Talking Fintech Oversight; SEC Urged to Bar Penny Stock Listings on Exchanges; Senate Panel Returns to Big Bank Bashing
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Financial regulation news hasn’t yet hit the summer slowdown. Lawmakers were in town this week, talking about AI in financial services. The Senate’s famed investigations subcommittee also held a high-profile hearing with bank executives. The panel’s Democrats demanded answers on why consumers aren’t getting reimbursed when they’re ripped off on Zelle. Meanwhile, the FDIC’s Republican vice chairman gave a major policy speech; more than a few saw it as a tryout for a second Trump administration.
Stepping back a bit, we dug into the arguments being made in the Eighth Circuit against the SEC’s climate rule. And we wrote about an under-the-radar fight over penny stocks, pitting brokers against the major exchanges. One prominent trading firm is asking the securities regulator to weigh in. For our Friday interview, we talked to a law professor who is worried that the current oversight regime for payment apps is failing consumers.
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Friday Q and A: In a recent speech, Michael Hsu took a provocative stand: Federal agencies, not states, need to be supervising financial technology companies that deal directly with consumers, he said. The acting comptroller supported the idea, which would upend the U.S. oversight structure for fintech firms, by citing an academic paper that argues the current approach is a “source of stress” for the banking system
This week, we sat down with the author of that study. Dan Awrey, a law professor at Cornell University, has played a largely behind-the-scenes role in Washington for years, counseling mostly Democratic policy makers on issues ranging from derivatives to digital assets. He’s an expert in financial “plumbing,” a decidedly unsexy specialty but one that can have real consequences for regular people. That’s especially true in payments, which Awrey has been focusing on lately. As one might guess from Hsu’s remarks, the professor sees a dire need for some changes. He’ll be outlining them in a new book this fall, called “Beyond Banks.”
Awrey currently is on the CFTC’s technology advisory committee; he’s also worked with the Treasury, the Fed, the President’s Working Group on Financial Markets and the Bank for International Settlements. Read on to learn why he thinks Americans are vulnerable not only when they use apps to trade crypto, but also when they pay via Venmo or Paypal – and why he doesn’t think state oversight is enough to protect them. He also has a few thoughts on why banks are behind in the technology race, the fallout from recent Supreme Court rulings and how polarization is making academics think twice about working in Washington. That’s an issue he has seen up close.
What follows is our (lightly edited and condensed) conversation.
Capitol Account: Your paper that Hsu highlighted lays out a number of potential problems with how we regulate new payments firms at the state and federal level. That structure stems from the “dual banking system,” which also has its share of critics. How did we get to this point?
Dan Awrey: The Constitution didn't expressly deal with the division of powers between the state and federal government in a way that would've made clear that this was all federal responsibility or all state responsibility. [So] you have the Supreme Court saying, `There is a federal system, there's a state system. They're both constitutional.’
CA: Do any other countries do it this way?
DA: None. The two that come closest are Canada and Germany, but none have the same regulatory structure.
CA: Is it still necessary to have two different levels of regulation in the U.S.?
DA: There's been convergence amongst the regulatory regimes that apply to state and federal banks over time. We don't live in a world where the principal cited benefit of the dual banking system – that is, diversity – really exists for the most part.
CA: You argue in the paper that popular payment apps like PayPal, Venmo and Cash App, as well as crypto firms like Coinbase and Circle, are stressing the dual banking system. What does that mean?
DA: The stress comes from the fact that we've created this very safe thing called the banking system, the sheer weight of which is incentivizing firms to explore other ways of organizing their business. [That] is taking them into regulatory frameworks that are less burdensome, but are also less ideal from the perspective of protecting customers. And [they] end up being connected to the banking system in ways that provide sources of stress themselves. We kind of have the worst of both worlds at the moment.
CA: Can you expand on that from the view of consumer protection? What are you worried about happening to average Americans using, say, Venmo?
DA: Bankruptcy. We have a whole framework not only with FDIC deposit insurance, but a resolution framework that has come to fully protect uninsured depositors as well. But it only applies to banks.
