued a local currency to replace the Soviet ruble two whole years (!) after Russia had abandoned it.

If the above paragraph makes total sense, and the underlying details are either familiar or irrelevant to you, there’s not much more on offer here so you may as well stop reading now.

If, on the other hand, the above paragraph gives you either brain freeze or an itch of curiosity, then please—follow me.

Umbilically Connected

If you haven’t read the primer on Soviet banking, much of this post will not make sense. If you have, you know that the branches of the Soviet Gosbank, known as the Soviet monobank, were at the capitals of each of the Soviet republics. And as we discussed in the prior section, the central banks of Russia and many other republics more or less started from bureaucratic mutinies mounted from within these regional branches.

These rolling bank mutinies let large slices of the Soviet financial system declare independence from the monobank. Its last remnants were finally swallowed by the Central Bank of Russia. But there was a problem: all the newly sovereign banks were still connected, almost by umbilical cord, to the former Gosbank branch in Moscow, which now was home to the Central Bank of Russia.

They still had access to the Gosbank intrabank, interbranch settlement network.1 And that settlement network had been designed to cater to a system where money was just a unit of account, largely between different organs of a single government.

Suddenly, that same payment network was now moving actual money.

And these newly seceded post-Soviet republics had newly birthed market economies in desperate need of a kickstart.

And thanks to the Gosbank policy of direct crediting virtual rubles at the branch level, these former regional branches had the organizational memory on how to run local credit allocation campaigns. And each was now a fully sovereign central bank, with the ability to unilaterally debit from the accounts of the Central Bank of Russia.

In July 1992, CBR tried to slow down the unilateral ruble debits by introducing credit limits for each post-Soviet central bank. Most central banks completely ignored the new guidelines (especially Ukraine), and hit their limits within 3 months.

To tighten the control system, Russia imposed a new restriction on countries that exceeded their credit limits of non-cash rubles. They had a daily limit of cashless rubles debits, only to be used to settle invoices of imports into Russia, but the limit of the transfers was capped at the value of exports sent out from Russia.

This fractured the cashless ruble by national boundaries. The cashless ruble deposits in each country developed their own fair market value and traded at different rates to each other, despite ultimately sharing a common origin. Very weird.

There’s no “I” in Ruble

Russia tried to keep the new governments inside of a single ruble zone that it intended to lead. Initially many of the post-Soviet countries were open to this arrangement. (Aside: as a bit of foreshadowing, the Baltic states and Ukraine immediately announced they’d leave the ruble zone.)

The other states were open to a currency union where they could steer the formation of monetary policy. Russia, never the one to treat its neighbors like peers, refused to allow anyone else in the ruble zone to have any voice in monetary policy.

Throughout this process, the non-Baltic, non-Ukraine countries were of two minds as to whether to leave the ruble zone. They feared retribution from Russia and didn’t want to lose access to the legacy settlement system, which significantly eased cross border trade. Plus, they loved the idea of being able to increase the money supply for their local economy while having the inflationary impact spread across all member states.

At the same time, they weren’t confident that Russia could stabilize prices, especially with the massive outflow of rubles from Ukraine as it left the ruble in 1992.

Russia’s proposition was: the CBR will be the site of issuing new currency, and the only institution involved in forming monetary policy. As it became clear that the ruble zone would just be the Russian Monetary Show, other countries began to introduce parallel currencies.

Alternative Currencies Sprout Up

Hyperinflation, as well as literal paper-and-ink-and-trucks-and-pallets capacity limits to money printing created a cash shortage across the ruble zone. Belarus, Moldova, and Azerbaijan rolled out “coupons” as a medium of exchange, to be used for common, large transactions like paying rent.

Belarus went to particularly great efforts to drive a higher percentage of cashless value exchanges. They issued checkbooks for high income individuals and requiring purchases of a certain size be made over check rather than cash.

And of course, governments began to introduce their own national currencies, issued to circulate in parallel with the ruble. If this seems chaotic, consider the times—total dissolution of the USSR—and the previous system (which itself had been dual currency).

The national currencies acted as a hedge against the ruble zone failing. By mid-1992, it became clearer that:

• Russia couldn’t stabilize prices domestically (remember how we said it had never managed a free-floating currency?)

• Russia was unwilling to cooperate on monetary policy with any other country in the proposed ruble zone

These two facts increased the expected value of a national currency. But adopting a national currency isn’t just a matter of policy, it’s also a matter of skill and capability. So in pursuing a national currency, each of the states began climbing a central banking learning curve. As they learned the ropes of how to manage a currency, the national currency pathway valuable relative to staying in the ruble zone.

Russia (and then everyone else) Jumps Ship

Russia realized that diplomatic talks weren’t working to convince the other countries to agree to a ruble zone that it dominated.

So it announced in July 1993 that in about 2 months, it would demonetize from the pre-1993 ruble, and in favor of a new one. Any post-Soviet countries were welcome to join the zone of the new ruble, if they realized that new currency emissions and monetary policy would only come from the CBR.

Immediately upon the announcement, Azerbaijan, Georgia, Moldova, and Turkmenistan left the ruble zone. The remaining countries—Armenia, Belarus, Kazakhstan, and Tajikistan—expressed their desire to join the new ruble zone.

As countries exited the old ruble zone, their supply of old rubles would be used effectively as “free” tokens to pay for imports from countries still using the old currency. The result was a flooding of pre-1993 rubles into any country still using them, as fewer and fewer countries had to circulate largely the same supply of old rubles.

This had the strange effect of making other countries leave the pre-1993 ruble, after its issuer Russia had. The CBR would not or could not roll out the new ruble fast enough to outrun this flood. To save their economies, all of the last remaining countries began issuing their own parallel currencies by November 1993.

Except Tajikistan.

Tajikistan took all of the circulating supply of pre-1993 rubles as every country exited. It went down with the ship. It would be nearly two years after every other country exited the ruble, in May of 1995, when Tajikistan finally adopted its national currency. It started its national economic story out with hyperinflation because of how slow it was to leave the ruble.

Lessons from Russia’s Bretton Woods

The collapse of the Soviet ruble zone is as strange as it is instructive. First off, it shows the importance of payment networks in shaping path dependencies. Much of the drama that unfolded was because of how hard it was to kickstart a banking system without access to the legacy Soviet payment rails. Not to mention those payment rails had been designed to issue money locally to the republic-level branches, but under Moscow’s name. When each branch was its own country, this turned into something like a pillaging of the faith and credit in Russian money.

Lessons for negotiating. The Central Bank of Russia, a kind of institutional antihero, was oddly willing to endure this attack on its currency from its neighbors. It thought this meant that they were still dependent on Russian banking and would ultimately be convinced to submit to Russian monetary policy.

While I wasn’t there, this seems like a negotiating position completely lacking in empathy, especially coming from a supposed monetary ally. It was much harsher than the position of the US at Bretton Woods. The US and Russia adopted similar positions at Bretton Woods and the ruble roundtable talks respectively, but the outcomes couldn’t have been more different. The US convinced the world to adopt the dollar as its reserve currency, while Russia destroys its currency.

Lessons for state capacity. The pillage of the Soviet ruble happened because Russian central bankers couldn’t move fast enough to clamp down on ruble debit abuse. They were too slow to roll out access control or permissions workflows. Quite literally this was a failure of a product team that could not meet its shipping commitments.

The cash crisis that drove other countries to develop their own currencies came because of both hyperinflation and the CBR’s inability to issue enough cash rubles to keep all the activity happening within its neighboring economies inside of the monetary zone.

There’s a lot of logistical work that goes into managing and rolling out a currency, and these countries had no idea how to do this until CBR’s own lack of logistical excellence forced them to develop it.

And finally, you can see a rough pattern among the countries who stayed versus the countries who left the Russian ruble zone. The ones who left immediately were the Baltics and Ukraine. Well before they sought to join NATO, these countries struck Russia right in its monetary system.

• Part I: The Birth of Russia’s Market Economy

• Part II: Russian Bandits and the Rule of Law

• Part III: The Mechanics of Soviet Banking

• Interlude: Soviet Barter And International Trade

We hardly need to take the United States as a model.

It is a country with its own painfully specific features. We must not forget that it is 200 years old and has been settled mainly by rebels, adventurists, and misfits, by what one may call dissidents who did not get on in their native civilizations and were drawn to the undeveloped continent, where they could do, think up, and try whatever they liked.

— Viktor Gerashchenko, head of Gosbank, in 1993

In Part III, we sketched out Soviet banking’s final stable form. Today, we’ll walk through the play by play of how it collapsed, and how through its collapse, modern Russian banking was born.

In Part III, I argued1 that the Soviet banking system was designed with a cardinal goal of eliminating the ability to transfer price information. Why was it such a critical, uncompromising policy goal to avoid price signals? Because prices created opportunities for arbitrage and profiteering, which the Soviets saw as criminal. Article 153 of the Soviet legal code explicitly outlawed “private entrepreneurial activity”, punishable by a “deprivation of freedom” of up to 3 years.

All financial activity in the entire Soviet Union was handled by a single bank, called Gosbank (“government bank”). It managed a two-tier monetary system, where two types of rubles circulated, on two totally separated circuits of trade. Worker wages and purchases were paid in the domestic “hard” ruble. State owned enterprises—the only multicellular organisms permitted in the Soviet economy—traded with each other in “virtual”, cashless rubles.

The best available English language literature seems to indicate that Gosbank’s only monetary instrument was the ability to issue new virtual rubles. It did so by directly crediting the virtual ruble accounts of individual enterprises.

But how do you know which businesses most need credit subsidy? Any bureaucrat worth their salt will tell you that you can’t terraform turf you have not properly mapped. In order to map out the Soviet economy’s balance sheets, Gosbank maintained the authoritative account of all inter-enterprise debts.

Never mind that this system—a purely virtual currency, whose entire transaction history is stood in a single authoritative ledger—is identical to a blockchain, except that the Soviet solution to the Byzantine Generals problem is to have only a single General.

Anyway.

Previously, I compared the birth of the Russian banking system to a zombie outbreak. The Soviet Union’s previously dead banking institutions sprang to life with a new sense of agency as the banking monolith fell apart. As more players within the system realized for the first time they had agency, it accelerated the collapse of the old Soviet banking model, and birthed the one we have today.

Act I: The Monobank Fission

Every zombie story starts with a case zero scene. In this story the outbreak started with the Law on Cooperatives of 1988, which legalized private enterprise in the USSR. It did so in part by making state owned enterprises responsible for their financial performance, meaning they would have to go bankrupt if they failed.

Now this wasn’t something one could simply declare. It required changes to the structure of banking. In order for it to be possible for businesses to go bankrupt, their access to credit need to be mediated by market forces. But all commercial credit in the Soviet Union was doled out by Gosbank to state enterprises, in the form of virtual rubles. The newly realized market agency of state owned enterprises needed to make a zoonotic hop to Soviet state banking.

There was probably a wood paneled room somewhere in Moscow with an oblong table, where Soviet economists gathered to deliberate how they might create a credit market. “Well of course,” one of them probably said, “we need to carve up Gosbank into a proper two-tier banking system.” That’s essentially what they did, splitting the monobank into an upper central bank, and lower banks that allocated credit.

The lower tranches of Gosbank were spun off into 3 special purpose banks called spetsbanks (“spec. (as in special) bank”). These spetsbanks would be more actively involved in the provision of credit, taking from Gosbank its responsibility of dealing directly with commercial customers. The spetsbanks would make lending decisions based on their assessments of the creditworthiness of businesses requesting credit. This meant Gosbank would lose its only monetary instrument of directing credit to individual businesses. In its place, Gosbank gained the ability to set interest rates at which the spetsbanks could borrow from it.

Gosbank Strikes Back

Gosbank was very unhappy to see these market reforms break its monopoly over Soviet finance. And because the carve-up left fuzzy mandates and overlapping scopes, Gosbank and the spetsbanks immediately began feuding.

In a Total Soviet Move™, Gosbank attempted a denial-of-service attack on the spetsbanks by barraging them with telegrams, memos, directives, forms and other paperwork that were meant to overwhelm the spetsbanks’ organizational processing power. The spetsbanks, in a Total Soviet Response™, hired more staff to clear their backlogs of Gosbank correspondences.

Gosbank tried to restrict the credit available to spetsbanks. The spetsbanks, knowing their privileged monopoly of credit shielded them from any real market accountability, gave out credit to enterprises like it was candy. Seeing the overstaffed and over-levered spetsbanks, the Soviet Council of Ministers thought the core problem was a lack of profit motive. So they passed a resolution that required the spetsbanks to operate out of their own revenues.

