How do regulations limit FinTech access to the payment system?
There are three ways the banking regulators are making it challenging for FinTechs to access the banking system.
The Penalty for Partnership: Regulatory bodies are making it increasingly expensive and risky for financial institutions to partner with these FinTechs by imposing steeper fines and regulations requiring banks to make significant capital investments and increase operating expenses. Data from S&P Global Market Intelligence shows banks providing banking as-a-service (BaaS) to FinTechs received 13.5 percent of severe enforcement actions in 20231. Another source reports a similar pattern, with more than 40 percent of severe enforcement actions targeted at this group2. Examples include institutions like Metropolitan Commercial Bank, Cross River Bank, Blue Ridge Bank, and Vast Bank, among others. Just as occurred when the regulators took similar actions related to internal correspondent banking, the typical reaction is for banks to exit the BaaS space completely. Customers seeking these services either forego them completely or look offshore to less-reputable alternatives. Informal surveys suggest the sudden loss of a banking relationship is a FinTech firm’s highest risk.
The SPDI Hurdle: In addition to enforcement actions, the Federal Reserve is effectively blocking FinTechs (and others) from using special purpose depository institutions (SPDIs) to access the payment system. Several states, like Wyoming, have passed legislation authorizing the creation of SPDIs, which have the authority to take deposits and facilitate payments but not to make loans. However, the Federal Reserve Banks addressing the issue have consistently denied applications from these entities to open “master accounts” and thus access to the payment system. The Federal Reserve Bank of New York recently rejected TNB’s application, which had been pending for more than six years. The Federal Reserve Bank of Kansas City rejected Custodia Bank’s application. Although the Fed issued guidelines to “clarify” the conditions under which special-purpose depository institutions might receive master accounts, there is no clear evidence the Fed has approved access for an SPDI since the guidelines were issued.
The Regulatory Labyrinth: Finally, the U.S. regulatory landscape can be a complex maze for FinTechs maintaining access to the payment system. They might be subject to licensing in all 50 states and multiple jurisdictions, on top of registering as a money services business.
Why limit FinTech access to the payment system?
Several justifications underlie the strict limitations on FinTech access to the payment system.
Safety and Soundness: Regulators emphasize the need for a robust system. Banks, unlike FinTechs, are subject to strict capital and leverage requirements. They are also subject to regular examinations of their operational resiliency. These arguments, however, fail to fully recognize the differences between banks and the competitors in the FinTech spaces. Unlike banks, payment-focused FinTechs do not make loans. There are few “assets” against which regulators would assess capital requirements, and no “leverage” to limit. In this sense, the balance sheets of these firms are, in some ways, more stable than those of banks. Second, many of these FinTechs are registered as money service businesses and examined regularly. Unlike chartered banks, payment providers must always account for 100 percent of customer assets. That is, customer assets must be held in the U.S. in insured depository institutions. Third, SPDIs are financial institutions, established and regulated by the various states and subject to their examination authority. FinTechs accessing the payment system need not be given the same privileges as insured depository institutions. There is no reason, for example, to grant them access to the Fed’s daylight overdraft facilities or Discount Window. These limitations significantly limit the risks FinTechs might impose upon the payment system. Under its existing processes, the Fed makes master accounts available not just to banks but to credit unions, branches of foreign banks, and to a variety of special-purpose trust vehicles. The Fed has little basis for concluding that a payment FinTech poses significantly greater risk to the payment system than the typical credit union.
Money Laundering Concerns: Granting access raises concerns about introducing money-laundering risk. By partnering with FinTechs, banks are essentially granting non-customers (FinTech clients) access to the payment rails without the same level of due diligence. However, both banks and FinTechs are subject to the same Know Your Customer constraints and are examined by their state regulators on the strength of their compliance programs. While banking regulators may not directly conduct these AML examinations, they have broad authority to examine banks, as well as those doing business through them.
Does Europe offer a viable alternative?
Europe and the United Kingdom offer an alternative approach with Electronic Money Institutions (EMIs). These licensed entities have access to the local payment system and can accept customer deposits and facilitate electronic payments on their behalf. According to one report, almost 600 EMIs operate across Europe and the UK, holding over €35 billion in customer deposits. They provide payment services to consumers and businesses without reported negative impacts on the European payment system or significant money laundering concerns.
What innovation opportunities are we missing with U.S. FinTech restrictions?
Restricting FinTech access to the payment system carries long-term consequences.
Stifled Innovation: Limited access chills the development of new financial products and services that could benefit consumers and businesses. Incumbent high-cost providers, like card networks, may maintain their dominance.
Unbanked Americans Left Behind: The 4.5% of U.S. households without bank accounts may have even fewer financial inclusion options.
The Future of Finance: More importantly, failure to open the payment system to competition and innovation could eventually threaten the monopoly banks now enjoy. Currently, there is no serious threat to the “intermediated” flow of funds through the payment system. Regardless of the originator or beneficiary, funds move from one bank to another, typically through a Reserve Bank. While cryptocurrencies' future is uncertain, the blockchain infrastructure on which they depend offers the possibility of a “disintermediated” funds-flow model, where an originator can send money directly to a third-party without ever knowing where, or even whether, you bank. Payment solutions bypassing traditional payment rails are being investigated in foreign exchange and remittance markets, where fees are high, and the timing of transactions is often uncertain. While a radical shift is unlikely in the immediate future, a willingness to explore innovative solutions like blockchain might be crucial for long-term progress.
Can the U.S. forge a balanced approach to FinTech Regulation?
The current limitations on FinTech access to the payment system present a challenge. While regulators prioritize safety and security, overly-restrictive frameworks could stifle innovation and hinder the U.S. from keeping pace with other countries.
The recent proposals from Acting Comptroller Hsu offer promising steps forward. A national payment-system license would ensure a level playing field for payment providers and would likely streamline compliance efforts for many FinTechs. Hsu has also proposed subjecting cryptocurrency firms, many of whom are active in this space, to comprehensive consolidated supervision (CCS) as a way of keeping a solid handle on their international activity. Again, this would be another positive step forward. It would level the playing field for participants in this space. However, a strong domestic framework is crucial. Without it, global regulation will shift to jurisdictions like Europe or the UK, who already have comprehensive approaches. Finding common ground — balancing innovation with responsible oversight — is key. Embracing responsible FinTech growth could unlock significant opportunities for consumers, businesses, and the entire financial system.
