The Necessary Humanity of Our Work

2023 year-end retrospectives focused heavily on artificial intelligence’s impact and prospects, one year after Chat GPT’s public rollout.  Typical was this view from Editor and Publisher, the news media’s most widely read trade publication: “The impact of ChatGPT and generative AI on the job market is a topic of much debate. Professions that involve rules-based tasks or rely heavily on processing large amounts of information, like journalism, law, medicine and architecture, will likely see significant changes. The potential of AI to augment human capabilities is immense, but it also raises questions about the future of these professions.”[1]

In some respects, AI’s arrival in daily business life is simply another milestone in the takeover by machines of humans’ work.  In 2000, Duke University spun off its business school’s continuing education program as Duke Corporate Education.  As one of the spinoff’s architects described the business model, prerecorded online programs would instruct company managers, executives would receive ample in-person, high-touch attention from faculty, and rising executives would receive mini-camp instruction with limited exposure to real people as instructors.

This mirroring of corporate hierarchies and resource allocation models may make economic sense.  Lost in the process though are benefits gained when faculty shape young minds through one-on-one encounters, whether in lecture hall q&a, student conferences and tutorials, or coffee shop conversations.  While these losses may not equate to AI failures like self-driving cars that run over pedestrians, the point remains that substituting machines for people can have costs that we overlook in the name of efficiency. 

So how important is human interaction, really?  Consider the findings of a British study that analyzed professional soccer results in more than 4,000 games played in 11 European nations during Covid-19, when fans were barred from stadium attendance.  “With fans present, teams won 0.39 points more per game at home than away.  With fans absent, the advantage was almost halved when teams won only 0.22 points more at home than away.  With fans present, home teams scored 0.29 goals more per game than away teams.  With fans absent, home teams scored just 0.15 goals more than the visitors.

“Furthermore, the lack of crowds affected how referees judged fouls against home and away sides. The data showed:  Referees gave more fouls against the home team in empty stadiums.  Referees gave a similar number of fouls against the away team in empty stadiums.  Referees gave far fewer yellow cards against away teams in empty stadiums.  Referees gave similar numbers of yellow cards against the home team in empty stadiums -- even though they fouled more.  Red cards followed a similar pattern which was less pronounced, yet still significant.”[2]

One can take these results as an argument either in favor or opposed to machine-intermediated sports performances.  The results may be more objectively fair.  Yet the games may be less satisfying for players and fans. 

In other professional performance realms, the value of one-to-one human engagement remains indisputable.  Ask anyone who his or her most influential teacher was and you will have an answer in under a minute.  Often it is the teacher who brought the student out of her shell, made math fun, helped the student turn his unruly self into a comedic genius, or otherwise had a transformative effect on the student at an impressionable age.

Similarly, my own and my clients’ experience is that collaborative relationships between patients and medical, surgical and psychiatric professionals significantly improve health outcomes.  For contrast, consider the movie “One Flew Over the Cuckoo’s Nest.”  Nurse Ratched is heartless and controlling in her management of the psychiatric ward.  “Your hand is staining my window,” she says dismissively to Jack Nicholson’s character in his first encounter with her across the transom of her nurse’s station.  The damage she does to her patients in the movie is so palpable audience members want to cry, scream, or both.

The disability insurance investigator who visited me when I was recuperating from a year-long hospitalization said, as actuaries, he and his colleagues look for four characteristics in a patient recovering from life-threatening illness: quality medical care, support from friends and family, religious faith and the will to live.  Take one away, he said, and the patient’s survival chances diminish.  Subtract two and it is usually game over, he added.  Notably, though he did not say so, all four factors are human-inspired.  Machines like a ventilator or a Wound-VAC may be necessary tools.  But the human touch is an equally essential condition for survival and recovery.

In my experience as a lawyer, care and concern for clients’ human experience of the situations in which they find themselves is at least as important as technically strong performance by their lawyer.  Indeed, the more vulnerable they are to adverse consequences, the more important is one’s empathy for their situation.

Fine arts too are a domain where AI-generated works can be good but not great.  Picasso’s “Guernica” could only be created by a person of his imagination and sensibilities.  Ditto Rembrandt’s “Return of the Prodigal Son.”  In The Return of the Prodigal Son: A Story of Homecoming,[3] theologian Henri Nouwen narrates his extended study of the original painting at The Hermitage—sitting in a chair opposite the painting for days at a time, thinking only about the work and the parable it represents. 

Nouwen argues only Rembrandt in his last years could have created such a masterpiece, informed not only by the Biblical story but by the artist’s own lifetime loves and losses, including the deaths of his wife and three of their four sons.  Nouwen’s work stands equally for the proposition that quality pastoral care by clergy of their congregants is not susceptible to formulaic solutions framed by AI or otherwise.

Our societal experience of new technology is to thrill to the possibilities it opens, only later to be chastened when we recognize its effects are not wholly beneficial to humankind.  As we struggle to “get right” the proliferation of AI, we need to remind ourselves, and one another, of the value of human involvement in our life’s work.  For as Covid showed us by the examples of bus drivers, hospital orderlies and poultry plant workers, human work is inherently dignified and dignifying, and we should not take it for granted.  Happy New Year.

[1] https://www.editorandpublisher.com/stories/ai-101-chatgpt-a-year-of-transforming-our-lives,247038

[2] Dane McCarrick, Merim Bilalic, Nick Neave, Sandy Wolfson. “Home advantage during the COVID-19 pandemic: Analyses of European football leagues,” Psychology of Sport and Exercise, 2021; 56: 102013 DOI: 10.1016/j.psychsport.2021.102013, cited in "Football without the fans: Effect of empty stadiums during pandemic,” ScienceDaily, 13 August 2021, <www.sciencedaily.com/releases/2021/08/210813100323.htm>.

 [3] Henri J.M. Nouwen, The Return of the Prodigal Son: A Story of Homecoming, New York: Penguin Random House, 1994.

Edge Cases

In the early 1990s, my brother-in-law and his family drove from Maine to Pittsburgh for a visit.  Because the drive home was a long one, they departed Pittsburgh at 4:00 a.m.  As they climbed through the Allegheny Mountains on the Pennsylvania Turnpike, a deer leapt from a bridge abutment into the road in front of their small GM station wagon.  Aware his two children were asleep in the rear of the station wagon, John glanced in his rear-view mirror.  Seeing a large truck following at close range, John kept his foot on the accelerator and took the deer at 60 mph.  The car was destroyed, but his family was unharmed.

For robotics and artificial intelligence experts, such as those currently designing autonomous driving systems, this event is a so-called Edge Case: a situation for which software is not necessarily trained, but to which it must respond immediately and correctly.  As robotics and AI move from controlled environments to assist activities of daily living, programming for Edge Cases becomes both more difficult and more important.  The inevitable hiccups are what led California to ban Cruze’s self-driving cars and GM to halt use of the vehicles nationwide.

The growing pains of the fourth industrial revolution now underway will get worked out, just as in the earlier revolutions seeded by steam power, distributed electric power, and early computers and automation.  The open question is how that will happen. For insight, I recently participated in a program put on by Carnegie Mellon University, “Manufacturing & Warehouse Robotics Forum.”  Despite its title, the program ranged far beyond manufacturing and warehouse applications.

Particularly interesting were panelists’ opinions about where the next 5-15 years will lead us.  “Human-centric platforms will be prevalent; historically robots were deployed in larger, fixed platforms [like manufacturing],” opined one expert.  Said another, “Every human will have two extra arms, significantly augmenting the human being.”  Robots will “move from [handling] objects to whole environments,” said a third participant.

Challenges ahead include creating “systems that are effective at collaborating with humans.”  Integration across robotic systems is another hurdle.  A 30-year robotics industry veteran said, “AI will be judged not by the 99% of situations it gets right, but by the Edge Cases.”  Does computer vision deployed in transportation read as an actual bicycle a painted image of one that denotes a bike lane?  Does computer vision read as an actual chicken a man wearing a chicken suit like Richard Pryor and Gene Wilder in “Stir Crazy”?  If the algorithm says, “Go ahead, run over the painted bicycle image,” it matters not.  Not so if it runs over Pryor or Wilder.

In the financial innovation space, the difficulties presented by Edge Cases led the Federal Reserve Bank of Boston and MIT Media Lab to quietly shelve their Project Hamilton, a bid to create a “high-speed transaction processor for a centralized digital currency, to demonstrate the throughput, latency, and resilience of a system that could support a payment economy at the scale of the United States.”[1]  Earlier this year, the Federal Reserve Bank of New York and eight big financial institutions conducted a pilot project to create a digital dollar that could be traded among participants in a closed network of institutions.  In July, the Fed announced the pilot had been completed, noting it had no plans to continue development of a digital dollar and any decision to do so would be a “political” one for Congress to make.

The decision to step back from creating digital dollars surely reflect industry and government officials’ misgivings following the collapse of crypto currency platforms including FTX and the speed with which Silicon Valley Bank, Signature Bank and Republic Bank failed earlier this year.  As a participant in the CMU-sponsored forum noted, AI operates as an accelerator.  Instead of having to program a computer to take a specific action, AI enables a computer to interact with its environment “on the fly”—with no or minimal lag time.  In a financial crisis, perhaps that is not a benefit.

Designers of manufacturing and distribution environments too need to rebalance speed, accuracy and safety as humans and robots collaborate more intensively.  A recent Michigan case, Holbrook v. Prodomax Automation,[2] illustrates the problem. 

Wanda Holbrook worked on a robotic assembly line for a Tier 3 supplier to Ford.  The line welded up trailer hitches installed on Ford pickup trucks.  A robotic arm in one of six zones on the line fed parts to a jig in the next zone where another robotic arm did the welding.  The robotic arm in a third zone picked the completed products out of the jig and placed them on a rack for cooling. 

When the robotic arm in the third zone failed to pick a completed hitch out of its jig, Wanda disregarded the required safety protocol to power down both the second and third zones.  She stepped directly from the third zone into the second zone to free the stuck hitch from its jig.  Computers controlling robots in the first two zones read her actions as making the jig ready to receive the next set of metal pieces for welding.  The robot arm from the first zone reached into the second zone, pinning Wanda’s head against the jig.  The second zone robot arm then tried to weld what it interpreted as a new hitch assembly, severely burning Wanda’s face, nose and mouth.  She died as a result of her injuries.

Because she failed to follow prescribed safety rules, the court, applying Michigan’s products liability statute, ruled in favor of Wanda’s employer and the manufacturer of the robotic assemblies involved in the case.  Yet it is not difficult to believe that error-prone humans will continue to misjudge their interactions with robots and suffer similarly severe consequences. 

The New York lawyer who summarized the Holbrook case for The Business Lawyer observed: “companies that design or purchase robots to work with humans should foresee the harm that can arise from a combination of robot malfunction, human error, and placement of humans and robots in close proximity.  Neither the robot designer nor the robot purchaser-user should implement security paradigms that rely on error-prone humans’ adherence to safety protocols.  The designer could instead program the robots to practice the first law of Isaac Asimov’s Three Laws of Robotics: ‘a robot may not injure a human being, or, through inaction, allow a human being to come to harm.’”[3]

In practice, that is an impossible standard to meet.  Robots, like any assistive device, cannot serve the functions for which they are designed and be expected to save humans from their own reckless behavior.  Engineers will do their best to idiot-proof robots and the software that informs their and our work.  But we humans need to have the intelligence, patience and humility to learn to work with robots as our helpers, respecting their power and the risks associated with our use of them.     

[1] https://news.mit.edu/2022/digital-currency-fed-boston-0203

[2] No. 1:17-cv-219, 2021 WL 4260622 (W.D. Mich. Sept. 20, 2021).

[3] R. Trope, “When Security Paradigms Fail,” 78 The Business Lawyer 258, 265 (Winter 2022-2023).

Making History Rhyme

In 1901, Huron County, Ohio, merchant S.J. Hawkins hired the Lake Shore and Michigan Southern, and Wheeling and Lake Erie railroads to transport to urban markets grain Hawkins bought from Northern Ohio farmers.  The railroads reneged on the contracts, reallocating railcars to other customers with bigger loads.  Hawkins’ grain rotted on a rail siding.  Acting as his own attorney, Hawkins sued and won damages from the railroads before the Interstate Commerce Commission.[1]  He was my maternal great-grandfather.

Congress created the ICC in 1887 in its first-ever legal regulation of an American industry.  The ICC’s mission was to (i) provide a federal forum for farmers and merchants to obtain redress of their grievances against railroads and (ii) create an orderly market where railroads could earn reasonable returns on investment by charging “just and reasonable rates” to all comers.  Previously, large volume customers like Rockefeller’s Standard Oil forced railroads into ruinous price wars and rebate schemes.

A federal solution was needed because state legislatures were uniformly in the pocket of the railroads.  Well into the 20th Century, the Pennsylvania Railroad’s lobbyist had his own seat on the floor of the General Assembly.  The inside joke among legislators was that at the end of a legislative session the presiding officer would announce, “The Pennsylvania Railroad having no further business to come before the Assembly, the Session is concluded.”  The federal solution was possible only because the U.S. Supreme Court in 1824 ruled in Gibbons v. Ogden that interstate commerce (as opposed to intrastate commerce) was exclusively the province of federal law.[2]  Almost 200 years later, that case remains the cornerstone of federal commercial regulation.