But mostly all this did was heighten the stakes of the feud between Gosbank and the spetsbanks, who now had fewer places to turn for bailouts (or financial armaments?) as they thrashed under Gosbank. The real problem wasn’t a lack of profit motive, but an unusual failure in the lending supply chain: Gosbank wouldn’t avail enough credit to the spetsbanks.

Normally, when central banks tighten their monetary policy, they do so for the sake of the currency they manage, to help stem its inflation. But in this case, Gosbank tightened its credit availability to strengthen its control over the spetsbanks.

Practically every state enterprise was exposed to the waste heat produced by this infighting. The state banks had no uniform operations, and they each offered different subsets of the banking services suite. In summary, every enterprise had to deal with all the state banks. For example State Bank A offered settlement services, while Bank B offered working capital, Bank C offered payroll loans for your workers, and so on.

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Cooperatives as a Financial Wormhole

As the state banks bickered, the heads of the state enterprises realized that the Law on Cooperatives had opened a novel pathway for them to convert their outputs, which were normally only sellable for virtual rubles, into cold hard cash.

Previously the state enterprises were only able to trade with each other, and could only settle their transactions in virtual rubles which were valueless and inaccessible to Soviet citizens. If you were an individual, there was no way to use a virtual ruble to pay for your rent, or for a dozen eggs, or a bottle of vodka. In fact, there was no way for you to even hold a virtual ruble—literally because 1) there were no material, physical banknotes (hence their “virtual” moniker), and 2) in a property-rights sense there was no way to open an individual account at a Soviet financial institution that could accept virtual rubles. This was the Soviet two currency system, and it was meant to shield Soviet production from price signals and subsequent profiteering.

Well the Law on Cooperatives allowed these state enterprises to open subsidiary cooperative entities. These cooperatives were allowed to interface with the open market and deal in hard rubles. For the first time, Soviet enterprises could sell the goods they had created for real, paper cash. Cooperatives were a financial wormhole that allowed enterprises to alchemize value that was previously trapped in virtual ruble funny money into hard cash, which could be used by end consumers and were therefore infinitely more valuable socially.

This was the moment it became clear that the Soviet economy had not been built in the absence of markets, but in a market vacuum. This was the moment that that vacuum burst. And as enterprises began pushing their product through their cooperative wormholes, they began to build massive piles of hard rubles with nowhere to put them to work. And just as much as nature abhors a vacuum, money abhors unemployment.2

Letting a Thousand Cooperative Banks Bloom

There was a massive and growing unmet demand for banking among the cooperatives. In 1988 Gosbank, under the leadership of its new director Victor Geraschenko, realized this presented an opportunity to dilute the spetsbanks’ control over the Soviet credit system. Gosbank, as the Soviet Central bank, was responsible for authorizing banking charters. It deliberately slashed the requirements for cooperative banks, allowing them to form with as little as 500,000 rubles in charter capital.

These new banks could exploit multiple arbitrage opportunities between the imploding command economy and the exploding market economy. They accepted hard cash deposits from the wormhole cooperatives and lent them out to those credit-starved firms building outside of the command economy. So now, not only was value leaving the virtual ruble system through the cooperative wormhole, but it was beginning to compound as it sat in accounts at freshly chartered private banks.

Because veto power to register a bank was still promiscuously distributed across many organs of the Soviet apparatus, most of the market demand for banking was served by cooperative banks that kicked up a cut of their action to either a state enterprise or Soviet administrator. Many of these banks formed to serve only one to three clients, usually large state enterprises who had grown disgruntled with the deteriorating state banking system and decided to convert their finance departments into single-client banks. Federov estimated that “pocket banks” accounted for at least 75% of the capitalization in the new commercial banking sector by 1989.

Gosbank’s push to accelerate the expansion of the banking universe put pressure on the spetsbanks, and there were more than 70 banks operating in the USSR by 1989. As more commercial banks formed and scaled off their own cashflows, they began draining the government banks of their best, most enterprising talent.

The spetsbanks didn’t take this threat lying down. They tried their darnedest to obstruct the new commercial banks. They’d refusing to open spetsbank accounts for them, which the new banks needed them access to the interbank settlement network. They’d freeze the assets the private banks held at their spetsbank accounts, or refuse to transfer funds to the their customers’ accounts.

Act II: A Bank Mutiny

From 1988 to 1990 more and more of the banking system turned hostile towards the spetsbanks.

In 1990, a political wedge formed as Boris Yeltsin, newly elected as the chairman of the Russian Soviet republic, distanced himself from Gorbachev’s unity-focused reforms. In July of that year, the USSR Council of Ministers moved to keep the spetsbanks under Soviet rather than Russian control. They announced that they would flip two of the three spetsbanks into commercial joint-stock banks, and give a controlling share to the Soviet Ministry of Finance.

This culminated in a banking secession. Within days, the Supreme Soviet of the Russian Federation (the Russian republic within the Soviet Union) called for the creation of a two-tiered banking system within Russia, and that all spetsbanks within Russian territory would be under the jurisdiction of the yet-to-be-formed Central Bank of Russia (CBR).

Gosbank, in yet another Total Soviet Move™, responded by sending out a telegram to the entire Soviet banking system to ignore any local legislation that contradicted their laws. And then it informed all the state banks that their computer networks would be comandeered by the Gosbank head office.

Ah yes. Telegrams and control. You get em, Gosbank! Flex that rational-legal bureaucratic authority. Here’s the problem, though. When order gets disrupted, rational-legal authority gets you a lot less mileage. This is because the rules are melting. The clay that had previously been kilned is un-drying. Proactivity now has much higher leverage than your rule kugel. Don’t things that don’t scale can move mountains because laws and offices and bureaus have decomposed, and we’re back to what’s it been all along: just people dealing with other people.

The Russian Federation, in its monetary battle with the Soviet Union, seems to have understood this in a way that Gosbank didn’t. At this point, the CBR was merely a figment enshrined in a series of documents. It controlled no accounts, it stewarded no currency. Insofar as it was anything at all, it was just a piece of paper.

Every eventually powerful institution starts out like this, just an idea. What brings the idea to life is action.

And in this crucial moment, the CBR’s founding chairman, Georgy Matyukhin, previously an economics researcher, behaved like you might expect a promising startup founder to immediately after they complete their incorporation paperwork. He moved—physically, with his body—to make his idea real. Here he explains it in his own words:

Then it was necessary to create the bank and find myself a place under the sun. The Russian …[branch of] Gosbank was located in Moscow. I directed myself there. But, despite the resolution [issued by Yeltsin]… they simply didn’t allow me into the building… Then I decided to “storm” the bank with a group of Russian deputies… Fortunately our “storm” succeeded, and [one of the deputies with ties to the Moscow Gosbank branch] introduced me to the staff of the bank, saying that in agreement with the resolution a Central Bank must be founded, and it would be desirable not to start from scratch but on the basis of the already existing bank. The collective supported this idea and we began to work.3

So Matyukhin successfully flipped Gosbank’s most important provincial branch into a totally new central bank, with the consent of the bankers.

Reader, can we just stop for a moment and take in how absolutely weird and unprecedented this is? When we think of seismic changes like this, they usually happen downstream of tanks rolling into presidential compounds, or civil wars. But here, both bloodlessly and without threat of force, an economist went up to the strongest regional branch of his government’s central bank, and told them “you guys wanna peel off and do our own thing, just for this region?”

To transpose it to more local landmarks, this would be like a professor of economics at Columbia, acting on an executive order issued by the governor of New York, marching to the New York branch of the Fed and successfully talking the staff into monetary defection to the newly sovereign Republic of New York. And that all Jerome Powell did in response was send out a press release saying “I vehemently disagree” and then threaten to have the Fed’s head of IT reset everyone’s passwords.

This Is, very, very weird.

But—

It’s what happened.

Matyukhin then offered all the individual spetsbank branches within Russian territory the opportunity to “go private” and become for-profit entities if they registered under and transferred their assets to CBR. By the time Gerashchenko made a similar counteroffer it was too late.

Thus began a wave of thousands of spetsbank branch administrators weighing their options. They deliberated whether they “go private alone” or merge into clusters with other neighboring branches to take advantage of larger consolidated balance sheets.

This privatization of the spetsbank branches was a watershed moment in how Russian capital would form. The initial capital required to register with the CBR was often provided by the handful of state enterprises each of these branches served. So when the spetsbank branches were incorporated as private commercial banks, the shares in those banks went to the state enterprises (who themselves were on a completely uncharted path to become private joint stock corporations).

Knowing that the institutional clay would not be this malleable for long, CBR moved fast to approve spetsbank privatizations and registrations. One branch manager says:

Strangely, we registered without any problem. The resolution “On Commercial Banks” was passed in the beginning of October 1990, and on October 31 we had already received in Moscow all of the necessary documents and status of a commercial bank.4

This was the second banking explosion, after Gosbank encouraged the formation of cooperative banks.

The result was that by late 1991 Russia had nearly 2,000 individual banks, where just 4 years prior there had been 1. As Juliet Johnson points out, this didn’t lead to a vibrant, robust banking system, with banks cooperating with each other to increase the availability of worthy credit to worthy borrowers. Instead it led to turf wars between newly formed banks jockeying for each others deposit fiefdoms, and the birth of thousands of undercapitalized banks, dangerously close to failure as soon as they were incorporated.

It also led to a brain drain from the central bank. Commercial banks poached CBR’s most talented new recruits. Within a couple years, fewer than 1 in 5 employees in Russia’s central bank had a college degree. And the majority of them were legacy hires from the Gosbank days, culturally bound to the Soviet way of pushing paper.

The bank privatization happened so fast and so politically that it didn’t get to incorporate foreign investors into the process the way other Eastern European countries like Poland did. In those countries, foreign investor involvement made the whole process less volatile, as outside expertise helped restructure banks and transferred desperately needed institutional knowledge about how to operate in a market economy.

Russia’s New Banking System

So now, after much thrashing and struggle, Russia had fashioned itself a new banking system. The Central Bank of Russia was a totally new creature in the history of Russian finance: a fully autonomous steward of a modern fiat currency, floating on international markets. Following the tradition of central banks in the West, the CBR was autonomous from the rest of the Russian government.

Normally, the theory goes: keeping central banks autonomous lets them implement sound monetary policy even when it’s unpopular (people love loose money but that eventually causes inflation, and people hate being credit starved, so tightening the money supply—usually the only way to really combat inflation—is an inevitable necessity, even if politically unviable).

So autonomous central banks can protect a currency while staying insulated from political blowback. This is a very bazaar-pilled cybernetic approach: autonomous central banks can respond to the economy without the pressure of election cycles.

What’s unique about CBR’s autonomy is that it was an absolute menace to both the Russian government above it and the commercial banks beneath it. It operated opaquely, providing almost no visibility to the public, the legislature, or the executive. And much to the frustration of the commercial banking industry that it spawned as part of its banking mutiny, the CBR was sporadic in its rates. They’d suddenly skyrocket, and then plummet without warning. This was in part because there was no real consensus within the CBR about how it should apply its monetary instruments.

This made lending hell for commercial banks. Don’t cry for them though: they still made a handsome profit despite this chaos by lending at exorbitant rates to credit famished entrepreneurs. Many of these entrepreneurs themselves were making a killing despite the high costs of capital by running the wormholes that converted virtual-ruble-denominated state production into hard rubles.

Act IV: Banking Infrastructure Strikes Back

The most interesting thing about Russia’s banking transition, besides everything, is the way that it put infrastructure center stage. This is a general property of crisis: stress tends to make implementation details critical.

Recall how we described the pieces of Gosbank’s infrastructure as a series of Chekov guns. For CBR, it was immediately confronted by two problems.

Great Expectations. In 1992 alone, the nominal value of loans made by commercial banks grew 10x. Despite hyperinflation, banks turned sizable profits off lending due to a massive interest rate spread between their deposits and loans. They also had another cheap source of capital: the CBR’s directed credit policy.

The CBR continued Gosbank’s directed credit policy, but it relied on commercial banks to handle the implementation of allocating the credit to specific enterprises. This effectively made the commercial banks the enterprise-level servicers of industry-level credit issued by CBR. As part of this arrangement, the credit that commercial banks received from CBR could only be allocated businesses in the intended industry, and at capped interest rates.

Commercial banks happily ignored these restrictions because they knew the CBR didn’t have the capacity to granularly monitor what happened to the credit after it had been transferred to them. The result was both surges of credit in industries that the CBR did not intend to target, and windfall banking profits despite hyperinflation.

By May 1992, it became clear to CBR that the Gosbank-era card file system had helped create moral hazard that enabled the ballooning debt balances. The problem lay with card file number 2 channel in particular, which gave CBR (and Gosbank before it) fully visibility into all inter-enterprise transactions.

