The dirty business between banks and regulators resurfaces

The fifth season of the Showtime series “Billions” ends with a scene that exposes the bad deal that governments make with banks and how that deal works against the interests of society.

It seems appropriate to reflect on these relationships now, when the “too big to fail” financial system that relies on this market is in its most fragile state for 13 years, and ask what, if anything, the crypto alternative offers.

In the scene, hedge fund manager Bobby Axelrod discovers he was lured into criminal vulnerability by his sworn enemies, New York Attorney General Chuck Rhoades Jr. and financier Mike Prince. After being tricked into taking deposits in his newly established Ax bank from a cannabis company, Axelrod discovers that he has violated his fiduciary duty of not “knowing your customer”. It turns out that the weed supplier was selling unauthorized products, a crime for which Axelrod and his bank are now also guilty.

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It is the “KYC” requirements that matter here. In addition to anti-money laundering (AML) compliance rules, they include a comprehensive monitoring system designed to prevent criminals from hiding their financial footprint. As we have often argued in this column and in the “Money Reimagined” podcast, the KYC-AML system has evolved into an undue constraint on financial access and a dangerous imposition on freedom and privacy, even if the intent of security original was reasonable.

But it’s the other side of the market that makes it interesting, the role that was so appealing to Axelrod (played by Damian Lewis) that he acquired an entity with a bank card and merged his once very long Axel Capital fund into it. popular. There are real benefits to being a compliant and regulated institution, benefits that make it easy to make money or, in Axelrod’s case, protect his wealth.

There are various benefits to this deal. There is Federal Deposit Insurance Corporation coverage for bank depositors. There is access to a Federal Reserve backstop if needed. And, as we discovered in 2008, the safety net for the largest banks also extends to the federal government, which provides bailouts in times of crisis.

These express and implied warranties are a license to mint money, literally. By hedging banks’ downside risks, they keep their sources of capital cheap, which allows banks to leverage those funds into profitable loans and investments, thereby narrowing the interest rate gap. Endlessly.

This is all part and parcel of the fractional reserve arrangement whereby banks essentially create our money by lending deposits. Since banks are an integral part of our economy, both for storing our money and for returning it to each other, the federal government provides these safety nets to mitigate the risk of a “rush” bringing down the entire system. , as feared in 2008.

Perverse results

The problem is that this market – KYC-AML compliance in exchange for safety nets – creates perverse incentives and outcomes.

The first is that in a world of sophisticated financial criminals, banks are forced to create increasingly stringent disclosure requirements for depositors. This particularly harms the poor, who cannot provide proof of identity and other documents needed to pass the course. Meanwhile, those rules are being used by people like Chuck Rhoades for personal vendettas or political interests.

Another perverse outcome emerged in the 2008 crisis autopsy. The perceived absence of downside risks creates moral hazard, prompting profit-seeking bankers to engage in overly indebted bets.

All of this has created a symbiotic relationship between regulators and banks that is very difficult to untangle without disrupting this otherwise broken system.

We see the problem in the revolving door phenomenon of regulatory agency staff moving to work on Wall Street and vice versa. And this explains the frustration in Caitlin Long’s voice this week, as crypto bank Custody CEO told a DC Fintech Week audience about the Federal Reserve’s double standards. Long, an articulate innovator, said Custodian will change its lawsuit against the Federal Reserve – citing it for blocking a Custodial application for a central bank account – to refer to the fact that BNY Mellon, the world’s largest custodian bank, has been authorized to hold bitcoins of its customers.

Global stress

Today, this global system is once again showing signs of fragility. The UK supports its debt markets; the surge in the dollar creates economic and political tensions in large economies like Japan and small ones like Lebanon; and a large multinational bank – Credit Suisse – is still rumored to be in serious trouble.

That’s why Edward Snowden’s tweet this week that resurfaced Satoshi Nakamoto’s famous inclusion in the first Bitcoin transaction was so fitting.

The Times 03 / January / 2009 Chancellor decided to bail out the banks https://t.co/yUdylzFprA— Edward Snowden (@Snowden) 11 October 2022

The privacy activist in exile has cunningly reminded us of the stakes of his technology. (Hint: it’s not “the number is increasing.”)

But we also recognize that Satoshi’s 2009 vision for an alternative monetary system – in which payments are not routed through government-regulated intermediaries but are made between peers – has, at least so far, failed to remove the old system.

This is partly due to the fact that US government agencies and other governments have demonstrated their unparalleled power to control the inbound and outbound routes of the crypto economy, which, inevitably, involve the very banks that cryptocurrency developers try to bypass. Whether it’s burdensome KYC rules or sanctioned list orders like in the Tornado Cash case, regulations and enforcement have clipped the wings of cryptocurrencies.

But it’s also because the cryptocurrency community itself has lost sight of the larger mission. He has become obsessed with token speculation, which has led some major industry players to adopt some of the same, if not worse, Wall Street practices of centralized custody, leverage and re-mortgage.

Occasion

However, the winter of cryptocurrencies offers a powerful lesson to the community now focused on BUIDLing to invent self-regulatory systems, approaches and solutions that can help eliminate these ugly elements.

There could be no better time for the industry to make its case. As Financial Times columnist Edward Luce noted this week, “the world is starting to hate the Fed,” thanks to its aggressive rate hikes and the resulting rise in the dollar. The fastest growing US exports, Luce wrote, is “monetary pain.”

Just like 2008, this troubling time will spark a host of new ideas for rethinking the global financial system. Unlike 2008, there is now a radically different technological model to build upon.

When policymakers get together to weigh these ideas, it’s unclear whether cryptocurrencies will have a seat at the table. But it’s sure to make a splash just outside the dining room.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.