Welcome to Breaking Banks, the number one global fintech radio show and podcast. I’m Brett King. And I’m Jason Henricks.

Every week since 2013, we explore the personalities, startups, innovators, and industry players driving disruption in financial services. From incumbents to unicorns and from cutting edge technology to the people using it to help create a more innovative, inclusive, and healthy financial future. I’m J.P. Nichols, and this is Breaking Banks.

Well, I am no stranger to getting up early. Normally, though, when it is a 4.30 call time, it is to catch a flight. A child is sick or a dog is puking, and it normally is not to get up to rap with Jason McCullough about third-party risk management and FDIC insurance.

But here we are. Thank you for joining me. You have the benefit of some time zone arbitrage.

Where are you actually dialing in from? I’m getting my Money 2020 season started early. I’m on site in Amsterdam, where actually you can go outside. It’s not in the basement of a casino.

So I’m sitting outside at the Money Beach Club, which is actually rather nice. Nice. Well, it sounds a lot better than my kitchen, where I’m sure a small child will make an appearance to talk about third-party risk.

We are in the midst of a saga with the Synapse Evolve Lineage situation, which I’d say is making ripples writ large within banking as a service and financial technology. Bring us up to speed, because you have been doing the large work and following the case and staying up late to listen to bankruptcy hearings and tracking everything that’s going on. But why don’t we catch up, because I think I at least am surprised that this saga has taken an Austin Powers on a steamroller sort of turn, where it is a disaster in slow making at the moment.

Yeah. I don’t even know if I can call this a silver lining, but the one slightly positive piece of news, if you can think about it that way, is it looks like the number of impacted users is probably in the hundreds of thousands, or maybe low single-digit millions, rather than the 10 million number that Synapse had cited in some of its filings. I’m certainly not the 20 million number that turned up in the headline of some coverage somewhere.

Not to say that those hundreds of thousands of people who were impacted are very seriously impacted. I mean, plenty of anecdotes and stories from users of Yana, users of Juno, to the court itself, to the media. So a lot of empathy for what those folks are going through.

As far as where the case stands, the most recent developments were last Thursday, Friday, with filings from both Synapse and Evolve, and then the court hearing. And basically, where we stand is Synapse says that Evolve should have approximately $150 million worth of deposits, but that the actual amount that Evolve has is around $100 million. So Synapse is alleging there’s a shortfall at Evolve of approximately $50 million.

Evolve says, basically, that it does not—not in these words, I’m paraphrasing—but that it does not trust the integrity of Synapse’s data, of its ledger. In its filing, it included some specific examples of the actual flow of funds in Evolve’s accounts moving one direction, and the balance, as indicated by Synapse’s ledger, going the opposite direction, right? Which, you know, is not how that’s supposed to work. The lineage in the court hearing last Friday also represented that it does not have confidence in the data or the ledgers that Synapse had produced to that point.

Friday also saw Chapter 11 trustee Yolanda McWilliams appointed, which, you know, given that she is the former chair of the FDIC, you know, hopefully has the confidence of the banks as far as working to resolve this in a way that the existing Synapse management team clearly seems not to have had that confidence. So that’s basically where we stand off the top of my head. Yeah.

Well, I mean, let’s abstract to what we’ve learned from this so far. And one of the big surprises for me, well, first, I’m not surprised that there were challenges with the ledger, right? Ledgers are actually so complex and so underrated in what they do. But the surprise to me is just how long it went on and the magnitude to which it is off.

Yeah. I mean, I remember reporting out a piece, it was probably last October, you know, as some of the Mercury Synapse Evolve stuff was, you know, starting to, I guess, escalate. And there were internal comms between Evolve and Synapse that I obtained and verified and reported out with somebody on the Evolve side saying something to the effect of the balances between what Evolve held and what Synapse that it should hold, varied by as much as a couple hundred million on the daily.

So it’s not like, you know, it’s not like all, it appears that all parties involved knew or certainly should have known that there were problems here. I mean, particularly the information also reported out a piece recently, that these issues were raised to Synapse’s board, right? Which included representatives from the firms that invested and recent Horowitz, I think Core Innovation Capital, and I feel like I’m forgetting somebody, Trinity. Yep.

All experienced fintech investors as well, which is also seems to be a surprise that, you know, a board with that level of sophistication would let something go on. What surprised you out of the situations? Like they’re a number one surprise for you? I mean, I’m surprised it’s turned out as badly as it has. You know, clearly I’ve been following, you know, Synapse and Evolve in sort of the wider bath space for quite a while.