Previously Gosbank’s policy of directed credit would allocate virtual rubles to insolvent enterprises. CBR saw that as long as card file number 2 remained open, the market would saddle it with the same expectations. So while it offset debts for the final time in the summer of 1992, it abruptly announced the closure of card file number two.

This signaled to businesses that they had to figure out their own finances.

Payments bottlenecks. The most significant infrastructural failure was also the most straightforward. The CBR found itself running a much more interconnected banking sector using centralized infrastructure. Every. Single. Bank payment in Russia went through the CBR’s settlement system. This meant every transfer had to be processed by hand, with pen and paper, at CBR’s head office. To make matters worse, as the CBR was still on the dual-circuit Soviet ruble, it needed to process these payments across two separate channels.

If this was arduous for the central bank, it was torturous for the commercial banks. Interbank transfers took about two weeks to complete on the paper system, as it was swamped by the hundreds of hundreds of transfers happening between Russian banks.

The CBR tried to streamline its payments workflows by repurposing yet another piece of Gosbank infrastructure, this time the payments-cash centers which Russia developed to remit its taxes back to the Soviet budget, called RTKs.

The rollout was one of the most consequential migration failures in the history of systems. Overnight, it created even bigger piles of new paperwork for CBR staff to process. It wasn’t clear who to send what documents to, so many commercial banks had to hire full time staff whose only job was to navigate how to get their transfer slips processed at the local payments-cash centers.

Many banks had employees who stood in line for weeks at a time just to get their bank’s cash out of these centers. Interbank settlements in Russia were already shambly, but the migration to using RTKs pushed the problem over the edge. The migration was such a mess that it contributed to Matyukhin losing his job when the Russian parliament’s called a vote of no confidence against him in 1991.

His successor?

No other than former Gosbank head Viktor Geraschenko, the same person who had attempted to thwart the formation of the CBR in the first place.

Conclusion

It’s quite hard to cinch shut a history on the birth of the modern Russian banking system, because it’s a process that is still ongoing today. In many real ways too, not in the cosmic “everything is always in motion” senses. But this was Russian banking’s big bang moment. The immense pressure from the blast was so strong that it triggered revolts at the highest levels of government. It left melted payment systems in its wake. It sucked in the deftest minds of the previous order and kneaded their talents into its sourdough, shooting ever outward.

Monetary mismanagement and economic shrinkage led to the implosion of the Russian ruble in 1997, a financial meltdown that wiped the country’s savings.

While true of any banking system, Russia’s final chapters in particular are far, far from written.

Even though we can’t get all the way to present-day, in the next (and, I promise, final) installment of this series, we’ll discuss the demise of the Soviet Ruble zone.

Bibliography

Fedorov, B. Reform of the soviet banking system. Communist Economies, 1(4). 1989. doi:10.1080/14631378908427623

Johnson, Juliet. A fistful of rubles: The rise and fall of the Russian banking system. Cornell University Press. 2000.

Johnson, Juliet Ellen. The Russian banking system: institutional responses to the market transition. Europe-Asia Studies 46.6. 1994.

Kim, Byung-Yeon. “Causes of Repressed Inflation in the Soviet Consumer Market, 1965-1989: Retail Price Subsidies, the Siphoning Effect, and the Budget Deficit.” The Economic History Review, vol. 55, no. 1, 2002, pp. 105–27. JSTOR, http://www.jstor.org/stable/3091817.

Nakamura, Yasushi, and Yasushi Nakamura. "Soviet Banking and Non-cash Money Management." Monetary Policy in the Soviet Union: Empirical Analyses of Monetary Aspects of Soviet Economic Development (2017): 99-124.

• Part I: the Birth of Russia’s Market Economy

• Part II: Russian Bandits and the Rule of Law

• Part III: The Mechanics of Soviet Banking

As I assemble Part IV on the Russian transition to capitalism, I wanted to zoom in on one particularly strange corner of Soviet money. Recall in Part III how the Soviet Ruble was designed to protect Soviet production from any and all price signals.

While we covered in detail how the USSR did this, the astute reader might have noticed a key missing detail: how did the Soviets protect themselves against international trade that itself would inevitably be driven by price signals?

The answer was simple: they didn’t trade with other countries. At least in theory, or on the record, or in currency. To make sense of the bizarre shape of Soviet trade, we need to first see how cross border trade happens normally.

Normally, in the import / export business, the company purchasing the goods needs the currency that the company selling the goods trades in. Intro Economics lecturers demonstrate this by describing trades happening in convoluted currencies, conjuring hypothetical scenarios like Moroccan soda importers, seeking to import Jarrito’s from Mexico, who need to change their local Dirham to Mexican Pesos. In the real world, they most will likely would just transact in USD, which has been the dominant currency for international trade for the last several decades.

Sounds like a huge pain in the keister, huh? Well it is. And we can even see a cosmic paw print of the weight of this headache, by looking at the malapportionment of the shares of the currencies that dominate international trade. Over half of all trade happens in US dollars, which—by the way—despite its massive share, is in fact at a 3 decade all-time low.

Just for fun, here’s a chart that demonstrates the network effect value that’s created from smoothing over currency pains in international trade1:

Now of course, Soviet factories would not accept US dollars for their goods. They’d be feeding into the global financial system set up by their geopolitical rival. Under the normal model of international trade, this means you’d need to get Soviet rubles to purchase Soviet goods.

Well, there was no way to get Soviet rubles, either “hard” or virtual, on foreign exchange markets. Nor was there any way to convert Soviet rubles back to a usable currency, because the only agent to take Soviet rubles, the USSR, jealously guarded its reserves of foreign currency.

But the USSR was one of the largest international markets, and its consumer base was famously and chronically underserved by domestic producers. So how did the enterprising importer trade with the Soviet Union? They bartered.

To import into Russia was to sell something to the Soviets. Specifically to the Ministry of Foreign Trade, who, after a lengthy negotiation, would agree to swap your goods for Soviet goods of similar value, as agreed upon by you and the Ministry of Trade. Once you received possession of your Russian commodities or merchandise then be on point for liquidating those goods into a usable currency.

These transactions were called “countertrades”. They were comprised of three separate contracts: an agreement for the Soviets to purchase Party X’s goods, an agreement for Party X to purchase Soviet goods at a later date, and a “protocol” to govern the relationship between the two contracts that would amount to good-for-good payment terms.

Sigh. All this work just to avoid prices set by markets. Was it worth it? From the perspective of Russia’s political economy, absolutely not. But as a tiny consolation prize, it did give us some of unbelievable scenes in international trade.

For example, a US computer company decided to swap its computers in exchange for Soviet Christmas cards. They completely flopped, because religious Americans would not buy Christmas cards stamped “Made in the U.S.S.R” on the back. That vignette is from one of the only examples I could find on the English-speaking internet.

Enter Pepsi

While there are many, many such stories that have been lost to the annals of time, perhaps the most well-documented case was the time Pepsi completed a "soda for war vessels" swap with the USSR. The swap of Soviet submarines for its soda facilities briefly made Pepsi "“the 7th largest navy in the world”2—tied with India, which at the time had a population of 800 million.

Upon receipt, Pepsi shipped them to a Norwegian scrapyard to melt them down and sell as scrap metal. Only upon arrival did they find out that the submarines had been constructed with asbestos, making them dangerous to melt down, and therefore dramatically lowering their real market value.

This cheeky anecdote is a distraction to the broader story of Pepsi’s launch in Russia. Which is a story, at its heart, about American corporate diplomacy. I want to stop on our hike here and take a minute to focus our attention on Pepsi.

Somewhere in the narrative arc of how Pepsi expanded into the Russian market, there exists a Wittgenstein ruler. I leave it up to you, reader or listener, to determine which relationship it might be.

According to NPR, Pepsi was the first “American consumer product to be manufactured and sold in the former Soviet Union”—an accomplishment as impressive as it is precise.

It was the result of a charm campaign that spanned three decades. The wingtips of that interval gave a sense of the level at which Pepsi was playing in launching in Russia.

Posing for photos alongside Richard Nixon, PepsiCo CEO Donald Kendall served his company’s flagship drink to Nikita Khrushchev (at the 1959 American National Exhibition in Moscow). Nearly four decades later, Pizza Hut, which at the time had just completed a spin off from its holding company PepsiCo, and Mikhael Gorbachev struck what we today would call an influencer marketing deal.

Gorbachev cameo-starred in a now infamous Pizza Hut commercial that aired internationally, but never in Russia. Twenty five years later, it feels like a stage production that captures some kind of pulse to what the vibe must have been back then, filtered through the funhouse mirror of a 90s pizza ad.

Now a weird internet staple, I embed its Youtube link below in case anyone hasn’t seen it or wants to save a Youtube search it watch it for old times’ sake:

Int. Pizza Hut—a family eating notices that former Soviet President Mikhail Gorbachev is sitting at a table nearby, feeding a child who seems to be one of his granddaughters.

Father begins to prosecute Gorbachev’s legacy. He and a late adolescent (?) son debate whether Gorbachev has created “economic confusion” or (classically) liberal progress and “opportunity”.

Mother breaks up the debate by finding common ground, saying he’s “given us many things, like Pizza Hut.”

Father and son reconcile.

Father, previously the prosecutor of Gorbachev’s legacy, rises to propose a toast, asking everyone to raise a slice for Mr Gorbachev. Gorbachev bashfully demurs their cheers.

Cue 90s disembodied voice narrator: “Sometimes nothing brings people together like a nice, hot pizza”.

Cut to shot of meat cheese melting off the slice as it tears.

The end.

For his appearance, PepsiCo paid the seal of the Soviet presidents a speculated $1 million USD ($2.4M in 2023). He reportedly put the funds towards his foundation meant to create an archive of perestroika. Gorbachev’s sponsorship payment, while not quite comparable to the nomenklatura privatization that happened around around him (which we’ll discuss in Part IV), invites some brow-raising followup questions.

What follows by no means constitutes legal advice—if you’re thinking of paying a former head of state for a sponsorship deal, consult your attorneys.

Exporting America’s Revolving Door

At the heart of American civic democracy is the principle that our policymakers are not for sale to the highest bidder. Over the years, we’ve developed a robust framework of laws and regulations to ensure this. Between stiff anti-bribery statutes and campaign finance laws, it is radioactively illegal to even suggest bribing a government official. Not to mention it is totally anathema to the spirit of the American Project.

That’s not to say that it doesn’t happen. Usually when bribery happens or is attempted (and the government finds out about it), the people involved go to jail. They can also go to jail for soliciting bribes while in office, like Illinois Governor Rod Blagojevich did when he conspired to sell the senate seat left vacant by Obama’s winning the 2008 presidential election.

The US federal government has extended this anti-bribery posture beyond its shores. In 1977 it made such payments a crime through the passage of the Foreign Corrupt Practices Act (FCPA), which prohibits US legal persons (including any company domiciled in any capacity in the United States) from bribing foreign officials. You may have heard it invoked in one of the most recent indictments levied against Sam Bankman-Fried by the Department of Justice, who allege he paid Chinese officials $40m to unfreeze $1B of Alameda Research funds.

Despite this anti-bribery mine field, there are legal ways to incentivize government officials to legislate and regulate in a manner amiable to the business community, or one of its myriad industries. In DC, one of the most powerful of these incentives is called the revolving door, a phenomenon whereby high level government officials routinely find themselves in high level private sector jobs after they leave office.

With government being government and the private sector being the private sector, this career switch comes with a steep jump in compensation. As a benchmark, after Hillary Clinton stepped down as Secretary of State, she could make as much from giving one speech as her old boss Barack Obama did in six months.

The revolving door is fascinating because unlike a straightforward bribe, it is retroactive and emergent.

The revolving door is retroactive in the sense that government officials have no firm promises of future high paying work. If they did, that would be pretty clearly a bribe. But they have a massive track record, and the general assurance that past performance, while no guarantee, often does predict future results. It’s hard to tease just how much government officials’ behavior is influenced by the very reasonable expectation of a lucrative, leapfrogged private sector career after they leave office. But it’s unlikely to be zero.

Finally, the revolving door is emergent. It’s not a single firm making the promise of future fortune, but rather the private sector job market for former prominent government officials. Professionals in many careers are infinitely more valuable when they have firsthand experience as the thing that they must interface with. Think about managers who are former engineers, or founders who have been in the market as a potential customer of the thing they’re building, or startup investors who have been founders.

Why would it be any different for high-leverage positions where one must interface with the federal government? How many US secretaries of state are there to give a keynote at your executive offsite? How many of them embody the shrewd, educated, highly calculating pragmatism that you hope to cultivate within your publicly traded bank’s leadership team? And of course, how much better off is your firm if current government officials can see the opportunities you have to offer for those who end their tenure on good terms?

