Evolution of Banking (and Frauds!) –
Part I
In a modern, digital age, global data breach incidents
feature in news more frequently than what we are comfortable with.
Evolution of Banking (and Frauds!) – Part I
In a modern, digital age, global data breach incidents feature in news more frequently than what we are comfortable with.
In a modern, digital age, global data breach incidents feature in news more frequently than what we
are comfortable with. Cybersecurity, which used to be a luxury until a few years back, has rapidly
climbed the priority charts of Chief Information Officers (CIOs) of global organizations to merit
the tag of necessity. Countries around the globe are at different stages of development and their
financial institutions are evolving each day.
Banks have traditionally been the hot target for attacks, as they are the ones in possession of most
prize reward – money! As banks compete to offer technology driven solutions to their customers,
attackers get a larger “area of attack”. The battlefield has entirely shifted to digital platforms
and attackers are gaining sophistication and expertise by the hour. Financial regulators around the
world have been issuing guidelines and bringing in laws to keep a check on these but a lot more
needs to be done.
In this three-part series on financial risks and regulations, we have a look at the evolution of
attacks and the efforts taken by regulators to prevent and counter them. This being the first part,
we will dig deep into history to cover some of the oldest financial frauds in history – how the
fraudsters operated and the action of regulators, if any. As we progress through time, we will see
how financial systems became more and more organized and how the regulators came in. The second part
will cover evolution of stock markets around the world and how access to privileged information was
used to manipulate prices. Third part would focus entirely on the digital playground.
There is a wide belief that history of financial crimes date back to the emergence of commerce and
money itself. Although our ability to single out the first attempted financial fraud is limited
owing to lack of documentation, we have picked out the attempts that have stood out and have been
documented.
300 B.C. – Hegestratos’ epic boat-sink failur
In what we found to be the earliest documented attempt at a financial fraud against insurance, a
Greek merchant named Hegestratos tried to make way with “bottomry”. It was a popular arrangement for
sea merchants as they assumed great risks in transporting goods across sea.
The journey duration easily ran into months and he ran the risk of encountering bad weather and
storms, which could damage and sink the ship. Under “bottomry” arrangement, a merchant would borrow
money from an insurer and promise to pay it back with interest once the cargo made its way across
the sea safely. If he failed to return the money, he would part ways with his cargo and ship, which
would be acquired by the lender.
Hegestratos made a seemingly airtight plan, in which he would start sail with an empty ship and sink
it mid-sea, selling the corn elsewhere. The only obstacle he found was that his crew caught him red
handed and got agitated on finding out his wicked plan of sacrificing their lives for financial
gains. The plot ended very differently than intended, ending with Hegestratos death due to drowning
while trying to escape his crew.
193 A.D. – Sale of The Roman Empire
Meticulous planning notwithstanding, the first instance of attempted financial fraud of human
history is known more for its audacity than success. We now fast-forward the plot by about 500 years
to find evidence of a heist that far exceeded Hegestratos’ plot in complexity and magnitude. Even
the results went to plan – in the short term at least.
The year 193 A.D. is known as “The year of The Five Emperors” in Roman Empire. Until this time, the
world often witnesses financial crimes in which the supposed guardians are hand in glove with the
perpetrators of crime. Luring the victim into a false sense of ownership and selling him something
that the fraudster never owned in the first place is modus operandi that finds plenty of evidence in
the modern era.
This was a year of political unrest which led to a civil war situation. Five rulers were vying for
the throne and were on constant lookout for upstaging the incumbent. Pertinax, who was named the
Emperor after the assassination of Commoduson new year’s eve. The Praetorian Guard, who were
supposedly loyal to Pertinax, assassinated him and held an auction to sell the empire. Julianus
seized the opportunity and offered 250 gold coins for every soldier in the army. To put things in
modern context, the amount was to the tune of a billion dollars in today’s currency. Julianus was
never recognized as a ruler and ended up being deposed quickly. The guards had sold something that
wasn’t theirs and ended up being executed by the subsequent ruler.
This incident had all the ingredients that have caused financial frauds over centuries – corruption,
abuse of power and treason – a theme that continues to dominate financial frauds in the modern era
where a lot of policy makers, leaders, bank officials and regulators have been implicated and
convicted.
The Panic of 1792
Financial frauds from ancient history might lead you to think that the underlying cause was lack of
organized financial system. After all, had there been reliable and verifiable sources of
information, perpetrators of fraud would have had a tough time manipulating people and selling what
wasn’t own by them. Bank of United States was formed in 1791 and one year later, America (and likely
the world) was to experience the first insider trading scandal. William Duer and Alexander Hamilton
– two stellar names in banking at the time – had risen in stature and used their power to manipulate
prices of securities. They had come up with innovative solutions in the past to help navigate times
of financial instability – and being a developing nation, America had plenty of it.
