3 Experts Explain Why Recent Bank Runs Are Bad For Crypto

• Just a decade ago, bank runs occurred at a much slower pace.
• Now technology-forward depositors have much more volatile accounts.
• The traditional approach to asset-liability management does not translate well for crypto clients.

“I’m nervous like I was in 2008.”

That’s how Jason Brett, a regulator with the Federal Deposit Insurance Corporation, or FDIC, during the Great Recession said he felt about recent bank failures.

The last two weeks have seen a domino effect of one bank collapsing after another.

Silvergate Bank, which established itself as a leading bank for fintech and crypto, started the trend after it closed on March 8 in connection with a liquidity crisis. Shortly thereafter, Silicon Valley Bank, or SVB, faced a bank run after some of its investments plummeted in value, and California state regulators shut it down. Two days later, New York state regulators shut down Signature Bank, another key provider for crypto customers, over contagion concerns.

The FDIC’s quick response to support depositors surprised Brett. But more than that, he had never witnessed a bank being closed on a Sunday, which was the case with Signature Bank. He said it would usually happen on a Friday.

“These are really extreme measures. I don’t know what they know, but if there is a big risk going on in the banking system, it could really hurt our economy badly in the next few years,” he said.

A question at the center of the debacle relevant to crypto is whether the fractional reserve system that many banks use works for tech-forward depositors in volatile growth sectors. Banks usually only need to make a fraction of their deposits readily available to customers. They invest the rest in, among other things, high-interest loans and government bonds.

But is this the best system for a volatile sector like crypto, where valuations can plunge quickly, and depositors may need to withdraw a lot of money quickly?

It’s a good question that needs to be revisited in light of the three US bank failures, according to Todd Baker, a senior fellow at the Richman Center for Business, Law, and Public Policy at Columbia Business School.

Some experts Insider spoke to have argued that the answer is no: the current system is not a perfect fit for crypto, and there is no adequate replacement in sight.

The era of digital banks is passing

One thing the past few weeks have made clear is that bank runs are now unfolding differently, especially for smaller banks serving specialized sectors.

“Bank runs are evolving into a different and much more dangerous beast because they’re happening faster,” Baker said. “They can be stimulated by the way audiences can move because of all the digital and social media connections that people have.”

Baker remembers that banking is a slower process. He was executive vice president of corporate strategy and development at Washington Mutual, or WAMU, until it collapsed in 2008. It was a U.S. savings and loan association that stood as the largest failure of an insured depository institution in the history of the FDIC.

To put things into context, the FDIC shut down WAMU after an eight-business-day period in which the bank lost about $16.7 billion in deposits, he said. By comparison, on March 9, SVB lost $42 billion in one day — and that was a smaller bank, Baker added. At the end of the closing day, SVB had a negative cash balance of about $958 million, according to a filing with the California Department of Financial Protection and Innovation.

“There are more ways to move money instantly than there used to be. And there are going to be even more ways to move money instantly. And all of that has implications for the stability of the banking system,” Baker said.

He also said two more cases helped bring down the three banks. First, they specialized in serving businesses that control many deposit amounts well above the FDIC-insured sum of $250,000, but that’s an age-old problem, he said. The second part is key: Silvergate, SVB, and to a lesser extent Signature Bank, had significant deposits from volatile business sectors and had deposit balances that changed significantly over time.

Caitlin Long, founder and CEO of Wyoming-based Custodia Bank, said she believes the banks could have easily avoided the recent collapses. She said she began sounding the alarm about potential settlement issues five years ago in several conversations specifically with bank regulators. Her earliest recollection of issuing a public warning about this issue was in a keynote speech in November 2020 at the Cato Institute’s annual monetary conference.

Long said she warned regulators again after FTX collapsed that banks serving the crypto sector face the danger of bank runs. Her anticipation of such risks stems from spending most of her career on Wall Street handling settlement issues through the SWIFT system, which allows financial institutions globally to send and receive encrypted information, and witness the delivery failures of the securities market.

Long said the application programming interface, or API, which gives business customers direct access to bank functions for large and instant transactions, moves money much faster. That’s why so many tech companies knocked on SVB, Long said. This level of access is still rare in the banking industry, she added. Most companies use a flat file, which they then send to the bank to process payments overnight. The moment you expose an API to the end user, the potential for your deposits to be withdrawn within hours increases exponentially, Long said.

Combine that with a sector like crypto—a high-velocity, high-risk, fast-moving market that sees extreme swings of up to 90% in either direction—it’s a recipe for disaster.

For example, just before the crowd of crypto firms began to collapse, as of March 31, 2022, Silvergate had about $13.3 billion in demand deposits that could be withdrawn within minutes and less than $1.4 billion in cash, Long said. Silvergate had to sell its long-term securities at a loss to meet withdrawals when money began to run out.

The way forward

The crypto market operates 24-7, while the rest of the world does not, Baker said. Banks such as Silvergate and Signature are setting up internal instant settlement vehicles to serve crypto trading market participants, such as exchanges. As policy makers work through their responses, they need to consider how they will serve the sector.

The loss of the Silvergate Exchange Network is a blow to the crypto ecosystem, according to a March 9 report from JPMorgan. The platform had been a central crossing point for fiat transfers for more than 1,000 institutional crypto firms. But between regulatory pressure and the collapse of FTX, mainstream banks are reluctant to fill the gap, the note said.

Long said banks cannot use the “loan-card, loan-long” model with depositors who can make quick withdrawals electronically. She had hoped that her bank, which specializes in digital asset payment and custody solutions for businesses, would provide a safer solution for serving high-risk crypto clients. She told Insider that Custodia proposed keeping 108% of customers’ demand deposits in cash in its main Fed account for the first three years, and 105% from year four onwards. The crypto bank applied for a master account in October 2020, and for membership in the Federal Reserve in August 2021, but both applications were rejected in January 2023.

Baker agreed that the traditional approach to asset-liability management does not translate well for crypto clients. But a 100% cash reserve on-demand deposit model is not possible, he said. Instead, he said banks should be extremely conservative and hold government bonds and other short-term securities that do not have significant interest rate risk.

Brett said policymakers could adopt a future rule requiring crypto customer deposits to be classified the same as broker deposits, which are more closely regulated and restrict institutions that aren’t well capitalized from accepting them.

It is uncertain how long it may take politicians to address these problems – there is no set deadline. But one thing to remember is that the crypto market has its steady four-year cycle that has always ended in a parabolic crypto rally. The bullish cycle begins when the rewards paid for mining bitcoin are halved and the number of newly minted coins decreases, increasing demand. This historically sends bitcoin’s price soaring, with other altcoins usually not far behind. With each new rally, the crypto’s market value increases before it breaks.

Policy makers may want to take note: The next halving is scheduled to take place sometime around March 24, 2024. It is possible that the next crypto bull run will begin soon after.

As for banks that want to specialize in these new sectors, they should be very careful because they don’t understand what the risk parameters are. It is clear, Baker said, that Silvergate did not understand the true volatility of the deposits.