BlockFi Under Fire in Texas, New Jersey, Alabama

Shady High Cost Lending, FinHealth & Insurance, Warren Renews Calls for Overdraft & Crypto Regulation

Hey all, Jason here.

One of the best aspects of being “self-employed” is that it has given me a chance to explore areas of the banking, fintech, and startup ecosystem that I didn’t have an opportunity to as a full-time employee in an operating role.

One such area is the investing side of the equation. I’ve had a chance to talk with numerous early stage founders, angel investors, syndicate leaders, and VCs over the past several quarters. Seeing fellow newsletter writers like Not Boring’s Packy McCormick raise an investment fund is truly inspirational (if you don’t already subscribe to his newsletter, you should!)

If you’re an early stage founder or investor, I’d love to hear from you. Feel free to drop me a line at jason@fintechbusinessweekly.com or set up a time for a ‘coffee Zoom.’

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The Key to Financial Health? Insurance.

Talking about “financial health” has become de rigueur within fintech circles in the past couple of years. In a nod to this, many products have added some element of financial education.

I’ve long argued that private bank and fintech companies are fairly limited in how they can impact users’ financial health, as the problem for many families is one of solvency, not “financial education” nor liquidity. The cost of the components of a middle class life — housing, education, and healthcare — have been steadily marching upward, while most families’ income has increased far more slowly.

A study out from the Journal of American Medicine reveals just how much of an impact the cost of healthcare and the resulting medical debt have on American families.

According to the study, Americans had $140 billion in medical debt in collections last year, with about 18% of all Americans holding medical debt that is in collections — the largest source of debt in collections.

The $140 billion number includes only debt placed with agencies for collections; it does not include other debt owed to medical providers, bills paid for with credit cards, long-term payment plans, nor debt that hospitals or medical systems are suing patients to recover, an increasingly common practice.

The research found that residents of states that expanded Medicaid eligibility after the passage of the Affordable Care Act had considerably less medical debt than those living in states that declined to expand coverage.

Expanded Medicaid coverage has been shown not only to improve physical health outcomes but also financial ones. According to the New York Times:

“The study found substantial improvements in measures of financial health for people who received coverage. It also found improvements in those people’s mental health — increases too large to be explained by new medical treatments alone.

Professor Finkelstein said the new paper was a reminder that health insurance often acts as a strong buffer against financial adversity.”

Dem Senators Introduce Bill on “Shady, High Cost Lending”

Sen. Dick Durbin (D-IL), along with Jeff Merkley (D-OR), Richard Blumenthal (D-CT), and Sheldon Whitehouse (D-RI) reintroduced legislation that would implement a federal rate cap at 36% APR.

According to Durbin’s press release, the bill would “protect consumers from shady, high cost lending” through the following mechanisms:

“Establish a maximum APR equal to 36 percent and apply this cap to all open-end and closed-end consumer credit transactions, including payday loans, car title loans, overdraft loans, credit cards, car loans, mortgages, and refund anticipation loans;

Encourage the creation of responsible alternatives to small dollar lending by providing tolerances for initial application fees and ongoing lender costs;

Ensure that this federal law does not preempt stricter state laws; and

Create specific penalties for violations of the new cap and support enforcement in civil courts and by State Attorneys General.”

A closer look at the text of the bill shows that it would require annual fees, cash advance fees, membership fees, non-sufficient funds fees, overdraft fees, over-the-limit fees, and charges for ancillary products sold in conjunction with or incidental to the credit transaction to be included in the APR calculation.

A couple of thoughts on this:

• It’s misleading to suggest that this bill would be a “cap” on traditional payday, car title, or overdraft loans. Owing to their small-dollar amount and short repayment timeframe, these products are unlikely to be economically viable as standalone products at APRs below 36%. An APR cap is a de facto ban on certain types of products.

• Implementing an APR cap at 36% doesn’t do anything to reduce demand for credit, nor does it mean that borrowers who previously couldn’t qualify for a traditional bank loan or credit card all of sudden are able to.

• The bill’s authors implicitly acknowledge this, by offering a carve out of $30 as an application or participation fee excluded from the 36% cap; however, even with this, the unit economics of smaller loan sizes are likely negative, given the costs of funds for non-bank lenders, customer acquisition, underwriting, servicing, and losses.

