DeFi

How The History Of Bank Runs Helps Us Understand The FTX Fiasco And Other 2022 Crypto Exchange Failures

Like many people who work in financial services, I’ve been fielding lots of questions from friends and family about the seemingly overnight implosion of crypto exchange FTX. To those who do not work in the financial services industry, it is hard to fathom how a crypto exchange that at one point was worth $32 billion could go bankrupt in approximately five business days.

To wrap your head around last year’s wave of crypto exchange failures, it’s useful to reflect on the history of banking crises and bank runs. The history shows both how this FTX calamity happened and how decentralized finance (known as DeFi for short) differs from the current FTX situation.

A brief history of bank runs

Bank instability has been an unpleasant fact of life for centuries. In America alone, numerous financial crises have led to bank runs and bank failures. Banks failed en masse during the Panic of 1819 and the Panic of 1837. Eight years after the end of the American Civil War, the collapse of the railroad industry led to the Panic of 1873, when people across the nation rushed to get their money out of banks before the coffers were emptied. At least 100 American banks failed in 1873, a huge number given that the country had only about a tenth of the population that it has today. The situation was so bad that the Panic of 1873 was known as the “Great Depression” at the time.

It wasn’t until the even worse recession in the 1930s that the Panic of 1873 passed the rhetorical baton and lost the Great Depression label. The 1930s Great Depression is the best-known example of mass bank failure and frenzied citizens swarming banks trying to withdraw their money. 9,000 American banks failed.

This problem of bank runs and the possibility of losing your life savings wasn’t limited to America – to pick two of many examples, Japan suffered a wave of bank runs and failures in 1927 and in 1825 the U.K. saw bank runs and a failure of 10% of the nation’s banks.

Why doesn’t this happen in the developed world anymore?

The Great Depression was so traumatic that it triggered banking reform movements around the world. New laws were passed to regulate banks and make sure they had much more cash on hand to meet customers’ withdrawal requests. But what really changed the course of history was the creation of the first national deposit insurance program in America in 1933 – the Federal Deposit Insurance Corporation (known as FDIC for short). The federal government promised to reimburse any Americans who lost money on a bank failure up to a certain threshold, starting at insuring $2,500 of deposits in 1933. As of 2023, the FDIC now insures up to $250,000 of bank deposits.

Over the course of the 20th century, many countries around the world created similar forms of deposit insurance. The invention of the deposit insurance program has (mostly) stopped bank runs in affluent nations. There are, however, some exceptions and situations where bank runs happened despite the creation of deposit insurance, such as the 1985-1995 American savings and loan crisis and the global 2008 financial crisis. For a sense of how traumatic the 2008 financial crisis was for banking, in 2009 and 2010, 297 American banks failed. In contrast, the last five years have seen only eight American banks fail.

The key difference between recent crises and past financial calamities is the existence of the FDIC. Due to deposit insurance, American deposit holders were made whole in both events. The FDIC touts that since 1933, no depositor has lost a penny of FDIC-insured funds. The FDIC and similar programs around the rich world have been so effective that most consumers living in developed countries don’t spend time worrying about the solvency of their bank.

Bank runs are still a chronic problem in the developing world

It’s important to acknowledge that bank runs are still relatively common in the developing world. In many countries, governments either do not provide deposit insurance or offer deposit insurance that exists only “on paper” – in reality, the government does not have the resources to reimburse citizens in the event of bank failures. Take Myanmar as an example of how banking can still be very risky and unreliable in the developing world well into the 21st century. Myanmar suffered a calamitous bank crisis in 2003, and the 2021 military coup made local banks unstable.

Bank crises in the developing world can create broader social unrest and lead to violence. The notorious 2001 banking crisis in Argentina saw violent protests and 39 deaths. For a more recent example, the crisis in Lebanon has seen armed bank customers breaking into bank branches trying to retrieve their frozen deposits.

Last year’s wave of crypto exchange failures are a reminder for citizens of developed countries of what finance is like without deposit insurance

To oversimplify, people who want to buy and hold cryptocurrency have two options. One option is to store their cryptocurrency on their own personal wallet and to buy and sell cryptocurrency using DeFi protocols. Alternatively, they can use a corporation like FTX to buy and hold cryptocurrency on their behalf.

When someone uses a company like FTX, they are trusting an opaque institution with their crypto. Since there is no deposit insurance for cryptocurrencies, FTX customers knew that if the crypto exchange proved to be insolvent, they could lose everything if they didn’t get their crypto out fast enough. That is why rumors and negative headlines around FTX created a sudden panic and a rapid bankruptcy. FTX customers are no different than panicked bank customers in 1929 at the start of the Great Depression.

Since crypto does not have deposit insurance, what is the solution to runs on crypto exchanges?

Since the crypto universe does not – and likely never will – have any kind of government guarantee in the case of a failure of a corporate crypto exchange, how can the ecosystem stop these kinds of traumatic events? It is important to distinguish corporations like FTX from DeFi and the cryptocurrencies themselves.

Cryptocurrencies and DeFi are different from traditional finance – they offer radical transparency. Anyone can view the state of a cryptocurrency via what’s called a block explorer. As the name implies, block explorers let users review the robustness of a blockchain, recent transactions, past transactions, etc. For example, you can use Etherscan to view the health of the cryptocurrency Ethereum. Likewise, decentralized finance is not controlled by a traditional corporation – DeFi enables crypto trading, borrowing, and lending based on code, and anyone can see the health of a DeFi service in real time.

This all may seem a little counterintuitive – to many, large financial corporations usually imply greater stability and safety. But without deposit insurance, bigger does not equal better. The public largely cannot see “behind the curtains” at corporate crypto exchanges. They can’t see potentially risky behavior and how these exchanges are managing client assets. So when the public finally learns the bad news, a panic ensues.

The lesson from the high-profile failures of several corporate crypto exchanges in 2022 is that consumers should hold their crypto in their own wallet. Consumers should also use the major established DeFi protocols that are battle tested and resistant to hacks. DeFi offers complete transparency – DeFi users don’t need to cash out in a panic because they can see the health of the protocol in real time, 24/7.

Corporate crypto exchanges with opaque business practices do not represent the founding principles of cryptocurrency: decentralization, transparency, and rules written into code. Consumers should remember that these corporate exchanges are and always will be susceptible to sudden collapses. For those that are interested in crypto, the last few months are a reminder that you need to take the time to learn how to responsibly use DeFi and that you should avoid corporate crypto exchanges.

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