Introduction
Cryptocurrencies are also part of the financial and investment sector. They are a digital alternative for all fiat-related financial services and options. Therefore, cryptocurrencies are also subjected to the risk that some traditional financial enterprises and entities can face.
Bank Runs are one of the risks that DeFi has not managed to overcome. This article is going to shed light on bank runs in DeFi and how to avoid getting caught up in them.
What is a Bank Run?
It is important to note that Bank runs are not specific to cryptocurrency enterprises and DeFi entities. They started with traditional financial networks. When the people first invented money, there were no appointed departments to control and manage them. However, with the arrival of democracy, the elected government institutionalized the fiat currency issuance with organizations called Central Banks.
At the same time, regional banks started to operate to extend financial services to the masses at large. Eventually, there were many private banks, but all of these banks were required to get registration from the government and report to them.
However, the earliest banks sometimes failed, and it resulted in rumors spreading around their consumers. During a period of depression or economic recession, the consumers of a particular bank could start to withdraw their holdings in large sums. It means that the bank can run out of liquidity resulting in driving it to bankruptcy. This phenomenon is called a bank run.
Notably, Bank runs are caused by the fear and panic spread among the masses who want to get their life savings and earnings out of a given bank in case of an unprecedented shutdown and end up accelerating it.
How does a Bank Run Work?
As mentioned before, Bank runs have been present since the arrival of the first banking enterprises in the world. During the time of great economic distress, people are bound to get suspicious about the stability of the banking services that they are availing.
Therefore, in case of a new rumor or leak of any unfavorable financial news can result in creating havoc among its clients.
As a result, the clients can make a beeline for the bank to withdraw all the contents of their savings from their accounts as soon as possible. It is important to note that banks do not keep the cash deposited by their consumers idle in a locker.
On the contrary, banks and other financial institutions invest the money deposited by their consumers to earn profits. Therefore, a bank only has the required amount of liquidity available at its disposal, mandated by the Central Bank.
Therefore, in case the consumers of a bank start to flock in great numbers to clear out their accounts, the bank can suffer from the drying of the available liquidity. Under such circumstances, the bank cannot continue to pay its employees, fulfill its minimum liquidity requirements, settle commercial transactions, and can go out of commission.
What is a Bank Run in DeFi?
As we know that cryptocurrencies are another alternative to fiat currencies but they are decentralized making them independent from governments. In a way, cryptocurrency enterprises such as exchanges can be viewed as a digital alternative for traditional banks.
In many ways, these crypto enterprises also operate in the same manner as real banking enterprises. It means that these organizations do not keep the funds provided by their consumer in a static state.
It is important to note that in case of a rumor or bad review, spreading among the investors can result in a bank running as well. The consumers can start to move their cryptocurrency reserves out of the exchange wallet accounts, and it can drain liquidity.
How do Bank Runs Work in DeFi?
Much like their TradeFi contemporaries, the cryptocurrency exchanges and other organizations also do not keep the funds of their consumers stagnant. These enterprises collect the funds and invest them in new projects, businesses, or other assets to generate profits.
Therefore, these organizations do not have 100% liquidity available at their disposal at all times. Additionally, since cryptocurrency exchanges are not regulated, they are also not checked by the government or any other regulators about maintaining the minimum amount of liquidity at their disposal.
Therefore, when there are cracks in the management of the organization or the consumers are getting skeptical. Even the smallest spark of doubt on social media or other media outlets can result in inciting consumers to rush to clear out the contents of their wallets.
Under such circumstances, the cryptocurrency exchange can do little to stop the dramatic and sudden loss of liquidity. In this manner, a bank run on a DeFi enterprise can take place.
When enough consumers have emptied their wallets, the exchanges run out of available funds or liquidity. It files for bankruptcy which means that the consumers who are still waiting to withdraw their cryptocurrencies end up losing their funds.
Why do Bank Runs Happen?
At first glance, it can seem that bank runs always happen in the same manner and for the same reason. However, in reality, financial management is fairly complex, and it requires considerable time to decipher its intricacies.
Bank runs can happen on account of several factors. It takes a lot of mishaps to malfunction a financial enterprise that is operated by highly educated people. Here are some of the top reasons that can lead to bank runs:
Economic Unrest
The most brutal bank runs in history happened on account of grave economic decline. Whenever there are conditions that result in the loss of economic stability, it creates the danger of generating a bank run. There are some cases where the bank runs were the result of a stock market crash.