Hamilton, secretary of the Treasury, was in the process of restructuring the country’s finance by
replacing outstanding bonds of various colonies by those issued by the new central government. This
was the perfect stage for big investors to get extra curious and seek out information about the next
set of bonds that were to be replaced. Being a recently independent, developing nation, the
slightest of tips was critical in staying a step ahead of the market and making windfall gains.
William Duer was a part of President George Washington’s inner circle of the elite and served as
assistant secretary of treasury. He was ideally placed to tip off his close group of friends to
execute appropriate transactions in their portfolio before leaking part of the news to public, which
was guaranteed to cause high volumes of trades and fluctuate prices to suit him. Duer continued to
abuse his position for numerous years and did not stop even when he had left the post – using his
contacts from the Treasury to gain access to insider information.
At the end, the bubble burst as investors rushed to cash in on their investments and it left Duer
with worthless portfolio and a huge debt he had acquired to build it, relying on his access to
insider information. He ended up in debtors’ prison and died in the year 1799.
1822 – The Prince’s Scam
Gregor MacGregor was a Glengyle (Scotland) resident and a Royal Navy officer who had served for well
over a decade and fought a number of wars in distant lands, including the Venezuelan war of
Independence. He returned to London and made an extraordinary announcement – that he had been
crowned as the Cazique (Prince) of the Land of Poyais along the Bay of Honduras. He painted a rosy
picture of the land and some of the salient points about it were:
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- The water was so pure it could quench any thirst
- Gold lay lined along the riverbeds
- Mines abundant with gold and silver lay unexplored, waiting to be harvested by settlers
- A large numbers of locals were eager to work for their British Masters
MacGregor even published a book to promote his cause of projecting Poyais as an exotic, Edenic
destination where a new, perfect like awaited settlers. Authored by a certain (or probably
uncertain) Thomas Strangeways, the book was titled Sketch of the Mosquito Shore: including the
territory of Poyais, descriptive of the country: with some information as to its production, the
best mode of culture & chiefly intended for use of settlers”.
The book elaborated on the riverside country’s riches and presented the perfect contrast to
Scotland’s unfriendly weather, rocky soils and rains. America was emerging as an investment
destination during that time and Poyais was marketed as a very viable alternative. In no time, his
interviews glorifying Poyais were on national newspapers and he talked about how “only the real men”
would muster the courage to settle there. He used his easy access to the elite circles wisely and
even started selling the currency of Poyais to prospective settlers.
His imagination amazes people to this day – history is littered with stories of financial frauds
where victims got conned into investing in companies that didn’t produce anything, lands that did
not belong to the seller, shares of firms that did not exist, etc. However, to convince the elite
and ordinary alike into investing in developing a land that did not exist – across countries and
continents required extraordinary skill – however destructive it might have been. Maria Konnikova’s
article the
conman who pulled off history’s most audacious scam for BBC presents his antics in greater
detail.
These instances might seem far removed from the technology driven, modern financial systems.
However, there is a common theme to be found – nearly all financial frauds happen due to an insider
hand. Someone close to the government, within the government or in the regulating body will always
have access to privileged information and it is only a matter of time before his integrity is tested
and he compromises his values for making a quick buck.
Financial regulators around the world were supposed to be independent, autonomous bodies that would
have nothing but the country’s economy as their priority items. Ironically enough, there are
countless instances where the regulator either decided to look the other way or did too little, too
late to prevent such frauds. As financial systems around the world matured, the policy making became
more and more sophisticated but we are a long way from where we would want to be.
Who is the real victim?
In an effort to promote business, governments and regulators around the world have often been
complicit in bending the rules to make way for market players. This ultimately leads to a situation
where a market participant becomes so dominant that is considered “too big to fail”. If and when
they fail, the ensuing market frenzy wipes off years of investors’ accumulated wealth and
governments ultimately have to step in with a “bail-out” package. It stabilizes the market but the
underlying question is – who was the real victim here? The package, after all, was the taxpayers’
money.
In subsequent parts of this series, we will see how global economies became interconnected and the
biggest of banks failed – slowing down global economies for years. Overoptimistic bankers and
opportunistic speculators never make a good team and we will have a look at how this combination
sank the biggest in business. We will cover some more financial frauds and see how there were people
who successfully outsmarted the systems for considerable periods before eventually getting caught
with their hands in the cookie jar and had their lives reduced to hundreds of years of prison time.
The modern era is where banking has truly become “digital”. One certain benefit of having technology
driven banking systems is that we have more and more statistics to dig into – something that wasn’t
the case hundreds and thousands of years ago. However, with convenience, it has brought many
additional ways to cheat the system and this will constitute the last part of the series.