This historical context came to mind as I read a transcript of last week’s U.S. Supreme Court oral argument in Consumer Financial Protection Bureau v. Community Financial Services Association.[3]  On its face, the case is about whether Congress violated the Appropriations Clause of the Constitution when it provided for the CFPB to be funded out of the budget of the Federal Reserve System.  Beneath the surface, the case is the most recent salvo in a campaign to eviscerate federal government agencies.

Community Financial Services Association (CFSA) mimics names like the Independent Community Bankers Association of America or National Association of Federal Credit Unions. CFSA’s members are so-called “payday lenders,” non-bank lenders who lend money to the working poor.  According to CNBC, “Texas has the highest payday loan [interest] rates in the U.S.  The typical APR for a loan, 664%, is more than 40 times the average credit card interest rate of 16.12%.”[4] Ohio formerly had the highest rates, but capped payday loans’ rates, amounts and duration in 2019.  Thereafter, the typical rate declined to 138%. 

“The rate of workers taking out payday loans tripled as a result of the pandemic [according to a survey of 530 small business workers].  About 2% of these employees reported using a payday loan prior to the start of the pandemic, but about 6% said they’d used this type of loan since [March 2020].”[5]

The CFPB in 2017 adopted a legal rule that curbed or prohibited some of the harshest features of payday loans.  For example, the rule says a payday lender can debit a borrower’s bank account twice to collect a payday loan.  If both debits are rejected for insufficient funds, the payday lender must get the borrower’s permission before making further attempts to debit his or her account.

The practical effect is to prevent a payday lender from debiting its customer’s account daily to collect payment as soon as a deposit like a Social Security benefit payment is credited to the account.  The rule also thereby prevents the borrower’s bank from imposing endless fees for insufficient funds. 

The CFSA sued to overturn the rule, objecting to the just-described feature among others.  Because Congressional authority to set terms on which agencies are funded is legally well established and because the CFSA is not a sympathetic plaintiff, the CFSA’s counsel at the Jones Day law firm likely expected to lose at trial in the federal district court.  So counsel added a Trojan Horse feature to its case: a potentially far-reaching constitutional law argument claiming Congress abdicated its constitutional responsibility by funding the CFPB through the Federal Reserve System rather than by annual appropriations. 

By filing the CFSA’s case in federal court in Texas, the CFSA’s counsel assured any appeal would be heard by the New Orleans-based Fifth Circuit Court of Appeals, which has a documented hostility toward federal government agency actions.

The strategy worked.  That court held the substance of the rule was legal but said Congress’s manner of funding the CFPB was unconstitutional.  Thus, the court gave with one hand and took away with the other.  Further, the court’s three judge panel wrote its opinion in sweeping terms that led observers to doubt the enforceability of all CFPB actions since the agency’s inception if the Fifth Circuit’s decision is upheld by the U.S. Supreme Court. 

The Fifth Circuit’s ruling set off alarms in such bastions of the financial establishment as the Mortgage Bankers Association. That group filed an amicus brief in the Supreme Court saying, “If the Court [adopts the Fifth Circuit’s approach and] issues a decision that extends beyond the Payday Lending Rule and asserts that these mortgage-related rules are potentially invalid because they were promulgated using funds appropriated through § 5497, it could set off a wave of challenges and the housing market could descend into chaos, to the detriment of all mortgage borrowers.  Lenders, servicers, and consumers have operated by the CFPB’s guideposts for more than ten years, and without those rules substantial uncertainty would arise as to how to undertake mortgage transactions in accordance with federal law.”

In contrast to this strong statement, last week’s oral arguments read like a law school classroom exchange: questions and answers about sterile hypothetical cases applying lofty constitutional principles to test the boundaries of the litigants’ arguments.  Opposing counsel carefully observed court decorum, such as by referring to one another as “my friend.” Yet everyone present understood what the Mortgage Bankers Association and other amici curiae said: at stake is the essential functioning of the CFPB and, by extension, many other government regulatory agencies.  In fact, 73% of federal spending is not subject to the annual appropriations process.[6]

In my own career representing clients, I have experienced regulatory overreach, including regulators’ decisions based not on statutes, regulations or case law but on “because I say so” mandates.  That said, effective federal regulation of the nation’s most essential commerce is critical to our economic wellbeing. 

The CFSA suit is an affront to that precept.  It comes before the Supreme Court at a time when the wealth and power disparity between the nation’s biggest and smallest businesses is as great as it has ever been.  Payday lenders are simply willing pawns in this contest. 

As S.J. Hawkins’ experience shows, the conflict between big, rich businesses and small, not-so-rich ones is age-old.  Different today is how big, rich businesses’ concentrate their financial firepower on influencing Congress and the Supreme Court the way they once targeted state government officials. 

The Court itself created the necessary predicate for that behavior.  In its 2010 Citizens United decision, the Court ruled the First Amendment free speech clause bars the government from restricting political campaign contributions by corporations.[7]  Citizens United is the cornerstone of the anti-federal agency campaign in the same way Gibbons v. Ogden made federal regulation of interstate commerce possible.  

The other then-and-now difference is that the battle over creating the ICC was fought on its merits: What, if any, limitations should be placed on the economic power of railroads?  Today’s battle is being fought by indirection, using corporate fiscal resources to influence Congress and the federal courts to choke off agencies’ fiscal resources.  The results in the CFSA case at the district court and Fifth Circuit suggest that tactic is being used because a direct attack on the agencies’ jurisdiction is a surefire loser.

Samuel Clemens is credited with the saying, “history does not repeat itself but it often rhymes.”  Whether and when rhyming happens cannot be known.  For all of today’s S.J. Hawkinses working to earn their keep in family-owned business we hope it occurs sooner rather than later.

[1]Hawkins’ ability to prosecute the cases himself was undoubtedly aided by his experience as a station agent for the Lake Shore and Michigan Southern Railway in the 1890s before opening his own business as a dry goods merchant in Norwalk, Ohio.  Both cases were decided Apr. 23, 1902.  Catalogue of United States Public Documents, No. 90, June 1902, available at https://www.govinfo.gov/content/pkg/GOVPUB-GP3-477328a1f2e0a5134869618fa37b6e3a/pdf/GOVPUB-GP3-477328a1f2e0a5134869618fa37b6e3a.pdf.

[2] 22 U.S. 1 (1824).

[3] Case No. 22-448, argued October 4, 2023.

[4] www.cnbc.com/2021/02/16/may-shows-typical-payday-loan-rate-in-each-state.

[5] Id.

[6] https://www.pewresearch.org/short-reads/2023/09/13/congress-has-long-struggled-to-pass-spending-bills-on-time.

[7] Citizens United v. Federal Election Commission, 558 U.S. 310 (2010).

Skyfall

When corporate accounting fraud comes to light, it feels like the sky is falling.  Suddenly, accepted business practices are cast into doubt.  Trustworthy people are revealed as rogues.    Everybody in the enterprise is suspected as being complicit until proven otherwise.  It becomes difficult to know what and whom to trust.

In the U.S., Enron remains the largest fraud ever. Executives Ken Lay, Jeff Skilling and Andy Fastow were convicted or plead guilty to financial crimes.  Lay died of a heart attack before he could be sentenced.  Skilling served 14 years and Fastow five.  Also crushed by Enron’s collapse was Arthur Andersen, which audited Enron’s financial statements, and numerous private companies whose credit exposure to Enron exceeded their net worth.

Europe today is sorting out its own Enron-scale accounting scandal. The case has received scant attention in the U.S. 

Wirecard was an electronic payments company founded in 1999 just before the dot.com market crash.  Its early history was rocky.  In 2002, investor Markus Braun bought the business and began processing payments for porn and internet gambling operators, business VISA and Mastercard refused to handle for Wirecard because it was illegal in some jurisdictions.  Wirecard’s staff substituted transaction codes for legitimate types of merchants.  The problem was solved, but the die was cast.

In December 2004, Wirecard carried out a reverse IPO, merging with a company whose shares were already owned by the public and listed on the German stock exchange equivalent of our Nasdaq.  The public company took Wirecard’s name and Wirecard avoided the legally rigorous process of registering its own shares in an initial public offering.

A series of acquisitions followed—nearly all of them in foreign nations with lax or nonexistent financial regulatory regimes, including Singapore, UAE, China and the Philippines.  Wirecard also established relationships with “partner” firms that were nominally independent.  The international business units became the wheelhouse of the fraud.  When Wirecard admitted in 2020 it could not “find” its own money, the “missing” funds totaled €2 billion. 

Functionally, the fraud resembled a multiparty check kiting scheme, only the payments were electronic rather than by paper checks.  Money was sent on a “round-trip” from Frankfurt to overseas Wirecard and partner firms who eventually routed it back to Frankfurt.  Wirecard also claimed it had €1.9 billion of escrow fund balances at two Philippine banks when in fact it had none.

In April 2015, Britain’s Financial Times newspaper began publishing stories questioning Wirecard’s business practices.  Wirecard responded ferociously.  The company enlisted German political and regulatory officials to open investigations of, and bring criminal charges against, Dan McCrum, the lead FT reporter.[1]  He, his wife and children, and other FT journalists were surveilled and threatened with violence by hoodlums allegedly in the employ of one of Wirecard’s law firms.  Other Wirecard law firms in England and Germany sued the FT, seeking damages equal to the decline in market value of Wirecard’s stock as the scheme began to come undone.

              In the end, as in Enron, the scheme unraveled because Wirecard employee whistleblowers fed the FT information about where to look for criminal activity.  With the results of their work, FT reporters constructed a roadmap of the fraud.  E&Y’s audit failure led to its being banned from auditing German public companies for two years.  Wirecard CEO Braun’s trial is ongoing at present. 

COO Jan Marsalek, the executive who directed the fraud, let his ties to Russian oligarchs and the GRU security service there be known to his associates as a means of intimidation.  He is now a fugitive rumored to be living in Belarus.  While the fraud was ongoing, he would mount counterintelligence operations using shady characters in an effort to compromise FT personnel.  Too, he was said to possess the formula for Novichok, the poison the GRU used to kill Russians living in England whom the Putin regime viewed as political risks.

              As always, the question is how could so many smart people be duped for so long?  We have regularly written that financial frauds need to be understood as dramas where, as the British unprotected railroad crossing sign says, “One Train Hides Another.”  Two completely opposite behavior patterns coexist—one that exudes success and moral rectitude while the other is a crime wave.

              Accountants, lawyers, investment bankers and business consultants seek plausible explanations for transactions that seem a bit off.  Inevitably, fraud perpetrators offer exactly that—plausible explanations.  What the interrogators miss is that truth is the polar opposite of what is claimed, not just a little bit off.  They are drawn into the drama and convince themselves all is above board.

              As we have also written, technology is a perpetrator’s most valuable weapon in today’s world.  It makes implausible schemes plausible.  A modest example: Oakwood Deposit Bank in a town of 700 people in Northwest Ohio failed in 2002 after the CEO embezzled $40 million.  He claimed the bank was successfully attracting deposits from customers far and wide via the internet.  Without the internet claim, he would have needed to gather deposits from households in a three-state area to create the deposit base he said the bank had—a physical impossibility.[2]  Technology’s extra value is as a force multiplier, making it possible to commit fraud on a scale that would otherwise be impossible and to build the fraud quickly.

              Post-Wirecard, European legislators and regulators have adopted many of the Sarbanes-Oxley Act’s requirements.  Although they are useful measures, they cannot and will not prevent financial fraud from taking place.  Fraud is always a story of human failings.  The Wirecard story includes many suckers and fools, most of them lawyers, accountants and investment bankers working for leading capital markets participants, including the German government.  There are only a handful of heroes, particularly Wirecard employees who quit in disgust and then found it difficult to find employment elsewhere because Wirecard defamed them to prospective employers.

              A late friend of ours, Gene Maloney, was an executive at Federated Investors and a devout Christian.  Gene paid his own way every week to teach ethics to business students at Boston University because he believed doing so was important community service.  Talking together one day in the year after Enron, I said to Gene, “Discipleship is costly, isn’t it.”  He replied, “You bet it is; but it’s well worth the investment.”

[1] McCrum’s account of the scandal is Money Men: A Hot Startup, A Billion Dollar Fraud, A Fight for the Truth, published by Penguin Press in 2022.

[2] https://www.washingtonpost.com/archive/politics/2002/04/07/ohio-bank-goes-bust/122d7cb0-52f9-4814-9f61-6445d1f9b38d/

FedNow, KPI and Transparency

The Federal Reserve System’s peer-to-peer payment system, FedNow®, debuted July 20, two decades after PayPal went public, creating the category of electronic payments for consumers and small businesses.  PayPal holds pole position in the industry: 37% of surveyed American consumers say they used the service in 2022.  Fifteen percent said they used Venmo, owned by PayPal.  The next three most frequently used services were ApplePay, GooglePay and AmazonPay, each with 12%.[1]  Meanwhile, “The global P2P payments market size was worth USD 2,219 billion in 2021. It is expected to reach USD 8,078.81 billion by 2030, growing at a CAGR of 17.53% during the forecast period (2022–2030).”[2] 

Zelle, the instant payments system developed by American banks, handled 2.3 billion payments with a total value of $629 billion in 2022.[3] 1,700 U.S. banks offer Zelle, 33% of all banks.  The system’s growth lately has been among banks having under $10 billion in assets, community banks in other words.

Given this market landscape, it’s fair to ask whether FedNow can succeed.  Presently there are just 26 participating banks and credit unions.  Of these, two are behemoths, JP Morgan Chase and Wells Fargo.  Two are top 10 institutions, BNY Mellon and U.S. Bank.  And the rest are community institutions, 15 banks and seven credit unions.