So the revolving door behaves like a bribe made by no one in particular, as a nominally meritocratic exchange of money for services that are demonstrably differentiated by your previous work experience in the public sector.

And the swivel that holds the revolving door in place is a founding principle of American democracy, which Abraham Lincoln described in the Gettysburg Address as “government of the people, by the people, for the people.” So when government officials are regular citizens. And when they leave office, they are simply regular citizens again, free to do whatever ordinary citizens can. No longer in the cathedrals of power, they’re ambling in the bazaar, weighing their offers and their options.

This all leads to:

One Final Historical Puzzle

Was Gorbachev the first Russian beneficiary of the American revolving door?

I would say yes, obviously. He was the pusher of market reforms which both ended the Soviet barter that PepsiCo had to navigate and opened the door for Pizza Hut’s entry into Russia, as the mother in the commercial earnestly tells us.

And despite being the former leader of the USSR, Gorbachev in the ad plays a now-ordinary Russian citizen. Which conveniently, is exactly how Pizza Hut wanted to present the real-life Gorbachev, for reasons both commercial (see Andy Worhol’s “A Coke is a Coke”, and replace “Coke” with “Pizza Hut pizza”) and regulatory (see the average FCPA settlement, which is north of $70 million).

But there’s one complication to the case that he was the first revolving door beneficiary. While Gorbachev was pushing his market liberalization, there was no prior track record of Soviet politicians getting cushy corporate deals. In fact, the very notion of a Soviet revolving door would have have been considered semantically correct but logically impossible.

This isn’t some definitional hairsplit. It’s central to the revolving door phenomenon: how can the possibility of lucrative private sector income sway a politician if it has never been offered before in their country? Is it even the revolving door at that point?

While we know that Gorbachev was paid by a major US corporation, we have no clue whether as President of the USSR, he ever expected to be.

The answer to that question Gorbachev probably took to his grave.

Bibliography

Marcie Marino. "Bartering with the Bolsheviks: A Guide to Countertrading with the Soviet Union." Dick. J. Int'l L. 8 (1989): 269.

Paul Musgrave. “The Doomed Voyage of Pepsi’s Soviet Navy.” Foreign Policy. 27 Nov. 2021.

• Part I: The Birth of Russia’s Market Economy

• Part II: Russian Bandits and the Rule of Law

• Interlude: Soviet Barter And International Trade

• Russian Banking's Birth by Mutiny

Much like the modern Russian mafia emerged as a response to Soviet organs’ inability to adjudicate commercial disputes, the modern Russian banking system emerged as a response to Soviet banking’s failures to provide a sound system of money and finance. While the monetary collapse of the Soviet Union was related to the political collapse, it happened on a largely separate track.

The fall of Soviet banking and the birth Russia’s modern banking system is a drop-dead fascinating episode in the history of infrastructure. But it won’t make any sense without some background on the hows and whys of Soviet banking.

You may recall that all production in the USSR happened according to the economic plan, and in the total absence of any price signals. In fact, price signals had been criminalized. What does banking for such an economy that even look like?

The shape of Soviet banking is so strange that it would be disorienting to navigate without a proper frame of reference. So let’s start with a primer on the anatomy of banking systems.

Banking as Storing and Teleporting Value

Banking serves two purposes: storing value and, as Patrick McKenzie says, teleporting it across space and time. Across history, there have been many, many ways of storing and transporting value. But in the last 200 years or so, the evolutionary paths of the world’s banking systems have largely converged. While each one has its quirks, as a set they now have pretty much arrived at the same organelles:

1. One Central Bank.

   Central banks are responsible for maintaining the world’s faith in their currency. They do this by A) managing the currency’s supply and circulation, and B) backstopping commercial banks as their lender of last resort.

2. Many Commercial Banks.

   Commercial banks take deposits from customers and then allocate credit to borrowers. They make money by lending at a higher interest rate than they take from depositors. Their price floors are set by interest rates, which are set by the system’s central bank.

3. Payments Infrastructure to Glue it All Together.

   If money is the ultimate example of network effects, payments infrastructure is what holds that network together. Banks work together to design payment networks that make it easy for them to facilitate transfers of funds. This often-overlooked logistical work is why, for example, a dollar in Kansas is worth as much as a dollar in New York (which, by the way, only became the case about 100 years ago). Over time, bits of payment infrastructure tend to grow into their own participants in the banking system.1

There are plenty of supporting cast members2—from markets for various financial instruments, to reporting agencies that credit score borrowers, to private payment networks, and regulators to prevent fraud, undue risk, and predation. But ultimately, they all aid in banking’s two goals of storing and moving value.

Banking as Revealed Societal Preference

Banking regimes and their histories are immensely fascinating, not just because they involve head-turning sums of money. Even more so, banking systems are portraits of revealed societal preference. A close inspection of any banking system will uncover volumes about the values of the society that made it.

Banking exists to move and store value. And it can’t do that without some clear notions of what that society considers valuable, what activity and actors it considers trustworthy, what it considers unjustifiably risky, and what income streams it considers thermonuclearly unethical, and so on. Banking systems can give surprisingly concrete answers to these abstract questions.

Want to understand how trust works in a society? Well, how difficult is it to draw funds from a customer’s account without requiring their explicit sign off for each individual transaction?

How many pages of paperwork do you need to fill out to access the payment rails to do this? Or do you need to wine and dine the head of a bank to butter them up for a “strategic partnership”? Will the bank need you to indemnify them against any abuse of said payment rails, should your access ever be compromised? Do said payment rails even exist?3

Want to understand who’s considered elite? Well, bankers are entrusted with society’s wealth. So where did all their banking executives go to school? Where do those bankers try to send their children to school?

You can also invert this question to gauge the importance of finance in the society: what’s the educational background of a randomly selected banker? In the United States, it’s likely an elite undergraduate program, and a similarly elite advanced degree. (Spoiler alert) in the Soviet Union, fewer than 1 in 5 people in banking had a college education.

Want to understand people’s faith in their public institutions? Well, how long ago was their country’s last currency reset? In what denomination do people prefer to keep their savings? How long can they typically stomach holding their funds in the national currency before changing to their money of choice?

How many years has it been since people bartered rather than transacted in currency? Another fun inversion: does that last question seem weird to you? Did you ever consider that YOU might be weird—in strictly world historic terms—for thinking that question is weird?4

Want to know how a country seeks to improve the lives of its citizens as a matter of national policy? Well, what types of economic activity enjoy government-subsidized credit? Conversely, what types of value chains find themselves structurally disenfranchised from payment infrastructure? Who are the banks worried to serve, lest their executives go to jail for money laundering, or aiding and abetting some terrible crime?

Are you feeling it now, Mr. Krabs?

My gist is that banking systems are how societies implement their social contracts. Propaganda and founding mythologies are a great way to hear a society self-express its values. But banking is the institutional muscle tissue that a society builds up to A) do more of what it values, and B) store the wealth that it creates in the process. And because of this, banking is a more honest portrayal of a society’s values.

Now describing banking as a revelation of preference might seem counterintuitive. The artifacts of banking are dense ledgers, profit and loss statements, graphs of current account balances and interest rates. The stuff hardly reads like a winning politician’s campaign slogan. But without a doubt, there are questions that you can ask any banking system understand the motivations that animate it.

To my recent surprise, this seems true regardless of distances of space and time. This is because there are questions that every banking system has to answer as it decides how to optimally store and move value for the society it serves. While far from an exhaustive list, here are some of the questions I ask every banking system I encounter:

• How does the currency work? How does it hold value?

• What is the societally optimal amount of credit?

• Who does the Bank serve?

• How does the Bank stabilize itself?

• Where do the practically guaranteed profits generated by the Bank go?

• Who gets to run the Bank?

If history is music, you can say that the notes of banking history are the myriad combination of answers to these questions. And we can make out the song of any banking system by reading its story with these questions in mind.

With that bit of framing, put on your scuba gear—we’re ready to dive in.

Soviet Money’s Conundrum

The single best entry point to understanding a banking system is its currency. In order for banks to store value, the currency held in their accounts has to be able to hold value itself.

So let’s look at how the Soviet Ruble pulled this off. Like the US dollar after 1971, the ruble was deemed valuable simply because the government issuing it said so. That’s about where the similarities stop though.

You see, at the heart of the Soviet monetary system was a very unique conundrum. That conundrum came from a central goal of the Soviet project: the abolishment of price discovery.

You see, a command economy only works if the economy can be commanded. This means when the economic planners declare that a liter of vodka costs a ruble, the price needs to stay put. What’s the point of a command economy that won’t follow instructions?

On its face, this seems like a simple matter of enforcement. Perhaps you send plainclothes police around to liquor shops to ensure they aren’t marking up prices. But even if you could force the stores into compliance, you wouldn’t solve the need to price seek. What could you do? Make it illegal for people to complain the vodka shortage?

At best you’d just push the arbitrage opportunity somewhere else. Enterprising go-getters would buy out the vodka stocks at their local, price-compliant liquor store. They’d sell it to neighbors and acquaintances for a price deemed fair by all parties. After all, vodka’s constantly out of stock and they have the only supply in town.

Over time, these vodka brokers would better satisfy demand than the formal market. Over time, as vodka brokers better understood their costs and customer demands, they’d sacrifice some of their margins to make their business a bit more predictable. The brokers would bribe store managers for advanced access to vodka before they hit store shelves, effectively front-running the competition. Tada! Without anyone in particular setting out to make one, an efficient shadow market for vodka would appear.

This isn’t a hypothetical. It actually happened, and Russia’s informal vodka markets were crucial training grounds for many violent entrepreneurs (and their customers) in the years before perestroika.

Price discovery like this was anathema to the Soviet project. The people in the shadow market were criminals under the Soviet code. And they faced years of back breaking labor in gulags if they got caught.5

Now here’s the doozy: the Soviets also wanted economic growth.6 But it’s impossible to engineer economic growth (at least at the rates we’ve seen for the last 150 years) without a steady expansion of the money supply.7 But in increasing the money supply, you would naturally encourage price discovery. Some firms would get access to the new money stock sooner than others, and would buy out the existing supply of goods and services, driving up the price for everyone, and thereby setting a new equilibrium.

So somehow, the Soviets needed to devise a monetary system that would allow them to grow the money supply without hampering their ability to dictate prices. Imagine your boss throws this monetary dilemma on your desk and says "I need a solution to this by Friday". What do you do?

Why of course, you construct a two-tiered currency system.

A Tale of Two Rubles

The primary currency was the “hard” ruble. It’s what Soviet workers were paid their wages in, and the currency they used for all consumer transactions. Here’s what the hard ruble looked like:

What did the second ruble look like? Well there are no photos of it, because it never existed in material form. The beznalichnyy (“cashless”) ruble was used exclusively by Soviet state enterprises to trade with each other. Its name stems from the fact that there were no physical banknotes for these rubles, making them (to my knowledge) history's first totally virtual currency.

An aside: the astute reader will note the irony that virtual currency, a field now dominated by crypto-libertarians, was essentially invented by their arch nemesis. As we’ll later see, the Soviets built solutions to many of the same problems as cryptocurrency does, but from the exact opposite direction. End aside.

The hard ruble flows on the consumer circuit, going directly from enterprise payrolls to worker wallets. Meanwhile the virtual ruble zaps between state enterprises, as a kind of trade token. And never the twain shall meet.

The two rubles were separated by two-layer a firewall. First of all, there was no method to redeem one type of rubles from the other. And second, private citizens couldn’t even open the kind of account that held virtual rubles.

The two tier ruble system resolved the Soviet monetary dilemma. At least it seemed to at the time. Its firewall shielded wages and consumer prices from the inflationary effects of increasing the virtual money supply. This allowed the economic planners to steer economic output with credit, without any fear of blowback.

How did they do this credit steering? I think it’s high time we introduced the Soviet “central bank”.

The Monobank

I use scare quotes when describing it as the Soviet “central bank”, because the word “central” suggests a position relative to other banks. But Gosbank was the only bank in the Soviet banking system.

This architecture was called a “monobank”, and it was common in the command economies of yore. The name explains itself: Gosbank handled all banking activity in the USSR. From household savings to funds transfers between the enterprises. There were no commercial banks beneath it.

Gosbank’s only monetary instrument was the ability to credit virtual rubles to different state owned enterprises.8 They would allocate virtual rubles based on factors such as each state enterprise’s relative importance to the Soviet economic plan, the health of their finances after trading with other state enterprises (in a kind of proto-market).

So when Gosbank wanted to increase the supply of rubles in the Soviet economy, it did so by increasing the virtual ruble budgets of specific state owned enterprises, an arcane monetary instrument called “direct credit”. This another stark contrast to modern banking systems, where central banks don’t interface with individual companies.