The depression of 2008 happened on account of the bursting of the housing bubble. This event resulted in bank runs that saw some of the major corporations in the world running out of liquidity to continue their operations.
Millions of people lost their jobs, and several businesses shut down forever. Economic catastrophes like a sudden spike in inflation or excessive money supply can lead to bank runs.
Loss of Goodwill
The concept of money rests on the trust and belief of its stakeholder. Since the abolition of the gold standard, Central Banks around the world have started to issue fiat currencies based on the goodwill and faith in the government of the said nation.
Therefore if the faith of the people becomes shaky in a DeFi enterprise, government, or private bank, it can result in another bank run. The moment stakeholders suspect that a company is unable to pay their dues or their clients suspect that the crypto enterprise has become unstable, they can rush to cash out their accounts as soon as possible.
This sudden hurry to withdraw all the funds from the accounts is the very reason that bank runs can happen sooner than later.
Faulty Management
One of the many reasons for bank runs to take place is faulty management. There are some of the biggest financial enterprises in the world that can gain popularity among investors without doing their due diligence. The recent demise of the cryptocurrency exchange FTX is a glaring example of financial mismanagement.
However, many argue that it was a deliberate scam. As per the testimony of the disgraced FTX CEO, he was not aware of the massive loans granted to the sister company Alameda Research. The cryptocurrency exchange was considered to be one of the biggest DeFi enterprises in the world when it went down to ashes.
Financial Scams
Another major reason for bank runs is financial scams. There is a certain limit until the investors can trust a financial enterprise without any solid proof. One of the biggest financial scammers of all time, Bernie Madoff, managed to fool the smartest investors out of their billions.
He managed to pull his scams by using his reputation as the former head of NASDAQ. When people suspect that a business is a scam, whether or not the information is correct, it is enough to cause a bank run.
Natural Disasters
There are many cases where natural disasters and other non-financial phenomena can result in bank runs. The 2011 earth quack hit resulted in wiping out $200-$300 billion from the Japanese economy. The Central Bank of the country had a narrow escape from an imminent bank run.
In the same manner, the ongoing global pandemic has resulted in wreaking havoc on the global economy resulting in rising inflation and loss of jobs. All major banks in the USA and other western countries suffered from economic crises, and bank runs following both World Wars.
History of Bank Runs in DeFi
Since the advent of the Federal Deposit Insurance Corporation or FDIC in the 1930s, Banks runs have stopped from happening. In case of a financial crisis, the government takes over the control of the bank and bails it out; for the most part, the people remain unaware if the management of the bank has changed, and they do not have to worry about the failure of a bank resulting in permanent loss of their funds.
However, despite the FDIC support, there are still some major financial disasters that can lead to such incidents. For example, during the 2008 financial crisis, the 6th largest bank in USA, Washington Mutual, was closed down on account of its clients withdrawing $16.7 billion in a short duration resulting in a bank run.
On the other hand, the bank runs in DeFi are smaller and less frequent in comparison. The biggest example of a bank run is FTX. This cryptocurrency exchange got in a feud with Binance CEO. As a result, its financial mismanagement and lack of credibility were exposed, leading to a historical bank run.
Another major bank run took place with the now dismantled stablecoin project called Terra network. The incident happened when $2 billion worth of TerraUSD coins were unstaked from Anchor Protocol. As a result, billions of these cryptocurrencies were liquidated in a small amount of time.
The Aftermath of Bank Runs
Now that it has been established why and how bank runs happen, it is time to understand what comes next. Here are some important after-effects of Bank Runs:
Influence on Cryptocurrency Exchange Operations
The direct result of a bank run for a financial organization such as a cryptocurrency exchange is the draining of liquidity. It means that the said business does not have enough cash to remain operational and fulfill its financial obligations.
The business is under the threat of getting sued by the investors and other commercial partners to get sued for not keeping up its part of the financial contracts. Therefore, the business tries to salvage as much liquidity as possible by revoking the withdrawal privileges of its clients. It means that people cannot move their funds to secure locations.