Culturally, the Fed is accustomed to holding the high ground.  Sales and marketing are not its forté.   Banks and credit unions seldom mix well.  And as a matter of functionality, processing speed for FedNow transactions is unlikely to be faster than commercial services like PayPal or Zelle. 

How can FedNow overcome those hurdles to market acceptance?  In a word, “transparency.”  Few words in our business and political dictionary today have a more muddled meaning.  Every company and candidate for elected office promises transparency.  Time and again, though, it is an empty promise.  Plug the word into a Google search alongside the name of a P-to-P payment service.  The results are either platitudes promising transparency or news of litigation settlements in which the companies are paying claims for not delivering it.

A leading example of this dichotomy between promise and performance came during Congressional testimony earlier this year concerning the bank-owned Zelle payments system.  Many banks refused to reveal to Congress the number and value of fraudulent Zelle transactions they handled.  Those like PNC that did disclose data proved the customer fraud issue is pervasive and growing.  Complaints are rampant that banks almost always force their customers to bear the loss in fraud cases.  The banks that own Zelle say they are working on the problem.  Meanwhile it persists.

The Fed’s and participating financial institutions’ opportunity with FedNow is to not just copy commercial services, but to innovate a new service-level standard.  Financial institutions and their regulators create and track myriad so-called Key Performance Indicators.  Ratios abound, covering capital, liquidity, profitability, efficiency, and so forth.  Why not create a set of metrics for P-to-P payment systems and publish the results?  Strive to make FedNow the gold standard among payment systems.  Challenge commercial services to reveal their KPIs.  Shame them into doing better by and for their customers.

It worked for airlines.  In the 1980s, after the industry was deregulated, carriers’ flights were almost always late on arrival.  Beginning in 1987, they reported on-time performance and flight delays to the U.S. Department of Transportation.  They adjusted their schedules so they could meet assigned arrival times.  And at least that aspect of air travel is less painful than it used to be.

It worked for auto makers.  J.D. Power & Associates’ rankings of auto brands’ build quality and service reliability have been a staple of automotive marketing since Subaru in 1984 first paid Power to use its results.  J.D. Power III founded the company in 1968 at his family’s kitchen table.  In the early days, the Associates were his wife who did market research and their children who stuffed envelopes.  In 2019, a Chinese-backed buyout fund sold the company to U.S. private equity firm Thoma Bravo for $1.8 billion.

Power today publishes an annual survey of retail banking customer satisfaction.  Seven criteria are measured including trust, problem resolution and convenience.  Power’s survey though is handicapped by its inability to access banks’ internal data on KPIs.  For example, what percentage of customer refund requests based on claims of fraud are paid?  What is the average response time to resolve claims?  What percentage of late fees are waived for customers whose relationship profitability exceeds established thresholds?  What decisions are made strictly based on algorithms despite advertising that touts an institution’s community-centric brand?  Well run financial institutions have all that data at hand and could share it if motivated to do so.  Those that do not want to self-report such data should bear the consequences in the market.

There is no reason the Fed cannot promote truth-in-electronic-financial-services as it did truth-in-lending in the 1960s.  Whether the Fed itself or a private company is the data repository and purveyor of comparative analysis does not matter.  It does, however, need to be a party outside of the banking/shadow banking system.  High quality financial institutions and their customers will all be better served as a result. 

[1] https://www.statista.com/chart/27785/most-popular-digital-payment-services-united-states.

[2] https://www.globenewswire.com/en/news-release/2022/08/25/2504945/0/en/.

[3] https://www.zellepay.com/press-releases/financial-institutions-joining-zelle-networkr-increased-40-2022.

Easy and Fast

According to the Federal Reserve System, noncash payments more than doubled in the last 20 years, totaling $128.5 trillion in the U.S. in 2021.[1]  For the four years 2018-2021, Automated Clearing House (ACH)[2] payments grew $27.2 billion, credit and debit card payments grew $2.3 billion and check payments grew $0.5 billion.  Thus, ACH represents 91% of non-cash transaction growth.  “Both ACH credit and ACH debit transfers grew more than 12 percent per year in value from 2018—faster value growth than card or check transactions,” according to the Fed.

This growth has spurred a significant increase in inquiries from our legal clients about electronic funds transfers.  Inquiries fall into three groups.  “Is this fintech service being pitched to me legit and how does it really work?”  “I am having difficulty using this service; what am I doing wrong?”  And “I got scammed; help me get my money back, now!”

Sadly, the third group predominates, evidence that marketing dwarfs risk disclosure in fintech companies’ presentation of financial innovations to prospective customers.  Websites claim their companies’ products are “seamless,” “frictionless,” “virtual,” “agile,” “resilient,” or all of the above.  If you sign up, you are destined to have an “awesome” experience. 

In place of cliché words should be disclosures about customers’ risk of loss, whether funds are protected by FDIC insurance while in the hands of non-bank financial companies, and how to get money back if you need to reverse a transaction, including directions for how to reach not an AI-enabled robot, but a human operator with authority to take prompt corrective action rather than just record your complaint. 

Another complication is the absence of a unified and internally consistent body of law governing non-cash financial transactions. 

·       Paper checks are governed by Article 4 of the Uniform Commercial Code (UCC), a state-level law first published in 1952 and adopted, with minor variations, in all 50 states.  Its rules, since updated, are simple.[3] 

·       Credit card transactions, also a 1950s innovation, are covered by at least six federal statutes, including the Fair Credit Billing Act of 1974 and the Fed’s Regulation Z, which governs interest rate calculations and disclosures.

·       1970s era Regulation E sets terms for debit card transactions.  It watered down the rules governing credit cards when it comes to claims for refunds.

·       Wire transfers and ACH payments have long been used for transactions among big business and financial institutions.  They are subject to Article 4A of the UCC, enacted in the early 1990s.  Since the turn of the century, small business and consumers have been drawn to wire and ACH transactions by Internet-based money transfer services like PayPal.

Who bears the risk of loss, and the maximum amount that can be lost, varies depending on which law applies.  Federal law limits to $50 losses from unauthorized credit card transactions, including those resulting from lost or stolen cards.  Credit card issuers seldom highlight this benefit to customers; but it is the strongest protection available for non-cash transactions. 

Debit card users can be at risk under Regulation E for the entire balance in their bank account to which the debit card is linked.  Under Regulation E’s requirements, cardholders must keep track of their cards and promptly notify the issuers of the cards’ loss or theft in order to be protected against losses.  The rising tide of losses in recent years has made banks less customer-friendly about refunds than they used to be.

Mostly unknown to small businesses and consumers is the UCC loss sharing regime applicable to wire and ACH funds transfers.  The essential feature of these transfers is their instantaneous effect.  The money is good upon receipt at the “beneficiary bank.”  The UCC permits the sender’s bank, the “receiving bank,” to reverse or “recall” erroneous transactions.  But the law places the burden on the receiving bank to satisfy the beneficiary bank about the bona fides of the recall request, including requiring the receiving bank to indemnify the beneficiary bank for any loss it experiences if it refunds the money and then gets sued by its customer.  For that reason, immediate action to recall an erroneous or fraudulent transaction is essential.  Once the beneficiary bank funds the customer’s account, rare is the case when the receiving bank and its customer recover the misdirected money.

Payment services like Venmo (owned by PayPal) describe the basics of the Article 4A risk allocation scheme in their user agreements.  Venmo’s agreement though is 27,800 words long, up more than 11,000 words since the pandemic.  Nobody but lawyers paid to do so read agreements that long or complicated.  Because the agreements are so thoroughly rooted in banking law and regulation, lay people of average aptitude haven’t a prayer of understanding the agreements even if they read them.

The dramatic rise in scams involving electronic transfers[4]  has prompted a commensurate rise in litigation.  In a recent local case,[5] criminals induced a title insurance company handling the refinancing of a $7 million loan for a suburban Pittsburgh office building to send loan payoff proceeds to a “spoofed” bank account at a large local bank.  The criminals set up the receiving account to look legitimate, including opening the account in the name of the lender whose loan was being paid off.  Quick legal action by the title insurance company led to court orders freezing that and other accounts to which the criminals transferred the stolen money.  Recovery of the money itself though will take months or years of investigation and litigation as the banks involved grind through their internal procedures according to UCC Article 4A.

The proliferation of so-called fintech companies that provide electronic financial services also raises the risk that funds in their hands are not FDIC-insured.[6]  The FDIC created “pass-through” insurance to insure accounts of customers of payment services such as Venmo.  Fintech companies that desire to offer pass-through FDIC deposit insurance must be approved for that purpose and must maintain sub-accounts in the name of each customer tracking funds kept with their company.  Big e-payment companies like Venmo now view pass-through insurance as a necessary part of their product offering; smaller ones often do not.  Because venture capital financing has recently become scarce, there is greater risk today that venture capital-funded fintech companies will go bankrupt when they run out of capital and their customers’ funds will be lost as a result.

A business and legal culture that tolerates fraud as a cost of doing business is a final impediment to safety and soundness of electronic financial services.  Banks chronically understaff operations centers responsible for investigating fraud.  They view investigating fraud as a cost with no business benefit to themselves. Legislators and regulators have not held the industry accountable for customers going home empty-handed most of the time.[7]  The Consumer Financial Protection Bureau this spring published cautionary guidance about the prevalence of fraud and consumers’ need to take precautions.  Absent enforcement action against nationally recognized financial intermediaries, the CFPB guidance is just “wind over the buffalo grass,” in the words of a Sioux proverb.

The pervasiveness of the problem came home to me recently.  I received an email from the Giant Eagle grocery company, asking about my customer experience July 2 at their Wilkinsburg, PA, convenience store.  I called the corporate office July 3 to say neither my wife nor I left our home across the Allegheny River from Wilkinsburg on July 2. 

The customer service representative explained our home phone number associated with a loyalty program account was entered at a point-of-sale terminal at the Wilkinsburg c-store and $3.00 was downloaded and applied to a purchase that was paid for with a debit or credit card.  I asked how that could happen.  “Likely, it was someone mis-entering digits on the keypad,” said the operator.  “Likely, it was someone fraudulently accessing my money,” said I.  “How often does this happen?” I continued.  “It happens with some frequency,” the operator replied evasively.  “But don’t worry; we will credit your account for $3.00,” she said brightly.  When I told my sister in Ann Arbor of the experience, she said her husband recently had the same thing happen to him at a coffee shop he favors.  His loss was about $50 from his loyalty rewards account.  The upshot: today, no amount is too small to be stolen and it’s not difficult to do.

Until we as a society take financial fraud seriously, by investing the resources needed to shut it down, we will continue to be our own worst enemies.  The top-20 U.S. banks and the government (Federal Reserve, OCC, FDIC and CFPB) should take the lead by cleaning up the fraud problem at the bank-owned Zelle® payment service and using that as a template to rewrite the law to reflect market realities cited at the beginning of this blog post.  Leading state financial regulatory agencies (e.g., New York, California, Texas, Pennsylvania and Illinois) and the Independent Community Bankers Association need to have input too, so K Street lobbyists do not tilt the scale completely in favor of big banks and big business.  Our financial e-commerce system “needs fixed,” as they say in Pittsburgh.  Done well, the fix can effectively serve us all.

[1] “The 2022 Federal Reserve Payments Study in Four Charts,” Take on Payments Blog of Federal Reserve Bank of Atlanta, June 26, 2023, available at https://www.atlantafed.org/blogs/take-on-payments

[2] The nation’s 12 Federal Reserve Banks and Electronic Payments Network (EPN) are the two national ACH operators.

[3] Under § 4-406(c), “If a bank sends or makes available a statement of account or items . . . , the customer must exercise reasonable promptness in examining the statement or the items to determine whether any payment was not authorized because of an alteration of an item or because a purported signature by or on behalf of the customer was not authorized.”  In practice, this means customers have up to 30 days to identify fraudulent checking account transactions.

[4] See the earlier installment of this blog titled, “Internet Banking and Multifactor Authentication,” January 12, 2023.

[5] Fidelity National Title Insurance Co. v. JPMorgan Chase Bank NA et al., case number GD-23-007127, in the Court of Common Pleas of Allegheny County, Pennsylvania.

[6] CFPB Finds that Billions of Dollars Stored on Popular Payment Apps May Lack Federal Insurance, CFPB Press Release, June 1, 2023, available at https://www.consumerfinance.gov/about-us/newsroom.

[7] Tristan et al. v. Bank of America NA et al., case number 8:22-cv-01183, in the U.S. District Court for the Central District of California.

Farm Aid

With the debt ceiling hurly burly behind it, Congress must now turn to more prosaic pursuits, including crafting the 2023 Farm Bill, due in September.  Enacted every five years since 1933, this legislation shapes agricultural economics in ways large and small. 

Under the last Farm Bill, adopted at the end of 2018, total federal funding on agriculture for the years 2019-2023 is projected to be $428 billion.  It would be an epic mistake for Congress to simply roll the priorities embodied in that law forward given what we have experienced since 2018: the Covid pandemic, the Ukraine war, chillier relations with China (which imported $36 billion of American ag products last year, a >3x increase over the 2019 level), increasingly severe weather events, unintended invasive insect introductions (e.g., Spotted Lanternfly), and mounting pressures on Western states’ scarce water resources.

The political bargain reflected in Farm Bills of the last 50 years has been federal funding of colossal growth in agricultural output, especially corn and soybeans, at the expense of family farms, and soil and water quality.  Political support from farm-state Congressmen has been directed by major agribusinesses, including Monsanto, Cargill, ADM, John Deere and Pioneer (a seed company).  Non-farm-state Congressmen have backed successive farm bills because 70% of the funds go to SNAP, formerly food stamps, for low-income Americans.