Gosbank’s Infrastructure

As the only banking institution in all of the USSR, Gosbank had expansive responsibilities that would surprise the market-native mind. Its mandate was embodied in a multi-function payment network was known as the card file system. Each functionality in the cardfile system was devoted to its own channel. Each channel would prove to be a Chekov gun in the transition.

One cardfile channel was devoted to settling tax payments and the receivables of other large establishments like utilities and railroads. This channel allowed Gosbank to draw funds from accounts without the payer’s prior authorization. The equivalent functions in the United States were built by the card networks and the ACH system. Both of these have robust dispute and chargeback resolution mechanisms that keep merchants overwhelmingly in good faith when drawing funds from customer accounts. No such mechanisms were existed in the USSR. This was a sensible design decision at the time, because debiting counterparty was the government (and often, the paying counterparty was also the government!).9 But it would prove to be a critical Chekov gun in the transition.

This ability to unilaterally debit accounts also extended to different branches of Gosbank, which were located in the capitals of each Soviet republic. These branches could unilaterally issue debits, withdrawing from their accounts at the head Gosbank branch in Moscow. This allowed the USSR to geographically control its credit postures, giving individual Gosbank branches the ability to declare their own local monetary policies based on what they felt was most needed. Another Chekov gun.

But the strangest Chekov gun of all: Gosbank tabulated the balance sheet of every enterprise in the Soviet Union. It’s a surprising but logical conclusion of the virtual ruble credit policy.

Gosbank’s credit policy intervened against the “natural” balance sheets that these enterprises would form after trading with each other. They allocated credit to cover the differential between what surpluses (or losses) the enterprises accrued on their own and how much Soviet planners believed should be available to them.

In order for it to track all inter-enterprise debts, cashless ruble transactions went through Gosbank through a channel in its settlement system call card-file number two (kartoteka dva). This made Gosbank more of the bookkeeper of the Soviet economy than its lender. The virtual ruble system was less a currency than the equivalent of tracking the entire national economy on a single Quickbooks instance.

Again, it’s both irresistible and illuminating to see cryptocurrency as the Waluigi of the cashless ruble. Like crypto, the virtual ruble existed exclusively as data in a single digital giant ledger. Also like crypto, the virtual ruble required no trust between counterparties to a transaction. But it pulled off both these features in the single most un-crypto way imaginable: by restricting its use exclusively to related parties, who themselves were all wholly owned subsidiaries of the issuer, a communist government. Kinda weird right?

Banking Cybernetics for Bazaars and Cathedrals

I want to take a moment to unpack that feeling of bewilderment we get when we look at Soviet banking. I want to suggest there’s something deeper behind your reaction than thinking you’re looking at a financial Ripley’s Believe It Or Not!. I believe that Soviet banking surprises us because it comes from a different school of cybernetics than the one we’re used to.

“Cybernetics” is a $7 word that gets reasonably and incorrectly clustered with cyberspace and science fiction. Really, it’s just the study of dynamic systems and how to govern and control them. For a more rigorous definition, I hand the microphone to Soviet mathematician Andrey Kolmogorov, who defines it as “the study of systems of any nature which are capable of receiving, storing, and processing information so as to use it for control.”

Cybernetics was a majorly influential discipline in the 20th century that cross pollinated knowledge from math, biology, information theory, engineering, and (of course) economics. I bring the discussion to cybernetics, because the je ne sais quoi that I’m alluding to here can feel either over-inferred or nearly invisible without this term to hang it on.

Cybernetics says there are essentially two ways you can better control a system. Either you A) get better at modeling—and responding—to the system’s various possible states, or you B) reduce the number of possible states it can be in. This matches the grain of an ideological fault line that software engineers recognize, of the bazaar vs the cathedral.

A bazaar-pilled society produces a very market-minded banking system, whose outputs are largely the result of commercial negotiations, refereed by regulators. This is even true of the central bank’s monetary instruments. Central banks use open market activities like trading government bonds to adjust the money supply. They also dictate interest rates, which sets a price floor for credit. And they even set guidance about future interest rates—essentially giving banks a weather forecast of how rates will look in 6 months, so no one’s balance sheets are caught off guard (though, invariably, sometimes they are).

The modern banking toolset is an impressive cybernetic accomplishment, primarily falling in the “better modeling” school. The banking systems we know and love have refined their ability to model and respond to changes in the state of the economies they try to cultivate. And they’ve built quite a toolkit for the many possible problems that can arise in the process.

The USSR, on the other hand, was cathedral-pilled (even though, ironically, the Soviets were atheist). Their economic production was directed externally, and architected according to a plan. The bank helped build the cathedral by faithfully executing the instructions of the planners.

The firewall between the two currencies, dictating prices, consolidating all of finance into a single bank, tracking every enterprise’s balance—all of these squeezed agency out of Soviet banking.10 It was a very cathedral-flavored cybernetics, that tried to steer the economy by restricting the number of possible states that it could be in. This is why the abolition of price discovery was such a critical goal.

Over time, the distribution of resources in the planned economy drifted significantly from how the market would have arranged them. Gosbank’s architects thought they were insulating their economy from profiteering and instability. But where Gosbank’s architects saw insulation, nature saw a vacuum. And nature hates vacuums.

The banking transition that followed looked much like a zombie outbreak, where the mind-virus that spread through the Soviet banking system was agency. Slowly everyone in Sovio-Russian finance began to see the scale of opportunity in rearranging and reappropriating the command economy’s resources in accordance to the wishes of the market.

The rupture of this vacuum more or less created modern Russia.

And that, we’ll get into next time.

Bibliography

Johnson, Juliet. A fistful of rubles: The rise and fall of the Russian banking system. Cornell University Press, 2000.

Johnson, Juliet Ellen. "The Russian banking system: institutional responses to the market transition." Europe-Asia Studies 46.6 (1994): 971-995.

A note on sources: there is shocking little literature available in English on Soviet banking. This Part is heavily indebted to the work of Juliet Johnson.

Russian companies were desperate for help in enforcing their contracts and collecting unpaid debts. The Russia government in the 90s, never having supported private enterprise before, wasn’t very good at this. This forced many businesses—far more than you might expect—to seek rule of law from enforcers made by the chaotic formerly-criminal market, for the chaotic formerly-criminal market: mobsters.

Time for a story about promises and how they are enforced.

Business is Just a Chain of Promises

Every business, supply chain, industry, and economy is held together as a series of promises. That’s because just about every transaction has a promise baked into it.

In the most basic form, if your business needed a loan you might say, “I promise I will pay back the value of this loan, along with the agreed upon interest, by the following date”. The promise of repayment is probably the most common promise made in all of business.

Most often the promise of repayment isn’t made in exchange for money, but for inventory. When you go to your neighborhood hardware shop, the hammers and screwdrivers and saws on their shelves are all purchased on credit terms. If you live in a developed country this is probably true for just about all merchadise see on all shelves of all stores. Suppliers offer their customers credit because inventory takes time to sell, and it’s only when the sale is made that the store has enough cash on hand to settle the original invoice for the inventory.

These promises don’t just govern debt transactions, but also transactions involving equity of the company itself. When someone invests in your company in exchange for ownership they’re accepting a promise as well. The promise your company is making isn’t about future repayment per se, but rather that the claim on the ownership of the company is real. This is a concern that only matters at some future point when your business has taken the investment money and made productive use of it.

Capitalism—i.e. a system in which people organize their productive efforts to accumulate money—is only possible because of promises. At the heart of every capital accumulative loop is a promise. That’s because accumulation happens over time, and promises are commitments that we make to each other about the future.

In the early days of the Russian market, it was very hard for businesses to keep promises because no one had ever done business before. To reduce your exposure to bad promises, you could tighten your circle of trust and limit who you traded with. Most businesses did. But even if their trading partners were trustworthy and meant well, the chaos meant there were all kinds of ways they could slide into insolvency. So when things got messy, how could you ensure your counterparties kept their promises?

The Guarantor of Last Resort for a Promise is the Rule of Law

All promises need recourse in the case that they’re broken. To some extent that recourse can be reputational. You could, for example, trash talk promise breakers to everybody you meet in your industry. But telling people that you were lied to you or stiffed for an invoice won’t fill the hole in your balance sheet. The only way to remedy the situation is to force them honor their word, preferably through a third party who will do the forcing for you.

That’s where rule of law comes in. A good rule of law can efficiently and predictably adjudicate economic disputes and ensure people get what they’re owed, to the fullest extent possible. When it does its job well, it even acts as a deterrent for bad behavior. And when businesses have a rule of law that they can rely upon, they’ll be able to do the magical promise stacking that allows them to grow.

So if you’re a business owner, you’re in the market for rule of law. For you, “rule of law” was not some lofty ideal that politicians, from Brezhnev to the Bushes, reach for in their speeches. It’s a tactile service with vendors who you can evaluate as concretely as you would an accountant or a plumber.

Soviet leaders hastily created a market and then shoved their state enterprises into that market and then plunged that market into turmoil. So they not only created a new demand for rule of law. Through the chaos caused by their mismanagement, they also pressurized that demand.

Let’s look at what vendors you had to choose from if you were in the Russian market for rule of law, starting with the incumbent.

The Russian State Had Never Enforced Ownership Promises Before

It’s best to start with the state’s enforcement of company ownership rights, because states are really the only ones that can enforce this type of promise in a way that makes it a tradeable commodity, e.g. a share on a public stock exchange. Also, ownership rights are most relevant for more complex corporate entities with a large list of shareholders. At the dawn of the transition, all the companies that fit this description were former state enterprises.

A lot of company ownership protections simply hadn’t been built yet. It’s never a great time to speed run to capitalism. But Russia’s leaders had many, many other fish to fry when they did: a failed coup attempt, a political breakup that created 15 sovereign governments, figuring out how those governments would work. So as a result, in the frenzy of privatizing their economy, they had some… oversights around the very basics of protecting ownership.

You can see this in the story of an airplane parts factory that transitioned from state to private ownership in 1991. The managers wanted to give workers ownership in the factory. Getting the details right was important: they had 15,000 workers to add to their cap table. So they consulted “Soviet experts” when drafting their documents. Eventually management realized that they had screwed up and created an organization that failed to protect the interests of any stakeholder—be they employee, manager, or shareholder. They sought advice on how to fix their mess-up, in a process that went roughly like so:

Management: “Well can we seek the guidance of securities regulators, like the Russian version of the SEC?”

Advisors: “Mmmmm, securities regulators don’t really exist yet.”

Management: “Ah, ok —no worries! Perhaps we can reach out to a corporate lawyer then who can help get us back on track?”

Advisors: “Yeahhh, those don’t really exist yet either.”

Management: “Shareholder advocacy groups?”

Advisors: “Those don’t ex—”

And it wasn’t just supporting institutions (and professions!) that were missing.

Russia’s first corporate laws lacked basic details needed for enforcing property rights. The first statutes on corporate organization, passed in the late 80s, boiled down to “C’mon you rascals! Shake hands, do business! It’s legal now!” They had zero guidance on the most basic shareholder rights, such as:

• After I get shares in a company, can I sell or transfer them to someone else?

• Does owning equity allow me to participate in the company’s management?

• What rights do I have to access information about the company’s financials?

• What fiduciary duties does the company’s management owe me?

• Where can I turn to enforce my shareholder rights?

In short, there were a lot of dotted-line silhouettes with I.O.U. sticky notes in them. While they had a lot to figure out when it came to shareholder rights, the Russian state quickly got to work on adjudicating economic disputes.

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The Russian State Was Only a Little Better at Enforcing Debt Promises

Most businesses rely on credit-related promises far more than equity related ones. Credit promises are more important for scaling up a business’s cashflows—quality dispute resolution creates less credit risk, which lowers the cost of capital, which makes it cheaper to unlock tomorrow’s cash today. In short, better rule of law makes it cheaper for a business to press the fast forward button on its growth. So how, exactly, did Russian courts handle the issue of promises around credit?

Their solution was repurposing the Soviet court that adjudicated disputes between state enterprises. That court was called gosundarstvennyi arbitrazh, or gosarbitrazh (“state court”). With the rise of private businesses, Russia introduced a successor to gosarbitrazh called arbitrazh (“Drop the gos”, Justin Timberlake tells Jesse Eisenberg, “It’s cleaner”).

Arbitrazh courts operated under a legal tradition that was completely new to the Russian justice system. Russia’s court systems were all built in the civil law tradition, which inherits from the system of law used by the Roman empire for its citizens (hence “civil”). Civil law is the dominant model of law in Europe.

But Russia’s arbitrazh courts were modeled on common law, the system of law used in Britain and its former colonies, including the United States. (Sidebar: After reading hundreds of pages of The Literature, I still haven’t found a clear reason as to why arbitrazh is a common law court.)

