February 18, 2023
On Feb. 8, a pitch came over the transom with a startling subject line: "The New Guaranteed 7% Return On Investment is REAL."
- This week's newsletter — 1,659 words, a 6-minute read — is the result of what I found after I hit "reply."
1 big thing: When a savings account is very risky
Compound Banc pays an eye-popping 7% on deposits — or at least things that look and feel a lot like deposits. But it's not a bank, and the deposits — technically, they're risky bonds — are not insured by the FDIC or anybody else. The product is aimed at very small investors: The minimum investment is just $10.
Why it matters: People looking for improbably high interest rates on their money have learned the hard way to avoid crypto. That's created an opening for dollar-denominated products taking advantage of various regulatory loopholes — and of the fact that Americans are increasingly comfortable handing over their money to digital institutions.
The big picture: Compound Banc's product is marketed as a high-yield digital account. Savings start compounding immediately at a 7% APY (annual percentage yield); savers can withdraw their money at any time without any fees or penalties. "No if and or buts about it," says the homepage.
The catch: Compound Banc is neither a bank nor a brokerage, and its savings bonds, if you read its SEC filings, are characterized by "a high degree of risk." Accounts at Compound Banc are not insured by the FDIC, the SIPC, or any other government regulator.
- "We primarily lend to sub-prime real estate borrowers," notes Compound on page 7 of its offering circular.
- The company's co-founder and chief strategy officer, Yuvraj Tuli, tells Axios he can source healthy "first-lien secured mortgages" with a one-year maturity, and with a loan-to-value ratio of 60% or lower, yielding between 13% and 14%. Some of these he can buy on the secondary market; others Compound will originate itself.
How it works: If the mortgage investments fall in value, that doesn't affect the amount of money Compound owes to its bondholders, which will continue to compound at a 7% annual rate.
Between the lines: "There is no source for any kind of repayment here," says Saule Omarova, a law professor at Cornell who was nominated by President Biden to be America's top bank regulator. "You just hope to god there is no run and all the real estate assets are doing fine."
- If Compound Banc loses money on its subprime mortgage investments, it could become insolvent, owing more money to its bondholders than it owns in assets. Its most recent SEC filing shows total assets of just $20,642 as of June 30, 2022, although since then it says it raised $5 million in equity capital from an obscure Bahamas-based shop called 26 Capital.
What they're saying: "It's the least risky investment someone can make," according to Compound's Tuli, even though the official SEC offering circular says otherwise. In fact, the least risky investment someone can make would be to put money into one of the FDIC-insured savings accounts that Compound is comparing itself to.
- "They certainly are being misleading about the risks involved with this," according to Pat McCoy, a law professor at Boston College with an expertise in financial regulation. "It’s seductive. It’s so beautifully done, it’s so optimistic."
The bottom line: Americans are increasingly comfortable investing on the internet, and it's not reasonable to put the onus on individual savers to try to work out whether any given bank (or "banc") has the wherewithal to be able to repay what it owes.
- The fact that Compound Banc has managed to go live without any real regulatory oversight — they say they have already issued some $1.5 million in bonds — demonstrates the limits of America's existing regulatory infrastructure.
2. The regulatory arbitrage
How is Compound Banc legal? Well, it might not be, according to experts Axios spoke to. (Both the FDIC and the CFPB declined to comment to Axios.) But the first thing Compound is trying to do is to walk a fine line between looking like a bank and being a bank.
Why it matters: Since 1933, only banks have been allowed to accept deposits. But the law doesn't have a clear definition of what counts as a deposit — and since the rise of money-market funds, the financial-services industry has been pushing the limits of how close it can get to selling something that looks like a deposit without having to be regulated like a bank.
- Compound Banc claims that it is not accepting deposits — rather, it's selling bonds. "It’s a bond product, but the consumer experience is behaving like a traditional savings account," is how Compound investor Sahibjeet Kaur, of 26 Capital, put it to Axios.
- Besides, enforcing that particular law would fall under the purview of the Department of Justice, and "historically, DOJ has not been too keen to enforce the legal prohibition on deposit-taking," as Omarova tells Axios.
Between the lines: The Office of the Comptroller of the Currency, which regulates banks, responded to a query from Axios by saying simply that "the OCC does not regulate Compound Banc." In other words: Not our problem.
The big picture: You can't call yourself a bank unless you're a bank. But can you call yourself a "banc"? Not really, says McCoy.