States have used federal funding to advance their own interests.  For example, California in the 1990s and 2000s funded creation of super-sized corporate dairy farms/factories.  California wagered it could do in dairy what it did in wine—take over the #1 position at the expense of farmers in New York, Pennsylvania and Wisconsin.  The strategy worked.  Today, California is funding innovations designed to reduce methane emissions from dairy and beef herds, believing that will win favor with consumers who shop with one eye on environmental stewardship.

Why should we care how the 2023 Farm Bill divides the fiscal pie or how our states use their shares?  Because the Green Revolution of the late 20th Century—dramatically higher yields due to heavy use of chemical fertilizer, pesticides and herbicides—has run its course.  Needed now are new technologies that preserve and protect natural resources essential for agriculture.  Robotics, energy conservation and land conservation all deserve greater support in the 2023 Farm Bill.  Conservation measures in prior bills have always been oversubscribed by farmers who desire to participate.  Robotics offer the prospect of improved yields using constant levels of natural resources.  Given our region’s prominence in robotics, we are in an ideal position to lead this effort. 

Exhibit A is Bloomfield Robotics, a company born of research at Carnegie Mellon University.  The company’s website says its computer vision technology when fitted to farm tractors “combines plant-level imaging and deep learning to assess the health and performance of every plant, at any scale continuously, with extreme precision and accuracy.”  Japanese farm implement company Kobota is among the investors in Bloomfield’s latest funding round.

Exhibit B is Fifth Season, another CMU-generated venture.  Fifth Season failed financially, as did two much larger vertical farming businesses, Kalera in Florida in April and AeroFarms in Virginia and North Carolina on June 8.  Vertical farming is promising technology to be sure.  Its Achilles Heel is the cost of production exceeds the cost of field-grown crops given current levels of federal support of that form of agriculture.  In Canada, 15,000 acres are devoted to greenhouse production of tomatoes, peppers and cucumbers.  The Netherlands is the world leader in controlled environment agriculture.[1]

Indoor agriculture using robotics also has the potential to eradicate agricultural child labor.  Big agricultural interests have long protected the exemption of children as young as 12 years old from the minimum wage requirement of the Fair Labor Standards Act.  As a result, children working in the fields on farms where their parents are also employed are paid as little as $2.00 to $3.00 an hour.[2]

Exhibit C is Fruit Scout, a Yakima, Washington-based company that uses computer vision to automate projection of fruit yields for Northwest U.S. fruit growers.  The company’s website claims, “FruitScout uses AI and computer vision to analyze photos you take of buds, blossoms, fruitlets, and fruits. Counts and sizes are calculated automatically, making sure you always know where your crop stands, from bud to bin.”

All three ventures are solutions that help agriculture stand against the natural consequences of severe weather and increased pest pressure.  The problem they share is they need more money to scale their businesses than private equity sources are willing to provide.  Meanwhile, federal funding is committed to preserving the status quo. 

Noting the 2018 Farm Bill’s allocation of just $694 million to research and development (0.16% of the legislation’s total funds), FarmAid.org offered this commentary: “Funding for public agriculture research in the U.S. has declined significantly in recent decades. Meanwhile countries like Brazil and China have increased investment in public research by as much as five times. While policymakers tend to agree that policy is crucial, when it comes to committing money to it, their enthusiasm wanes. For instance, the 2018 Farm Bill created the Agriculture Advanced Research and Development Authority (AGARDA) as a pilot program, modeled after the high-tech military research agency, the Defense Advanced Research Projects Agency (DARPA). Congress authorized using as much as $50 million a year on AGARDA, but the project just received its first $1 million in 2022.”[3]

DARPA is the foundation for much of the success of CMU, its peer academic institutions and the companies they have spawned.  Addressing challenges American agriculture faces via AGARDA requires a DARPA-like sense of urgency and financial commitment from Congress.  State departments of agriculture and economic development similarly need to up their game.

We can achieve a future that serves the world’s food needs with greater efficiency and better stewardship of precious resources.  Needed though is a sense of purpose and urgency, not just a rerun of the last fifty years’ spending on programs whose time has passed.

[1] https://www.washingtonpost.com/business/interactive/2022/netherlands-agriculture-technology/

[2] http://www.ncfh.org/child-labor-fact-sheet.html.

[3] https://www.farmaid.org/issues/farm-policy/farm-bill-101/

Reshoring Requires Reinvestment

              Interviewed late in his life, Richard King Mellon (son of Richard Beatty Mellon and nephew of Andrew Mellon) was asked why his family moved to reduce industrial pollution in Pittsburgh more than two decades before Congress enacted the Clean Air Act and Clean Water Act.  Mellon’s answer: the family was motivated less by altruism than by self-interest.  Out-of-town managers and executives offered opportunities at Mellon-controlled companies declined them due to the city’s deplorable condition.

              Mill communities around Pittsburgh fared less well.  In 1971, the year after R.K. Mellon died, ALCOA abandoned its first and largest aluminum manufacturing plant, located in New Kensington, 20 miles up the Allegheny River from Pittsburgh.  Aluminum City was the community’s nickname.  The plant closure initiated a death spiral for the community, now officially an Opportunity Zone under the Tax Cuts and Jobs Act of 2017.  Opportunity Zone is a designation reserved for the most economically distressed communities in America.

              Ten days ago, Pennsylvania Governor Shapiro and regional civic leaders announced plans to spend $81 million to attract advanced manufacturing businesses to 175,000 square feet of the former ALCOA plant, approximately four acres.  Pennsylvania’s share will be $30 million.  Private parties will provide the rest.  At the project’s center is Re:Build Manufacturing, an eleven company enterprise recently assembled by movie mogul and Pittsburgh native son Thomas Tull. 

According to its website, “Re:Build’s goal is to help revitalize the U.S. manufacturing base over the coming decades, creating substantial opportunities for our employees and the communities where we operate. We aim to do that by building America’s next great industrial company—growing a family of businesses that combine cutting-edge enabling technologies and operational superiority in aerospace and defense, cleantech, health, industrial equipment, lifestyle, and mobility. Our expertise is in product innovation, advanced components, systems production, and industrial automation.”

Tull’s challenge is no less daunting than R.K. Mellon’s when he surveyed post-WW II Pittsburgh.  Re:Build’s 16 operating principles are a critique of capitalism as practiced by Wall Street since 1980.  Thus, Principle 02 begins, “Machiavelli was wrong! Winning at all costs is not winning at all.”  Principle 08 implicitly indicts private equity funds: “We buy businesses to build them over the long-term. We do not buy businesses with a plan to sell them.”

Our 40 years of experience creating, reviving and sustaining businesses in this region says platitudes are cheap.  Defining what we call “the art of the possible” and achieving it is what matters.  As the president of a 300-employee manufacturing company on the Ohio River said to us, “You are telling me you will accomplish in six months what I have tried and failed to accomplish for the last decade.”  To which we responded, “Yes, that’s right.  Not because we are smarter or harder working than you, but because we are not you.”

The last of the Mellon-owned businesses to be dismembered was the Mellon Bank.  Former executives have told us then-CEO Marty McGuinn sold the retail bank because he concluded he could not change the entitlement culture of employees.  As evidence he was correct, a former colleague was commissioned by the bank to survey employees about the bank’s health insurance.  Survey results showed most employees considered their insurance coverage to be the least generous among Pittsburgh companies.  In fact, it was the most generous. 

As another example, a banker considering purchasing the plum retail locations Mellon kept despite the sale to Citizens Bank stopped at one such location and asked to deposit $1 million.  “You will have to go downtown for that,” said the employee who waited on the banker.

All of which is to say the New Kensington project leadership will need to inculcate in employees and community members alike the belief that Re:Build Manufacturing is not a jobs program put on by rich carpet baggers.  Rather, everybody must reinvest—in themselves, their employers, and their community and region.  That is a difficult message to hear and embrace.  Yet only if that behavioral foundation is laid can the rest of the initiative succeed.

Moonshot

              In December, I read that a team of five students from my high school in Delaware, Ohio, had entered NASA’s national App Development Challenge for high school students.  The competition’s requirement was to write software to enable lunar exploration by robotic rovers that will be sent to the Moon in NASA’s Artemis program, now underway.  A Moon landing by a human crew is planned for 2024.

              I wrote to the students’ math teacher and mentor, Ms. Joanne Meyer, to suggest they and she might enjoy visiting Pittsburgh to meet people working behind the scenes to make Moon travel a reality again.  She and the students agreed.

              Last week they arrived—now one of three winning teams, and the only one from a public high school.  In mid-April, NASA flew them to Houston where they presented their work to NASA brass and toured NASA’s training and development facilities.  For their two day Pittsburgh trip, I arranged for them to visit Carnegie Mellon University, the Moonshot Museum on the city’s North Side (adjacent to Astrobotic, the company that build the Peregrine lunar lander that will go to the Moon in a matter of weeks), the CMU-affiliated National Robotics Engineering Center, and VEX Robotics, a CMU-spinout company that develops robotics curricula for K-12 education.

              The students—Rosemary Cranston, Adam Fronduti, Paul Gabel, Jacob Payne and Meg Wolf—are a vibrant admixture of smarts, curiosity and budding awareness of their own life potential.   Ms. Meyer is a proud mentor who savored seeing her charges swap ideas with their hosts.  The hosts explained their work and engaged the students as peers—the ultimate compliment to the students.

              My goal in arranging the tour was to introduce the students to the work that underlays NASA space missions and to associated career opportunities.  My co-host, Dr. Lynne Porter, is an Executive-in-Residence at CMU who mentors students developing robotics there.  She is also a graduate of Ohio Wesleyan University in Delaware, Ohio, the students’ hometown.

              After our Monday site visits, we ate lunch together and I shared excerpts of President John Kennedy’s “Why We Go to the Moon” speech at Rice University in September 1962.  Cold War tensions were peaking, the Cuban Missile Crisis was six weeks in the future, and Americans fretted the Soviet Union had put a cosmonaut into Earth orbit first—Uri Gagarin in April 1961.  Polls showed 58% of Americans questioned whether the U.S. space program was worth the cost.  Former President Eisenhower opined, “Spending $40 billion to go to the moon is nuts.”

              Aware of the political capital Kennedy had at stake, speechwriter Ted Sorensen delivered a tour de force.  The speech opens with an historical perspective. 

            “Condense, if you will, the 50,000 years of man’s recorded history in a time span of about a half a century. . . .  About 10 years ago, under this standard, man emerged from his caves to construct other kinds of shelter. Only five years ago, man learned to write and use a car with wheels. Christianity began less than two years ago. . . . Only last week, we developed penicillin and television and nuclear power. This is a breathtaking pace and such a pace cannot help but create new ails as it dispels old. . . .

“So it is not surprising that some would have us stay where we are a little longer, to rest, to wait. If this capsuled history of our progress teaches us anything, it is that man in his quest for knowledge and progress is determined and cannot be deterred.”

Then comes the payoff pitch, Kennedy’s challenge to his audience that is now a staple of television histories of space exploration. 

 “We choose to go to the moon in this decade and do the other things not because they are easy, but because they are hard. Because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we’re willing to accept. One we are unwilling to postpone.”

              Kennedy was the first American president born in the 20th Century.  Our student visitors are among the first generation born in the 21st.  In a time when we feel beset by internal political divisions, China’s bid for economic and military parity with the U.S., the recent pandemic and other challenges, Kennedy’s message should comfort and inspire us anew.  With young people like Rosemary, Adam, Paul, Jacob and Meg rising to lead us, we can have confidence in the future they will create.

Why Me?

Community bankers in unison have said their banks should not have to pay the special insurance assessment the FDIC plans to levy to cover the $22 billion cost of the Silicon Valley and Signature bank failures.  Late last month, the Biden Administration said it agrees with the bankers.  The FDIC’s special assessment proposal is due in May.

The bankers are running the same playbook that worked in the last crisis: “We did not create the problem; so, we should not have to pay to fix it.”  The 2010 Dodd-Frank Act, as amended, exempts community banks from many of the law’s most costly requirements, like writing living wills that lay out how to liquidate the business in a crisis.  Independent Community Bankers Association CEO Cameron Fine was famously effective lobbying Congress to win that result.  After all, every member of Congress has at least one of the nation’s nearly 5,000 community banks in his or her district.

The bankers’ position is understandable as a matter of human sentiment.  In today’s environment though, it is not in their, or our, economic interest to exempt a numerically large class of financial institutions from helping replenish the FDIC Bank Insurance Fund. 

Deposits in U.S. banks were $17.6 trillion at February month-end.[1]  A $22 billion special FDIC assessment equates to $0.00125 per dollar of deposits—one tenth of one cent—if spread across the entire deposit base.  More than $6 trillion of deposits are held at four banks: JPMorgan, Wells Fargo, Bank of America and Citibank.  The next 25 largest banks collectively hold roughly $5 trillion.  So, if the FDIC apportions a $22 billion assessment among only the 30 largest banks, the cost will be $0.002 per dollar of deposits they hold.  That is $10 per $5,000 of deposits, less than a third of what most banks charge retail depositors for a checking account overdraft.  In other words, hardly enough for customers to notice, especially if the assessment is payable over several years.

