Hey everyone. First off, I’d like to profusely apologize to my fellow members of the “Anti Fintechs Fintech Club” for my headline—I just needed to make the headline shorter and fintech startups sounds wordy.
“Fintechs” isn’t a real word: fintech is an adjective and a way to describe a type of company, not a noun.
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DEEP DIVE
Over the past few years, the fight over granting tech startups access to the Federal Reserve banking system has been an oddly hot topic in the fintech ecosystem.
While that sounds uninteresting or nerdy (or a combination of both) I promise you that this has a lot of implications for fintech and crypto companies.
First, some backstory: at a high level, fintech startups have never been able to access traditional banking infrastructure. One of the reasons neobanks started popping up left and right was banking-as-a-service companies acted as a software layer between banks and startups—banking-as-a-service companies still need to partner with 1 or more federally regulated bank in order to operate and offer services.
Bank charters are hard to come by—there are only a few thousand in the US, and they’re not granted often. Fintech companies only recently got interested in getting bank charters: it lets you store deposits, and lend off of those deposits; lets you operate and lend in all 50 states, etc. But its such a costly and time consuming process that only a few fintech companies actually managed to get one: Square only recently got a bank charter, and that was in Utah; Varo applied and got their own charter from the OCC, which cost a ton. We’ve written about bank charters in the past, and this essay isn’t about them, but it’s an interesting catch-22: fintech companies want to offer deeper financial services and products, but that means getting regulated like a bank or institution, which might not be worth the headache and costs.
The Federal Reserve master accounts are similarly restricted, and has only been accessible to banks historically. And fintech companies have really only just started working with the Federal Reserve duing COVID. Fintech companies became distribution partners for the Federal Reserve’s PPP program through the Small Business Administration (SBA). From a consumer benefit perspective, the decision was a net-positive: fintech companies helped facilitate loans to black business owners at a rate consistent with banks. The Federal Reserve of New York’s conducted a study, writing: “Although fintech lenders had a small share of PPP loan volumes, they likely served borrowers who would not have received loans otherwise. Applicants who approached fintech lenders for PPP loans were more likely to lack banking relationships, be minority owned, and have fewer employees.”
I’d be remiss not to mention the fact that fintech was probably one of the largest sources of PPP fraud too: a March 2022 study reported that fintech lenders could be the source of up to $64 billion in PPP fraud.
For the fintech industry, COVID illuminated the benefits of becoming more closely intertwined with the federal banking system—the study above also said that fintech lenders collected $8.4 billion in revenue through the PPP program.
The unexpected financial windfall catapulted the fintech industry, and lots of operators became more interested in exploring new relationships with central banking infrastructure, like Federal Reserve master accounts. With these, institutions can offer products like ACH payments, wires, checks, etc. Fintech and crypto companies offer this already, but they need to partner with a chartered bank in order to do so. But getting Federal Reserver master accounts, fintech companies could bypass banks and significantly reduce costs too.
After much debate, the Federal Reserve propose a new tiered system on March 1st: Tier 1 is for “federally insured institutions” and have a ““a less intensive and more streamlined review;” Tier 2 faces an intermediate level of scrutiny and is for firms that are supervised federally but uninsured; Tier 3 is for institutions that don’t have any federal oversight or insurance and has the “strictest level of review.”
Most fintech companies would fall under Tier 3, and the Federal Reserve seems eager to start opening the door for fintech companies to access central banking services. This, of course, has angered the banking lobby, which wrote a letter to the Federal Reserve asking for more oversight, particularly for “nontraditional banking institutions.”
But, the final day for comments is in 2 days, May 11th, and barring an unforeseen hurdles, the proposal should pass eventually. The main point of contention is around whether or not fintech companies are “eligible” for a Fed master account; the law firm Davis Polk writes that insured and uninsured banks are legally eligible, which would mean that fintech companies are too. And if that’s the case, the implications for fintech products could be big. For large consumer fintech companies, it could make sense to get a Federal Reserve master account and boost margins by cutting out third-party costs. For crypto companies this could be a game changer—as crypto regulation becomes a reality, getting a Fed master account might be a cheaper and faster way to satisfy regulatory requirements. Companies like Kraken have already been working with the Fed, and firms looking to custody crypto and tokens for clients would benefit from a Fed Master Account too.
Overall, there’s a big potential for fintech companies to have access to better infrastructure to provide improved products, which I think is a positive for the fintech ecosystem. Sure, you’ll deal with more regulation, but a lot of fintech and crypto companies are eagerly heading in that direction, in sharp contrast from previous eras of fintech. Not only can you get closer to the core banking system and build directly on top of it, but it can generate big returns too.
Thanks so much for the read! Let me know what you think by responding to this email. See you next week.
— Ian
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