• If the public policy argument is that small-dollar and shorter term loans result in ‘bad’ (economically negative) outcomes for consumers from which they need to be protected, legislators could argue that case. Implying an APR cap will result in lower cost of credit for consumers is disingenuous.

• The bill would require lenders, including credit card companies, to include costs like annual/membership fees, cash advance fees, late fees, and non-sufficient funds fees in APR calculations. While this sounds good in theory, it’s unclear to me how a lender could include something like a late fee in an upfront APR calculation, when it’s unknown if a borrower will incur such a fee.

• Inclusion of charges for ancillary products. This sounds relatively innocuous, but could hit companies like Dave or MoneyLion, which derive a meaningful portion of their economics from “expedited funding fees,” which likely would need to be included in APR calculations and in the 36% APR cap.

While I applaud the spirit of this legislation, an APR cap is a price cap; capping the price of credit, even in the name of “consumer protection,” will inevitably result in less supply. A hard cap at 36% might make good politics, but it doesn’t make good policy.

There is room to level the playing field in how APRs are calculated across products (credit cards, overdrafts) and disclosed to better inform borrowers’ decision making. Further, there are evolving technologies, particularly open banking and payroll data APIs, that offer new data sources and approaches to underwriting consumers with poor or no traditional credit history — boosting competition, access and inclusion, and, hopefully, lowering prices — without government-mandated price caps.

Curious how those who would be impacted by the bill perceived it, I had the opportunity to chat with Larry Ivory, the President and CEO of the Illinois State Black Chamber of Commerce.

Ivory commended longtime Illinois Senator Dick Durbin’s legacy and the positive intent of the bill, but pointed out the likely unintended consequences. As many in the African American community have had issues with credit in the past, he said, an APR cap would leave many without any access to credit, leaving them with few options to deal with financial emergencies or invest in new businesses. The racial wealth gap means that African Americans have far fewer resources to fall back on or friends and family to tap for help.

Ivory emphasized the need for credit enhancement and restoration in the African American community, acknowledging it could be a long and expensive project, rather than a perceived quick fix like an APR cap. He pointed out that predatory lending becomes less of an issue once you’ve helped people repair their credit.

I also reached out to fintech lender OppFi, which offers products at rates as high as 160% APR, to get a point of view of how this legislation could impact users of such products.

The company had this to say:

“We support the need to create more clear guidance to protect the millions of consumers; however, limiting credit access through arbitrary rate caps only further excludes millions of Americans.

The proposed 36% APR rate cap as part of the Protecting Consumers from Unreasonable Credit Rates Act put forth by U.S. Senator Dick Durbin (D-IL) for consumer loans would hurt millions of Americans who need quick access to small dollar loans. An 36% rate cap would not only legislate away access to much needed credit for 150 million everyday consumers, it would also drastically create unintended consequences for consumers who would be forced to find funds in unregulated markets.

We believe in creating common sense regulations that can serve as guardrails to protect consumers’ ability to access credit without stifling financial choice. These protections should include amortizing principal with each payment, reporting to the three credit bureaus, and eliminating prepayment penalties, NSF and late fees.”

Warren Urges CFPB to Look at Overdrafts, Crypto

At a virtual event held last week celebrating the 10th ‘birthday’ of the Consumer Financial Protection Bureau, Elizabeth Warren (D-MA) highlighted that there are still many areas where the Bureau can make a difference, specifically pointing to overdraft policies and cryptocurrencies.

Overdraft fees have been a hot topic lately, with Warren grilling JPMorgan Chase CEO Jamie Dimon and others over the overdraft fees they have collected during the pandemic. At the event, Warren renewed her criticism of overdrafts, saying:

“This is an area where there's a lot of predatory behavior by giant banks that make billions of dollars in profits and squeeze every last penny out of customers who are struggling.”

Warren characterized crypto as an ‘unregulated’ market plagued by scams. She called for regulators to work together, including the CFPB, saying:

“Crypto is an area that I think all of our financial regulators are going to need to work together to address, and that means the CFPB needs a seat at the table in those discussions on these issues.”