CA: Why does that matter for customers of these fintechs?
DA: The bankruptcy process creates delays…customers typically, especially if they are deemed to be creditors of that firm, don't get their money back until the conclusion of that process. We've seen this several times now – the Celsius bankruptcy, the FTX bankruptcy.
CA: Do people eventually get reimbursed?
DA: The vast majority…are unsecured creditors in bankruptcy…Ultimately we would expect them not only to be delayed in being repaid, but not getting all of their money back – and in some cases, only pennies on the dollar.
CA: How does this get fixed?
DA: I think there's a couple of things that you’ve got to do. One is something that most jurisdictions, quite frankly, have already done and the U.S. hasn't, which is to have a special regulatory charter for payment firms that are not banks. Then to subject those firms to specific types of portfolio restrictions, activity restrictions, affiliated party transaction restrictions and a resolution regime that has one job – to make sure customers get their money back fast and are repaid in full in bankruptcy.
CA: As we look at all these financial technology developments, should Americans be scared? Or excited?
DA: There's a lot of good news here for consumers. Non-bank payment platforms are giving them access to a set of products and services, at price points that they have not seen before…But that's often where the dangers lurk – behind all the shiny new things.
CA: Where do you see us in 20 years? Do you think there will still be cash?
DA: In my business, there's always the temptation to lean on Star Trek – the 23rd century is not that far away. The Star Trek universe eliminated cash. The technology exists to eliminate cash today. But as much as money is a financial institution, and an economic and legal institution, it's also a social institution. I don't see cash being fully eliminated, probably ever…(Friday)
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Risky Stocks: Virtu Financial has tirelessly, and very publicly, battled Gary Gensler over his overhaul of stock trading rules. Now, the firm is looking for help from the SEC chief, inviting him to weigh in on an industry fight with big money on the line. The under-the-radar tiff revolves around penny stocks, and it pits market makers and brokers against the major stock exchanges.
Earlier this month, Virtu petitioned the commission to force the exchanges to quickly delist companies when their shares fall under $1. The firm also wants the trading platforms to mandate additional disclosure from issuers.
Virtu and a number of brokerages that are quietly backing the effort argue that it is right in the wheelhouse of the SEC – and an easy fix that would go a long way toward protecting retail traders. Dodgy companies, they say, shouldn’t benefit from the imprimatur of being on Nasdaq or the NYSE.
“The bottom line is that current SEC rules that allow high-risk penny stocks to be listed on major stock exchanges present serious investor protection concerns,” writes Thomas Merritt, a Virtu deputy general counsel. “We believe that it is long past due for the commission to take a fresh look at its rules around the listing of such securities and ensure that investors are armed with the information they need to assess the investment risks.”
(Industry sources also believe the effort would be a better use of the agency’s time than Gensler’s market structure revamp.)
An SEC spokesperson declined to comment on the petition.
The agency’s regulations in the area date back to 1990 when Congress passed the Penny Stock Reform Act, aimed at curtailing broker sales abuses and manipulation of small-cap stocks. The rules, which require increased disclosures, generally define a penny stock as having a price of under $5 a share (or limited assets or revenues).
But the SEC also exempted stocks that trade on a national exchange. That’s because, as Virtu notes in its petition, the big exchanges were thought to have listing standards “stringent enough to weed out the riskiest issuers.” The exchanges’ criteria call for delisting companies that trade below $1.
For a long time the system worked pretty well, but in recent years more and more stocks priced under $1 have been trading on the platforms – some 557 as of last December, Virtu points out in its letter. The exchanges allow a 180-day grace period for a company to boost its share price, and firms can get another six months to come into compliance.
That means a whole lot more dicey stocks trading on venues that retail investors perceive as having high standards. Here is how Virtu describes the problem:
“These are classic penny stock companies that are often tied to pump-and-dump trading activity and other forms of market manipulation. They are exactly the type of stocks that the Penny Stock Reform Act and commission rules intended to keep off the major exchanges to protect investors. Yet, under today’s listing rules, these stocks are eligible for listing on exchanges despite their substantial risks – and can remain listed for long periods of time even when they violate the exchanges’ continuing listing requirements.”
