The job in banking, as I have recently written, is to provide a safe place for customers to keep, access, and think about their money.

The temptation in banking is to use those large piles of money to make more money.

A few good ways of doing this include:

  • Lending money.
  • Investing money.
  • Lending yourself other people’s money (which you control) in order to invest more money.

Most of the bad stuff that has ever happened in the history of banking comes back to the tension between these two things – the job and the temptation.

For just one example, let’s go back to the days of wildcat banking in the United States.

The period between 1837 and 1862 is known as the Free Banking period in the U.S. Yes, it is absolutely as terrifying as it sounds. Andrew Jackson (the worst U.S. president, hands down, IMO) was vehemently opposed to centralized banking of any sort and took several steps during his time in office to push the regulation of the U.S. banking industry down from the federal government to the states (and territories). 

The result was chaos. States and territories gave out bank charters like candy at Halloween and applied little to no regulation or supervision. Consequently, these state bank charters became excellent mechanisms for ripping people off. These so-called ‘wildcat banks’ would issue their own paper currency, supposedly fully collateralized by government bonds or real estate notes, but often undercollateralized or not collateralized at all.

A counterfeit of an 1828 note from Catskill Bank in New York, which features an image of a wild cat.

The peak of this mania happened when Michigan, shortly after becoming a state, passed the General Banking Act, which allowed any group of landowners to organize a bank by raising at least $50,000 capital stock and depositing notes on real estate with the government as security for their banknotes. As you might imagine, this democratized access to bank charters was a bad idea and led to a proliferation of wildcat banks, one of which was memorably found to have “cash reserves” consisting of boxes of nails and glass topped with silver coins.

By 1863, everyone had had enough, and the federal government passed the first of two National Bank Acts, which created a national currency based on federal debt and established the Office of the Comptroller of the Currency (OCC) to supervise all national banks.

This pattern – banks and bank-like entities succumbing to temptation and behaving badly with the money in their stewardship, society regulating those specific bad behaviors out of existence, and new banks and bank-like entities appearing and finding novel bad ways to behave – has been playing itself out continuously for hundreds of years. 

It is the evolutionary history of banking.

And if you study that history, you will find that the most successful evolutionary trait in banking is the ability to be boring.

Allow me to explain by segmenting today’s financial industry into three groups.

#1: Not Boring

Sam Bankman-Fried’s (SBF) vision for FTX was to become a global substitute for banks, as he explained in his pitch to the VC firm Sequoia:

I want FTX to be a place where you can do anything you want with your next dollar. You can buy bitcoin. You can send money in whatever currency to any friend anywhere in the world. You can buy a banana. You can do anything you want with your money from inside FTX. 

But the motivation to create FTX originally came out of SBF’s frustrations trying to get money into and out of his crypto quant trading firm – Alameda Research:

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The biggest headache for Alameda wasn’t finding the opportunities, but executing the trades. At the time, when it came to crypto exchanges, the choice basically boiled down to Coinbase or Binance. Coinbase makes a point of being regulated by authorities in the U.S., but as a consequence, didn’t offer the kinds of options contracts and derivatives professional traders need to hedge their bets. Binance, on the other hand, offered the kinds of derivatives SBF was familiar with when he traded for Jane Street – but as a company, it was continually moving from country to country in an attempt to evade all jurisdictional authority. Neither exchange was particularly good to trade on.

So SBF built the crypto exchange that he always wanted, grew it into the second largest crypto exchange in the world (after Binance), and then succumbed to temptation:

Crypto exchange FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm, Alameda Research, setting the stage for the exchange’s implosion, a person familiar with the matter said.

FTX Chief Executive Sam Bankman-Fried said in investor meetings this week that Alameda owes FTX about $10 billion, people familiar with the matter said. FTX extended loans to Alameda using money that customers had deposited on the exchange for trading purposes, a decision that Mr. Bankman-Fried described as a poor judgment call, one of the people said.

All in all, FTX had $16 billion in customer assets, the people said, so FTX lent more than half of its customer funds to its sister company Alameda.

