Ugly Bargains Between Banks and Regulators Are Rearing Their Head Again

The "know your customer" and anti-money laundering system imposes constraints on financial access and inhibits liberty and privacy, even though the original security intent was reasonable.

AccessTimeIconOct 14, 2022 at 4:20 p.m. UTC
Updated Oct 14, 2022 at 7:04 p.m. UTC
AccessTimeIconOct 14, 2022 at 4:20 p.m. UTCUpdated Oct 14, 2022 at 7:04 p.m. UTCLayer 2
AccessTimeIconOct 14, 2022 at 4:20 p.m. UTCUpdated Oct 14, 2022 at 7:04 p.m. UTCLayer 2

Season Five of the Showtime series “Billions” ends with a scene that exposes the ugly bargain governments strike with banks and how that deal works against society’s interest.

It seems apt to reflect on those relationships now, when the “too-big-to-fail” financial system that’s built on that bargain is in its most fragile state in 13 years, and to ponder what, if anything, the crypto alternative offers.

In the scene, swashbuckling hedge fund manager Bobby Axelrod discovers he has been lured into criminal vulnerability by his arch nemeses, New York Attorney General Chuck Rhoades Jr. and financier Mike Prince. After being baited into accepting deposits at his newly incorporated Axe Bank from a cannabis company, Axelrod is told he was in breach of fiduciary duty for not “knowing your customer.” It turns out that the weed supplier had been selling unauthorized product, a crime for which Axelrod and his bank would now also be culpable.

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It’s the “KYC” requirements that matter here. Along with anti-money laundering (AML) compliance rules, they comprise an all-encompassing surveillance system designed to prevent criminals from hiding their financial footprints. As we’ve frequently argued in this column, and on the "Money Reimagined" podcast, the KYC-AML system has evolved to become an excessive constraint on financial access and a dangerous imposition on liberty and privacy – even if the original security intent was reasonable.

But it’s the other side of the bargain that makes this interesting, the part that was so attractive to Axelrod (played by Damian Lewis) that he acquired an entity with a bank charter and folded his once high-earning Axe Capital fund into it. There are real perks that come with being a compliant, regulated institution, perks that make it easy to make money – or in Axelrod’s case, to protect his wealth.

There are various benefits in this deal. There’s coverage by the Federal Deposit Insurance Corporation for banks’ depositors. There’s access to a backstop of funding from the Federal Reserve if it’s ever needed. And, as we discovered in 2008, for the biggest banks the safety net even extends to the federal government providing bailouts in times of crisis.

These explicit and implied guarantees are a license to mint money – literally. By protecting banks’ downside risks, they keep their sources of capital cheap, which in turn allows banks to leverage those funds into profitable loans and investments, milking the interest rate spread ad infinitum.

All of this is part and parcel of the fractional reserve arrangement through which banks essentially create our money by lending out deposits. Because banks are integral to our economy for both storing our money and paying it to each other, the federal government provides those backstops to mitigate the risk of a “run” bringing down the entire system, as was feared in 2008.

Perverse outcomes

The problem is that this bargain – KYC-AML compliance in return for backstops – creates perverse incentives and outcomes.

One is that in a world of sophisticated financial criminals, banks are compelled to create ever more stringent disclosure demands on depositors. This especially hurts the poor, who cannot furnish the identity proofs and other documentation needed to pass muster. Meanwhile, those rules are weaponized by the likes of Chuck Rhoades for personal vendettas or political interests.

Another perverse outcome came to light in the post-mortems of the 2008 crisis. The perceived absence of downside risks creates moral hazard, leading profit-seeking bankers to engage in excessively leveraged bets.

All of this has created a symbiotic relationship between regulators and banks that’s very hard to disentangle without disrupting this otherwise broken system.

We see the problem in the revolving door phenomenon of regulatory agency staff moving to Wall Street jobs and vice versa. And it explains the frustration in Caitlin Long’s voice this week as the CEO of crypto-based Custodia Bank told a DC Fintech Week audience of the Federal Reserve’s double standards. Long, an articulate innovator, said Custodia would amend its lawsuit against the Federal Reserve – citing it for stalling a Custodia application for a central bank account – to reference the fact that BNY Mellon, the largest custodian bank in the world, has been approved to custody its clients’ bitcoin.

Global stress

Now this global system is showing signs of fragility once again. The U.K. is propping up its debt markets; a soaring dollar is creating economic and political tensions in big economies like Japan and small ones like Lebanon; and talk is rising again that a major multinational bank – Credit Suisse – is in serious trouble.

It’s why Edward Snowden’s tweet this week resurfacing Satoshi Nakamoto’s famous insertion into the first Bitcoin transaction was so apt.

The exiled privacy activist artfully reminded us of what’s at stake in his technology. (Hint: IOt’s not “number go up.”)

But let’s also recognize that Satoshi’s 2009 vision for an alternative system of money – where payments aren’t routed through government-regulated intermediaries but are made peer-to-peer – has not, so far at least, come anywhere near to dislodging the old system.

Partly, that’s because U.S. and other governments’ agencies have demonstrated their unparalleled power to control the on- and off-ramps into the crypto economy – which, unavoidably, involve the very same banks that crypto developers are seeking to bypass. Whether through onerous KYC rules or through sanctions list orders as in the Tornado Cash case, regulations and enforcements have clipped crypto’s wings.

But it’s also because the crypto community itself lost sight of the bigger mission. It became obsessed with speculation on tokens, which led some prominent operators in the industry to adopt some of the same – if not worse – Wall Street practices of centralized custody, leverage and rehypothecation.


Still, crypto winter offers a powerful lesson for the community, now focused on “BUIDLing,” to come up with systems, approaches and self-regulatory solutions that can help weed out these ugly elements.

There could not be a better time for the industry to make its case. As Financial Times columnist Edward Luce noted this week, “The world is starting to hate the Fed,” thanks to its aggressive rate hikes and the resultant surge in the dollar. The U.S.’s fastest growing export, Luce wrote, is “monetary pain.”

Much like 2008, this unsettling moment will spur a host of new ideas for redesigning the global financial system. Unlike 2008, there is now a radically different technological model to draw from.

When policymakers gather to assess these ideas it’s unclear whether crypto will get a seat at the table. But it will certainly be making a racket just outside the dining room.

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Michael J. Casey

Michael J. Casey is CoinDesk's Chief Content Officer.