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.
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 provides 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.
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.
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