You know, this is about as catastrophic as an outcome as I could possibly envision, right? Certainly, we’ve seen plenty of consent orders for plenty of other banks, which, you know, touch on issues that your average end user, you know, does not know and most likely does not care about. You know, we can discuss TPRM and due diligence and, you know, board governance and all that. But at the end of the day, you know, people care about, is my money safe and can I get it? And now, you know, in this situation, the answer to that is no.

I mean, I guess one thing that somewhat surprised me is, you know, some of these fintechs, in particular Yotta, which seems to be the largest one impacted, acting like they were caught off guard or they were actually caught off guard by the demise of Synapse and the impact on their business. I mean, anyone who’s been sort of paying attention in industry, you know, has known the trajectory was not good for quite a while. And then in the court of public opinion, trying to spin it as if, you know, like very publicly stating, it’s like, oh, how could we have known? It’s like we all knew.

Yeah. I mean, again, there’s no way that this should have been a surprise to any company that was using Synapse as a vendor, given the criticality of the services Synapse was providing. And in the Yotta case specifically, the idea of being caught off guard, particularly in the case of Yotta, just doesn’t match up with behavior that, you know, that the company has exhibited.

I mean, it began opening new accounts via another Bass Platform unit and units being partner threads late last year. I mean, it’s just, it strikes me as incomprehensible that, you know, any fintech client of Synapse and Yotta in particular, you know, couldn’t, could not be aware of what was happening. Yeah.

Aware and not take more evasive action related to that, like if you could see this and you knew enough to start opening new accounts elsewhere, how can you claim I’m just trying to help get people their money back when you have a fiduciary duty and you knew this was not just a likely risk, but it was a risk that was actively unfolding? Yeah. I mean, the complete lack of any kind of like business continuity, you know, operational resilience, both on the fintech side and on the bank side, right? I mean, for, you know, for Evolve and Lineage and the other bank partners, you know, we’ve seen in the consent orders mentions of verifying the sort of financial stability of third party partners. So, I mean, you know, some of the questions I have, which may or may not get answered one day is like, you know, was Evolve, you know, monitoring Synapse’s financial situation? You know, if no, why not? If yes, and they sort of saw this, you know, the last external capital Synapse raised was in 2019, you know, it’s 2024.

So you know, at what point did the alarm bells, you know, not ring at Evolve as they saw this partner whose financial situation was deteriorating and Evolve also knew there was a sort of ledger integrity issue? I mean, I guess, you know, the one smart thing Evolve did was try to start shifting those programs off their bank and over to AMG and Synapse brokerage to mitigate their risk. So instead of solving the problem, you know, they tried to offload it to other places. Well, to me, that’s the more fundamental surprise around this from the banking perspective is they knew, they had to have known there was a challenge around ledgering and, you know, this is a minor frustration become major frustration is banks are so good at imagining every possible thing that could go wrong.

But they didn’t pay attention to one of the most obvious things that could go wrong that should have been caught really quickly. Because what is one of the fundamental jobs of a bank is to keep track of how much money comes in and how much money goes out. Yeah, I mean, I think the podcast you did with Kia discussing FBOs, I found really helpful at illustrating some of that complexity.

I mean, it feels, I mean, it feels like it should just be like a basic fundamental thing, right? The bank should know how much money is there. But when you start to unpack, you know, well, you know, ACH windows, wire windows, you know, card clearing and settlement, and this stuff is happening, you know, at Synapse. And there’s four different bank partners with, you know, various pots of money, you start to realize the amount of complexity, you know, and how difficult that presumably made it for any single bank to really understand what was happening here.

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Learn more at AlloyLabs.com. Alloy Labs, banking unbound. I think this goes, if you look at some of the larger incumbent vast banks, the amount of infrastructure that they’ve built and the people and the processes that they’ve had to go do this. You Alex and I talked about this a few weeks ago is, you know, banking as a service island is Alex’s call is no place for tourists.

You know, and unfortunately, there are a lot of tourists, both banks, entrepreneurs that see problems that they wanted to go fix and venture capitalists that thought they understood everything around us. Yeah, I mean, I think the tourist metaphor is a perfect one. I mean, a comment from the attorney representing lineage, I forget exactly what he said, but it was basically like, you know, we’re just a small bank.

We only have, you know, whatever, 40, 50, yeah, yeah, like people, you know, sort of, you know, give us a break. We need to work through this. And I was like, uh, maybe you shouldn’t have been engaged in this line of business.

