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. 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.

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.

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.

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.

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:

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.

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.