FTX turned out to be a modern wildcat bank. The loan it made to Alameda was secured by a bunch of FTT (a crypto token issued by FTX), which, while valuable on a superficial level, isn’t really any better than a box of nails and glass for avoiding a solvency problem. All that was required was for someone to notice, and boom, you’ve got yourself a good old-fashioned bank run, as Matt Levine at Bloomberg explains:

The reason for a run on FTX is if you think that FTX loaned Alameda a bunch of customer assets and got back FTT in exchange. If that’s the case, then a crash in the price of FTT will destabilize FTX. If you’re worried about that, you should take your money out of FTX before the crash. If everyone is worried about that, they will all take their money out of FTX. But FTX doesn’t have their money; it has FTT, and a loan to Alameda. If they all take their money out, that’s a bank run.

With FTX, Sam Bankman-Fried gave every appearance of trying to do the core job that a bank does. He looked like he was trying to be boring! He bought a suit and spent a lot of time in DC. He wrote ‘we will not fuck with client assets’ into FTX’s Terms of Service (TOS), and he tweeted about it earlier this week:

FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries). 

Except none of that was true. When crypto crashed this spring, SBF just couldn’t resist the temptation to use that big pile of money sitting in front of him.

And if you believe that FTX is the only big centralized finance (CeFi) player in crypto that is willing to play fast and loose with customer deposits, I’ve got some USDT I’d like to sell you.  

#2: Trying to be Boring

There are two different examples I want to talk about in this group.

The first is Coinbase.

As explained in the quote above, one of the reasons that SBF started FTX was that Coinbase was too boring. And he’s right! Coinbase is boring! It’s a public company that is based in the U.S. and operates itself like an extremely boring bank. Here’s Matt Levine again:

Imagine a weird sort of bank. You come to the bank with $100 in paper bills, and you deposit it in the bank, and the bank takes your paper bills and sticks them in an envelope with your name on it. Then it sticks the envelope in a vault, and if at any point you ask for your money back, it opens the vault and hands you your envelope. This sounds like a bad business model: The bank needs to pay for real estate and tellers and vaults, and it is not doing anything with your money. But the other weird thing about this bank is that, every day, you come in and say “hey I’d like to exchange my dollars for euros” or “my euros for pounds” or whatever, and each time you do that the bank charges you a dollar. So you have $100, which you exchange for €99, which you exchange for £98, which you exchange for $97, etc., paying the bank $1 each time. If all of the bank’s customers do this every day, then the bank makes plenty of money to pay for real estate and tellers and vaults and executive bonuses, without doing anything else with your money. It just takes the $100 out of your envelope and replaces it with €99, etc., always keeping exactly the right amount of money (in whatever currency you like that day) in exactly your envelope.

Coinbase is basically just a bank that keeps your deposits safe and makes them accessible whenever you need them. Its entire business model depends on its customers frequently exchanging the deposits they have in one currency for a different currency and paying a fee each time they do. Coinbase used to offer margin trading (loaning money to customers to enable them to trade more), but it shut that service down based on guidance from the Commodity Futures Trading Commission. It was planning to offer a product that would allow customers to earn a 4% APY by loaning out their deposits to other customers, but it canceled that when the SEC told them to. Coinbase’s CEO (Brian Armstrong) frequently bitches about how annoying U.S. regulators are (particularly the SEC), but his company continues to operate in about the most boring way possible and, as a consequence, burnishing its brand as one of the most trusted companies in crypto.

The second example I want to talk about is neobanks.

Neobanks aren’t, technically speaking, banks. However, by building their services on top of regulated partner banks, most neobanks have chosen to be ‘bank adjacent’ in a way that makes them significantly more boring than they otherwise would be. The costs of this model are not insignificant. Everything that neobanks like Chime, Current, and Dave want to do – from the smallest tweak to their TOS to the launch of a new product — runs through their partner banks. Actually, ‘runs’ is the wrong word. ‘Crawls through their partner banks’ would be a more accurate description. If the partner bank has a concern or, more importantly, if their regulators have a concern, that can immediately become a big problem for the neobank. And, of course, the neobank is splitting the revenue that it generates with its partner bank(s), which makes the already challenging unit economics that much more challenging.

Contrast this to neobanks that aren’t building on top of partner banks – like Eco – and it becomes easy to see just how much these bank-adjacent neobanks are giving up. 

That said, the benefit of handcuffing themselves to their partner banks is that it makes it easy for these neobanks to do the core job that banks do – providing a safe place for people to keep their money. Being able to tell customers that their deposits are insured by the FDIC provides both an intangible brand value (I can trust this company with my money) and a very tangible break-glass-in-case-of-emergency value to the customer (my money isn’t going to disappear). That second value isn’t all that useful to the neobank itself (if FDIC insurance is needed, then the neobank is already in an unrecoverable amount of trouble), but it’s enormously useful in protecting the reputation of neobanks as a whole.