The dispute, not surprisingly, is also about money. And it has been percolating for several years as the number of penny stocks on the exchanges continued to rise.
Market makers like Virtu, which buy retail orders from brokers and execute them, are often stuck with the shares of the small companies. And they can be hard to unload, or the subject of pump-and-dump scams and overseas frauds.
Brokers, too, have taken big losses, Virtu notes. Many penny stock companies looking to keep their listings engage in so-called reverse stock splits, which consolidate the number of outstanding shares and increase their price. When these reverse splits happen, the announcements are often rushed out and brokers’ back office systems don’t always catch them, resulting in costly administrative errors.
“Brokers have likely lost tens of millions of dollars, if not more,” Virtu writes. In one well-known example, Robinhood was caught unaware of a stock split last year by a company called Cosmos Health, causing a $57 million loss. (Nasdaq, for its part, adopted a new process last year to halt trading ahead of a reverse split. It also required two-day notice.)
Virtu and its broker allies contend that most of those stocks should be trading over-the-counter, where investors have a better sense that they are not dealing with a blue-chip company. OTC Markets, for example, uses “compliance flags” like a skull and crossbones to warn traders about the risks…(Thursday)
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Fun With Big Banks: The Senate Permanent Subcommittee on Investigations earned a reputation as the bane of Wall Street following the financial crisis, hauling up top executives for hearings tailor-made to bring out the “Occupy” pitchforks. Its fire of late has focused on other corporate malfeasance, from Boeing’s catastrophes to the PGA Tour-LIV golf fiasco.
The panel returned to bashing big banks on Tuesday – this time with the goal of cajoling them into ponying up restitution when consumers fall for scams. This afternoon’s hearing showcased a critical report on Zelle, the peer-to-peer payments app owned by large lenders. It didn’t pack the public-relations punch of, say, Carl Levin interrogating Lloyd Blankfein about “shitty” deals, but Democratic Chairman Richard Blumenthal did his best to skewer executives from JPMorgan Chase, Wells Fargo and Bank of America over what he stressed was their inadequate response to digital financial crimes.
“Zelle and the big banks who own it know that Zelle’s speed and convenience makes it a target, and they are well aware that every single day, some of their customers will be hurt,” Blumenthal said. “They’re willing to accept the risk as the cost of doing business. But it is a cost for their customers, not for them, in the vast, vast majority of instances.”
The bankers at the witness table seemed a bit new to the Washington spotlight, and often spoke tentatively. But they took pains to point out that they’re not the ones ripping people off. And they insisted that they’ve been doing herculean work to combat the problem.
“In 2023, the rate of fraud and scam disputes on Chase Zelle was the lowest it had ever been,” said Melissa Feldsher, JPMorgan Chase’s head of commerce enablement. Noting that more than 99.9 percent of transactions on the system aren’t disputed, she outlined how the bank warns customers about scams – and uses AI to detect them. “We must acknowledge that banks alone cannot stop financial crimes,” she said. “This is a societal problem.”
In contrast to previous blockbuster probes from the subcommittee, the Zelle investigation came only from the Democratic staff. Ron Johnson, the panel’s top Republican, largely took the other side. He underscored that he was impressed by ways the banks seek to stop consumers from being tricked, and skeptical they should be paying more. “The bottom line is a crime is being committed,” he said. “It’s not the bank’s fault.”
Democrats, however, argued that Zelle’s owners should cover more consumer losses – and they proposed a few legal and regulatory changes that could shift more costs onto banks. “Why not reimburse everyone?” Blumenthal asked.
Under current law, the companies are required to pay back customers when a thief gets into an account without their permission. But firms don’t have to make a consumer whole if the payment is “authorized,” which often happens when people get duped.
While that line between “fraud” (unauthorized transfers) and “scams” (authorized transfers) seems pretty clear, applying it to individual cases requires some due diligence. The committee’s report makes the case that banks – left to their own devices – can’t be trusted to do those investigations…(Tuesday)
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