The community bankers’ objection is virtue signaling, not a financial imperative for their institutions or customers.  Potential adverse consequences could ensue.  Would larger banks extract a price for bearing the burden alone?  Suppose they impose higher pricing for liquidity lines of credit they provide to smaller banks.  Or share less of the interest rate spread on loan participations they sell to smaller banks.  Or extract higher fees for services they provide smaller banks, like facing letters of credit.  The ways to get even are many. 

The FDIC too might extract a price for community banks’ standing aside.  Suppose the FDIC insures community bank deposits up to $250,000 while offering $1 million of insurance to depositors at systemically important financial institutions (SIFIs in the Dodd-Frank acronym).  What would that do to deposit flows?

Exempting community banks from an FDIC special assessment could feed public perception that community banks are held to a lower standard of safety and soundness.  Some members of Congress and media outlets attributed the problems at SVB and Signature to their being “regional” banks not subject to Dodd-Frank requirements applicable to SIFIs.  That misinformation tanked share prices of financially sound regional institutions like Key and Huntington national banks.  Misperception became painful reality—quickly.

Most fundamentally, the premise of FDIC insurance—or any insurance scheme—is that by spreading risk and losses, all members of the insured group absorb losses in amounts that are tolerable, avoiding a cascade of failures induced by panic.  The more finely risks and losses are parsed, the less likely the whole insured community will be willing to bear them. 

We already have a large and growing shadow banking system, which now includes thousands of fintech companies whose risks are poorly understood and nowhere quantified.  Who knows what hand grenades are tucked inside their picnic baskets?  Exempting community banks for sharing losses heads us in the wrong direction.  Rather, we should cast a wider net, bringing all institutional participants in the financial economy into the risk and loss sharing scheme of financial system insurance.

[1] https://www.ceicdata.com/en/indicator/united-states/total-deposits#.

Innovation Matters

Eighteen years ago, at the request of Pennsylvania Governor Ed Rendell, Renaissance Partners developed a business plan to save >400 manufacturing jobs at Pennsylvania House Furniture in Lewisburg, Pennsylvania.  The company had a proud history since 1887 making case goods—dining room tables, chairs, coffee tables, end tables, sideboards, buffets, china cabinets, beds, dressers and other items—all from Pennsylvania hardwoods, especially cherry.  In 2004, Pennsylvania House gross revenues were $75 million.  Its Lewisburg facility was 15 acres under roof, on 41 acres of land.

La-Z-Boy Furniture owned Pennsylvania House at the time, the sixth corporate owner in 35 years.  Two years was the average tenure of company presidents in the 15 years that preceded our work.  Governor Rendell directed us to find a way to save the business after La-Z-Boy announced it would close the Pennsylvania operations and send production to China.

La-Z-Boy publicly said it would support a plan to save the American jobs.  When we presented our plan, which included equity investment from a fund backed by Pennsylvania employees and teachers retirement systems, La-Z-Boy reversed course.  The company refused to sell at any price the most valuable assets, including the registered trademark “Pennsylvania House” and the distribution network of retailers. 

After production moved to China, retailers steered customers away from Pennsylvania House products, saying manufacturing quality had declined.  Today, all that’s left is the registered trademark (owned by a Chinese company) and the ability to purchase vintage Pennsylvania House pieces from used furniture dealers.  

The wider story is Pennsylvania employment in the hardwood products industry fell 33% in the last 15 years, from 90,000 jobs to 60,000.  From furniture to flooring, quality materials and construction have been sacrificed on the altar of big box store sales of poorly made goods at hefty prices.  This phenomenon is detailed in an article titled, “Pottery Barn Unstuffed.”[1]

So, it was refreshing last year to get to know an entrepreneurial company bucking this trend, Steller Floors of Tyrone, Pennsylvania.  https://www.floorsbysteller.com/  Steller’s founders/owners developed and patented an innovative hardwood flooring system.  Steller has received funding from both public and private investors, including Ben Franklin Technology Partners in State College.[2] 

The company exclusively uses the finest Appalachian hardwoods, which it manufactures into boards that click together using a Steller-patented fastener system.  The flooring floats, which means it can be installed over concrete floors and need not be nailed or glued into place. 

This unique system speeds installation, enables quick and easy replacement of damaged planks, and pemits flooring to be taken up and reinstalled elsewhere when commercial renovation cycles make that desirable.  To resist water damage, the boards are sealed on all six sides—top, bottom and all four sides—compared to the top-and-bottom-only coating of other hardwood flooring products.  For those attracted by tax saving opportunities, Steller flooring is eligible for accelerated depreciation under I.R.C. § 1245.

Company co-founder Dr. Britta Teller personifies the passion behind the Steller product.  “We asked ourselves, ‘How do you make a difference? How do you make sure the place you live is good?’ You have to invest in it. You pour blood, sweat and tears into it. It’s work. And we’re watching that work pay off.”

When we visited her, Britta said she was proud to have hired that day another production worker at a living wage and with full benefits.  Yes, quality costs money; but our communities gain when we set aside the “beggar thy neighbor” economics that have driven so much offshoring of U.S. goods production.

Please take a few minutes to view the Steller portfolio at the company’s website: https://www.floorsbysteller.com.  Consider the company’s product for any renovations you or those you know are planning.  The Steller team is creating jobs with a future, here in the U.S., one job and one day at a time.  Let’s give them a neighborly helping hand.

[1] “Pottery Barn Unstuffed:  A $1,200 Bed With Particle Board? Plastic Legs on a Fancy Chair?  We Took a Chain Saw to America’s Biggest ‘Lifestyle Retailers’,” Smart Money, Oct. 2006, available at http://amelydesigns.com/PDF_Files/pottery%20barn%20article.pdf

[2] https://www.benfranklin4pa.com/post/stellerflooring-company-flourishes-thanks-to-innovative-system-that-makes-replacement-easy. 

Cross Currents

In 1880, 43-year-old J.P. Morgan turned down 31-year-old Thomas Edison’s request to finance Edison’s plan to electrify a one-quarter-mile-square section of lower Manhattan.  Morgan’s domineering father and senior partner, Junius, had publicly dismissed electricity as “a fad.”  Edison went ahead anyway, using funds he raised by selling off his patent portfolio. 

Edison made sure his Pearl Street Station generating plant’s service area included J.P. Morgan’s home and the offices of the New York Times.  Invited to join Morgan and watch Edison throw a switch to get current flowing to the 85 customers who had signed up, a Times reporter filed a detailed but reserved account of the event.  Editors published it as “Miscellaneous City News”:

“The 27 electric lamps in the editorial rooms and the 25 lamps in the counting rooms [of the Times] made those departments as bright as day, but without an unpleasant glare. . . .  The light was soft, mellow and grateful to the eye, and it seemed almost like writing by daylight to have a light without a particle of flicker and with scarcely any heat to make the head ache. The electric lamps in the Times Building were . . . tested by men who have battered their eyes sufficiently by years of night work to know the good and bad points of a lamp, and the decision was unanimously in favor of the Edison electric lamp as against gas.”[1]

Commercial innovation and private capital exist in constant tension with one another.  Obituaries for Silicon Valley Bank hailed the bank for creating and sustaining an equilibrium between these opposing forces.  And for being a pillar of the Silicon Valley ecosystem. Tech industry observers have written optimistically about reviving SVB’s business.

For example, Pitchbook’s Andrew Woodman’s wrote last Friday, “Eventually, we will see a new version of SVB emerge—albeit under the auspices of new management that will likely have different priorities, and perhaps different values, than its predecessor. . . .  The concern is that any potential new owner, particularly a large, established bank, may not have the skill set, the inclination or even the risk appetite to cater to the specific needs of SVB’s startup clientele.”[2]

SVB’s success began with its location in Silicon Valley.  Among startup companies, SVB had pick of the litter.  SVB touted its cultural affinity with VCs and their portfolio companies.  Other banks tried but failed to replicate the SVB business model.  PNC, for example, created VentureBank@PNC in 1998.  After the Dot-Com bubble burst in 2001, PNC closed the venture and wrote off its loans and investments.

SVB’s business model was different.  Most banks earn most of their money on the spread between interest charged on loans and interest earned on deposits.  For this reason, loans to customers typically represent 60-90% of total assets. 

Although SVB’s loans were just 30% of its assets, the bank also made money by acquiring from business loan customers the right to buy stock at favorable prices if the businesses succeeded.  Cashing in these rights was a steady contributor to SVB’s earnings until late last year.

When SVB said it needed to raise more capital, venture capitalists believed nobody would provide it because the bank’s investment portfolio was, at today’s prices, in a loss position that exceeded the bank’s total capital.  They also believed everybody would behave as they did—demand their money immediately.  That arithmetic said the last $30-40 billion deposits were uncovered. 

A new and improved version of SVB is unlikely to emerge for four reasons.  First, the SVB business model is broken.  There will be no earnings from sales of equity investments in startup companies for an indeterminate period.  The inherent constraint of having startup businesses as loan customers—a loans to assets ratio of just 30%— means such a bank cannot achieve a competitive return on equity.  That no bank emerged to buy SVB when regulators offered it for sale ten days ago suggests a buyer will not be found.  Banks that considered acquiring SVB likely wanted the U.S. Treasury to pay the banks to take SVB. Treasury apparently said no, so potential buyers left the table. 

Second, the regulatory environment for banks has turned dark and will stay that way.  Public finger pointing now underway will disincline regulators to approve any business model that is the least bit non-standard. Silicon Valley moguls are unlikely to fund a restart of the SVB business model because they have no interest in having federal authorities pore through their personal finances, which any restart effort would entail.   

Third, a non-bank lending firm taking up the mantle of SVB is not feasible because to offer loans priced at bank loan rates, the enterprise would need to lend out 8-10 times its capital.  No non-bank financial company can attain that degree of financial leverage without taking deposits.  At that point, the business meets the legal definition of a bank and is subject to regulation as such.  See reasons one and two above.

Last, the culture of banking and the culture of venture capital are too different.  Banks take small risks.  As an accounting reserve for potential loan losses, they generally set aside one percent of the total loans they make.  If their loss ratio reaches five percent in a recession, that’s a big number.  Venture capitalists take larger risks.  They need multiple investments in a fund to pay off; but they do not generally need eight or nine of ten investments to be winners. Venture capitalists do not want to think like bankers. Bankers who think like venture capitalists do so at their peril. SVB proved that.

Junius Morgan was wrong about electricity being a fad.  Yet it was only after Edison and Westinghouse proved generating and distributing electricity was commercially viable and safe—and millions of Americans visited the 1893 World’s Columbian Exhibition in Chicago, which was lit by electricity—that the House of Morgan, and federal, state and local governments, electrified the nation. 

The objects of the game have changed.  Its most basic rules have not.

 [1] https://ethw.org/w/images/a/ae/Edison_and_Pearl_Street%2C_Text%2C_031410.pdf 

[2] https://www.pitchbook.com/news/articles/svb-successor-banks-new-management 

Taking Chicken Little's Lead

Postmortems about Silicon Valley Bank (SVB) have poured in since the FDIC took the bank into receivership last Friday morning.  SVB’s situation was so dire by Thursday night, nearly $1 billion negative cash position and $42 billion of pending deposit withdrawals, the FDIC did not wait until the end of business Friday as it usually does. 

Finger pointing and opinionating (a word a client of mine coined) have come fast and furious from knowledgeable and ignorant people alike.  Investors dumped shares of “regional” banks like Key Bank, Comerica and Huntington with no more reason to do so than commentators having tagged them like SVB as “regional” banks.  When the FDIC closed SVB, Garry Tan, the head of fabled tech company accelerator Y Combinator immediately declared it “an extinction level event.”

At the root of SVB’s problems was its dramatic intake of deposits during the Covid crisis.  Flush with cash, investors flooded venture capital funds, the funds flooded startup companies with new investment money, and the startup companies flooded SVB with bank deposits.  The bank’s balance sheet nearly doubled in size during 2021, cresting $200 billion and making SBV the nation’s 16th largest bank by assets.  Typically, bank balance sheets grow at the same rate as the national economy, 3-5% a year.

SVB bought government and corporate bonds with the influx of deposits, standard practice in the banking business.  Those bonds lost value though as the Fed repeatedly raised its benchmark interest rate.  SVB’s failure to either reduce the size of its investment portfolio or buy hedging contracts that would compensate it for diminished value of the portfolio as rates rose was its big mistake.  The bank’s management was overconfident in the tech economy and thought the $21 billion of bonds it held in its “available for sale” portfolio was a sufficient liquidity cushion should depositors want their money back.

In the barnyard parable of Chicken Little, the dimwitted chicken says the sky is falling when an acorn drops on her head.  Other animals take her statement at face value and panic.  Eventually the fox eats them all. 

Here, the bank announced March 8 it sold its AFS investment portfolio at a loss of $1.7 billion.  The bank’s CEO on a conference call acknowledged the bank would need to raise additional capital.  He said the bank would survive as long as depositors did not create a bank run.  Which big money depositors like Peter Thiel promptly did.  They internalized Chicken Little’s message and acted on it.  They failed to recognize that a pea-brained chicken could misinterpret the meaning of an acorn falling on her head.  They, as larger, smarter animals could withstand an acorn’s falling on their head and should not panic.  As a Midwest tech venture investor said to me, “where else but at SVB can a company with $5 million get a credit facility for $10 million?”  That is the fox now stalking tech startup companies.

Federal officials’ decision to protect SVB depositors for all amounts on deposit is a necessary expedient.  It does not answer the Midwest venture investor’s question.  Doing that will require the venture capital community to construct a replacement for SVB that can meet the banking needs of tech startup companies. 

