Regulators Should Conduct "Material Loss Review" Of Synapse Disaster
“The System Has Failed,” Synapse Trustee, Moved To Tears By Situation, Tells Bankruptcy Court
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Regulators Should Conduct “Material Loss Review” Of Synapse Disaster
US banking regulators aren’t omniscient — they suffer from cognitive biases, organizational dysfunction, and make mistakes, just like any other institution.
And, like most, regulators generally try to learn from their mistakes to avoid repeating them.
That’s why an element of the Federal Deposit Insurance Corporation Improvement Act of 1991, which added the Prompt Corrective Action (PCA) framework to the FDI Act, includes a requirement to conduct a material loss review when the deposit insurance fund (DIF) incurs a loss of $50 million or more.
Per the statute, the inspector general of the relevant federal banking agency shall create a written report that:
reviews the agency’s supervision of the failed institution
ascertains why the institution’s problems resulted in a loss to the DIF
and makes recommendations for preventing such losses in the future
The significant bank failures in 2023 — Silicon Valley Bank, Signature Bank, and First Republic Bank — all saw subsequent material loss reviews by the relevant federal banking regulator’s Office of Inspector General.
Silvergate voluntarily liquidated and repaid all deposit liabilities, meaning it didn’t result in any loss to the DIF, but the inspector general still undertook a review of the Federal Reserve’s supervision of the bank and released an executive summary of the report.
In the Synapse situation, there remains a shortfall of somewhere between $65 million and $95 million: the four banks involved, AMG, American, Lineage, and Evolve, and their respective federal and state regulators still don’t even know how much the shortfall is, more than six months since Evolve froze access to users’ funds, and years since Synapse and Evolve first internally acknowledged reconciliation problems and a shortfall in customer funds.
Yet, federal banking regulators continue to duck any responsibility for their role in the disaster, despite pleas from the Synapse Chapter 11 trustee, former FDIC Chair Jelena McWilliams, that they step in to help reach a resolution that would see end users made whole.
Jerome Powell, Chairman of the Federal Reserve, Evolve’s primary federal regulator, memorably answered a question this summer from Senate Banking Committee Chair Sherrod Brown (D-OH) by saying the Fed supervises Evolve, but that “we don’t supervise Synapse.”
A common refrain when discussing the Synapse situation has been that, unlike SVB, Signature, or First Republic, no insured depository institution has failed.
And that’s true! When it comes to the role deposit insurance plays, no bank has failed, and it’s true that the FDIC has no role or legal authority to make depositors whole.
Yes, the optics of invoking the systemic risk exception to cover uninsured depositors of SVB and Signature, including venture capital funds, their portfolio companies, and wealthy executives, while allowing everyday users of fintech apps like Yotta and Juno to get pennies on the dollar back, if that, are terrible.
But the systemic risk exception is a power defined in law — there is no such legal capability to address a situation like Synapse, one that was, apparently, never contemplated by regulators.
The most comparable authority may be the CFPB’s victim relief fund, though restitution to users typically follows a bureau enforcement action. To date, apart from referencing Synapse in public remarks, the bureau has taken no publicly known actions related to the matter.
The FDIC has proposed two rules, ostensibly in response to Synapse’s collapse.
One, a rollback of 2020’s loosening of brokered deposit rules, was widely viewed as outgoing Chair Gruenberg’s pet project and is functionally dead in the water, given Gruenberg’s pending resignation and the change in administration.
The second, a proposed rulemaking on requirements for custodial deposit accounts with transaction features, also known as the “Synapse Rule,” was introduced with a 5-0 vote, suggesting it is more likely to be progressed, even as the composition of the FDIC board changes next year.
But both the dead-in-the-water brokered deposit rollback and the Synapse Rule imply culpability of Synapse and the banks involved. What about the regulators themselves?
The issues with Synapse and Evolve did not develop overnight; in fact, they were something of an open secret in industry.
Even if Evolve’s primary federal regulator, the Federal Reserve, didn’t have the benefit of access to confidential information via its supervision of the bank, Evolve’s problematic fintech and crypto relationships, including with notorious fraud FTX and bankrupt BlockFi, have been publicly known since late 2022.
There have been publicly known allegations of a shortfall in customer funds as early as October 2023 — seven months before Evolve froze access to users’ funds.