#3: Has No Choice But to be Boring

The third group is regulated banks, AKA the vast majority of the market.

The thing I find fascinating about fractional-reserve banking, at a high level, is that it is a really good way to resolve the tension between the job that banks are required to do and the temptation that all banks and bank-like companies face when doing that job.

With fractional-reserve banking, we’ve basically told banks:

Look, we know you won’t be able to stop yourself from using this big pile of money in front of you to make more money. We’re not going to try to stop you or get you to suppress your natural instincts. Go do what you do. Take risks! Lend! Invest! … Just one thing … we’re going to absolutely bear hug you with regulation. You’re going to have reserve requirements and capital ratios that are going to seem, to you, insanely conservative. We’re going to subject you to constant supervision and stress tests. If something goes really bad, we’ll backstop you with liquidity and make sure that your customers are made whole. And if you screw up just this much, you’ll be buried under an absolute mountain of fines and other enforcement actions. Sound good? OK, have fun out there!

We’ve built a box that gives banks the freedom, while inside it, to indulge their money-making instincts (which, it should be noted, help facilitate a lot of economic activity in the process) while simultaneously constraining any especially bad behavior and containing the fallout from any exogenous risks. The purpose of the box is to keep banking as boring and predictable as possible at both a macroeconomic level (preventing another global financial crisis) and an individual-consumer level (your money is always safe and accessible) while also allowing it to be as competitive and profitable as possible at an industry level.

It’s a tricky thing to get exactly right. The box has never been perfect. It evolves. When we find a really big hole, we usually patch it up. When we go a few decades without finding a hole, we sometimes will start neglecting the box or stripping away bits that seem unnecessary.

Regulators play a key role in guiding this evolution and acting as the industry’s ‘Reciever of Memory’. Take the Acting Comptroller of the OCC, Michael Hsu, as an example. My friend and fellow bank nerd Kiah Haslett pointed out to me that Mr. Hsu has a tendency to reference the 2008 financial crisis nearly every time he speaks in public. It doesn’t really matter what the specific subject is – crypto, BaaS, whatever – anything complex and novel in banking seems to trigger an almost Pavlovian response from the Acting Comptroller. The crisis permanently shaped the way that he sees the market and approaches his job, as he himself shared in some comments from last year:

Today, I want to discuss the importance of safeguarding trust in the banking system and of guarding against complacency. These two imperatives anchor my priorities and inform all that I do. They derive from my experiences around the financial crisis of 2008. The trauma of that event continues to cast a long shadow, especially on the people who depend every day on the banking system to work safely and fairly for them. Trust and vigilance can help us deal with the past, while also guiding us going forward.

Let me start by giving some context and background on myself. I am a career public servant and have been supervising financial firms in one form or another since 2002. I started as an attorney at the Federal Reserve and became a supervisor when I moved to the Securities and Exchange Commission (SEC). From 2004 to 2008, while overseeing the major U.S. investment banks, I had a front row seat to the rise of securitization, the black magic of financial engineering, and the collapse of the shadow banking system. At the Treasury Department, while helping to firefight the crisis, I acutely felt and sympathized with the public’s anger at having to bail out too-big-to-fail firms. My time at the International Monetary Fund gave me perspective on financial stability, which proved helpful when I returned to the Federal Reserve in 2010 to assist with post-crisis initiatives.     

What Does All This Mean?

The tension between the core job-to-be-done in banking (providing a safe place for customers to keep, access, and think about their money) and the broader temptation in banking (leveraging money to take risks) builds slowly. It’s like the tectonic plates. It takes a while for the pressure to build.

Ever since the 2008 financial crisis, it’s been building. The emergence of fintech and crypto during that time produced a lot of novel ideas for how to conceptualize, build, and deliver banking services. It also introduced a lot of new ways to make money, commit fraud, and sidestep regulation.

I feel like we’re getting close to a breaking point. Rising interest rates are washing out Ponzi schemes and unsustainable business models. VCs are pushing their portfolio companies to get to profitability. Regulators are focused on financial technology innovation with a level of intensity and organization that I’ve personally never seen before.  

What does this all mean, and what comes next?

I don’t know, but here are a couple of thoughts:

Centralized finance will become much more boring. 