SBV’s failure will not trigger a replay of 2008’s global financial crisis.  It does, however, bear a resemblance to that calamity in one way.  After the roof fell in on subprime asset-backed bonds, making investors in Steve Eisman’s FrontPoint fund instant billionaires, FrontPoint employees Danny Moses, Porter Collins, and Vincent Daniel sat on the steps of St. Patrick’s Cathedral and regarded the civilized world for what they felt sure would be the last time.  They were wildly rich, but feared there would be no place left where they could invest their lucre.

That’s the cliff over which startup tech companies were launched last Thursday by Peter Thiel and his kind.  We can only hope they have been sufficiently chastened to change their behavior by thinking of the community’s interest as well as their own.

Buy American: Strategy or Pablum?

Hearing President Biden’s State of the Union address touting Buy American requirements for federally funded infrastructure projects, I recalled a law review article I coauthored 45 years ago, “American Antitrust Liability of Foreign State Instrumentalities: A New Application of the Parker Doctrine.”[1]  My research in 1978 identified 23 states that already had Buy American laws on the books.  Given what has transpired since then, how helpful are such requirements and are there better tools to address our trade deficit?

Professor Donald Baker proposed the article’s topic to my law school classmate Kevin MacKenzie and me.  Baker had just returned to teaching, after heading the U.S. Justice Department’s Antitrust Division during Gerald Ford’s presidency.

There, Baker observed the opening moves of Asian nations’ bid to supplant America’s manufacturing sector.  At the heart of the matter were subsidies Japanese and, later, Chinese governments paid their state-sponsored manufacturing companies.  Professor Baker suggested MacKenzie and I explore whether U.S. antitrust policy could be an effective antidote.

We prepared our article as antitrust law experts placed growing emphasis on econometric modeling of commercial behavior.  In 1975, Harvard Law professors Areeda and Turner “published a landmark article ‘attempt[ing] to formulate meaningful and workable tests for distinguishing between predatory and competitive pricing by examining the relationship between a firm's costs and its prices.’  Their proposal was that, for a firm with monopoly power, ‘[a] price at or above reasonably anticipated average variable cost should be conclusively presumed lawful,’ and a price below that cost ‘should be conclusively presumed unlawful.’ The rationale was that prices at or above average variable cost exclude less efficient firms while minimizing the likelihood of excluding equally efficient firms.”[2]

The Areeda and Turner standard embodied two changes to existing legal precedents.  First was use of variable cost as the determiner of legal or illegal behavior.  Second was adoption of a “per se” rule (“conclusively presumed” lawful or unlawful), rather than requiring a plaintiff to prove monopolistic “intent” of a competitor.  Proving intent in an antitrust case is nearly impossible.

In a series of decisions from 1986 to 1993, the U.S. Supreme Court bowed to the Areeda and Turner view, then undercut it.  In its definitive 1993 Brooke Group decision,[3] “the Court held there are ‘two prerequisites to recovery’ where the claim alleges predatory pricing under section 2 [of the Sherman Act].  Plaintiff must prove that (1) the prices were ‘below an appropriate measure’ of defendant's costs in the short term, and (2) defendant had ‘a dangerous probability of recouping its investment in below-cost prices.’ The Court elaborated on the recoupment prerequisite, concluding that ‘plaintiff must demonstrate that there is a likelihood that the predatory scheme alleged would cause a rise in prices above a competitive level that would be sufficient to compensate for the amounts expended on the predation, including the time value of the money invested in it.’”[4]

The unstated premise of the Court’s holding and the academic papers on which it was based was that companies behave as rational economic actors.  That premise is sound when competitors share the same incentives.  It is suspect and often false when foreign states and their state-controlled economic enterprises are market competitors.  For they have a political interest to achieve dominance and the government financial support to engage in otherwise irrational economic behavior.  From 1890 through WW II, the United States government subsidized U.S. industries, especially steel, to displace British producers whose output in 1880 exceeded ours by tenfold.[5]  Asian producers, supported by their governments, have done the same to us in the last half century.

The opportunity to use antitrust law as a policy lever to address our trade imbalance is long gone.   Antidumping laws and tariffs were the tools chosen instead and have not been effective.  Today, only direct economic action will do.  Economists say Buy American laws are good political theater, but economically inconsequential.[6]  Only concerted action by both the private sector and the federal government can turn the tide.  Whether and when that will occur remains the question of the day.

[1] Bauerle, James F. and MacKenzie, Kevin I. (1978) "American Antitrust Liability of Foreign State Instrumentalities: A New Application of the Parker Doctrine," Cornell International Law Journal: Vol. 11 : No. 2 , Article 7.  Available at: https://scholarship.law.cornell.edu/cilj/vol11/issue 7.

[2] .U.S. Dep't of Justice, Competition and Monopoly: Single-Firm Conduct Under Section 2 of the Sherman Act , Chapter 4: Price Predation (2008)(“DOJ Section 2 Report”). Available at: www.usdoj.gov/atr/public/reports/236681.htm.   In the first year of the Obama Administration, the Antitrust Division withdrew the DOJ Section 2 Report on the basis that it was too timid in the enforcement policy it articulated.  The DOJ Section 2 Report, however, remains a useful historical record of the evolution of antitrust policy.  https://www.justice.gov/opa/pr/justice-department-withdraws-report-antitrust-monopoly-law 

[3] Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993).

[4] DOJ Section 2 Report.

[5] W. Serrin, Homestead: The Glory and Tragedy of an American Steel Town (1993).

[6] “Biden’s ‘Buy America’ Bid Runs Into Manufacturing Woes It Aims to Fix:  Infrastructure Officials Complain they Can’t find U.S. Suppliers for Items They Need to Buy American by Law.  Available at:

https://www.washingtonpost.com/us-policy/2023/02/18/biden-buy-america-roads-bridges.

Conflicted Codependence

Every adult American knows the American and Chinese economies have been increasingly intertwined since the 1980s.  China transformed an impoverished agrarian economy into the world’s low-cost workshop for consumer goods.  Big U.S. businesses like GM, Caterpillar and pharma companies built operations in China to tap its domestic market growth potential.  The same companies simultaneously divested from the American industrial economy, stressing our domestic economy and politics. 

What began as a symbiotic relationship has grown fractious, leading to adjustments now in process.  “Re-shoring,” “near-shoring,” production moving from China to other low wage nations including Vietnam and Mexico, and rebuilding of American capacity to make strategically important goods like pharmaceuticals and advanced computer chips all reflect this adjustment.  Recent increases in the rate of economic inflation in the U.S. are, at least in part, a byproduct of the fraying of the China trade.

              Curious about the correlation between these changes and domestic inflation, I read economist Stephen Roach’s just released Accidental Conflict: America, China and the Clash of False Narratives.[1]  Roach spent his career at investment bank Morgan Stanley rather than in academia.  He writes for the lay person, providing useful economic data and analysis.  His assessment is well-informed, balanced and timely. 

              The root problem, he says, is America’s savings rate is too low and China’s is too high.  “In many respects, the U.S. and Chinese economies are mirror images of each other.  The United States consumes to excess while China’s consumption share is the lowest of any major economy in the world.  Conversely, China produces to excess . . . .  Trade between the two nations brings their duality to life--China as the ultimate low-cost producer supports America as the ultimate high-spending consumer.  Yet without U.S. demand the Chinese producer would have floundered.”[2]

              China’s domestic consumption lags because Chinese remember when their government in the late 1990s pulled out from under them the social safety net of government benefits, the so-called “iron rice bowl.”  Too, the repressive nature of the Chinese regime extracts a price in the form of behavioral conformity and risk avoidance.  So, Chinese save rather than spend as a matter of self-protection and survival. 

China’s leaders have been stymied in their efforts to change that behavior.  They believe China’s economic miracle entitles it to stature on the world stage equivalent to the United States.  In this, Roach says, they are fixated on the fact that China and the U.S. today have nearly equal GDP even though per capital GDP in the U.S. remains far greater than in China.  In his 2021 speech commemorating the centenary of the Chinese Communist Party, Xi Jimping spoke of the great power that comes with economic scale as “a great wall of steel forged by 1.4 billion Chinese people.”[3]

              Americans’ pride in our economy’s innovative dynamism blinds us to our dependence on foreign capital, Roach says, a weakness that is growing.  Military containment of China, desired by us and resented by them, is not feasible on the model of the Cold War.  Even if we were committed to it politically, we do not now have the economic strength to carry it off, he asserts.  Our co-dependent relationship with China is starkly different from our mid-century relationship with the Soviet Union, whose economy and ours were never interdependent.  The income-based savings rate in the U.S. declined from its 1971 peak of 13.5% to a 2005 low of 3.1%.[4]  All those factors make it naïve and dangerous for Americans to believe we can win a second cold war.

              Not surprisingly, Roach’s prescription for conflict de-escalation is conversation, collaboration and interdependence.  He repeatedly quotes Henry Kissinger’s 2019 remark that the two nations are now “in the foothills of a cold war.”[5]

              As a frame for understanding how ongoing changes in the Sino-American story will affect us, Roach’s analysis tells me the low rate of economic inflation of the last decades is history, although he does not say so explicitly.  Plentiful and cheap consumer goods offset the impact of declining real wages.  Americans at the top of our economic pyramid experienced above-historical-average gains in wealth.  For all the reasons Roach identifies, that equilibrium has been upset.

              Roach leaves no doubt rebalancing the two nations’ economies and geopolitical positions will be hard work.  It is tempting and certainly easier to succumb to jingoism and trading retaliatory blows.  Roach’s title expresses his fear—that false beliefs about one another will lead the U.S. and China to escalate conflicts that could be managed if common sense and mutual respect prevailed.  His book is an invitation and roadmap to avoiding that outcome.

[1] Published by Yale University Press, 2022.

[2] Roach at pp. 328-29.

[3] Roach at p. 290.

[4] Roach at p. 209.

[5] Another analysis of the implications of conflict over Taiwan asserts the U.S.’s great weakness is its inability to replenish military materiel given our reduced industrial base while China’s great weakness is the mass starvation its people would suffer if U.S. food imports were cut off.   https://www.newyorker.com/magazine/2022/11/21/a-dangerous-game-over-taiwan

Zero Trust

Public release last month of OpenAI’s ChatGPT artificial intelligence software brought both bravos and brickbats. The New York Times headline last Saturday read, “A New Era of A.I. Booms, Even Amid the Tech Gloom.”[1]

Users have marveled at the ease of creating pseudo fine art using only a brief word prompt like, “day at the beach.” Meanwhile, Los Angeles computer programmer, designer and lawyer Michael Butterick sued Microsoft, OpenAI and GitHub, claiming ChatGTP and similar programs pirate existing code. Buttrick’s real beef is that he and fellow coders will become obsolete because ChatGTP uses existing code to teach itself how to write new code.[2]

More serious critics say the new software is flawed because it cannot distinguish truth from fiction. Two detractors put it this way: “The philosopher Harry Frankfurt defined bullshit as speech that is intended to persuade without regard for the truth. By this measure, OpenAI’s new chatbot ChatGPT is the greatest bullshitter ever. Large Language Models (LLMs) are trained to produce plausible text, not true statements. ChatGPT is shockingly good at sounding convincing on any conceivable topic. But OpenAI is clear that there is no source of truth during training. That means that using ChatGPT in its current form would be a bad idea for applications like education or answering health questions. Even though the bot often gives excellent answers, sometimes it fails badly. And it’s always convincing, so it’s hard to tell the difference.”[3]

To test this critique, I asked ChatGTP, “Who will be the first naturalized citizen of the U.S. elected President?”

Thirty seconds later came the reply. “It is possible that a naturalized citizen of the United States could be elected President in the future, but it has not happened yet. A naturalized citizen is a person who is not a U.S. citizen by birth, but who has become a citizen through the naturalization process. To be eligible to become President, a person must be a natural-born citizen of the United States, which means they must have been born a U.S. citizen. It is not uncommon for naturalized citizens to hold high public office in the United States, but to date, all Presidents have been natural-born citizens. There is no way to predict when or if a naturalized citizen will be elected President of the United States.”

The reply is not wrong per se, expressed conditionally as it is. Missing though is the essential fact that the U.S. Constitution requires the President and Vice President to be natural-born U.S. citizens. A constitutional amendment would be needed to permit a naturalized citizen to hold either office. The second and third sentences contradict one another. The fourth sentence is beside the point and misleading.

In the words of AI pioneer and psychologist Gary Marcus, “the problem is not with GPT-3’s syntax (which is perfectly fluent) but with its semantics: it can produce words in perfect English, but it has only the dimmest sense of what those words mean, and no sense whatsoever about how those words relate to the world.”[4] Marcus illustrates, saying if you ask a GTP-3-programmed robot to clean the house while you are away, you may return to find the sofa has been cut into pieces and placed in the closet.

At a deeper level, LLMs do not have a sense of community with humans nor any awareness of human values. This makes generative AI a dangerous tool in the hands of bad actors.

Financial institutions are already swamped with scams perpetrated using computer-generated deceptions. Phishing, spoofing, deep fakes and other frauds all depend on victims accepting falsehood as truth. Generative AI makes creating those falsehoods easier, less expensive and more plausible. Or as Marcus says, the cost of creating bullshit is approaching zero.

To counter the threat, industry and government are developing next generation authentication tools and frameworks for using them. Up for public comment now is a draft guide for implementing the Zero Trust Architecture promoted by the National Cybersecurity Center of Excellence of the National Institute of Standards and Technology (NIST), part of the U.S. Department of Commerce.[5] The “zero trust” phrase is somewhat misleading, however.

