5 Lessons Learned from the Synapse Crash

When Synapse Financial Technologies filed for bankruptcy in April, the financial industry was still reeling from the failure of a Silicon Valley bank a year earlier and the subsequent run on some banks.

The Synapse failure highlighted some of the key risks inherent in fintech programs that rely on a “benefit” account. This is a type of deposit account where a third party (which may be the bank itself) opens and maintains an account with the bank for the benefit of another party.

Fintech platforms offering deposit accounts often open FBO accounts with partner banks to hold their end-customer funds, which appear as a single account on the bank’s records but contain a pool of funds for many end-users. Typically the third party maintains detailed records of customers and transactions on their systems.

When a bank fails, access to deposit accounts is typically frozen until the Federal Deposit Insurance Corporation evaluates insurance claims. The agency needs quick access to detailed and accurate end-customer account information from third party systems.

However, the Synapse turmoil has brought to the fore the other side of the coin: what happens if the third party managing the FBO account fails and its records become inconsistent or inaccessible? This scenario created significant problems for Synapse’s partner banks, leaving some end customers without access to their funds even months later.

April 22, Synapse has filed for Chapter 11. By May 11, four partner banks had lost access to middleware provider Synapse’s records, unable to identify end users for withdrawals. As of September 12 Trustee’s reportOf the $219 million in FBO custodial accounts, $165 million, or 75%, was distributed to end users, leaving $54 million, or 25%, remaining. Recent Law Firm Report Trautman Pepper Iidentified a $65-$95 million shortfall between bank funds and amounts owed to fintech end users, with unclear responsibilities for ensuring customer integrity.

“FBO accounts are not inherently a problem. They have been used for many years to support critical banking services and should remain a feature of our banking environment,” Patrick Haggerty, senior director at financial services consultancy Klaros Group, said in an email. “However, as the number of use cases increases, so do the risks. Banks offering FBO accounts should expect to face increased regulatory scrutiny. Expectations are rising, particularly around contingency planning and financial controls.”

Amid the Synapse trials, the FDIC proposed accounting rule last month to improve the accounting for bank deposits received from third parties or non-bank institutions that accept those deposits on behalf of consumers and businesses. The proposal aims to address risks associated with these third party agreements, such as incorrect account registration, and protect depositors.

Trautman Pepper’s report examines the root causes of Synapse’s failure and lessons learned that can be taken into account to avoid future failures.

Multiple organizations, account types

Synapse operated through several entities and accounts, including Synapse Brokerage, after acquiring a small broker-dealer firm. The new modular banking product has opened brokerage accounts for more than 100 of its fintech partners across four banks. Synapse encouraged fintechs to use the product as it facilitated the free movement of funds between different banks.

According to the report, the middleware provider assured that it knew where the money was and that its strategy for segmenting and distributing services across multiple banks was to ensure that each partner bank was oblivious to what share of the total deposit base it held . Synapse has insisted on modular banking even for existing fintechs that have signed up for the direct model and have reportedly moved some fintechs’ end-user funds into its brokerage division without permission.

“The money is in the bank,” Matthew Bornfreund, a partner at Troutman Pepper, told Banking Dive, adding that banks are responsible for tracking who owns the money.

“Banks have long been allowed to outsource responsibilities and hire suppliers,” Bornfreund said. “But the bank is also the insured party (Federal Deposit Insurance Corporation)And so if the Federal Deposit Insurance Corp. wants to make sure that they know whose deposits are linked, it makes sense to have the party that is the insured party be responsible for maintaining those records.”

When a bank and fintech company merge, it is important that both adhere to the third-party risk management guidance released last month while understanding the account agreements governing the partnership, compliance with the FDIC False Advertising Rule, and what each party is looking for assessments and improve account accounting practices in accordance with the FDIC’s final accounting rule.