- In some states, that's explicitly forbidden, but in others, including Florida, where Compound is registered, the term can sometimes be used, if there's regulatory permission.
- That permission did come, from Russell Weigel III, the commissioner of Florida's Office of Financial Regulation. But in granting it, Weigel explicitly specified that "the company will not engage in business purporting to be a financial institution."
- What's more, even if Florida allows Compound's use of the word "banc," that doesn't mean federal regulators would be OK with it. "If the FDIC investigated, it would be very concerned about the impression generated by 'banc'," McCoy tells Axios.
How it works: Compound is selling up to $75 million in deposit-like bonds — the maximum allowed under Regulation A, a way for small companies to issue bonds without incurring the expense and scrutiny associated with a full public securities offering.
- "They’re playing this multilayered regulatory arbitrage game," says Omarova.
What's next: Compound doesn't intend to stop at $75 million. Kaur, the investor, tells Axios that as soon as Compound has issued its first $75 million in bonds, it will spin up a second $75 million issue, and so on. Eventually, he says, after two or three offerings, it might be more economical to do a public S-1 offering, since those aren't capped in size.
- In theory, the amount of money in Compound accounts could grow much faster than Compound's own assets.
- Even those customers who regularly check SEC filings will only find infrequent and out-of-date updates on how much Compound has in assets or how those assets are performing.
3. How regulators could crack down
The two regulators who are best placed to scrutinize Compound Banc are the FDIC and the CFPB, both of whom declined to comment to Axios. For the time being, however, only the SEC has the obligation to scrutinize Compound.
- Both the FDIC and the CFPB have the authority to issue a temporary cease-and-desist order, says McCoy: "They could shut it down very quickly." The idea would be to stop the solicitation of investor funds, at least temporarily, while simultaneously putting out a press release warning customers about the risks involved.
The big picture: Compound Banc's website "raises a number of significant questions that I suspect will quickly doom this scheme," says banking policy analyst Karen Petrou of Federal Financial Analytics.
- Petrou was one of two experts who used the word "Ponzi" in conversations with Axios. That's not necessarily because they think Compound Banc is a Ponzi, and more because they are concerned that its business model is prone to Ponzi-like death spirals like the one we saw at the now-bankrupt crypto exchange, FTX.
- Here's how that could happen: Compound Banc's liabilities continually grow at a rate of 7%, while its assets are tied up in volatile mortgage products. Customers have only infrequent glances into how much those mortgage products might be worth — much like FTX customers didn't have visibility into the asset side of FTX's balance sheet.
- So long as a firm isn't asked to give its customers' money back — meaning that its inflows exceed its outflows — it survives, even if it's insolvent. Only when customers collectively decide to withdraw their money, do they discover what is (or isn't) backing it.
Where it stands: As this newsletter went to press, only in very small print at the bottom of the Compound Banc homepage does the company say that its product isn't FDIC insured, even though higher up it explicitly compares its yields to the "FDIC National Average."
- The homepage does, however, lead with the yield on the bonds, expressed as an "APY." That's a regulated legal term under the federal Truth in Savings Act, which means the CFPB forces regulated banks to show their APYs on an apples-to-apples basis. Using that term therefore "buttresses the impression that this is a regulated bank savings product," according to McCoy.
- Products regulated under the Truth in Savings Act offer various consumer protections, none of which Compound seems to be offering.
- There's also nothing on the website that makes clear that the bonds are high-risk, beyond a tiny link to the official SEC offering circular. Indeed, Axios received one email from Compound with the subject line "Avoid Risk and Earn Big."
- Compound Banc COO Anoop Singh told Axios in a statement that "investors should be reviewing our extensive Risk Factors before making an investment."
The bottom line: It's incredibly easy, these days, to spin up a slick website that looks like that of a regulated financial institution. It's the job of regulators to make sure consumers aren't misled.
4. A trillion-dollar pool of deposits
Gone are the days when opening a bank account online was perceived as being in any way weird or risky.
Why it matters: Almost $1 trillion sits in U.S. bank accounts that were opened online, per the FDIC.
The bottom line: When people opened accounts in person, it was much harder for them to inadvertently end up transferring their money to an unsafe or unregulated institution.
Thanks to Kate Marino for editing this newsletter, to Lisa Hornung for copy-editing it, and to Brian Westley for legal review.