The need is obvious: legitimate electronic financial commerce requires devices and systems to protect its integrity. A true zero trust environment is one in which transactions grind to a halt because no trust exists anywhere. That is the stuff of which financial crises are made, viz, the 2008 global banking crisis when none of the nation’s biggest banks knew which of their counterparties were truly solvent. To preserve a world in which trust continues to exist despite AI advances will require unprecedented investment of human and financial capital. That is the cost ignored by Silicon Valley denizens in their effort to frame our future in their image and profit mightily in the process. Perhaps it is time to require them to co-invest in creating the protections we and they need to prevent that future from being wholly dystopian.

——————————————————————————————————

1 https://www.nytimes.com/2023/01/07/technology/generative-ai-chatgpt-investments.html

2 https://www.nytimes.com/2022/11/23/technology/copilot-microsoft-ai-lawsuit.html

3 https://aisnakeoil.substack.com/p/chatgpt-is-a-bullshit-generator-but

4 https://www.technologyreview.com/2020/08/22/1007539/gpt3-openai-language-generator-artificial-intelligence-ai-opinion/

5 https://csrc.nist.gov/publications/detail/sp/1800-35/draft. “A zero trust architecture (ZTA) focuses on protecting data and resources. It enables secure authorized access to enterprise resources that are distributed across on-premises and multiple cloud environments, while enabling a hybrid workforce and partners to access resources from anywhere, at any time, from any device in support of the organization’s mission. Each access request is evaluated by verifying the context available at access time, including criteria such as the requester’s identity and role, the requesting device’s health and credentials, the sensitivity of the resource, user location, and user behavior consistency. If the enterprise’s defined access policy is met, a secure session is created to protect all information transferred to and from the resource. A real-time and continuous policy-driven, risk-based assessment is performed to establish and maintain the access. In this project, the NCCoE and its collaborators use commercially available technology to build interoperable, open, standards-based ZTA implementations that align to the concepts and principles in NIST Special Publication (SP) 800-207, Zero Trust Architecture. This NIST Cybersecurity Practice Guide explains how commercially available technology can be integrated and used to build various ZTAs.”

Internet Banking and Multi-Factor Authentication

[I]t all boils down to one key distinction: which credentials can be hacked and which cannot. A one-time code is a human-readable, transferable identifier, which means it can be phished and used to steal accounts in the same way as passwords. Multi-Factor Authentication via [mobile phone text messaging] is an easy compliance option for banks and distributors under strict regulations like PSD2 [a European regulation for electronic payment systems], but this approach can and must change. Regulatory changes take longer than industry awareness, but mindsets are likely to change over the next year. --Andrew Shikiar, “FIDO Alliance Predictions 2023” [1]

In its 2020 Survey of Household Economics and Decisionmaking (SHED), the Federal Reserve Board staff asked consumer participants about problems they experienced in their banking and credit activities. “Overall, 29 percent of adults said they experienced at least one of the five problems asked about. The most common problem, fraudulent transactions, affected 16 percent of adults. This was followed by unexpected fees (11 percent) and customer service delays or problems (8 percent). The remaining issues, closed accounts and credit limit reductions, were less common, affecting fewer than 1 in 20 adults.”[2]

Notably, all demographic groups identified fraud as the leading problem they face, with higher income respondents identifying fraud as their biggest issue at a higher rate than lower income respondents. With pressure from Congress and bank regulators growing, the industry is weighing changing its practices governing customer reimbursement for fraud losses. In candid moments, bankers acknowledge their dilemma. They depend on customers’ trust. Yet nothing breaks trust more quickly than fraud or other loss of money from accounts believed to be safe.

Adverts for mobile banking tout convenience and ease of use. Yet those attributes and customer ignorance about loss prevention make fraud artists’ work child’s play. Previous posts to this blog covered P-to-P payment system fraud (November 7) and the rise of generative artificial intelligence as a threat to security systems used by the financial services industry (September 12).

Despite universal use of dual factor authentication, cybersecurity professionals like the above-quoted Andrew Shikiar say more is needed. He is executive director of FIDO Alliance, a non-profit organization that seeks to standardize authentication at the client and protocol layers. He writes, “Smishing, or text phishing, saw massive growth in the second half of 2022, and it should continue to invade our notifications next year. Additionally, these attacks could become even more difficult to spot as criminals refine their techniques. The proliferation of personal data available online, along with improved AI and tools for extracting that data, will make these attacks more convincing and fool even those who think they are well-informed. The silver lining: As smishing spreads, consumers will trust [smart phone text messaging] as a communication channel less, clearing the way for service providers to adopt other tamper-proof authentication methods.”

His argument is the gist of our September 12 blog entry. Many software developers herald biometric authentication as the next wave of security technology. Comparing users’ fingerprints, face scans or voiceprints to on-file customer data for those biometrics is offered as the most-secure authentication tool available. We recently spoke with the head of a voice-recognition company evolved from U.S. government-sponsored activity in that field at Carnegie Mellon University. The company’s systems build on linguists’ decades of work cataloging and classifying languages throughout the world, including regional and local variations. For example, the Dictionary of American Regional English [3] is a compendium of word usage, dialects, and grammar from which it is possible to identify American speakers’ demographic profiles. Linguistic scholars including my father have contributed to DARE’s development since the 1950s.

Hurdles to adoption of biometric authentication include the lack of agreement on which biometrics to use, the cost and time needed to build reference databases, and the scale and complexity of the U.S. legal system, including need for a statutory means to allocate losses when inevitable database breaches occur. In other aspects of data security for financial services, Europeans have advanced further than Americans.

Sweden’s banks and government created BankID in 2003 as a secure e-ID at a time when Sweden led the European Union. BankID can be used for identification when traveling within the European Union, as well as to enable secured financial transactions including filing tax returns. Eight million Swedes have a BankID, three-quarters of the nation’s population.[4]

Great Britain’s TSB Bank in 2019 began offering customers a “Fraud Refund Guarantee.” The bank’s website says, “This [product] is a first in UK banking and it goes further to cover TSB customers against fraud than anything that has come before it. At other banks, on average only 47% of stolen money is refunded to fraud victims. Under our fraud refund guarantee, we refund 98% of claims.”[5] The maximum guaranteed amount is £1 million.

Europe’s Payment Services Directive 2 (PSD2) requires Strong Customer Authentication. Account users must authenticate their identity with at least two of three factors: something you own (e.g., a mobile phone), something you know (e.g., password) and something you are (e.g., biometric data). The authentication factors must be independent of one another. U.S. banks, Mastercard and VISA have adopted the same standard, referred to in the U.S. as 3-D Secure 2.0. Industry professionals, however, remain divided as to whether two factor authentication is sufficient and what forms it should take, as reflected in Andrew Shikiar’s comments at the top of this column.

As internet banking was born, the Federal Reserve Bank of New York in March 2000 issued a white paper, “The Emerging Role of Banks in E-Commerce.”[6] Two-plus decades later, the paper’s assessment seems one part spot-on and another part naive. “Banks are also planning to offer a product that would protect e-commerce participants against fraud arising from the misrepresentation of identities. Using encryption technology, each bank would certify the identities of its own account holders and serve as the intermediary through which its account holders could verify the identities of account holders at other banks. In this way, both sides of an e-commerce transaction would have some assurance that they were not dealing with an impostor.”

We may get to that promised land someday. For now, though, internet financial services remain a world where consumers too often do not understand the risks they are taking until it is too late.

[1] https://www.globalsecuritymag.fr/Predictions-2023-de-l-Alliance-FIDO.html.

[2] https://www.federalreserve.gov/publications/2021-economic-well-being-of-us-households-in-2020-banking-and-credit.htm (emphasis added).

[3] https://www.daredictionary.com/

[4] https://www.bankid.com/en/

[5] https://www.tsb.co.uk/Fraud-Prevention-Centre/Fraud-Refund-Guarantee

[6] https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci6-3.pdf

Designing Digital Dollars

                The Federal Reserve Bank of New York last week announced a 12-week pilot program for a dollar-denominated Central Bank Digital Currency (“CBDC”).  Participating financial institutions are BNY Mellon, Citibank, HSBC, Mastercard, PNC, TD Bank, Truist, U.S. Bank and Wells Fargo.

                The participants’ press release characterized the effort as a “proof of concept project that will explore the feasibility of an interoperable digital money platform known as the regulated liability network (RLN). . . .  [The project] will test a version of the RLN design that operates exclusively in U.S. dollars where commercial banks issue simulated digital money or ‘tokens’—representing the deposits of their own customers—and settle through simulated central bank reserves on a shared multi-entity distributed ledger.  [The project] will also test the feasibility of a programmable digital money design that is potentially extensible to other digital assets, as well as the viability of the proposed system within existing laws and regulations.”[1]

                Developing a functional, safe, secure and widely-accepted digital payments system for CBDCs will be the most ambitious international banking project ever undertaken.  The just-announced pilot is a first step in that direction.  A fully developed system is likely to emerge only after lots more work, trial and error take place, and only when a core group of economically powerful nations agree to it by treaty or convention.[2]  Other nations will join later in the interest of bolstering their own economies.  A particular challenge the RLN pilot intends to address is “interoperability” among a series of distributed ledgers.[3]

                Even within the Federal Reserve System, not all Governors agree digital dollars are needed.  Fed Governor Christopher Waller argued last month that the U.S. dollar’s role as the world’s reserve currency will not be diminished by lack of a digital form factor.  Benefits of CBDC pale compared to the risks, he said, including money laundering, international financial stability concerns and financing of terrorism.[4]

                Waller’s concerns are valid, but he is mistaken to think the dollar’s primacy is unassailable.  On the eve of WW I, British bankers would have said the same about the pound sterling.  Regardless, exploration and adoption of CBDC is a Herculean undertaking that will require users to reframe their thinking about the nature of money and how it is used as a store of value.  For comparison’s sake, consider the rise of all-purpose credit cards, the nearest equivalent mass market banking innovation of our lifetime.

                Amid post-WW II prosperity, about a dozen banks experimented unsuccessfully with all-purpose credit cards.  Leading banks derided the innovation as "lowering banking's image by engaging in an activity more properly associated with pawnshops."[5]  Yet the idea caught the attention of California’s Bank of America, which was a large bank that prided itself on serving “the little fellow” other large banks avoided having as customers.

BofA in the mid-1950s set up a six-person product innovation team led by 41-year-old Joseph Williams, a Philadelphia banker who moved to San Francisco-based BofA, attracted by its middle-brow culture.  He modeled BofA’s credit card on Sears Roebuck’s and Mobil Oil’s offerings, including a 25 day grace period for payments, 18% interest rate on carried balances and an assumed credit loss ratio of 4%.  For proof of concept, in 1958 the bank distributed BankAmericard-branded cards to every one of its customers in Fresno—60,000 people in a city of 240,000.  No credit application needed; the card arrived in the daily mail.  Fresno was chosen because the customer base was big enough to be statistically significant and because if the new product flopped, it would be easier to explain away the failure to bank regulators and the media than if it occurred in a major market. 

BofA courted Fresno retail merchants to accept BankAmericard, arguing it would increase sales of merchandise and relieve them of the expense of maintaining and collecting house credit accounts for regular customers.  Unspoken was the fact that BofA could also more profitably offer consumer credit because it could afford the then-expensive IBM mainframe computers on which banking business had come to rely.  The computers were the processing engine for all the retail transactions paid via BankAmericard.

                Thirteen months after the Fresno test, the bank had 2 million cards in circulation and 20,000 participating merchants.  What worked well in Fresno faltered badly in Los Angeles.  “[C]rooks were quick to decipher the symbols on a stolen credit card, so they knew what the floor limit was. That way, they could make hundreds of small purchases under the limit without having to worry about a merchant calling the bank and finding out the card was stolen. [BofA] discovered that prostitutes were adept at lifting cards from johns. It learned how easy it was for merchants to cheat them. It learned that thieves could break into its warehouse and steal unembossed BankAmericards, which they would then offer to sell back to the bank. Because credit card crime was so new, the bank had a hard time getting the police interested in pursuing these thefts; because it feared the thieves would emboss the cards and use them, it often did buy them back.”[6]

                The Los Angeles debacle led BofA executives in late 1959 to weigh quitting the business.  They decided not to, believing consumer credit was a growing business segment for their bank and the economy generally, and because they thought Los Angeles had already brought them every bad outcome possible.  A decade later, millions of Americans, including me, had their own BankAmericard.  In my case, it came with a $300 credit limit even though I had no steady job and was 16 years old.  Today, the 25-day grace period and 18% interest rate remain industry standard.  Industry credit losses average 5%, a point higher than BofA estimated in 1958.

                Like credit cards, CBDCs are likely part of our future because global economic integration will continue despite current reconsideration of its ways and means.  The needed financial and legal infrastructure, as well as customer education, are only beginning to be conceived.  The unfolding calamity damaging millions of FTX crypto exchange account holders will put added pressure on the Federal Reserve System to create safe, reliable means for domestic and international electronic financial commerce.  The time has come and there is much work to be done.

 [1] https://www.businesswire.com/news/home/20221115005936/en/Members-of-the-U.S.-Banking-Community-Launch-Proof-of-Concept-For-A-Regulated-Digital-Asset-Settlement-Platform

[2] Letters of credit are an example of a widely used tool of international business finance that are not governed by any law, but instead are subject of two conventions contractually agreed to by users, the Uniform Customs & Practices for Documentary Credits (UCP 600) issued by the International Chamber of Commerce and  the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit.  The UCP was first issued in 1933 and has been revised six times, most recently in 2007.  Contracts customers enter into with banks for issuance of letters of credit incorporate the UCP by reference, making it part of the contract.