BlockFi Faces Mounting Regulatory Backlash Over Interest Accounts

Crypto lending and trading platform BlockFi is facing mounting regulatory backlash over its “BlockFi Interest Account” product.

Screencap from BlockFi.com as of 07/24/2021

For those who aren’t familiar with the concept, the account basically works as follows:

Users deposit crypto into the account (BlockFi accepts popular cryptos like Bitcoin, Ethereum, and Litecoin as well as stablecoins like USDC, Binance USD, and tether).

BlockFi then lends these assets to “trusted institutional and corporate borrowers,” according to its FAQ. Those borrowers pay interest on the borrowed crypto asset, part of which BlockFi retains and part of which it passes along to depositors. BlockFi holds a reserve of deposits in order to meet depositor withdrawal requests, which are honored in 1-2 business days, according to the site.

In this very newsletter last December, a representative for the company described BlockFi Interest Accounts in the following way:

“When clients send crypto to their BlockFi account or purchase additional crypto within the BlockFi Interest Account, that digital asset is replaced with an obligation to return the same amount of that crypto plus any interest earned.

In order to pay our clients crypto interest on a monthly basis and to meet withdrawal requests on a timely basis, we engage in a number of activities, including

(1) keeping a material amount of digital assets available for withdrawal with third parties such as Gemini, BitGo, and Coinbase;

(2) purchasing, as principal, SEC-regulated equities and predominately CFTC-regulated futures; and

(3) applying risk management to the lending activities in the institutional market. The credit risks to these institutions are mitigated by credit due diligence and/or collateral (such as cash, crypto, or other assets).”

The product is designed primarily for those with crypto assets they intend to hold for the long term; depositing them with BlockFi allows the holder to generate yield, in addition to any capital appreciation.

Institutional and corporate entities borrow crypto from BlockFi to engage in trading strategies or arbitrage opportunities; a spokesperson for Compound described the demand for this type of leverage and liquidity as “near insatiable” in last week’s newsletter.

When I first started noticing products like the BlockFi Interest Account (they are far from the only company engaging in this business model), my first reaction was that they function as de facto banks: they’re matching savers and borrowers, engaging in maturity transformation, have responsibility for managing credit and liquidity risk, and collect a net interest margin for this.

I asked Todd Baker, senior fellow at the Richman Center for Business, Law & Public Policy at Columbia University; and the managing principal of Broadmoor Consulting, if this was a fair way to think about it, and he clarified that, unless the offering qualifies as a ‘demand deposit’ or the provider implies that it is a ‘bank’ in its marketing, it would likely be outside the purview of state banking regulators.

He went on to say:

“State securities laws (called “blue sky laws” because speculative investment hucksters were selling people a piece of “blue sky”) have quite broad application (often broader than the federal laws) to virtually any kind of pooled investment vehicle. BlockFi takes in money and promises investors “interest” based on investments that it makes in crypto lending on a pooled basis. That is typically considered an 'investment contract' and therefore a securities offering.”

Regulators Are Circling

In a scenario not dissimilar to the regulatory scrutiny Prosper drew 13 years ago, multiple state regulators are asking questions about the structure of the BlockFi Interest Account.

New Jersey’s Bureau of Securities argues that the BlockFi Interest Account constitutes a security (defined on page 7 of NJ’s Uniform Securities Law) and, as BlockFi hasn’t registered it as such, it is in violation of New Jersey law. The Bureau’s cease and desist order finds (emphasis added):

“BlockFi, Inc. (“BFI”) is a financial services company that generates revenue through cryptocurrency trading, lending, and borrowing, as well as engaging in propriety trading. Since March 4, 2019, BFI, through its affiliates BlockFi Lending, LLC (“BlockFi”) and BlockFi Trading, LLC (“Trading”) has been, at least in part, funding its lending operations and proprietary trading through the sale of unregistered securities in the form of cryptocurrency interest-earning accounts. BlockFi refers to these unregistered securities as its “Crypto Interest Account” or the “BlockFi Interest Account” (the “BIAs”).”