If you didn’t have the resources to execute on it appropriately, I mean, I will give a bit of a break to the current, you know, board and management, because they’re not the ones who made that decision. You know, the board was replaced and, you know, management replaced a number of months back at this point. But it does illustrate the sort of tourist problem where it’s like, yeah, you don’t dabble, you know, you don’t take a short holiday to Bass Island.

You know, you need to be prepared for the long haul and invest accordingly. And, you know, another surprise related to this is actually the regulatory response or lack of response. I wish we had Kia here so she and I could, you know, disagree vehemently here.

Have you been surprised at all about the regulatory stance and the clarification the FDIC has recently made? Yeah. I mean, I’m kind of of two minds about this, right? I mean, from a sort of narrow, legalistic read, I do tend to agree with the point of view that FDIC don’t have a lot of clear authority to act here. You know, in the comparisons to SVB, for a lot of reasons, namely that, you know, SVB was a bank and that bank failed, which is just fundamentally different than what’s happening here.

You know, however, on the flip side, you know, for normies, for end users whose money is stuck and have long equated the idea of FDIC insurance equals, like, my money is safe and I’m going to get it back, entirely understand that frustration. I mean, I am, I continue to be surprised that, you know, of all the banks that have received consent orders related to BAS, somehow, Evolve has not yet received one, which is a bit, you know, confounding when you just look at the sheer severity of this problem and then, you know, scale of other issues they’ve been tied to, you know, other problematic programs or problematic middleware providers. Yeah, that is definitely a bit surprising to me.

Well, let me expand on my surprise on the FDIC’s clarification that, you know, it is only for bank failures, which I’m not advocating for an FDIC bailout here, right? Like, you can’t go rewrite regulation and authorities, but for a regulatory body that on a regular basis sends out, you know, notices and cease and desist on the use of their logo and the placement and the wording, how come there was never a clarification around the nature of the insurance? They’ll get upset about the use, where the logo sits and it doesn’t, you know, have the right phrasing, you know, by the bank, but there was no real clarification for the norm is, right, that end user to understand the nature of the insurance. Yeah. I mean, the updated FDIC disclosure rule, you know, I guess, in a sense, tries to address that.

I believe it went into effect in April, although enforcement is deferred until next year. But ask yourself, you know, does the sentence, and I think Current is a good example of a company doing this correctly, but a regular person reading the sentence, you know, Company X is a fintech, not a bank, you know, banking services provided by Bank X, deposits may be eligible for pass-through insurance, you know, if they meet criteria, like that means nothing to like 99% of people. So, it’s not clear to me that like a disclosure regime, a different and more forceful disclosures regime will actually solve the problem, well, one of the problems that happened here.

And, you know, it is also no surprise the number of armchair quarterbacks that have come out from, you know, regulatory experts slash legal say, ah, you know, like, of course, these disclosures are perfectly clear, and everyone should understand this. But I want to push back on some of them to say, you know, yes, the pass-through insurance should work, except we’ve never actually had it tested, right, around the implementation of these three criteria, and especially testing, what happens if the documentation isn’t clear in terms of who has which amount, and how this gets handled? Yeah, I mean, my talking point on this is, I think it’s a great testament to the success of the American banking and regulatory system, including the role of deposit insurance, as well as prudential regulators, that average people don’t need to think about, you know, is the bank I’m putting my money in safe, whether it’s JPMorgan Chase, or, you know, Libertyville Bank and Trust, some small town, you know, one branch bank, that is a success. However, you know, I think the Synapse case illustrates the unearned benefit, the trust that users have in the banking system, that non-bank fintechs are happy to capitalize on as far as, you know, making users feel safe and good about using the products, but, you know, sort of belies some of the risks that those users are unwittingly taking.

Yeah. What do you think the longer-term implications are for, you know, not just banking as a service, but as we think about the fintech companies and the innovation that we’re focused on? I mean, this, it gives a, you know, very significant piece of ammunition to anyone who wants to, you know, oppose, you know, quote, unquote, fintech, right? Now, is that establishment banks that see fintechs as a threat to their business, maybe? Is it certain you know, people or certain segments within politics or within the regulatory establishment, you know, also entirely possible? Yeah, and I do think it makes, you know, it’s going to make it substantially more difficult for anyone who needs to partner with a bank as far as, you know, the expectations around, you know, financial wherewithal runway, as well as, you know, all of the due diligence and TPRM stuff that was already, you know, heavily escalated due to the consent orders that have come out in the past several years. Yeah, I think it’s going to have an interesting Darwinian effect, right? So I think it’s going to see a bunch of the tourism, you know, pushed out, but I think it ultimately is actually very good that we’re going to have more serious players focused on more serious problems, rather than just the next neobank for this or for that, or, you know, solving small problems that we’re getting way too much funding in the pursuit of growth.

