Hey fintech friends,
Synapse’s bankruptcy and subsequent wind-down has left many open questions about the path forward for its ~100 customers and tens of thousands of end users holding funds on the platform. It has also brought to light the complexities and risks involved in building Banking as a Service, and underscored the human cost of getting it wrong.
In the fallout of this collapse it’s important to learn from the vulnerabilities that led to this point. It’s also important to acknowledge the unique challenges that Synapse grappled with– in its bank partnership structure, its struggles with regulatory compliance, and seeming inability to maintain an accurate ledger.
Let’s dive into what’s happened at Synapse, the specific factors that led to its collapse, and what takeaways experts including Simon Taylor, Trevor Tanifum, Alex Johnson, and Faraz Rana say the industry should carry forward.
tl;dr: Synapse’s rise and fall
Synapse was founded as a banking app for underbanked consumers in 2014, before quickly pivoting to offering B2B Banking-as-a-Service infrastructure. By its peak in 2022, Synapse had raised $50.7 million in funding from investors including a16z, supported over 18 million end users, and held $9 billion in assets across the platform, primarily deposited with Evolve Bank & Trust. However, internal turmoil began surfacing as Forbes reported employees and customers were fleeing the company, citing inadequate experience in building banking solutions, technical flaws in the product, and allegations of a “verbally ‘abusive’” CEO, Sankaet Pathak, who was also embroiled in a 2019 lawsuit over gender and age discrimination (Pathak could not be reached for comment).
By late 2023, Fintech Business Weekly reported that Evolve terminated its relationship with Synapse, leaving Synapse scrambling to migrate customers and users to another bank. Synapse's largest client, Mercury, also announced it was migrating from Synapse to a direct integration with Evolve.
What led to Synapse’s collapse?
While BaaS partnerships have been the subject of intensified regulatory crackdowns, Synapse's collapse unveiled a set of unique challenges– meticulously reported by Fintech Business Weekly– that set Synapse apart from other BaaS platforms. Synapse's dependency on a single bank partner, Evolve, compounded by compliance gaps and technical deficiencies in its ledger system, became acutely problematic during Synapse's migration from Evolve– ultimately resulting in Synapse laying off most of its 200 employees, filing for bankruptcy in April, and a court-appointed trustee now scrambling to unfreeze access to funds for tens of thousands of users.
1. Bank partnership structure
End-to-end BaaS platforms (Unit*, Synctera, Stripe Treasury…) strive to work with multiple bank partners to maximize capacity, flexibility, and redundancy. Synapse, on the other hand, primarily relied on Evolve to hold users' deposits– and didn't have enough alternative bank capacity when Evolve forced them to migrate.
Synapse made two big structural changes in an attempt to re-house customer funds:
"Modular Banking": In a Medium post, Synapse's CEO details the company's strategic switch from "Multi-Banking" (working with multiple banks, each of which supports full-service BaaS deployments) to "Modular Banking" (each bank partner supports a separate, limited set of functions). Presumably this model might lower banks' perceived risk of partnering with Synapse.
From Synapse CEO’s Medium post: “Modular Banking” (Oct 2022)
Cash Management: Synapse launched a cash management program through its registered broker-dealer, Synapse Brokerage, in 2022. As Pathak's Medium post goes on to detail, cash management enabled "Synapse, as opposed to an underlying bank holder, to be the account administrator of record" for funds held in Synapse Brokerage accounts (which were subsequently swept into interest-bearing, FDIC-insured accounts at other financial institutions in Synapse's brokered deposits network).
End users of three Synapse customers– Yotta, Juno, and Copper– were unexpectedly informed that their DDAs at Evolve were being converted to Synapse brokerage accounts on an opt-out basis. Instructions on how users could actually opt out were buried in the terms of service and entailed contacting Synapse directly, so it's unlikely that many users took action.
Unfortunately, users haven't been able to access funds held in Evolve DDAs or Synapse brokerage accounts since Evolve paused payment processing for Synapse-related programs two weeks ago. Evolve testified that Synapse's ledgers haven't proven accurate enough to validate and return DDA balances to their rightful owners, and further claims that Synapse revoked access to the dashboard Evolve needs to authorize payments (Synapse's brokerage accounts are custodied at AMG National Trust, but in keeping with "Modular Banking", Evolve is responsible for processing payments to AMG accounts).
2. Compliance risks
Banks have been pulling back from BaaS given heightened regulatory scrutiny in general, but Synapse's compliance program presented would-be bank partners with a particularly glaring set of flags. Whereas a good portion of BaaS platforms steer clear of what banks consider "high-risk" use cases, Synapse exhibited a relatively high appetite for these programs and struggled to find banks willing to support customers in industries like crypto. Synapse's support for high-risk use cases probably made "Modular Banking" a tougher sell for banks too, since bank partners would theoretically be exposed to risk from a greater subset of Synapse customers than they would in a "Multi-Bank" model.
3. Ledgering issues
A final factor in Synapse's demise was its apparent inability to maintain an accurate ledger. At some point in the breakup process, Evolve discovered a $14 million hole in one of Synapse's client FBOs that seemingly resulted from Synapse erroneously charging clients for card transaction fees that Synapse, itself, was supposed to cover. This set off a back-and-forth dispute that's netting out to $50 million in customer funds that Evolve claims is missing from Synapse's FBOs. Synapse has been in a separate dispute with Mercury since Mercury sued its former BaaS partner for $30 million in a breach of contract and fraud case earlier this year; Synapse's (now former) CEO claimed that Mercury, in fact, owes Synapse $50 million after Mercury overdrew from Synapse's FBO while migrating to a direct integration with Evolve.
Synapse's CTO testified during this month that the company had issues "calculating balances related to its sweep program, resulting in an inaccurate ledger and 'material deficiencies' with the balances held at AMG, American, and Lineage."