Alabama’s “show cause” order, which requires BlockFi to respond within 28 days to avoid a cease and desist, makes the same argument (emphasis added):

“BlockFi allows investors to purchase a BIA by depositing certain eligible cryptocurrencies – including Bitcoin and Ethereum – into accounts at BlockFi. BlockFi then pools these cryptocurrency deposits together to fund its cryptocurrency lending operations and proprietary trading. In exchange for investing in the BlAs, investors are promised an attractive interest rate that is paid monthly in cryptocurrency.

The Show Cause Order alleges that, despite advertising on its website that BlockFi is a ‘US regulated entity’, BlockFi fails to disclose to investors that its BIAs are not registered with the ASC or any other securities regulator.”

While BlockFi makes a point of highlighting it holds money services business/money transmitter and state (fiat USD) lending licenses, it is not licensed as a bank nor broker-dealer, nor registered as an exchange.

On Thursday, the Texas securities regulator filed an order largely consistent with New Jersey and Alabama’s, though it wouldn’t take effect until signed by a judge at a hearing scheduled for October 13th, giving BlockFi time to respond.

Common themes of the states’ regulatory actions are that BlockFi Interest Accounts constitute unregistered securities and thus investors don’t enjoy the protection of the SIPC or FDIC, and that BlockFi fails to adequately disclose material information, including risks, to investors.

I reached out to BlockFi for comment but did not receive a response. The company has posted some information on its website, acknowledging the regulatory actions while disputing the suggestion that the BlockFi Interest Account is a security.

With Federal Leadership Vacuum, State Regulators Step In

To be honest, I’m not sure what to make of this action coming from state securities regulators. While I’m not surprised to see scrutiny of this type of product, the fact that it’s coming from individual state regulators is a disappointing signal for crypto regulation writ large.

An outright ban on this product structure seems unlikely; but a patchwork, state-by-state regulatory approach will also be a poor outcome, stymying innovation with overly complicated, time consuming, and expensive regulatory and compliance processes.

While the crypto space would benefit from improved clarity from stronger regulatory guidance, either under existing laws or new ones passed by Congress, this would preferably be done at the federal, not state level.

“Make No Mistake” that Securities Laws Apply, ‘Crypto’ or Not, Says Gensler

Also on the topic of crypto and securities law this week, Gary Gensler, Chair of the Securities and Exchange Commission, addressed the topic heads-on in a speech he gave before the American Bar Assoication.

While the bulk of his remarks were on derivatives and futures law, he made a point of addressing how these laws intersect with crypto, saying (emphasis added):

“Before I conclude, I’d briefly like to discuss the intersection of security-based swaps and financial technology, including with respect to crypto assets. There are initiatives by a number of platforms to offer crypto tokens or other products that are priced off of the value of securities and operate like derivatives.

Make no mistake: It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.

If these products are security-based swaps, the other rules I’ve mentioned earlier, such as the trade reporting rules, will apply to them. Then, any offer or sale to retail participants must be registered under the Securities Act of 1933 and effected on a national securities exchange.

We’ve brought some cases involving retail offerings of security-based swaps; unfortunately, there may be more.”

The types of products in play here are distinct from the BlockFi case covered above.

Here, Gensler is drawing attention to crypto instruments tied to underlying securities. Binance notably has drawn a strong response from regulators for offering crypto tokens whose value is tied to stocks like Apple, Tesla, and Coinbase; Binance is currently winding down this offering.

Most Consumers Have Exited Pandemic Assistance

According to a CFPB analysis, most borrowers who opted for a pandemic-related accommodation have exited such assistance. Accommodations for mortgages remain elevated, as do student loans, as the CARES Act automatically put most federal student loan payments into suspension.

Image via Consumerfinance.gov

The CFPB report also analyzed the relationship between a number of factors and the likelihood of exiting a mortgage accommodation.

To interpret this chart, the first category in each grouping is a baseline (0), with the other categories shown as more or less likely than that baseline to exit mortgage assistance. For example, borrowers in majority Black census tracks were less likely than majority white tracts to exit a mortgage accommodation, while those in majority Hispanic census tracks were more likely to exit accommodation.

Image via Consumerfinance.gov

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Other Good Reads This Week

The State of Fintech: Investment & Sector Trends to Watch (CB Insights, free but requires sign up)

Former traditional finance workers explain why they jumped ship for crypto (The Block)

FICO Score’s Hold on the Credit Market Is Slipping (WSJ)

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