And, per internal communications between Evolve’s open banking controller Chris Vendetti and Synapse’s director of finance at the time, the companies were aware of reconciliation discrepancies of as much as “a couple hundred million” as early as November 2022.
Perhaps most interestingly, the enforcement action against Evolve and its holding company by the Federal Reserve, which was issued in June 2024, stemmed from a safety and soundness examination of Evolve issued in August 2023.
Despite these and numerous other red flags, the situation was allowed to deteriorate to the point of Synapse filing for bankruptcy, leaving its partner banks to attempt to return funds to their rightful owners, with the Federal Reserve and other regulators saying, essentially, “not our problem.”
While there may not be a legal requirement to conduct something akin to a material loss review in this situation, there is arguably a moral imperative to do so.
Synapse depositors deserve not only to be made whole but deserve answers about how and why this situation occurred and how financial institutions and their third-party service providers can prevent a situation like this from happening again — something, one would think, federal regulators would be interested in themselves.
“The System Has Failed,” Synapse Trustee, Moved To Tears By Situation, Tells Bankruptcy Court
The Synapse Chapter 11 trustee, former FDIC Chair Jelena McWilliams, was moved to tears by the plight facing Synapse depositors during last week’s bankruptcy hearing.
The reaction was in response to a question from bankruptcy judge Martin Barash about the likelihood of depositors receiving their funds back, absent “large-scale litigation between and among the banks and the various constituencies.”
McWilliams described the situation as “incredibly demoralizing” and “personally painful.”
She briefly recounted the story of her father losing his “meager savings” when the banking system of the former Yugoslavia, which lacked a deposit insurance framework, collapsed in 1991, a story she’s told previously.
McWilliams’ father, she told the court and listening end users, had to return to work as a day laborer at the age of 68, earning just $5 a day.
“The system has failed so many end users in so many ways,” McWilliams said, leaving end users to pursue private litigation, though McWilliams acknowledged many may lack the resources to do so.
Since the last court hearing, multiple putative class action cases have been filed against all four key banks involved: Evolve, Lineage, AMG, and American.
With the bankruptcy process seemingly nearing an end and the new civil litigation, the status report and hearing held few new details.
Of the approximately $219 million in FBO funds held on May 24th, about 87% have already been distributed (though there were FBO funds disbursed prior to the trustee’s appointment on May 24th.) Approximately $27.7 million in FBO funds remain to be distributed.
At this point, the trustee is focused on selling Synapse’s assets, though there have been no actionable bids to date and, at this point, it seems unlikely there will be. The trustee is focused on continuing to facilitate communication and ongoing reconciliation efforts among the banks, to the extent possible, and preserving records and data.
AMG and Lineage wrote in a joint status update that (spacing adjusted):
Lineage and AMG have reconciled all Synapse-related money movements in and out of both institutions. AMG and Lineage have also reconciled the transactions between the two institutions and are working on a combined report of Cash Flow Summaries to share with the Trustee.
Lineage and AMG remain willing to work with Synapse and Evolve Bank & Trust to exchange information that might be useful in locating and understanding the source and amount of the shortfall and any identified or apparent discrepancies.
AMG added in its own status report that it has hired an external third-party CPA firm to audit transactions related to Synapse Brokerage, which has found “no irregularities or exceptions.”
AMG claims in its status report that (emphasis added) “[i]t now appears that the individual end user balances were correct on the Synapse-provided trial balances, with some reconciling items.”
AMG’s efforts to reconcile and confirm balances involved verifying transactions with Lineage and American; it attempted to do so with Evolve, its status report says, but Evolve did not respond. AMG’s filing further criticizes Evolve’s reconciliation efforts, describing Evolve’s and its consultant’s process as “done in a black box with little transparency” and specifically flagging the reconciliation’s arbitrary start date of September 30th.
“[I]t appears that Evolve is attempting to attribute any Synapse-related shortfall to the last 8 months of Synapse’s existence,” AMG argues, “even though Evolve has been Synapse’s first and primary banking relationship since Synapse’s inception in 2017 and even though Synapse reported Evolve account discrepancies prior to October 2023.”