A dollop of humility: legal genealogy is a discipline to which many outstanding historians and lawyers have dedicated their entire careers. There’s more nuance to it than we can fit in the HTML payload of this humble newsletter.

With that said here are the basics of how, exactly Russia’s civil law-trained legal professionals struggled with arbitrazh’s common law flavor.

First, Russian lawyers had never carried the burden of proof before. In civil law courts, the rationale for decisions comes primarily from the statutes on the books. The model of justice in civil law trials is inquisitional: they’re driven by the judge, who requests evidence from the petitioner (the person or entity who files the case) and the defendant.

In common law courts on the other hand, the rationale for decisions comes from precedents set in prior cases. The model of justice is adversarial: trials are driven by the petitioner and the defendant who prepare and present the most persuasive evidence they can to the judge. This means the parties carry a burden of proof in establishing their respective cases. The petitioner presents evidence to demonstrate the guilt of the defendant, while the defendant must contest the accusations made by the petitioner with their own evidence. If the petitioner fails to present convincing evidence to prove their case, they lose. If the defendant fails to present convincing evidence to rebuke the petitioner, they lose.

These were totally new norms, which created a frequently occurring comedy sketch that played out in arbitrazh courtrooms across Russia.

Judge: “Ok petitioner, please present your case”

Petitioner Lawyer: *stands up, tersely re-reads the contents of his or her petition to file the case with the court*

Judge: “Please present your evidence to the court.”

Petitioner Lawyer, blushing: “Evidence, your honor?”

Not all judges were consistent in their demands that lawyers prepare proper evidence. Judges who had entered the Russian court system after the formation of arbitrazh had an easier time. These new procedures came naturally because they had a blank slate of how judging was supposed to work.

Older judges who had served in the Soviet gosarbitrazh had old habits to unlearn. Stuck in their civil law ways, these elder judges were less likely to enforce the new burden of proof requirements. They also struggled with the new responsibilities demanded of them by common law.

Russian justices had never had to document the rationale for their decisions before. Civil law decisions do not need the same detailed rationale as common law decision. Decisions rarely exceeded 2 pages, which is “baby shoes, never worn” levels of short in the word-philic realm of law. But in common law, judges need to write detailed decisions. Documenting their decision rationale establishes precedent that will be used to resolve future cases with similar fact patterns.

But this is a totally new skillset for the median 90s Russian judge. And the midst of a crisis that blows up demand for your services is not a great time to learn new skills.

This all meant slow resolutions for arbitrazh cases. Arbitrazh had a statutory service level agreement that it would render decisions no more than 2 months from filing. But most cases from 1993-1997 took closer to 4 months. And thousands of arbitrazh cases were stalled for over a year. These slow timelines were agonizing to business owners: as arbitrazh took its time, hyperinflation was decaying the underlying value of the claims they were filing for.

Common law, shmomon law - the REAL problem was enforcement. At the dawn of arbitrazh in 1992, Russian justices had never forced independent companies to comply with court orders before. In the gosarbitrazh era, decisions executed as smoothly as a piece of software—they were a transfer of funds from one state wallet to another. Making independent businesses comply with these laws was a different beast altogether.

For most of the 90s, arbitrazh courts had no dedicated enforcement officers. Instead, they had to rely on the spare capacity of sadebni izpalniteli (“bailiffs”), who enforced decisions for the general civilian courts. When the bailiffs did enforce, they had a whole new learning curve to climb. Enforcing arbitrazh findings required a totally different skillset from the usual beat of general jurisdiction enforcement. Collections for a typical arbitrazh case might require officers to seize hard assets—think tractors, CNC machines, pallets of plywood, or chicken cages—from the defendant company, and then find buyers to purchase the assets in exchange for cash, which then would go towards settling the petitioner’s claim. That’s totally different skillset from a typical general jurisdiction case, which involves stuff like chasing down absentee dads for child support.

In well-functioning justice systems, defendants comply with court orders because of the legitimacy of the court and the consequences of non-compliance. The arbitrazh courts, still nascent, had neither going for them. So the entire enforcement process was driven by petitioners who had to push resistant, overworked court officers to do their jobs.

Even when petitioners did try to collect, the process was agonizing. The typical enforcement workflow was convoluted. First the court would tell the defendant to pay. When the defendant didn’t (because why would you listen to a new court that can’t enforce its decisions?), then the petitioner would ask the court for an enforcement order. The court would issue the enforcement order, forcing the defendant’s bank to pay the petitioner. The bank would reply to the court: “sorry lol insufficient funds, apparently they emptied their account last month?,” but in legalese. Petitioner would request help from the bailiffs, who are statutorily required to resolve the case in 20 days (narrator: they don’t).

And then one of two final scenes, either: court enforcers fail to find the defendant at their registered address, cold case! Or they DO find the defendant, but they don’t have the trucks or vans to take their assets back to the arbitrazh warehouse for liquidation. Because who among us remembers to account for transport capacity when we’re architecting our country’s first commercial court? Or more commonly, they’d find nothing there.

Defendants had many ways to play dead. To shield their funds from seizure, they’d open multiple accounts for their business. They’d siphon funds from their main checking. They’d transfer their assets to shell companies. They’d transfer their company’s assets to their own personal ownership. They’d register assets under the names of wives, siblings, trusted managers. They knew that Russian courts wouldn’t break the limited liability boundary to collect debt, a practice known in lawyer land as piercing the corporate veil.

Successful enforcement was uncommon—the most optimistic sources say 50%, but many sources estimate as low as 20%. Even if you did manage to collect, from filing the case to wiring the restitution, the arbitrazh process could easily take more than six months.

Did I mention this was 6 months during hyperinflation? If you think I’m overstating hyperinflation, then I’m probably stating it the right amount because it was on top of the mind of every business owner who was owed money. Hyperinflation put a very real and sizeable monetary value on enforcement speed.

The arbitrazh courts were backlogged with cases as lawyers and judges learned how to dance to the tune of common law. Decisions were enforced by ineffectual, overworked court officers who treated commercial cases as a second job. When they did enforce, defendants played shell games to hide the money they owed.

But the sky was still falling, even if the Russian courts couldn’t catch it. Businesses, desperate to escape this chaos, felt a burning need for order. They needed the promises that were made to them to be kept, even if by force. And they were ready to pay handsomely.

With all that pent-up demand, a functioning rule of law was bound to materialize.

Bandits Were Very Effective Promise Enforcers

Enter the meatheads, warlords, and security agents who provided rule of law as a for-profit service to Russia’s first businesses in the 1990s. These “violent entrepreneurs” protected the life, liberty, and property of business owners better than the Russian state itself. In the process they made a killing and served as an extremely rare natural experiment in how monopolies of violence form.

The first, and most famous strain of these violent entrepreneurs were the bandity (“bandits”), another name for Russia’s mafiasos. It goes without saying that the bandits are and were terrible. Without exception. Anyone who makes a living from beating people up (or threatening to), or (even worse) sets out to make an entire organization where that is their business model, is terrible.

But they ended up providing the rule of law that many Russian businesses needed, even if it wasn’t the one they deserved. And though they occupy a very dark-grey moral area, they’re worth studying. We can learn a lot about how and why our own rule of law works by examining their outsider statecraft. What we see in both our regime and in their regime is likely intrinsic to a good rule of law itself.

Bandits were not a fringe presence in Russian business life. But sizing their market share is somewhat difficult. As you can imagine, businesses wouldn’t be eager to report that they pay for the services of a criminal enterprise. The hard data is spotty, but we do have a quantified lower bound. By 1997, 17% of small businesses and 4% (!) of large businesses still depended on bandits for protection.

This was after the worst of the transition had passed, after the arbitrazh courts' times had improved significantly, and after arbitrazh had its own enforcers. Many interviews and criminal databases show that bandits were prevalent, especially earlier in the transition (we'll discuss why below).

Bandits emerged from Russia’s martial arts gyms. The original bandits were semi-professional wrestlers LARPing Goodfellas. Like everyone else around them, the bandits were completely new to their trade. Their initial training consisted of watching mobster flicks from America and Hong Kong, imported from overseas through Russia’s newly opened trade corridors.

These martial artists, who got into the Russian rule of law industry at its ground floor, set its center of gravity. A good 3 in 5 of the founding wave of bandits were wrestlers, boxers, or disciples of kung fu, judo, or karate. These first bandits were overwhelmingly young, most aged 18-24. But this wasn’t just a spontaneous process of dudes getting black belts and then pursuing a life of crime. It was a trend that came from surprisingly high ranks of sports institutions.

Many of the leaders in Russia’s martial arts circuit were also pioneers of Russia’s extortion-protection industry. In 1994-1995 alone contract hitmen took out the vice president of the World Boxing Association, the chairman of the Russian Professional League of Kickboxing, and the founder of the International Academy of Martial Arts — all of whom had dazzling parallel careers in protection racketeering.

Initially, bandits made their money from extortion. This was an easy first business: there were many new businesses to extort in the late 1980s, and police still saw entrepreneurs with the radioactive glow of criminality because culture and mores change slower than the Supreme Soviet can pass laws. But the good times didn’t last.

Over time, there were no more new businesses to extort. So the market entered a zero sum phase, where the only way for a bandit to grow their market share was to take from someone else’s. “Customer retention” was now paramount, so the bandits shifted their focus from extortion, e.g. simply terrorizing businesses for money, to “protection” - e.g. preventing other bandits from terrorizing their businesses for money.

But as customers’ business grew, demands for protection became increasingly complex. At first it was simply a matter of physically protecting your customer from other bandits. But table stakes features of rule of law quickly got elaborate to keep up with customer needs. Here’s Denis, a lieutenant for a Petersburg bandit crew explaining his team’s services to Vadim Volkov (the sociologist whose book Violent Entrepreneurs inspired this series):

Volkov: What did you do actually?

Denis: Well, we had a large warehouse, for example, and we checked potential customers [i.e. those who loaned goods for retail trade - VV], collected information about them, went to see their offices, found ways to arrange the whole thing so that they could not cheat. On the whole, we worked as an ordinary security service. Or when those businessmen could not pay back on time we met other businessmen’s partners, so to speak. We asked them [the “partners” [[aka the counterparty’s bandits - AA]]: ‘do you vouch for him?’ And they did, or conversely, if our businessman could not repay, we worked out a payment scheduled, calculated when he could repay and gave our guarantees.

Volkov: Was it not easier to cheat?

Denis: What for, then there will be a conflict, and we’ll have to hide. Who will run the business while we live on the mattresses? They cheat when the money is really big.1

Putting the above in finance lingo: Bandits conducted due diligence on their customers’ wholesale clients for working capital financing, helped their customers restructure their debt, and provided guarantees (backed by force) to their customer’s counterparties. Volkov even cites examples of Franken-statecraft, where entrepreneurs would get a legally binding decision from arbitrazh and then hand the decision to their bandits for who would then go collect it (!). Just a few years in, and the Russian bandits were much more familiar with violent promise enforcement than the Robert DeNiro and Joe Pesci characters that first trained them.

Bandit rule of law was based on reputation for use of force. Bandits gossiped with each other. Their gossip webs formed one big lore circuit that allowed them to turn episodes of violence, particularly colorful ones, into reputations. These reputations worked very similar to the reputations in our own lives.

For example, bandit employees had their reputations in their bandit gangs, and their bosses might promote them for particularly valiant work. Here’s one criminal enforcer, Vadim, explaining how he got fast tracked for management:

Once we guarded a cargo train that had two platforms with expensive cars for [Nursultan] Nazarbaev [then-president of Kazakhstan]. Each car was worth sixty thousand US dollars. The train suddenly stopped in an open field. Some bandits pulled up and wanted to unhook the car platforms. And there were many of them. We pulled out guns and started shooting along the train to keep them off, just to win some time, because we had managed to connect by radio to a nearby military helicopter unit and to call a helicopter. When it appeared they understood it wouldn’t work out for them and retreated. After that I was given my own brigade.2

For most of us, we’d expected to put in extra hours, perhaps help estimate a few more tickets, and write product requirements for our team to get that promotion. For Vadim, he had to call in military attack helicopters to fend off an attempted heist of motorcade vehicles.

Even more important than internal reputations were external ones, between bandit gangs. The bandit gangs used these reputations to gauge the “seriousness” of their industry peers. The Literature is rich with colorful stories of how bandits settle disputes. You’ll find lore of bandits driving hijacked tanks to their rivals’ offices. Or of bandits calling in fighter jets as reinforcements to a meetup. Bandit gangs built their notoriety off of stories like this.