It’s hard to overstate just how much of the crypto industry’s credibility with institutional investors and policymakers was wrapped up in FTX and Sam Bankman-Fried. 

To give just one example, Sequoia – one of the largest and most successful VC firms in history and a major backer of FTX – quietly pulled down a massive feature that it had commissioned about SBF after news broke about FTX’s solvency issues this week (don’t worry, I managed to preserve a copy of the profile … you’re welcome!) Purely from an investment perspective, marking their $150 million investment in FTX down to zero hurts, but it’s not exactly keeping the partners up at night, given that the fund that the $150 million came out of has already returned $7.5 billion in gains. Despite that, Sequoia couldn’t stomach leaving the article (which is quite cringy) up because of how embarrassing it was. VCs are professionals, but they’re also humans with big egos. They don’t like being embarrassed.

The same dynamic is going to play itself out on Capital Hill. SBF spent a lot of time and money lobbying legislators and working with them to craft industry-friendly crypto rules. The failure of FTX puts those politicians (another group of humans with big egos) in an embarrassing position.      

It seems obvious that this mess will lead to a great deal more scrutiny being applied, by both U.S. regulators and institutional investors, to all CeFi players in crypto (DeFi is its own ball of wax), which should have the healthy long-term effect of pushing more companies out of group #1 (Not Boring) and into group #2 (Trying to be Boring).

And speaking of Group #2 …

The ‘Trying to be Boring’ Path will become harder to walk.

The existential problem for companies in Group #2 is that their strategy – intentionally making their business super boring so that customers will trust them and regulators will ignore them – puts them at a significant competitive disadvantage to companies in Group #3.

Remember, Coinbase is essentially a bank that only makes a small amount of money when its customers exchange their deposits from one currency to another. If that activity slows down (which has been happening), they have no other way of making money.

Neobanks are in the same boat. Their ability to iterate and introduce new products is constrained by what their bank partners will allow them to do (and how fast they are able to help them do it). And the few sources of steady revenue that neobanks do have are being shared with their partner banks! The only reason that they’ve been able to get as much traction in the market as they have is that VCs were willing to finance their growth with no guarantee of profitability. Those days are over. 

Group #2 companies have essentially tied one hand behind their back, in an attempt to build a trusted brand in an industry where trust is everything. That’s admirable, but probably not sustainable from a competitive perspective. 

More fintech companies and crypto companies will become fully regulated. 

Group #3 is going to become more crowded. Between the competitive advantages and the pressure from regulators and investors, it seems inevitable.

My question is how easy or difficult will regulators make it for companies to jump from Group #2 to Group #3? Will the SEC move on from its regulation-by-enforcement approach on crypto and finally give Brian Armstrong the regulatory clarity he’s been asking for? Will the Fed and the OCC make the process of acquiring an existing bank charter or getting a de novo one easier and/or less expensive?

It might feel a bit counterintuitive at this moment, but I hope regulators seize this opportunity to create a more streamlined path for companies to join Group #3.   

The consolidation of directly-regulated financial institutions will accelerate.

Regardless of what regulators choose to do, I think it’s inevitable that the ranks of group #3 will swell. Consequently, I also think that the pace of consolidation within that group of institutions will accelerate.

Building a profitable, directly-regulated bank is really hard. It’s been an uphill slog for Varo, and that’s not unusual for de novo banks! During the Great Recession, the failure exit rate of de novos that formed between 2000 and 2008 was twice the rate of small, established banks, according to FDIC researchers.

Many of these companies will fail to thrive and will make for tempting acquisition targets for the more established financial institutions in the market.  

Embedded finance may be an unexpected growth vector.

The competitive disadvantage that pushes most companies out of Group #2 and into Group #3 won’t apply to one category of bank-adjacent service providers – embedded finance brands.

Non-finance brands that choose to integrate financial services into their products probably won’t mind working with a partner bank (or, more likely, a BaaS Platform like Unit or Bond). Most of them probably won’t want to get their hands dirty and do a lot of iterating and customizing. They’ll want to pick off of a menu. And, most importantly, they won’t prioritize unit economics over everything else, which should make a healthy revenue split on financial services revenue (like debit interchange) more palatable to them than it would be to a neobank.

Non-finance brands offering financial services will want the consumer trust and brand protection that comes with being bank-adjacent (Group #2), but they likely will see little benefit in becoming banks themselves (Group #3).

Alex Johnson
Alex Johnson
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