 [3] In its simplest expression blockchain technology works as a cross-referencing network of computers.  When a transaction is entered on one computer’s blockchain registry, it automatically replicates itself in the registry on all the other computers, which also perform programed tasks to determine if the transaction is accurate, legitimate, and meets other preestablished criteria.  The interoperability problem is how do you connect all of the networks so they all function as one.  Imagine the box score part of a baseball stadium scoreboard that gathers and presents data from other scoreboards at games in other cities that day and vice versa.  The scoreboards both report information to fans and validate it as a matter of league records and team and player standings.

 [4] https://www.federalreserve.gov/newsevents/speech/waller20221014a.htm

 [5] J. Nocera, “The Day the Credit Card Was Born,” The Washington Post, November 4, 1994, available at https://www.washingtonpost.com/archive/lifestyle/magazine/1994/11/04/the-day-the-credit-card-was-born/d42da27b-0437-4a67-b753-bf9b440ad6dc/

[6] Id.

Eclipsed

                Last week’s Blood Moon lunar eclipse presaged two financial events that had nothing but everything to do with one another.  Christie’s auctioned Paul Allen’s art collection in New York City for more than $1.6 billion, the largest haul ever from a single-owner collection.  The late Microsoft cofounder’s will dictated that all proceeds go to philanthropic causes.[1]  Meanwhile, 125 miles away in Delaware federal bankruptcy court, crypto asset exchange FTX filed Chapter 11.[2]  FTX’s Q1 2022 funding round valued the company at $32 billion, just three years after its founding.  Hailed as a Millennial generation genius committed to serving humanity, FTX founder Sam Bankman-Fried gambled his and his co-investors’ entire stake and rolled snake eyes. 

                In its meteoric rise, FTX attracted eight and nine figure investments from superstar venture capital firms, including Sequoia, Blackrock, Softbank and Tiger Global.  Other investors included the Ontario Teachers’ Pension Plan, the Alaska Permanent Fund and the Washington State Investment Board.[3]  The Alaska and Washington investments were via Sequoia’s Global Growth Fund III, which bought into FTX. 

Sequoia hyped FTX, publishing on its website in mid-September an article titled “Sam Bankman-Fried Has a Savior Complex—Maybe You Should Too.” The article recounts the Sequoia investment committee’s Zoom call due diligence interview of Bankman-Fried.[4]  “[He] told Sequoia about the so-called super app: ‘I want FTX to be a place where you can do anything you want with your next dollar.  You can buy bitcoin.  You can send money in whatever currency to a friend anywhere in the world.  You can buy a banana.  You can do anything you want with your money from inside FTX.’  Suddenly, the chat window on Sequoia’s side of the Zoom lights up with partners freaking out.  ‘I LOVE THIS FOUNDER,’ typed one partner.  ‘I am a 10 out of 10,’ pinged another.  ‘YES!!!’ exclaimed a third.” 

Last week, Sequoia wrote off its investment in FTX and removed the article from its website. 

FTX’s bankruptcy is ironic.  The premise on which crypto assets have been created, bought, and sold is that market participants can regulate themselves and their assets solely by means of so-called “smart contracts” among themselves.  No other legal framework is needed.  Blockchain technology makes the contracts self-executing.  Once a market participant presses “enter” on her computer everything else is automatic.[5]

FTX initially operated from Hong Kong but moved to Barbados during Covid.  There, like other crypto asset businesses, it operated outside U.S. jurisdiction in a world of its own making.  No federal or state securities law registration of crypto asset offerings.  No federally chartered banks to be third-party custodians of crypto assets.  No legislatures or courts to set behavioral boundaries for market participants.  No rules except its own—until FTX overleveraged its balance sheet, made speculative bets on companies that faltered, and drastically overweighted investment in its own cryptocurrency.  When the roof fell in, Bankman-Fried and his team grabbed what they had steadfastly avoided—protection of U.S. federal law.

Beyond irony, the FTX case in our opinion is a benchmark event in the evolution of our global financial system. FTX will be dissected and analyzed as more than 100 nations now contemplate creating their own digital central bank currencies.  China leads the pack, having debuted its digital yuan during the recent Olympic Games there.  Chinese citizens are now being told to use digital yuan every day.  Transaction data collected by the government gives it more control over citizens’ lives.  The government also hopes digital yuan will help that currency attain parity with the U.S. dollar as an internationally-accepted reserve currency.[6] 

The U.S. is taking a more measured approach.  Beyond legal complexities, creating a digital dollar presents a thicket of technical issues, summarized in a report released by the White House in September.[7] 

The signal difference of digital central bank currencies from crypto currencies is the involvement of an issuing central bank and the financial and legal regimes that follow.  What exactly a central bank’s role should be is a hot topic.  Commercial bankers fear central banks issuing and administering digital currencies will make commercial banks irrelevant.  That outcome is theoretically possible, but politically unlikely.  Non-bank payment system participants all have their own interests to protect—VISA, Mastercard, P-to-P payment systems, Western Union and even the U.S. Postal Service.  So do big tech and telecom companies, e.g., Apple, Google, AT&T and Verizon.  They see themselves as rightfully occupying the center of the financial transactions hourglass.  Multiple federal agencies also have a stake in the outcome.  Also to be reckoned with are New York and California financial regulators, who always impose rules of their own on parties operating in their jurisdictions.  The resulting battle royale will likely take years if not decades to resolve.

In the best of all worlds, the FTX bankruptcy case will point up needs that must be met to arrive at a safe and sound system for digital currencies that serves everyone well enough.  Too, a stronger legal regime among nations will be needed if digital currencies are to have transnational utility.  Amid those realities, tech entrepreneurs and those who fund them will need to overcome their perennial habit of getting drunk on their own wine, as they did when they threw money at FTX. 

Adam Fisher, the author of “Sam Bankman-Fried Has a Savior Complex,” writes of his visit to FTX’s picture-perfect Barbados residential compound:  “As I fry up an omelet for myself . . . my thoughts drift until they shoal in the lee of The Great Gatsby. . . . [D]amend if [Bankman-Fried’s Barbados campus] is not West Egg.  But is crypto the new jazz?  And, if it is, does that make Sam Bankman-Fried the new Jay Gatsby?” 

Trying to answer his own question, Fisher contrasts the two men but overlooks their essential commonality.  Gatsby and Bankman-Fried both use cold-blooded rationality to become wealthy. Yet psychic gratification is what animates them.  Gatsby craves Daisy’s love and so throws lavish parties at the big house with the blue lawn and the green light at the end of the dock.  Bankman-Fried craves “effective altruism” on a grand scale, scheming to build a trillion-dollar personal fortune he can give away, eclipsing Paul Allen’s and his peers’ achievements.  For both Gatsby and Bankman-Fried and his co-investors, the constructed reality is an illusion.  That it ends badly is no surprise really; rather, it is inevitable.

[1]  https://www.cnn.com/style/article/paul-allen-collection-christies-auction-record/index.html

[2] https://www.nytimes.com/2022/11/11/business/ftx-bankruptcy.html

[3] https://decrypt.co/114235/ontario-teachers-95m-ftx-pension-fund-limited-impact

[4] https://web.archive.org/web/20221109230422/https://www.sequoiacap.com/article/sam-bankman-fried-spotlight/

[5] I first encountered “smart contracts” eight years ago when attending a law school reunion.  A very able classmate then working for Silicon Valley companies described his work on smart contracts.  It seemed far-fetched to me at the time.  I now better understand where he and others were going.

 [6] https://www.wired.com/story/chinas-digital-yuan-ecny-works-just-like-cash-surveillance/

[7] https://www.whitehouse.gov/wp-content/uploads/2022/09/09-2022-Technical-Design-Choices-US-CBDC-System.pdf

P-to-P Payment Services: Eight Tips to Reduce Fraud Risk

Peer to peer payment services have become mainstream consumer financial tools in the 20 years since PayPal debuted.  Fraud, however, is “common and everywhere,” according to a banking industry consultant interviewed by the New York Times.[1]   The Times story focused on Zelle, the five-year-old system owned by Bank of America, Truist (the 2019 combination of BB&T and Sun Trust banks), Capital One, JP Morgan Chase, PNC, U.S. Bank and Wells Fargo.  $490 billion changed hands last year via Zelle, compared to $230 billion via Venmo, the next biggest P-to-P operator.  1,200 U.S. banks offer Zelle to their customers including three of the four trillion-dollar institutions that together control 70% of U.S. bank deposits. 

               Sen. Elizabeth Warren recently made headlines when she released a report showing fraudulent transactions over Zelle growing significantly while banks reimbursed customers for their losses only about 10% of the time.[2]  Industry trade groups say Warren’s claims are exaggerated.  Data released by several participating banks, including PNC, do show the number and dollar value of fraudulent Zelle transactions are growing in sync with P-to-P service growth.  Most banks the Senate Banking Committee surveyed refused to release data on fraudulent transactions affecting their customers. 

                One aspect of the problem is consumers expect to be protected from P-to-P losses because in other electronic financial transactions (EFT) they always have been protected.  Federal law since the 1960s limits consumer losses on credit cards transactions to $50.  The amount of the limit has never changed.  If it was indexed for inflation, it would be $500 today.  Debit cards do not enjoy that legal protection; but banks often reimburse debit card customers who promptly report theft of either their cards or account funds.  Like debit card transactions, P-to-P transactions are governed by Regulation E, which was written in the 1970s, long before the Internet enabled EFT on a grand scale.

                From a consumer’s point of view, the weakness of Regulation E is it only protects them against “unauthorized” funds transfers.  When consumers send money via P-to-P systems in response to fraud artists’ inducements, banks take the position the consumers “authorized” the transactions and so must bear the loss.

                Shifting the loss to banks, as Sen. Warren would do, creates moral hazard, giving consumers no incentive to act cautiously and inviting even bigger fraud losses.  Banks’ operating costs would swell, leading the industry to shift the costs to customers one way or another.

                Until Congress, regulatory agencies and the industry work together to protect P-to-P users against fraud, consumers must exercise self-help.  How?

1.       Pay Cash or Use a Credit Card.  Cash is old school, but it works as well as it ever did.  The legal protections governing credit cards make them consumers’ best bet for EFT .  Banks promote debt cards and P-to-P systems instead for two reasons.  First, consumers using them do not get the “float”—the use of the bank’s money from the transaction date until the next monthly credit card bill is paid, assuming the account is paid in full every billing cycle.  Second, credit cards issuance is dominated by the biggest players, VISA, Mastercard and a handful of big banks.  Those parties charge small and mid-sized banks licensing and other fees for using the big players’ systems.

 2.       Create a Dedicated, Low-Balance P-to-P Transaction Account and Use it Sparingly.  P-to-P transactions are a convenience, not a necessity.  If you cannot resist using P-to-P payments, keep a small amount of money in an account you only use for such payments, e.g., $500 or $1,000.  Because banks often impose fees on accounts with low balances, consider placing the P-to-P account at a credit union, where low balance fees are rare.

 3.       Treat Account Information Like Cash.  Do not share any information about any of your accounts, including mobile phone numbers, with parties to P-to-P transactions.  There is no good reason to do so.  Do not provide information to people who telephone or email you claiming to be from fraud protection units of financial institutions.  Often those calls are criminal gambits to know your account information to steal your money.

 4.       Keep Banking and Securities Accounts Separate.  Since Bank One and Merrill Lynch pioneered the CMA account in the 1980s, linked banking and securities accounts have been convenient, useful and commonplace.  If you make or accept P-to-P payments, segregate your securities holdings in accounts that have no connection to your bank accounts.

 5.       Know Your Rights are Limited.  P-to-P company Venmo’s standard terms and conditions are 16,000 words of legal and technical writing.  That is two hours of concentrated work for a person reading 133 words a minute.  Most people do not have knowledge sufficient to understand what the contracts mean.  So they click “I agree” and keep moving.  You need to recognize the contracts strip you of most legal rights you otherwise have to make claims against the service providers.

 6.       Monitor Transactions.  Banks, for a fee, offer business customers so-called positive-pay and reverse-positive-pay services that match checks written against checks presented for payment as a protection against check fraud.  Some banks offer these services to consumers for their checking accounts.  At some point, similar services are likely to be offered for P-to-P customers.  Until then, users should scrutinize each P-to-P transaction, including considering any aspects of it that seem even the slightest bit unusual.

 7.       Be Distrustful.  For fraud to succeed, the victim must trust the perpetrator.  Fraud requires a story line.  The story line must be plausible.  And it must be acted out convincingly.  The victim is seduced to believe the story and act as the perpetrator desires.  Healthy skepticism and common sense are defenses.  Use them.

 8.       Build and Sustain Personal Relationships.  Most people who work in banking want to help their customers.  Today though, the nation’s largest banks are relentlessly depersonalizing customer interactions to increase profits.  That is a good reason to patronize community banks.  “Look for the helpers,” said Mr. Rogers, the children’s television impresario.  In the P-to-P banking world, the wisdom of his advice grows every day.

[1] https://www.nytimes.com/2022/03/06/business/payments-fraud-zelle-banks.html

[2] https://www.warren.senate.gov/oversight/reports/new-report-by-senator-warren-zelle-facilitating-fraud-based-on-internal-data-from-big-banks