And ironically, these stories helped gangs, and the bandit justice system writ large, reduce the actual violence needed to resolve individual disputes. If you knew that someone wasn’t afraid to get forceful, you’d think twice before you went against their word. If you didn’t do as they said, they would have to beat you up (or worse) to preserve that reputation. Bandits preferred not to have to use force if they could avoid it, and they even had a term “frost-bitten” to describe someone who was overly eager to use force. As a measure of their cultural footprint, this term entered the public’s vocabulary and was even used by a politician to characterize a NATO airstrike campaign that he considered overly zealous.

A bandit with a reputation can issue a credible threat. That threat is also a promise, but in its bizarro bad guy form, and only guaranteed by the bandit's track record. For example, if you walked through the markets of Petersburg in the early 1990s, you’d see kiosks displaying hand painted signs that read “Security provided by A.I Malyshev”, name-dropping a prominent local crime boss. This was a credible threat: A.I Malyshev (whoever he might be) would find you and you hunt you down if you harassed one of these stores. And with it, the stores were left alone.

Bandit justice scaled upmarket remarkably well. The bandits started out protecting businesses in the shadow economy, and the layer of the formal economy that interfaced with the informal, primarily wholesalers. But due to gaping holes in Russian commercial law and enforcement, bandits offered rule of law to a surprisingly large number of large organizations. By the end of the 90s, even after the protection industry had gone legit (more on that in a bit), at least 4% of large enterprises still relied on criminal groups for protection.

That number was collected in a survey done by academics, and almost certainly underrepresents actual upmarket traction. Volkov says the bandits’ customers included Baskin Robbins (!) - so mobsters got a cut of every 31-flavored scoop. They also oversaw scores of transactions that flipped state enterprises into private hands.

For some time, bandits were much better at collections than the Russian state. Without the ability to print their own money, the bandits had to earn their revenue. Bandits were an appealing enforcement option for many Russian businesses in part because of their cost—10-15% of gross revenues, or 40-50% of collected debts. Compare this to the 80-90% aggregate tax rate across the Russian state’s national, regional, and local levels. The only way the bandits could sustain themselves at this “low” tax rate was with airtight collection departments.

The really enterprising ones conducted reconnaissance on your trading partners and knew where they stayed, where they kept their cars, what properties they held under their wives, children and siblings’ names. And they had no qualms breaking through limited liability shell games to collect what you owed. You could play dead with arbitrazh enforcers, but that was a much more dangerous game when bandits came knocking.

Many bandit organizations installed their own accountants (!) to book manage and audit (!!) the finances of the companies they protected. If you owed them money, or had otherwise entered into an agreement with them to swap one of their assets (muscle, reputation, connections) in exchange for a claim on your future cashflows, they required due diligence on your ability to repay.

Hence bandits’ emphasis on getting very good at auditing and accounting. One bandit once said to a Moscow journalist:

If [government] tax inspectors had learned to work with businessmen as we do, the state would have no problem collecting taxes. Have you ever heard, for example, of someone offering a bribe to our auditor?

If a professional wrestler can brag that he a runs a better tax collection department than you, an authoritarian government with a massive surveillance apparatus, then maybe you have some soul searching to do.

Speaking of the Government’s Response: Private Protection v2

The Russian government’s response to the bandits was weird, but clever. Normally at this point in the movie, the police commissioner announces a war on gangs and begins scouring the city for the criminal warlords terrorizing our streets. Hans Zimmer strings start playing with a zoom-out arial shot of the overcast city skyline. Of course that also happened, and the Russian government set up various anti-organized crime initiatives. But they didn’t stop there.

Remember that there was much more going on at this time in Russia than just the formation of its capitalism. As part of the transition out of the Soviet regime to a sovereign Russian republic, the intelligence and security ministries underwent intense restructuring and downsizing. The security agencies laid off, dismissed, or furloughed hundreds of thousands of agents due to dwindling budgets.

At first the security ministries started a program where underemployed agents could work in the private sector, often at banks, as “roofs”, slang in Russian for private protection agencies. In 1992, they cemented this arrangement with a law that made private protection legal called “About Private Detective and Security Activities in the Russian Federation”.

Why would Russia legalize competition for its monopoly on violence? Russian intelligence managers wanted the laid off agents to make productive use of their relationships and keep them within the sphere of influence of the Russian intelligence community.

Once Russia legalized private protection, thousands of agencies formed. What was meant to be a jobs program for laid off security officers became a turning point in the rule of law industry. The supply shock permanently transformed the pricing model for rule of law. For the first time, Russian businesses could purchase justice-as-a-service for a fixed cost (of only $100-600 per month!). After 1992, all the easy profits boiled out of the market.

In addition to better pricing, it expanded the range of personalities in the rule of law market. By 1998, the private protection industry in Russia employed over 850,000 people, with nearly 1 in 4 of them licensed to carry firearms. It wasn’t just intelligence and security officers who got in on the action. Legal private protection allowed Russia to integrate many veterans of its war in Afghanistan into the market economy. The Herat Organization, for example, a roof named after the province in Afghanistan where its founders served, employed nearly 5000 people by the end of the 90s.

This changed the culture of the industry too. Many businesses began the heroic process of cutting off their ties with bandits for less violent, less criminal protection. With these characters, the importance of access to government intelligence databases and quality reconnaissance became relatively more important. Meanwhile, a reputation for violence became relatively less important. But the informal economy still had ample need for bandits, so their strongest market position was with smaller and medium size wholesalers of fast turnover products selling to mom and pop retailers.

For many industries in the 90s, private protection became a table stakes requirement, like legal or accounting. With justice priced so democratically, it became a standard for people doing business. So standard, in fact, that many banks would check in with your roof as part of their diligence process for financing:

A Moscow company applied to a bank to finance the lucrative deal but the bank demanded that its “roof” should first meet the “roof” of the trade company. The [trade] company did not have a “Roof” and its director had to urgently find an old “friend” who dealt in private enforcement and ask him to join negotiations with the bank as his “roof.” The loan was issued under the guarantees of the “friend.”

Again, here again is the importance of a credible promise. Would a bank trust that you could (and would) repay if you didn’t have a roof that could hold your trading partners (and you, frankly, as well) accountable?

The government legalizing the protection industry meant that at least Russian businesses could get the rule of law they needed, without relying on criminal enterprises.

What This Mean for Justice?

There are a few lessons to learn from the market-driven need for rule of law in Russia’s transition decade. You’ll find this relevant if you want to better understand how business interfaces with government, OR if you want to understand why certain people, or certain groups, find themselves at the center of seismic, historic changes.

States are businesses. The traditional story of state formation involves force: forcing people to pay you taxes, forcing people to follow your rules, et cetera. People who study states and how they form fixate on the role of force, probably to a fault. They flatten the process down to a hostage situation: armed, buff dudes take a territory forcing everyone within it to pay them a tribute.

Sure. That happens sometimes. But Russia’s bandits reveal an embarrassing blindspot in that story. Russia’s state was plenty strong—it had the world’s second most powerful military, nuclear weapons, a sweeping surveillance apparatus, and was coming out of an authoritarian regime where all the infrastructure, especially the financial infrastructure, was under their control.

So how did the bandits get so big that they were able to build multinational conglomerates and form their own political parties? They served the needs of a massive market segment, and provided an actual functioning rule of law. They broke the Russian state’s monopoly: not just on the use of force, but—more importantly—on tax revenue. They reinvested their earnings to grow their operations, and acquire new customers.

History is replete with episodes of this rough narrative shape. Competent statesman realizes that they can make their jurisdiction a magnet for taxable cash flows by making themselves useful to businesses. They set up institutions that make it easy to stay compliant, help protect businesses in transactions, and do what they can to encourage businesses in their realm to grow. Many of those businesses do grow, and the state has more revenue, which it uses to build itself up and become more robust.

People who fixate on force think that these pro-business states are simply better hostage-keepers, namely that they charge less in taxes. That’s some of the story—of course businesses don’t like to pay taxes. But they also do want robust protections, and they would prefer robust protections over zero taxes. This is why you don’t see any big businesses flocking to re-domicile in Somalia, despite its highly favorable tax environment.

History is made by midwives, not great men.3 History’s alpha accrues in the transitions. The people who broker transitions are the people who make history. That makes you wonder, who gets to broker history's transitions? It’s the people who are closest to the site of transition who have the skills and values necessary to give the world what it needs to transition. This explains the paradox of Russia's bandits outmaneuvering the state.

Russia needed promise enforcement in order to transition to capitalism. The bandits, while jerks, were reliable jerks. They did what they said they’d do more consistently than any other “enforcement partner” that businesses could access, including the Russian state. In a chaotic market, they were order-making. Bandits could make your counterparties (and you!) honor promises—regardless of inflation, political climate, illiquidity, or whatever.

Their culture was well-suited to the moment. The bandits’ warrior values, combined with reputations built through gossip, allowed them to scale trust. Person-to-person relationships which were the main “trust technology” that at the time, as the Russian state had never enforced a functioning rule of law before. The bandit social network, which had no trouble spanning Russia, made it easy to enforce agreements across cities.

And of course, the bandits were adaptive and fast-moving. These virtues are important in any transition, because transitions happen fast. By the time the Russian state caught up, the bandits had become a fixture of the business landscape, and compounded their growth through reinvestment. They saw that the easy racketeering money wouldn’t last forever, so they pointed their reinvestment efforts towards buying legitimate businesses. To this day, the founders and leaders of bandit organizations are part of the fabric of Russian society. Russian political candidates for office are routinely (and credibly!) accused of having ties to 90s bandit organizations.

That’s it for the bandits: they paved their lane by having the right skills (and values) at exactly the right place and time. They gave Russian businesses a viable legal runtime by enforcing promises.

In the next part of this series, we’ll discuss how the Soviet banking system navigated this transition.

Bibliography

Arbitrazh Procedure Code, 2002. https://www.wto.org/english/thewto_e/acc_e/rus_e/wtaccrus58_leg_61.pdf

Gray & Hendley. Developing commercial law in transition economies: Examples from Hungary and Russia. In The rule of law and economic reform in Russia (pp. 139-146), 2019.

Kathryn Hendley. “Remaking an Institution: The Transition in Russia from State Arbitrazh to Arbitrazh Courts.” The American Journal of Comparative Law 46, no. 1 (1998): 93–127. https://media.law.wisc.edu/m/zdkym/ajcl_1998.pdf.

Vadim Radaev. "Russian entrepreneurship and violence in the late 1990s." Alternatives: Global, Local, Political 28, no. 4 (2003).

Vadim Volkov. Violent Entrepreneurs: The Use of Force in the Making of Russian Capitalism. Cornell University Press, 2002.

• Part II: Russian Bandits and the Rule of Law

• Part III: The Mechanics of Soviet Banking

• Interlude: Soviet Barter and International Trade

By the end of the 1980s, the Soviet Union saw the writing on the wall: their centrally planned command economy wasn’t working. Their people were poor, their supply chains were broken and rusty, and they struggled to compete in the global economy. They needed to evolve towards something more open and market-based. Their leaders didn’t know much about markets, no more than you might learn from reading a book. But they had built a near-religious belief that the solutions to their country’s many problems could be found at the intersection of supply and demand.1

Soviet leaders thought that transitioning the Russian economy to capitalism simply meant getting out of the way and letting the market do its thing. They had no idea that markets, especially national markets, are built up by over decades by millions of people performing millions of interconnected jobs. They had no idea that a market is an ecosystem whose balance is as complex and delicate as a rain forest’s. They had no idea that government doesn’t exist just to constrict business but also to enable it, to nurture it, and to protect it. So when Russia’s leaders finally did transition to capitalism, they birthed a market in crisis.

The Crime of Entrepreneurship

Let’s start with some background on the Soviet Union, a land before markets.

Soviet politicians and propaganda treated all entrepreneurship as profiteering. I’ll spare you from having to guess what the Soviets thought of any word whose root was “profit”: it was a crime.

Here are statutes outlining the punishments for the crime of entrepreneurship in the Soviet criminal code:

Okay, so markets are illegal, profits are illegal, and businesses are illegal. How did people in Russia get stuff they needed? Through state owned enterprises, whose outputs had been meticulously planned out years in advance. The people’s leaders had scheduled out the economy for everyone, and very much did not want their universe dented.

By the mid-1980s, it was abundantly clear that a centralized economy couldn’t give citizens what they needed. So the Soviets decided to reform it to be more open, under an agenda called glasnost. The agenda was made of many plans and laws, including the 1988 Law on Cooperatives, which made entrepreneurship legal for the first time.2 Immediately, street hawkers and small businesses - the microorganisms of a capitalist ecosystem - sprouted up in city centers across Russia.

Market opening reforms continued until 1990, when the Soviet economic agenda radicalized into a full-on transition to capitalism. So how, you may ask, did communist central planners expect to transform their economy into a free market? It turns out through a kind of central planning swan song - one final economic plan that would permanently lift price controls, legalize private property, and oversee the transition of nearly a million government enterprises into civilian hands.