Bankruptcy
According to Synapse's CEO, the decision to file for bankruptcy in April came about after Synapse failed to raise an additional $100 million from existing investors. Pathak recounts that the aim of this raise was to acquire a chartered bank, but in absence of this, Synapse's only viable path forward was to get acquired. Payments provider TabaPay agreed to purchase Synapse for $9.7 million (well under the $50 million Synapse had raised since inception) and, per Synapse's CEO, TabaPay wanted Synapse to file for Chapter 11 to avoid "lurking... iceberg liabilities that you don’t even know what they are"– concerns likely driven by Synapse's ongoing disputes with Evolve and Mercury. The TabaPay acquisition ultimately fell through, and Synapse and Evolve continued to point fingers at each other for it.
What happens now
A federal bankruptcy court has appointed former FDIC chair Jelena McWilliams as trustee to oversee Synapse's wind-down. As FDIC chair, McWilliams had championed regulatory and technological initiatives to further financial inclusion and presided over a rule allowing fintechs to use brokered deposits– uniquely relevant qualifications given the job at hand.
It's unclear how long it will take to return funds to the tens (or potentially, hundreds) of thousands of Synapse end users impacted by this collapse. While Synapse’s bank partners and fintech customers coordinate on detangling Synapse’s ledger, an infuriating report last week revealed that Synapse’s management is basically sitting on its hands– as an employee told Forbes,
“Synapse has made no attempt to reach out to any of our platforms (our Fintech customers) or their end-users. From my understanding, the additional time you granted Synapse to operate was to give us time to put into place an orderly wind down process. To date, there is no process in place and as I indicated already, no communication other than what has been reported publicly.”
McWilliams is pushing the court to remove Synapse’s management, arguing that leadership has “grossly mismanaged the estate.”
3/ How hard is that and what would need to happen to unlock all the funds?
Someone smarter than me said the parties involved are going to need forensic accountants.
And that set off light bulbs and alarm bells for me.— Matt Janiga 💥♻️ (@regulatorynerd) May 25, 2024
Some of the ~100 fintechs built on Synapse have already made the swift decision to deprecate their banking products (like Copper), while others are being forced to shut down altogether (Mainvest).
Takeaways
For regulators
While existing regulatory guidance is intended to prevent these occurrences, this guidance is only effective to the extent that it is proactively implemented and enforced.
In our previous Signals piece on updated regulatory guidance for banks' third-party relationships, we highlighted that banks working with third-party vendors, BaaS, and fintech partners are expected to implement comprehensive risk management frameworks to safeguard customer assets. The collapse of Synapse underscores the necessity of these regulations.
For banks, comprehensive risk management entails conducting thorough due diligence on partners, continuously monitoring, and potentially conducting regular audits on partners’ programs. This includes verifying that fintechs have robust security measures, adequate financial controls, and effective governance practices in place. As Faraz Rana, CEO of Affinity and former Chief Legal Office of Bread, a BNPL fintech that works across a bank sponsor, explains:
“Ultimately, the market will need to adjust to the reality that, in a bank-fintech partnership model, the bank is in charge - they own the customer, the data, and the compliance piece of the equation. The fintech, according to the regulator, is just the marketing piece.
The role of the BaaS is to add value to both parties - do too little and they have no reason to exist, do too much and it looks like they’re protecting the bank. It’s tricky and a nascent market - but there’s always a market for any smart middle person that adds real value.”
This scrutiny and oversight should not be reserved solely for BaaS providers, but for all third parties who have responsibilities that affect customer funds, especially those who are not regulated by any entity directly. Given that startups often lack the extensive history and reputation of more established vendors, banks should adopt a more rigorous due diligence process tailored to the unique risks associated with early-stage companies. This could involve deeper financial assessments, more frequent performance reviews and audits, and tailored oversight.
For BaaS platforms, customers, and users
Synapse’s bankruptcy has already been a major blow to trust in BaaS partners, as Alex Johnson from Fintech Takes details:
“Everything in fintech is downstream of customer trust. The Synapse crisis has demonstrated that end customers have placed their trust in an operational model (BaaS) that has some significant vulnerabilities — vulnerabilities that those customers would never have tolerated if they had understood them.
Everyone in the financial industry — fintech companies, VC investors, regulators, and banks — has a vested interest in addressing these vulnerabilities because a lack of trust from our customers hurts everyone.”
While the Synapse episode makes it painfully clear how vulnerabilities in the banking stack can impact people and businesses, it also highlights opportunities for the industry to grow. Trevor Tanifum from FS Vector explains:
"Contrary to popular belief, this is not an indictment on the FBO model.
This collapse underscores the inherent risks banks face when juggling too many fintech partners. I expect regulators may start asking a new question: 'how many fintech partners is too many for a bank?'
Banks are already prioritizing well-funded companies that embrace ownership of risk and compliance; this trend will continue. We will see banks taking on fewer total partners, which might create opportunities for new banks to enter the space.
For fintechs, the question continues to be, 'how do we do business in this environment?' The answer: de-risk your business. Banks will be more selective of prospective partners, and banks perceive risk through a regulatory and compliance lens."
For fintechs & digital banks
As for fintechs and neobanks, Simon Taylor of Fintech Brainfood explains that the show must go on:
BaaS remains lucrative for banks with few good choices. The ones who have hired large compliance teams are still delivering market leading results (26% RoE for the Bancorp for example).
In a world where community banks are a dying breed the reward remains strong but the risk is significant. The reputation of BaaS has taken a beating, and a generation of companies has learned the hard way that picking the right partner stack is critical.
But financial services remains the world's largest profit pool. So long as there is opportunity there will be entrepreneurs trying to extract that.
* Unit is Sophie’s former employer.
