Synapse’s failure shows that regulation cannot replace knowledge

In the wake of Synapse’s bankruptcy, which has left tens of thousands of consumers in a difficult situation, there is a growing scream As the publication puts it, “this could be a turning point for banking as a service ordinance.”

But while consumer protection and financial stability are key, over-regulation will stifle innovation, reduce competition, and potentially hurt consumers more than it helps. Any regulation should also address the root cause of the problem.

In case of Synapse failurethat the root cause is less a regulatory issue than a knowledge issue: The middleware vendor’s staff simply didn’t understand basic banking concepts like sub-accounting or customer fund management. After all, fintech executives aren’t bankers, and many don’t have the skills and experience necessary to properly manage deposits and maintain detailed ledgers.

So rather than introducing blanket regulation, policymakers should focus their efforts on more narrowly focused areas—namely regulatory sandboxes and consumer education.

Regulatory sandboxes allow fintech startups to test their products in a controlled environment where necessary oversight does not restrict innovation.

Sandboxes have been used around the world to test innovations such as biometric identification, electronic know-your-customer initiatives, and other financial models and products. The process is taken with clear goals, testing criteria and timelines. For example, the 2017 UN report illustrated how London-based money transfer provider WorldRemit used the Bank Negara Malaysia sandbox to test a remote customer identification solution. The project enabled the company to accept mobile photos of customer IDs, and BNM created additional e-know-your-customer guidelines that allowed WorldRemit’s competitors to leverage this important innovation.

Something similar could be developed in the US, where participating banks agree to a time-limited test period with fintech partners, under the watchful eye of regulators and with safeguards to ensure proper accounting and management of funds. Along the way, fintechs could bring in banking experts to build and manage their platforms and establish a basic understanding of banking operations and accounting.

The Consumer Financial Protection Bureau tried to do something like this with its Compliance Assistance Sandbox program, or CAS. CAS was beneficial because one of its main goals was reduce “fear of regulation” that fintech companies face — a major reason new products are abandoned or not developed at all. The program not only provided beta testing opportunities between banks and fintech companies, but also provided the latter with additional support through no-action letters and disclosure waivers.

However, the program, which ran from 2019 to 2022, was ultimately eliminated and replaced by the Office of Competition and Innovation. It is time for us to reassess the feasibility of implementing such programs. Passing through Rep. McHenry Financial Services Innovation Actthat would establish federal regulatory sandboxes within federal agencies would be a good start.

Efforts should also focus on educating consumers about the risks and benefits of fintech products. Empowered consumers can make informed decisions, reducing the need for heavy-handed regulatory intervention. At the same time, fostering a culture of transparency and accountability within the fintech industry itself can mitigate many risks without harming innovation.

New FDIC rules which will go into effect on January 1, 2025, will help by creating an even more detailed framework for how we communicate which products are FDIC-insured, as well as clear and conspicuous disclosures for those that are not. That’s a great start — but more can be done.

While the Synapse bankruptcy and similar incidents point to the need for some level of oversight, it is crucial that governments do not overreact.

Fintech thrives on innovation, competition, and the ability to quickly adapt to new challenges. As a result, many have leveraged technology to create cutting-edge solutions that traditional banks often can’t match. Heavy regulation can stifle this spirit of innovation, which, as the World Economic Forum says notesstimulated the development of small and medium-sized enterprises, offered new banking services to remote communities and strengthened the position of women entrepreneurs.

In contrast, a lightly regulated environment encourages competition, which benefits consumers through lower prices, better services, and more choice. Traditional banks have long enjoyed a regulatory moat that protects them from competition. Fintech firms, unencumbered by such regulations, have been able to challenge this status quo. Overextending regulatory requirements to fintech firms could therefore not only harm these exciting startups but also inadvertently protect established banks from competition, reducing the pressure on them to innovate and grow.

A balanced approach that focuses on light regulation, complemented by regulatory sandboxes and strong consumer education, can ensure that fintech continues to thrive and benefit consumers while addressing legitimate concerns. Let’s not suppress the very features that make fintech a force for positive change in the financial world.