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Losing access to funds can be a shock for customers of financial technology firms.
The news media has extensively covered the crash and burn trajectories of some of the
leading crypto companies since FTX led the way into bankruptcy in November 2022. Soon to
follow were BlockFi, Celsuis, Voyager, and many others that were not as high profile. Crypto
companies were highly criticized, and in some instances deservedly so, but what about the
failures on financial technology firms providing traditional products? Customers are at much
higher risk from the non-crypto providers because in many cases the customers do not
recognize the risks and underestimate the consequences of failure.
Financial technology (fintech) companies that provide banking-like products are a hidden
risk to customers, and for the most part, customers appear oblivious to the risks they
assume when using the services of such firms.
By way of example, a wave of fintech providers either ceased operating or experienced
substantial disruption in April 2024 when a behind-the-scenes provider of services to these
fintech companies, Synapse Financial Technologies, declared bankruptcy. Copper, Mainvest,
Yotta, Juno, YieldStreet, and many more firms were impacted.
Similar non-bank fintech firms such as Mercury, Brex, Fold, Wise and many more provide
banking-like services to customers, and as they grow so does the potential impact to
customers in case of a failure.
FTX logo. (Photo by Jakub Porzycki/NurPhoto via Getty Images)
NurPhoto via Getty Images
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In the case of FTX and some of the other crypto-related bankruptcies, almost two years after
the firms ceased operating, only now are customers beginning to expect to receive return of
some of their funds. In larger bankruptcy cases it is not uncommon for the process to take
years, and for customers to only receive repayment of a fraction of their funds.
Customers of some of the fintech firms impacted by the collapse of Synapse were shocked to
discover that they could not access their funds. It has been almost six months so far, and
for some customers there is not even a timeline about when they can access their funds. It
is even unclear how much of their funds will be returned. Jason Mikula has reported
extensively on the aftermath in FinTech Business Weekly.
As customers have repeatedly explained to the court in the Synapse bankruptcy hearings,
customers believed, or even perhaps were led to believe, that their deposits were insured in
case of failure. That was not accurate.
Cryptocurrency Firm Failures
Cryptocurrency, and bitcoin in particular, is a new and exciting asset class that providers
investors with risks and rewards that may not be correlated with other assets.
History teaches that in anything new that promises high potential rewards some of the
earliest promoters may also be those with the loosest grasp of ethical and lawful behavior.
In America we can look back to the swindles associated with land in the gold rush or the
shenanigans around stock promotion in the early part of the twentieth century. The
Securities Act of 1933 and The Securities Exchange Act of 1934 were enacted to curb the
abuses and provide investor protections.
Some crypto market participants seem compelled to repeat history. The wreckage of the early
movers in the crypto industry included substantial criminal activity at FTX, and
questionable business models at some of the crypto-lending firms that encompassed high-risk
activities that had resulted in countless failures in traditional lending firms.
There were only a few of us sounding the alarms about these firms before their failures.
Customers did not understand that they were at risk. The failure of these cryptocurrency
related firms had a significant impact on certain customers, and a negative impact on all
their customers. Since the firms did not hold themselves out to be alternatives to
traditional banks there were few, if any, customers who relied upon these firms to the
exclusion of a traditional banking relationship.
Fintech Firms
Some customer-facing fintech firms do market themselves as alternatives to the traditional
banking sector. These fintech companies provide a customer experience or set of products and
services that may not be available from traditional banks, and hence appeal to a certain set
of customers.
Fintech firms do not operate completely independently, and generally require the services of
what is usually called a “partner bank.” The banking relationship is needed for a number of
reasons including holding the customer deposits and access to the traditional payment
systems.
Banks in the USA are exiting the business of partner banking, and in an article published
earlier this month, I discuss the withdrawal of banking support for customer-facing fintech
firms.
While banks are subject to rigorous supervision, required capital levels, and safety and
soundness standards, fintech firms are not covered by those strong regulatory requirements.
Fintech companies are generally required to have some form of regulatory permission to
operate, but those licenses are lightyears away from the highly regulated operating
environment for banks chartered in the USA.
The Federal Deposit Insurance Corporation headquarters (Photo credit KAREN BLEIER/AFP via
Getty ... [+] Images)
AFP via Getty Images
Fintech firms are also not covered by the Federal Deposit Insurance Corporation (FDIC). The
FDIC provides depositors insurance against the failures of banks, and as reported on the
FDIC website, since FDIC insurance began in 1934, no depositor has lost a single penny of
insured funds due to bank failure. There is no question that FDIC insurance is one of the
many reasons for the strength of the U.S. banking system.
The FDIC only insures against the failure of a bank, and not the failure of a fintech
intermediary. Therefore, as long as the bank continues to remain in good condition, if a
fintech fails customers are potentially completely exposed should the customer’s funds not
have been properly secured.
The FDIC operates to ensure that bank customers have continuous access to their funds. In
the highly unlikely event that a bank becomes troubled to the point the FDIC is required to
intervene, the insurance agency generally does so after the close of normal business hours
so that by the time the bank reopens the next business day the customer accounts are
transferred to a well-capitalized entity. The goal is to ensure that customers are not
impacted.
Customer funds deposited in a fintech, which are then placed in a bank, may not even be
covered in the event that the bank fails. The insurance relied upon in such an occurrence is
the FDIC pass-through insurance, and there are conditions that must be met for such
insurance to apply. Customers of fintech entities are therefore not even guaranteed
insurance in the highly unusual event of a bank failure since the customer is relying upon
the fintech firm to maintain all the conditions for pass-through insurance.
Customers have an expectation that their funds will always be safe, and banking in the USA
is virtually synonymous with FDIC-insured banking. Fintech providers are neither necessarily
safe nor insured. The gulf between the consumer protections for a FDIC-insured bank compared
to any non-bank fintech is so vast that comparisons are virtually meaningless.
Moving Forward
Financial innovation is generally a net positive, and placing customer funds at risk,
especially when customers may not fully understand the risks they are undertaking, is by
definition a net negative.
The current system of standalone fintech firms that treat traditional banks as account
servicers and infrastructure providers should be phased out. Sustainable growth will be
found through a combination of the strength of the traditional banking system with the
innovation of the financial technology industry.
Joint ventures between banks and fintech companies are the way of the future.
Through joint ventures the fintech industry may be brought into the well-regulated banking
industry, and customers will benefit from the safety and security of bank supervision. The
passage of the responsibility for ensuring customer funds are safe to the banks will result
in the banks caring far more about the operation of fintech firms. Standards for capital,
technology, compliance, and the management of the fintech enterprise will be required as
banks are expected to be managed safely, provide uninterrupted customer service, and to be
fully in compliance with all applicable regulations.
The banking industry must be in the leadership position when it comes to financial
innovation. The banks should take the lead in these ventures for management, compliance, and
ensuring safety & soundness.
Fintech companies should be seeking to find banks to engage in joint-ventures. Banks should
identify ideas, technologies, and teams for which they wish to be associated, and to enter
strategic discussions. The economics need to be fair, however, and that means that the banks
should receive significant participation in the upside.
Customers in the USA deserve the protections of the highly regulated banking system whenever
they entrust their money to an entity that offers banking-like services.
Follow me on Twitter or LinkedIn.
Gene A. Grant II
Editorial Standards
Forbes Accolades
2024-10-18 14:15:00
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