For its part, Evolve published an open letter to impacted end users in late November, implying that other Synapse partner banks, not Evolve, are holding users’ funds:
Synapse directed Evolve to send all funds belonging to Yotta, Juno, and Yield Street End Users to another Synapse Brokerage ecosystem bank and these transactions were completed via the Federal Reserve System. This occurred in a series of transactions, in which Synapse moved more than $300 million away from Evolve, between October 11 and November 1, 2023. These include:
On October 11, 2023, Synapse directed Evolve to send all of the funds belonging to Yotta End Users – approximately $182 million to another Synapse Brokerage ecosystem bank.
On October 17, 2023, Synapse directed Evolve to send all of the funds belonging to Juno End Users – approximately $43 million to another Synapse Brokerage ecosystem bank.
On November 1, 2023, a Synapse Brokerage ecosystem bank originated ACH transactions transferring more than $90 million in Yield Street End User funds from Evolve to another Synapse Brokerage ecosystem bank.
However, Evolve’s letter doesn’t address money movement in and out of the Synapse ecosystem and between the partner banks before September 30, 2023, or from November 1, 2023, until the May 11, 2024 freeze — a period during which Evolve continued to provide payment processing to Synapse Brokerage.
During the hearing, asked why, to date, Evolve has only disbursed $24.7 million of the approximately $47 million in FBO funds it holds, Evolve, represented by Orrick’s Aravind Swaminathan, a former Assistant US Attorney who once investigated cybercrime, fraud, and embezzlement, declined to answer, citing ongoing litigation.
Asked about the status of the $35 million in reserve funds Evolve held, Swaminathan declined to answer, citing the same reason.
Swaminathan did say the bank is “optimistic” about the conversations Evolve is having with the other banks regarding data sharing and that it is “committed,” if it gets the data, to getting full reconciliation “over the finish line.”
Bankrupt Voyager Sues One-Time Partner Metropolitan Commercial Bank, Alleging Fraud, Securities Violations, Stemming From FDIC Claims, FBO Structure
In an example of how long it can take to unwind claims in a complex bankruptcy, part of what’s left of crypto lender Voyager Digital filed a lawsuit late last month against its one-time bank partner, Metropolitan Commercial, on behalf of 31,867 end users, who are attempting to recover cryptoassets currently worth more than $750 million.
Voyager Digital was once a high-flying crypto startup that functioned, essentially, like a bank — only without the charter, prudential oversight, access to emergency liquidity, or deposit insurance that traditional banks have.
Like banks, Voyager allowed users to “deposit” assets, both crypto and traditional US dollar currency, and, in return, offered users “rewards” (interest payments).
But unlike traditional banks, which were paying near-zero interest during the booming crypto market of the early 2020s, Voyager promised outsized yields — as much as 9% on USD Coin (USDC), a stablecoin pegged in value to the US dollar.
Voyager’s attractive yield helped it to grow quickly, with a reported 3.5 million users and nearly $6 billion in assets at its peak.
The large majority of Voyager users were small, retail investors, with 97% of accounts holding less than $10,000 in assets.
Like its traditional banking counterparts, Voyager deployed users’ crypto assets, including USDC stablecoins, as loans in order to generate the yield it paid to users and retained a portion of the interest payments as its own revenue.
Voyager’s yield-generation product, at various times branded as “Voyager Interest Program,” “Voyager Rewards Program,” and “Voyager Earn,” was structured similarly to other popular crypto lenders, like BlockFi and Celsius, with numerous state regulators considering it to be an unregistered security.
Unlike traditional banks, Voyager lent users’ assets to a highly concentrated, small number of highly risky crypto trading firms, including Three Arrows Capital, Galaxy Digital, Genesis Global, and Alameda Research.
When the the TerraLuna algorithmic stablecoin collapsed in May of 2022, touching off that year’s “crypto winter”, Voyager was ultimately one of the casualties, when the counterparties it had lent hundreds of millions worth of its users’ crypto to were unable to pay it back.
By July of 2022, Voyager sought Chapter 11 bankruptcy protection. There have been multiple aborted attempts to acquire Voyager or its assets, including one by FTX in 2022 and another by Binance’s US affiliate in early 2023.
Voyager’s bankruptcy proceedings have been abnormally complicated, given that many of the counterparties to which it lent users’ assets also collapsed into bankruptcy, including Alameda, convicted fraudster Sam Bankman-Fried’s crypto trading firm.