That swan song was the 500 Days Plan, a top-down blueprint to speed run all of Russia into capitalism in, well, 500 days. I’m sure the 500 Days Plan was a glorious feat of bureaucratic poetry (no English version is available online). But any startup founder could have told Gorbachev that no matter how well-crafted your plan, it will fall apart upon contact with the market. Plans can only anticipate so much of what a market needs, because markets are made up of people, and people are complex, and complexity is unpredictable, especially when it’s aggregated.

Like Rome, a market economy is not built in a day. It builds up organically over decades of interaction between customers, talent, capital, and infrastructure. Compressing this timeline down to 500 days wasn’t just unrealistic. It was cruel. It was a disaster. It was Soviet planning’s final atrocity.3

You Can’t Just Learn How to Do Capitalism in 500 Days

Russian capitalism at its birth was everyone doing everything for the first time, at the same time, everywhere.4 This created a totally unique chaos: the chaos of a dysfunctional market, comprised of beginners in every station, with no sense of its own rhythm, and no stable prospects. That chaos is extremely challenging to describe when viewed from above.

That's probably why historians (especially academics with no commercial experience), discuss it so briefly. But if we view the chaos from the ground up, through the eyes of an Russian entrepreneur, we can see clearly both its shape and the burning need for order that it created.

The most immediate form of this chaos was the new strains of evil the market enabled. First, entrepreneurs found that success brought with it money, which in turn brought with it the attention of extortion-seeking thugs. Second, the markets were rife with fraudsters looking swindle honest businesses and promise breakers who had no scruples breaking a legally binding commitment.

For sure, beating and betrayal were traumatic experiences that left business owners feeling vulnerable. But the most important chaos came not from malice, but from novice incompetence. And that incompetence could be found at every layer of the market, starting at the very base.

Russian business owners had never managed cash before. The flow of cash in and out of company accounts is the beating heart of every well-run business. Cash flows in from your customers who pay the invoices you send them. Cash flows out from your bank account to pay the bills. The choreography of these tides is called cash flow management.

Like cooking, cash flow management is a simple skill that you can spend a lifetime mastering.5 When you do it right, the money from your sales comes in before your bills are due, so you don’t need to deplete your bank account to pay them. The money that's left over you can then reinvest into your business. This is the "capital" loop that comprises capitalism: you take the money you earn and you pour it back into your business to grow it further.

Also like cooking, cash flow management can be disastrous when screwed up. Either you are out of stock and waiting for customers to pay you before you can buy more, or your bank account is empty and your shelves are flush with stock that won’t move. In either case, your cash crunch can turn fatal if the patience of your vendors, employees, or landlord runs out before you have the cash to repay them.

This is why every business is rightly concerned about its cash flows. Many businesses, especially the ones that sell to other businesses—e.g. manufacturers and wholesalers—also must worry about the cash flows of their customers. Because if their customers cannot manage their cash flows properly, then there is a good chance that those customers will be unable to pay when their invoices are due.

On the day that the Supreme Soviet passed the Law on Cooperatives, the number of people in Russia who knew how to manage their cash rounded to zero. Same for the number of people who had collected an invoice from a customer. Remember, this activity was criminal and the vast majority of Soviet citizens did not want to know the real meaning behind the euphemism “a deprivation of freedom”.

So businesses, especially wholesalers, had to stake their own cash flows—the heartbeat of their companies—on the business management skills of customers who had literally never made a ruble before. Harrowing.

“No brainer!”, you might say, “Just require your customers to pay cash up front - problem solved, next question.”

If only it was that easy. There are many stripes of business, from grocers to pharmacies to wholesalers, that have to hold inventory for some time before they can sell it. Having worked in the supply chains of all three of these trades, I can tell you: the businesses you sell to don’t have cash to pay for the cooking oil, or the aspirin, or the bales of t-shirts that they purchase from you.

So if you sell to these types of customers, you can’t tell them to “sorry, cash only.” The very nature of their business means you have to provide them credit. As a result, all wholesalers and manufacturers have forced risk exposure to the cash management skills of their customers. If enough of your customers are in a cash pickle at the same time, their insolvency spreads upstream to you.

The only durable solution to this is widespread cash management expertise, so that everyone generally pays their invoices on time with cash generated from sales. But that would take years for Russian businesses to develop. What was the solution in the short term? Credit! Which brings us to the next problem…

Russian lenders had never managed credit risk before. In the first few years of the transition, thousands of private lenders and banks formed to dole out financing. If your business was tight on cash, it was often easier to get a new credit line than it was to chase down past-due invoices. And these institutions had healthy balance sheets: thanks to a near-operatic central banking crisis, Russia’s streets were flooded with capital looking for work.

Banks, totally new to the world of credit risk, disregard pesky best practices like “reserve requirements” that might tamper their growth rates. More importantly, lenders didn’t have much to work with when it came to underwriting their borrowers for creditworthiness.

First of all, there was no credit history to go off of. There were no credit reporting agencies in Russia (they didn’t pass a credit bureau law until 2004).6 Lenders most commonly use the credit scores of the owners of a business to extend it credit. This works particularly well for credit scoring small businesses which are commonly just a legal structure to house the direct work of the owners.

Second was the problem the very discipline of business accounting itself was still new to Russia, because who needed money counters back when money making was illegal? And if you, the lender, did receive financial statements, there was no way of verifying that they hadn’t been primped to tell a rosy story that wouldn’t be corroborated by, say, a visit to the business’s stock room.

Let’s take a step back and look at how this all works in a functional credit industry. Normally, when a lender starts up, its founders and management have done several stints previously in the credit departments of established financial institutions. They’ve been on teams that have managed the health of loan books for the long haul. They know, through years of hard-earned experience, how to judiciously expand the credit of their most trustworthy borrowers, and prune the credit lines of the less reliable ones.

In a well-functioning credit market, the market itself is a merit function as to whether a new lender gets to set up shop in the first place. This is because, after anything larger than an experimental loan book, lenders have to borrow the money they lend out from investors. That money comes from larger financial institutions—usually banks, union pensions, university endowment funds, or family offices (aka teams who manage money for extremely wealthy individuals). These establishments are notoriously skittish around credit risk because their mandates boil down to “don’t make number go down”.

They often require lenders to agree to restrictions on maximum and minimum loan size, the industry of borrowers, repayment periods, and more.

And oh, do they need data. They’ll demand snapshots of the loans you’ve originated, as well as your customer base (known in the industry as a “loan tape”, a carry-over phrase from the era when this data was stored on magnetic tape). They’ll want to see your loan originations, grouped by time cohorts, matched up with different versions of your underwriting model to assess how well your underwriting has improved with new loan performance data. They’ll demand fully fleshed out financials going back to the very beginning of your operation.

They’ll scrutinize all of this data closely. And finally they’ll scrutinize how effortlessly you’re able to produce this data. This is because lending is an operationally intensive business, and any lender who can’t pass an industry standard diligence process probably doesn’t have their act together enough to be entrusted with other people’s hard-earned money. If you can’t produce a detailed loan tape or itemized financials, how can I trust you to give out my money to thousands of customers and then get it back, with interest?

Their diligence is this thorough because the interest rate they charge you is lower than the interest rate that you charge your customers, leaving them less margin for error. Thanks to this emergent industry wisdom, the odds are slim that a new lender quickly goes bankrupt after opening its doors. And because all the other lenders in the industry had to go through this same vetting process, even if the new lender fails, the credit industry as a whole is probably still okay.

Russia’s credit system in the 90s was sort of like this picture of a healthy industry flipped on its head. No one had any experience yet, no one had any track record yet, no one had any data yet. So no one had any idea what they were doing yet.

A few borrowing cycles in, and businesses had maxed out their credit lines, oftentimes across multiple lenders. The lenders made the biggest rookie mistake in credit: it’s much easier to give out money than it is to get paid back. If the percentage of your loan book that is “non-performing” (i.e. loans that have been unpaid, for 90 days or more according to most lenders’ definition), exceeds the interest you charge on your loans, congratulations you’re officially losing money. And a lot of Russian lenders realized they were losing money.

Just a few years in, and the industry had its first ever credit bubble. The balance of Russia’s non-performing loans grew 5x from 1994-1996, when adjusted for inflation. Speaking of inflation…

Russian central bankers had never managed a currency before. Prior to 1992, the ruble that Russians had in their pockets was not a real currency as we understand it today. Yes, you could use it to purchase goods, but the “price” of those goods was not the result of supply and demand. Instead they were the rates set by central planners.

And the rubles that citizens used daily, the rubles people earned as wages, were not the same rubles that state enterprises used to do business with each other. The Soviets issued what may be the first purely virtual currency, the beznalichny (meaning “cashless”) ruble for these transactions. Beznalichny rubles weren’t “real”, in that there was no banknote representation of them and there was no way for state enterprises to use them to pay for their workers’ wages.

There was a separate “clearing” ruble that the Soviet Union issued to allow foreign businesses to get rubles to purchase goods exported by Soviet enterprises. The Soviet banking system had issued them as different banknotes, and set the exchange rate between the “clearing” ruble and the domestic ruble.

With a purchasing power determined by top-down bureaucrats, and firewalls to shield it from the gravitional forces of markets, the money in Russian pockets was less of a currency and more like arcade tickets that you could trade for prizes—I mean groceries.

So with the transition to capitalism, the ruble had to transform into a real currency. In July 1993 Russia re-monetized, meaning the central bank said “hey you have 60 days to trade your old Soviet rubles for the new Russian ones, after which they’ll be funny money”. From then on, the ruble’s strength determined by how well the Central Bank of Russia managed it, and the strength of the economy whose transactions it had the privilege to denominate.

Unfortunately, this process got off on the wrong foot. Due to aforementioned central banking drama (which we’ll discuss at a later date), the ruble devalued 785x from 1992-1994. To understand the very visceral impact this had on doing business, imagine yourself as a wholesaler of denim in Moscow.

You invoice a customer, one of the largest fashion outlets in Leningrad, for a purchase they make on credit. You give them 90 days to repay, known in industry jargon as “Net 90”. Giving a customer 90 day payment terms is fairly typical in the world of wholesale. What’s not typical at all is the invoice losing 85% of its value by the time it’s due, thanks to hyperinflation. But if you raised that invoice in 1992, a year when the ruble plummeted 26x, that’s exactly what would have happened.

Oftentimes, your customers would pay late even if you didn’t give them credit terms (because, remember, like you, they struggled with cash flow). When doing business in a hyperinflation economy, an invoice settled late is indistinguishable from theft. The customer gets the goods up front and by the time they pay, the money they hand over is worth a fraction of what it was when the transaction was booked. So in effect, they got stuff for free without your consent.

Can you see how all these pieces fit together to make it terrifying to trade? Nobody around you knows how to manage their cash, so your invoices never get paid on time. And while you try to collect those unpaid invoices, hyperinflation decimates their value. And even if you find a lender with a high enough blood alcohol content to finance you, that’s just kicking the powder keg down the road or onto someone else’s yard.

Survival in a market like this requires shorter time horizons and shrunken circles of trust. I’ve seen this very same dynamic play out first hand in my time having done business in the informal economy in Kenya, primarily with mom-and-pop corner stores and their suppliers, neither of whom can rely on the government to protect them or their business. In places where every company develops these survival instincts, they percolate into a culture that can make it frustratingly hard to do business.

Businesses had zero assurance besides their direct relationship with (and character assessment of) their counterparties that a transaction would clear. These pressures confined trade to Dunbar-scale webs, limited by person-to-person bonds. Everyday Russians, knowing that they had little other recourse, only dealt with proximate and familiar individuals - people whose collars they could grab should something go wrong.

This worked fine for the smallest businesses. But what about the businesses that didn’t want to stay small? Or those that could only work at a large scale, such as factories or wholesalers or refineries or mines? What about those who wanted to trade with businesses in other cities? Where—WHO—could they turn when there was no collar to grab?

It turned out that there was quite a bit of money to be made by anyone who could that question. And while there was much about the market that Russian leaders didn’t understand, they were spot-on about one very important fact: for every problem the market encounters, it will come up with a solution.

We’ll discuss that solution next time.

Bibliography & Further Reading

Cheryl W. Gray, Kathryn Hendley: “Developing Commercial Law in Transition Economies: Examples from Hungary and Russia.”

Vadim Radaev: “Russian Entrepreneurship and Violence in the Late 1990s.”

Vadim Volkov: Violent Entrepreneurs: The Use of Force in the Making of Russian Capitalism.

Svetlana Glinkina: “The Shadow Economy in Contemporary Russia.”

Juliet Ellen Johnson: “The Russian Banking System: Institutional Responses to the Market Transition.”