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After a major short-seller accuses Block of facilitating “frictionless” fraud, the payments industry speculates as to how regulators will respond. In the meantime, Block insists it will see Hindenburg in court.
In a new exposé published by Hindenburg Research, an investment research firm that focuses on short-selling, US payments firm Block is accused of “systematically” taking advantage of the “unbanked” and “underbanked” customers it claims to serve.
After a two-year investigation into Block’s business practices, Hindenburg claims that Cash App, Block’s mobile payments app, is a go-to platform for fraudsters and other criminals.
Block has previously promoted Cash App as offering a kind of “magic” through its “frictionless” payments.
However, according to Hindenburg, Cash App’s real magic lies in its ability to “facilitate fraud against consumers and the government, avoid regulation, dress up predatory loans and fees as revolutionary technology, and mislead investors with inflated metrics.”
During the COVID-19 pandemic, Block claimed that Cash App’s user base grew rapidly to more than 51m monthly transacting users, and that this growth was driven by its low customer acquisition costs.
But Hindenburg’s research alleges that Block has “wildly overstated” Cash App’s genuine user numbers and has “understated” its customer acquisition costs.
According to former Block employees interviewed by Hindenburg, between 40 and 75 percent of Cash App accounts are either fake, involved in fraud or are duplicate accounts tied to the same individual.
“Core to the issue is that Block has embraced one traditionally very “underbanked” segment of the population: criminals,” said Hindenburg.
“The company’s ‘Wild West’ approach to compliance made it easy for bad actors to mass-create accounts for identity fraud and other scams, then extract stolen funds quickly.”
Following the publication of Hindenburg’s report, Block’s share price dropped more than 25 percent over a two-day period, allowing Hindenburg to profit from a short position that it disclosed in its research.
In response, Block has dismissed the claims made by Hindenburg, and has said it will pursue legal action against it via the Securities and Exchange Commission (SEC).
“We intend to work with the SEC and explore legal action against Hindenburg Research for the factually inaccurate and misleading report they shared about our Cash App business,” Block said in a statement.
“Hindenburg is known for these types of attacks, which are designed solely to allow short sellers to profit from a declined stock price. We have reviewed the full report in the context of our own data and believe it’s designed to deceive and confuse investors.”
Investors divided following Hindenburg exposé
Hindenburg’s report has led to a split among investors — some of whom say they will continue to back Block, and some of whom are urging caution while Hindenburg’s claims are investigated.
Among those who have said they will stand with Block is ARK Invest, a tech-focused investment firm that holds a 1.7 percent stake in Block.
Maximilian Friedrich, analyst at ARK Invest, said that Hindenburg’s report singles out Block unfairly as a conduit for fraud, when the issues raised in the report are universal among financial service companies.
For example, one of Hindenburg's claims is that Cash App was used fraudulently during the pandemic to withdraw stimulus money through the US government's CARES Act.
Cash App gained about 11m new direct deposit users in the first few weeks of the programme, which Hindenburg alleges led to "floods" of funds into Cash App accounts with minimal know your customer (KYC) checks.
Friedrich said that although Cash App was “likely” used for fraud during the pandemic, other financial service companies faced the same problem on an even larger scale.
He added that due to Cash App’s limits on how much users can withdraw from the platform, Cash App may have mitigated the total amount of federal funds lost to fraud compared with that of other platforms.
“Fraud is an optimisation problem,” said Friedrich. “Companies have a risk engine that they're continuously perfecting and can tune up or down.
“Some fintechs might have temporarily tuned them down to provide a lifeline to many struggling individuals and businesses ignored by banks during COVID.”
In terms of the regulatory response to Hindenburg’s report, Friedrich indicated that it may galvanise efforts to add “more friction” to payment apps — a move that would slow down growth but would help to catch more fraud.
This could become a priority with the launch of the FedNow instant payments system in July, he said, which would introduce a new dimension of fraud risks to the US payments system.
Among investors who appear to have been spooked by Hindenburg’s report is Morgan Stanley, Block’s third-largest shareholder after Vanguard and Blackrock.
In a research note, Morgan Stanley said that finding out how widespread are Cash App’s fraudulent accounts should be a key concern in light of Hindenburg’s report.
“We’ve previously discussed how Cash App seems to have lower verification requirements that potentially may not meet all standards of KYC and AML rules,” said Morgan Stanley.
“This could eventually lead to a culling of some fake or fraudulent accounts, and investors should be prepared for a potential downshift in Cash App user growth or monetisation.”
Over to you, regulators
Last week, while speaking at the Pay360 conference in London, digital ID specialist Lu Zurawski said the payments industry has had a tendency to prioritise “frictionless” at the expense of security.
Later, while speaking to VIXIO, Zurawski said these priorities are in need of re-balancing, particularly in light of the evidence presented by Hindenburg.
“Superficially, some of the headlines sound like they need an urgent regulatory response,” said Zurawski, a commercial lead at Digital Trust Services. “But unlike with Wirecard, I am not convinced we'll see payments regulators' knees jerking too violently here.
“Whatever happens next though, it does highlight what I said at Pay360. There has to be a better way of verifying that users of payments systems are real, authentic humans, holding verifiable credentials that can be exchanged simply between transacting participants.”
Other payments industry professionals, who asked not to be named by VIXIO, agreed that Block’s focus on “frictionless” appears to have opened up the platform to users who could not possibly pass a KYC check, including criminals.
As one source said of Block: "Every one of these new so-called ‘innovators’ that cuts corners to make a quick buck, whether through sloth, stupidity or criminality, makes the landscape more complicated for companies trying to do it the right way, while simultaneously shining a spotlight on why it needs to be done the right way."
Although Hindenurg’s report may result in a lawsuit against it, some legal observers have questioned whether such action by Block would be wise, given the strength of the evidence against it.
Kelvin Low, law professor at National University of Singapore, said it is unlikely that Block would sue, as any lawsuit would subject the company to discovery procedures.
He added that Hindenburg’s previous research has a strong track record of convictions for those it has accused of fraud, including, for example, Terry Milton, the founder and chairman of electric car maker Nikola.
“Short-sellers are absolutely essential to the proper functioning of markets,” said Low. “And what they do takes tremendous chutzpah as it is very high risk. It's not something you do on a whim.”