In the latest case related to the matter, the administrator for Voyager’s wind-down entity alleges that Voyager’s one-time bank partner, Metropolitan Commercial, “aided and abetted” Voyager’s scheme by providing an omnibus “for the benefit of” (FBO) account, key to operating its business, “encouraging” Voyager to violate money transmission laws, and approving or at least demonstrating knowing indifference to Voyager’s deceptive marketing.
According to the suit (spacing adjusted and emphasis added):
MCB allowed Voyager to use and continue to use (i) MCB’s FBO Account, which facilitated Voyager’s ability to reap the benefits of its fraud; and
(ii) MCB’s good name and associated FDIC insurance in its marketing, which lent false credibility to Voyager and helped lull retail customers into believing that they could use Voyager’s Platform as safely as holding savings with a bank.
The MCB-provided FBO account was key to Voyager’s business, as it enabled users to hold fiat US dollars and more seamlessly trade between fiat and cryptocurrencies, including USDC.
The FBO structure was also part of Voyager’s gambit, the suit argues, to avoid the need to obtain money transmission licenses (MTLs) in each state it operated in, as banks are exempt from state MTL requirements. But while the bank exemption applies to fiat US dollars, it does not apply to cryptocurrencies or stablecoins, for which many states explicitly require licensing.
Voyager leaned on its relationship with MCB to justify making claims that users’ “USD” was FDIC insured — a claim that engendered significant confusion, leading many users to erroneously believe their USDC holdings, earning high rates of yield, were also insured.
Voyager at times falsely claimed that FDIC insurance would protect users “in the rare event that [their] USD funds are comprised due to the company or [its] banking partner’s failure.”
Voyager made widespread use of these FDIC claims across its website, marketing materials, social media channels, and public appearances, viewing it as a key differentiator vs. other crypto lenders, according to the lawsuit.
The FDIC eventually sent Voyager and its chief executive, Stephen Ehrlich, a letter demanding it remove or correct misleading deposit insurance claims — though the FDIC didn’t make this demand until July 2022, after Voyager had already frozen user withdrawals and sought bankruptcy protection.
The suit argues that MCB was or should have been aware of Voyager’s actions, including its highly concentrated and risky lending practices, and that Voyager was acting as a representative or agent on behalf of the bank. MCB benefited from Voyager’s alleged deception via the significant volume of deposits Voyager users brought to the bank and the fee revenue the program generated, the suit argues.
MCB stood to gain financially and knowingly aided and abetted Voyager’s scheme to defraud and to mislead customers into opening and maintaining accounts, the suit says, by:
encouraging, assisting, and scheming with Voyager to evade state MTL regulations and requirements
continuing to allow Voyager to access and use its MCB-provided FBO account
continuing to allow Voyager to use MCB’s name, logo, and reputation
approving, explicitly or tacitly, the misrepresentations in Voyager’s marketing, including its deceptive use of FDIC claims
Voyager end users, many of them who understood their “USD” funds, including USDC stablecoins, to be as safe as if they were in a traditional bank account, have faced significant hardship.
“MCB’s actions were a substantial factor in causing actual damages to Voyager’s customers,” the suit argues, “including the lost value of their assets held on the Voyager Platform and not receiving the FDIC insurance they had been led to believe would cover that loss.”
The suit alleges direct and vicarious fraud and securities violations, among other allegations, and seeks actual and punitive damages to be determined at trial.
Since the collapse of Voyager, MCB has been hit with a wide-ranging enforcement action that included a combined $30 million penalty, though it is not clear to what extent, if any, MCB’s relationship with Voyager contributed to the order. The bank also officially announced its intention to exit its crypto and banking as a service lines of business.
A spokesperson for Metropolitan Commercial Bank told Banking Dive that the “alleged false and deceptive statements and actions by Voyager are the sole responsibility of Voyager, its principals and successors and not of Metropolitan Commercial Bank.”
FT Partners: November Saw 44 Fintech Deals Raise $343 Million
Other Good Reads
Is the Joe Biden-era blockade on US bank M&A finally over? (Financial Times)
Consumer Credit Cards Show Few Signs of Financial Stress (Kansas City Fed)
The Silicon Valley Billionaires Steering Trump’s Transition (New York Times)
The banks warned her it could be a con. The scammer’s influence was stronger. (Washington Post)
CFPB Orders Federal Supervision of Google Following Contested Designation (CFPB)
Ninth Circuit Considers Master Account Arguments (Bank Reg Blog)
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