Fintechs, crypto and banks must follow the same set of rules

Customers and investors value fintech companies because they are perceived as nimble and more capable than banks of delivering a superior customer experience. The impression lingers, at least in the minds of some investors, that fintech entrepreneurs are still able to live by Facebook founder Mark Zuckerberg’s motto: “Move fast and break things.” It is time for these perceptions to end.

Compared to banks, the fintech industry has some systemic advantages for participants, but to balance things out, there are usually additional risks borne by customers. To ensure that the United States retains the world’s leading financial services industry, we need to rebalance the distribution of risk so that consumers aren’t stuck with the tab when things go wrong. One way to do this is to change the way banks interact with fintech companies, and regulators seem to be making that happen.

The emerging cryptocurrency asset class and the FTX failure is an excellent example of how the system in the United States has allowed the risk associated with institutional failure to migrate to clients. Whether it’s payments, financing, or investing, the majority of Americans today use the services of one or more fintech companies, and many mistakenly believe they have the same protections as chartered banks.

Fintech companies profit from regulatory arbitrage

One of the perceived advantages for fintech companies, at least for investors, is that they are not subject to the same capital requirements as banks and can therefore be founded with much lower levels of investment. This means that companies are not necessarily well equipped to survive periods of financial crisis and that in case of failure the costs are passed on to customers through losses. The cryptocurrency world is now littered with companies such as FTX, Voyager Digital, Celsius
Genesis, BlockFi and others.

The owners and managers of fintech companies are also subject to much less scrutiny. Anyone with access to funding can be a founder of a fintech company, but regulators ensure that banking operators are held to a much higher standard.

Part of the reason for the rise of the fintech economy was rooted in regulatory arbitrage. Simply put, banks and fintech companies don’t compete on a level playing field. Banks are heavily regulated by the government and must adhere to strict rules and guidelines, including capital requirements, lending standards, and consumer protection. Banks are also grappling with considerable compliance burdens that fintech firms have so far mostly avoided, and penalties for technical failures are disproportionately greater for banking firms.

For example, consider what happened to USAA and Capital One
. In March 2022, the USAA Federal Savings Bank was valued at $140 million civil monetary penalty by the Financial Crimes Enforcement Network (FinCEN) for failing to implement and maintain an effective anti-money laundering program, and in August 2020, the Office of the Comptroller of the Currency (OCC) assessed a $80 million civil suit. money penaltyagainst Capital One regarding a data breach.

Banks are required to have everything in place and functioning properly at all times. New developments must be fully tested and fully integrated into the bank before they are introduced to customers, and things that go wrong are viewed very negatively.

Banking-as-a-Service under regulatory pressure

Banking-as-a-Service (“BaaS”), somewhat similar to the concept of “Open Banking”, is one of the main ways banks interact with the fintech and crypto-fintech community, and it is a regulatory pushback target. BaaS is not dead, but the business will need to be reshaped as regulators pressure banks to take responsibility for their fintech customers.

Simply put, BaaS is the technology-enabled delivery of banking products to non-banking third parties. These fintechs are customers of the bank who then directly acquire customers themselves, and these fintech customers are most likely not even aware that they are consuming products from the underlying bank.

Multiple US banking regulators are paying increasing attention to the overall risk profile of banks, which has led to much more attention being paid to third-party relationships. Banks are under pressure to ensure that they fully understand the risk characteristics of businesses that receive services from the bank.

In a BaaS relationship, the fintech essentially interacts with the customer on behalf of the bank, which means that all bank and fintech activities must comply with applicable regulations. Expect increased attention to know-your-customer rules, bank secrecy (anti-money laundering) law provisions, marketing and advertising standards, and all aspects of credit.

Banks can never outsource liability

Banks can outsource certain activities, but they can never outsource responsibility. This means that banks are required to ensure that their fintech BaaS customers comply with the rules to the same extent as if the bank were conducting the business itself.

There are a number of banks in the United States that participate in the BaaS space. Expect them to demand more from their fintech partnerships. The cost model for fintech companies will need to be reassessed in light of rising compliance costs, and they will need to be much more transparent to their banking providers.

Enforcement has already started. In 2022, Blue Ridge Bank NA entered into a formal agreementwith the Office of the Comptroller of the Currency (OCC). Blue Ridge Bank accepted strengthen the regulator’s oversight of BaaS activities. In the OCC’s order, the bank agreed to obtain no objection from the OCC before entering into new contracts with fintech partners or adding new products in cooperation with existing partners.

Perhaps for cost and compliance reasons of maintaining the banking relationship, the cryptocurrency exchange Binance announced that Signature Bank will no longer process Swift transactions under $100,000 for crypto exchange customers.

Fintech players have taken advantage of the banking sector. Until now, the U.S. fintech industry has relied on banks to do the heavy lifting and absorb compliance and regulatory costs. Maybe that time is finally coming to an end.

Regulators are reminding banks that they are responsible for the activities of their fintech partners, and that will lead to changes. No doubt there will be a change of model that subtracts from the profitability of the fintech model. Perhaps banks will stop supporting the growth of their fintech competition and we can see banks safely and solidly lead the financial services customer experience again.

The author’s employer is a client of Signature Bank.


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