That I think it actually, you know, in the same way, with Bitcoin, you know, becoming, you know, the hot asset that everyone’s going to get rich on and, you know, you only live once, you know, you know, hodl this thing kind of disrupted the amount of innovation around what we could do, right? That frothiness actually kept fundamental innovations from taking place. I mean, it’s always interesting. And in retrospect, like, look at people sort of touting just the sheer amount of capital raised in that sort of 2020 to 2022 timeframe as, you know, an unalloyed positive thing, right? I mean, the question should be, how much money can you deploy effectively? And, you know, to your point, so much of what we’ve seen in the past couple of years, you know, copycat startups, you know, neobank for pet owners, I think there’s more than one of those, actually.

And the pipeline, particularly in like consumer, from VCs to advertisers, you know, Google, Facebook, Instagram, the New York City subway. And so it’s like, are those funds that were deployed to actually build something? Or were they not to put too harsh of a spin on it, but like kind of just wasted? And, you know, I think looking back now, you know, the answer is how much capital could FinTech absorb usefully? I think it was quite a bit lower than the numbers we saw in the past several years. Well, and I think Frank Rotman would drive that point home.

When you have too much money, you find ways to spend it. And not necessarily on the ways that are really creating value and leveraging your business model. No, I think that’s exactly right.

So on the European front, is this even making news across the pond? Or is this a distinctly United States kind of phenomenon in terms of how it’s playing out? I mean, people have definitely noticed I was at a dinner a week or two ago, FinTech dinner here in Amsterdam. And the folks sitting around me were definitely aware, aware of it. I mean, we have a level of details that you and I might have.

I mean, something that I think the difference between the two markets illustrates the relative success of these non-bank chargers that exist in the UK and Europe, specifically the e-money license, right? You know, you have Bass firms here or FinTech firms here that operate on that e-money license, which in a sense is kind of like, this is a simplification, but codifying the kinds of structures you see in the US, right? Where the EMI has an obligation to segregate and safeguard customer funds that need to be held at an insured depository institution. The difference is, because of that EMI license, there is a clear regulatory supervision regime that as much as we’re hoping for somebody to use the BSEA to come in and actually supervise and examine FinTechs in the US, there are better tools, I think, here in the UK and European markets to more effectively supervise these non-bank FinTech entities. And I think it just speaks to, I know Kia would love for this to be the catalyst for an overhaul of the regulatory regime in the US that clarifies and codifies who owns which swim lane.

And while I appreciate her optimism and I really wish it would take place, it really does show the importance of regulation in promoting responsible innovation and that it does not have to be a roadblock. No, absolutely. I mean, the sentiment that we’ve seen in other industries, non-financial industries and Uber is like the classic example of, they pursued that business model knowing that it was illegal in a lot of the jurisdictions that they operated in and grew so big and so fast and solved a legitimate customer pain point that they were able to bend regulation to fit their model.

Financial services companies almost never have the luxury of that happening. And so to the extent that regulations and regulators can provide clarity, it should make the operating environment easier. What responsibility do you think should be pushed back to the board and the investors? That’s a really difficult question.

I mean, at the end of the day, well, this is also challenging in startup world because even when you have a board, that board may not have control depending on what stake a founder or co-founders hold. So it’s like, to what extent is a board and I don’t know the exact structure or how things change with synapses born over time. But boards are not always necessarily empowered to carry out their responsibility of governance.

I mean, again, another out of category example, but look at Tesla, the board there functionally does nothing. But I certainly think that there are legitimate questions about what did the board know? When did they know it? What actions did they take or not take and why? But I’d hesitate to speculate too much beyond that. Well, it’ll be a fascinating shakeout.

Thank you for carving out some time during the Busy Money 2020 season. Apologize to all the listeners who got to hear both my children and my dog. But the only time Jason and I could make this work out was a 5am recording.

Yeah, you sound like you need another cup of coffee. And I do too, actually. For very different reasons.

But thank you, Jason, for dropping your insights. Yeah, thank you so much. That’s it for another week of the world’s number one fintech podcast and radio show, Breaking Banks.

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