Because partnership agreements are fundamental, they must clearly delineate the respective roles and responsibilities. assessment of the partner’s performance and the process to be followed in case of inconsistencies or violations is recommended in the report

Irregularities in accounting statements

Another important lesson: Fintech relationships involve a wide range of account types and structures, so access to FBO account registries is necessary, but FBO account registries are not sufficient to identify and correct accounting irregularities.

In response to registration problems, the FDIC proposed new reconciliation requirements for “deposit accounts with transactional features.” The proposed recordkeeping rule would require the bank to maintain “direct, continuous, and unrestricted access to the records” of any third party maintaining CDAWTF records.

However, the Trautman Pepper report argues that “third party general ledger accounts” is a better term because the term more accurately reflects the risks associated with a bank not maintaining its books directly and can be applied to any type of account, not limited to depositary accounts. accounts.

Banks also need to focus on “accounting hygiene” by requiring fintech companies to have separate accounts that more clearly define customer funds, transactions, fees for third-party payments, emergency reserves and network settlements.

Banks should distinguish individually identified sub-accounts from general pooled accounts, especially when middleware companies like Synapse are involved, the report says. However, the report said the FDIC’s recordkeeping rules do not take into account subaccounts, which is a common feature of fintech partnerships. Middleware providers help bridge the gap between legacy banks and fintech companies by leveraging the latest technology.

Mistakes of the partner bank

Banks and fintech companies should have a plan in place in case the partnership fails. These plans must address the operational risk associated with an account registry failure, identify ways to mitigate the risk, and deploy reserves to ensure the integrity of end users in such an emergency.

After Synapse went bankrupt, Evolve Bank & Trust received a cease and desist order from the Federal Reserve approximately two months after Synapse filed for bankruptcy based on an audit conducted in early 2023, while another bank partner , Lineage Bank, received a consent order. FDIC in late January of this year. Although the timing of the previous exam in both cases was not specified, it was clear that the partner banks were aware of the compliance issues associated with their middleware provider Synapse.

The consent orders against two of Synapse’s partner banks addressed their board governance and BSA/AML issues without detailing the underlying issues that may cloud those partner banks’ relationships with parties other than Synapse.

To track the flow of funds in any multi-party banking and fintech partnership ecosystem, a different accounting solution is needed, the report said.

Regulatory omissions

Regulators should prioritize the most critical risks when passing a consent order to a bank, moving away from a “check the box” model of supervision and toward a “risk-based” model of supervision, the report says.

Regulators have highlighted the complexity of banking-as-a-service arrangements and have relinquished supervisory responsibility for regulating the non-banks involved. To address this issue, supervisory processes could be updated to engage more directly with banks’ fintech partners, allowing for earlier identification of technology-enabled risks and allowing the bank and fintech to take corrective action, the report said.

Another question raised by the report, citing a delay of more than 300 days between the actual exam and the issuance of the consent order, was whether managers needed additional resources to operate more efficiently.

“How do (the Financial Industry Regulatory Authority) and banking regulators work together?” noted Alexandra Steinberg Barrage, partner at Troutman Pepper. In Synapse’s case, there was a broker, “but was there coordination as to what the broker actually did, or what its modular banking business model actually was?” she said, adding that it is difficult to know because there is not much information.

Gross mismanagement

Qualified personnel are critical to an effective bank-fintech partnership. andintechsPrioritizing speed over market may conflict with compliance requirements, the report said. In bank-fintech partnerships, fintech companies need leaders with deep risk management and banking supervision experience, a strong focus on compliance, regular and adequate training programs, and the need for interdisciplinary teams, the report says.

The interagency guidance also requires banks to assess the depth and experience of fintech partners’ human resources, ensure their own employees have the necessary risk management knowledge, and evaluate the qualifications of key personnel.

“Right now, the industry is already taking really important steps to create standards that will bind them, because right now they are not monitored or reviewed by banking regulators; however, they are so critical to the functioning of these bank programs,” Steinberg Barrage said.

“So, as a next step… we’re working with people on the banking and tech side who are very focused on best practices, evolving that to ultimately hold the industry accountable,” she said, “and I think that’s absolutely the time is right for this.”