Editors' pick: Originally published March 22.
It is interesting to note, and seemingly counter-intuitive, that the second-largest Ponzi scheme of all time happened in a country with some of the strictest banking regulations in the world.
Ezubao, formerly the largest peer lending marketplace in China, turned out to be a gigantic scam that defrauded more than 900,000 investors to the tune of $7.6 billion.
Although the company shut down in December and police arrested a slew of top executives, the real culprit isn't the company but the lack of effective regulation in the growing field of "shadow banking."
Shadow banking is a catch-all term for banking services that don't originate from a traditional bank. This includes money market accounts, various securitization vehicles and peer lending.
Shadow banking has grown rapidly worldwide for many reasons but mostly because traditional banking is riddled with problems and the heavy regulation of banks stifle their ability to innovate.
Banks have long proven to be frustratingly inefficient, borderline incompetent or even surprisingly reckless. Bank failures were common in the United States until the Federal Deposit Insurance Corp. was created in 1933.
The FDIC isn't necessary because banking in itself is risky but because bankers' greed sometimes pushes bank policies to recklessness. Deposit insurance was created to solve the issue of "trust" and give peace of mind to depositors.
This peace of mind costs depositors about 1.5% per year, and as we saw during the world wide financial collapse of 2008, bankers still secretly gamble with depositor funds anyway.
Many shadow banking instruments are designed to use market forces to cut the bloat from banking services. For example, money market accounts use short-term cash-equivalents to park cash efficiently.
Mortgage securitization provides a sometimes easy, risk-averse way to invest in secured loans. Peer lending disintermediates traditional banks, allowing individuals to underwrite personal loans, and it passes the reduced overhead savings along in the form of lower rates for borrowers and higher returns for investors.
These are all legitimate endeavors, using techniques that traditional banks just can't handle.
China's banking reputation of inefficiency, political favors, corruption and recklessness are even more pronounced than their American counterparts, because the pressure cooker of regulation hasn't been able to cope with the economy's drive toward modernization.
China only introduced deposit insurance last year. Interestingly, the reason wasn't to soothe depositor worries -- the banks are state-owned, after all, which until last year meant that every dollar was backed by the government -- but to introduce risk into the system while keeping it at bay.
In the past decade, state politicians have allowed shadow banking to take off in China to solve some of the bank industry's issues. The few that Ezubao purported to solve were to provide good investment opportunities for people with money and access to capital for business borrowers without political connections.
In the beginning, government officials praised Ezubao because they recognized the benefit of pumping capital into the economy while not leaving the state-run banks on the hook.
The economic boom of the past three decades afforded many Chinese the ability to invest, while the Internet provided the means to find opportunities, but lack of oversight allowed Ezubao to steal money using a classic Ponzi scheme. As most people are aware, a Ponzi scheme consists of faking good investment returns by distributing the money collected from new investors to previous ones, in lieu of, well, actually investing.
Although it stole less money, the Ezubao scandal defrauded a much wider audience than that of America's Bernard Madoff. Instead of a rich insider stealing from the wealthy top 1%, many Ezubao investors are from poor, rural areas.
Some commentators have stated that the 900,000 investors should have known better, but it isn't as if the Ezubao investors were stupid. Part of the reason that Ezubao was successful in attracting investor dollars was that it made sense: Promised returns weren't out of this world, each loan was supposedly "secured" with "business equipment," and the idea to use Internet technology to eliminate overhead and service the loans sounded legitimate.
Obviously this was a lie: It is estimated that upwards of 95% of the loans issued on Ezubao were fake.
It may seem like those are the two alternatives: a bloated and highly regulated banking sector backed by the government that offers depositors little to no return or a libertarian market forces shadow banking system, which offers the possibility of either a high return or complete loss.
But only two things are needed to prevent a fraud like Ezubao: third-party custody and loan servicing, with the first one providing by far the best protection. Investors' money shouldn't be kept by the marketplace but by an accredited company that ensures that the money is really there.
Incidentally, this is the system used in America, and most U.S.-based peer lending marketplaces demonstrate that the cost of a qualified custodian doesn't prohibit offering excellent performance.
In addition, China also has the opportunity to design a secure, transparent and automated verification system. Fraud can be made virtually impossible if transactions are completely transparent.
The working example is Bitcoin. The genius of Bitcoin is that the history of all the transactions are publicly available and un-forgeable. If investors are able to see where funds are going and that they are, in fact, being distributed according to the stated transaction history, regulators have a detailed and live log of all transactions and third parties handle custody and servicing, it will be much less likely for an untrustworthy individual to steal investor money and get away with it.
For a long time, banks have provided only frustrating returns for investors. Successful peer lending platforms such as Lending Club in the United States or Zopa in the United Kingdom have demonstrated that, if done right, financial innovation can benefit all, from borrowers to investors.
These examples show that the solution isn't massive deregulation, nor in accumulating even more directives. The solution is in smarter, lighter rules that are intelligently adapted to our high-technology, ever-connected world, with a set of checks and balances to protect investors along the way.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks of the company mentioned.