Eventually, the affected company is left with no option but to file for bankruptcy. When a company files for bankruptcy, it gains legal precedence for not being able to honor its payable. For cryptocurrency exchange account holders, it can be very bad news.
Most cryptocurrency exchanges offer non-custodial wallets meaning that the contents of the account are under the ownership of the company, and they also have private keys in their possession.
Therefore, if such a cryptocurrency exchange goes under, it can seize the funds of the consumers and file for bankruptcy, meaning that the consumers cannot get their funds back until the financial proceedings have been carried out. Bank runs also ruin the goodwill and reliable reputation of a company forever.
Impact on Users and Stakeholders
The users who are affected by a bank run can suffer from a sudden massive loss. They may not be able to recover their lost funds ever. However, there is some hope that government organizations and financial regulators are working to issue a decree that the firm release the funds of their clients on accounts of financial mismanagement or scam.
On the other hand, the affected users can also reach out to the law using a class action lawsuit that entitles them to a court hearing and additional payments in lieu of other damages. However, bank runs also result in the loss of trust and confidence among investors.
Every time a cryptocurrency exchange bites the dust, the investors may become skeptical and liquidate their positions. The best way to deal with Bank runs is to learn about precautionary measures and learn to spot the telltale signs of probable bank runs.
How to Prevent Bank Runs?
It may seem that bank runs mimic the destructive forces of nature that are impossible to prevent. But some solutions can help in delaying or avoiding them altogether:
Patching Loss of Liquidity
The root of all disasters during a bank run is the loss of liquidity. It does not matter if the rumors about the unreliability of a business are true or false. Once these ideas have gained enough traction among the stakeholders, it becomes impossible for the enterprise to stop the proverbial bleeding.
Just like wounds can be made less fatal by stopping the rapid loss of blood, bank runs can be prevented by slowing down the loss of liquidity. As a last resort, the enterprise can enforce a temporary halt on any unnecessary withdrawals.
At the same time, the company may also reach out to its clients to restore their lost faith in the stability of the enterprise. Honest communication and transparency are the best ways to convince consumers to stop making big withdrawals at once and avoid a possible bank run.
Finding a Bailout
The main difference between the bank run of a traditional bank and the DeFi enterprise is FDIC. In most cases, the cryptocurrency exchange does not have the back from the government or insurance against bank runs.
When a typical bank goes out of commission, the government enterprises are there to handle the situation by granting them a bailout. On the contrary, when a cryptocurrency exchange goes under, it is unlikely to get any support from the government, even if it is regulated.
The affected enterprise can reach out to another cryptocurrency entity to merge or lend money to it as a bail-out option. This is another last resort case that is taken to ensure the safety of the consumers and to keep the organization afloat. However, this method might not always work out as intended.
Insurance Coverage
Deposit Insurance is a type of coverage that ensures that the account holders who have committed their funds are protected. When the users have deposit coverage, it ensures that they can get hold of their funds even if the business goes under. It is one of the best security options that cryptocurrency stakeholders can undertake.
Cryptocurrency exchanges can work with private insurance companies to cover all their clients. Some private corporations may agree to cover the clients of the cryptocurrency enterprises for a fixed premium fee.
The government has started to regulate cryptocurrency exchanges, but it is yet to offer them coverage under FDIC like traditional banks. However, most insurance companies do not offer coverage for cryptocurrency-related funds on account of their high-risk nature.
Set Term Deposits
Another great way to prevent a bank run is by setting up term deposits. It evolves, incentivizing investors to keep their funds under the custody of banks and cryptocurrency exchanges. It can be achieved by offering a percentage of interest against the deposited amount.
It can be seen as a savings account or staking option. As a reward, the consumers can earn additional income in exchange for their investments. On the other hand, the financial enterprise can ensure a given amount of liquidity at all times and avoid any bank runs.
The condition of term deposit also binds the clients to only withdraw their funds after a set duration to qualify for the interest income.
Conclusion
Bank runs are terrifying, and they can turn the profits and funds of investors into dust within a matter of hours. Investors can adopt precautions such as using only reliable cryptocurrency exchanges, checking for Proof of Reserves, storing funds in custodial wallets, diversifying their investments, etc.
Using these techniques, cryptocurrency investors can avoid any unsavory situations, and they can keep benefitting from the advantages of cryptocurrency trading without getting discouraged by bank runs.