Crypto Needs an FDIC-Like Protocol to Prevent Liquidity Crises

How does the FTX fallout resemble the history of bank runs?

AccessTimeIconNov 15, 2022 at 10:10 p.m. UTC
Updated Nov 16, 2022 at 10:33 p.m. UTC
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There is no lack of talk on Twitter about the failure of FTX. Some are saying “I told you so” while others are asking “what the hell happened.” There are Tom Brady memes, tweets about Sam Bankman-Fried’s rise and fall as well as accounts of real financial pain. You’ll read about fear, depression and desperation. You’ll read about hurt. Confusion.

The fall of FTX, however much we boil it down, is clear. Nouriel “Dr. Doom” Roubini has called crypto the “mother of all scams.” The truth is rarely so simple, but if we look back over the past century of economic history we’ll find that the events that just occurred are hardly new. And, we might even find a path forward.

Adam Hofmann is CEO and founder of Nimble, a decentralized insurance protocol. A version of this article was published originally on Medium.

While leverage and insolvency issues affect more than just centralized exchanges (CEXes), the biggest crypto failures this year have often happened after the blockchain equivalent of a “bank run” – or the mass withdrawal of crypto assets from those exchanges.

One step in the right direction would be to decentralize the storage of cryptocurrency, but that is not the only solution.

The Great Depression and bank runs

Banks can, and do, fail. Historically, they failed at greater numbers than they do at present. Prior to the Great Depression, the average number of bank failures was around 630 per year. And during the worst of the Depression Era, bank failures climbed steadily from 1,350 in 1930 to an overwhelming 4,000 in 1933.

TLDR of the Great Depression: Wall Street investors traded around 16 million shares on the NYSE on Oct. 29, 1929. Billions of dollars were lost, investors were cleaned out, followed by financial panic as the world spiraled into the longest economic downturn in history.

Bank failures often resemble crypto failures. Imagine this scenario:

Say 1,000 people deposit $1,000 in The National Bank for a total of $1,000,000. As cool as it is to imagine that $1,000,000 sitting in a bank vault just waiting for Jason Statham to break in and steal it.…that is not what happens.

Instead, in most economies, banks are allowed to keep “fractional reserves” of those deposits. In other words, banks keep a small percentage of deposits as collateral and lend out the rest. This allows economies to grow and currencies to circulate.

Let’s assume banks keep 30% of deposits as collateral. If $1,000,000 is deposited, $300,000 will be held in “the vault” and $700,000 will be invested and/or loaned. With proper risk management, that $700,000 is used conservatively in stable and tested ways, so it can be made liquid to cover the rare occurrence when all $1,000,000 is called to be withdrawn at once.

But, what if the bank decided to invest in Beachfront Property in Idaho [spoiler alert: there isn’t any beachfront property in Idaho]? Well, it’s safe to say they won’t be getting that $700,000 back. If the original 1,000 people head to The National Bank to withdraw their funds. Um – yeah, the bank will only have $300,000.

Now, let’s walk through bank failures after the Great Depression for more context:

Bank failures in 1930

Most bank failures in the 1930 looked something like this:

  • Economic pressure started a series of bank failures; the ripple effects crushing depositor confidence
  • Depositors ran to the banks to withdraw their funds causing 1,350 bank failures
  • The Federal Reserve didn’t step in to support liquidity solutions as most failures were to “non-member” banks
  • Even though they were “non-member banks”, depositors lost $237,359,000

Apply inflation to depositor losses in 1930, and what do you get? About $4 billion in lost deposits. For comparison, the “neobank” Celsius lost users about $4.7 billion.

In an echo of crypto today, people in the 1930s waited for regulation and federal guidance, which likely came slower than most at the time would have expected. Regulators today do feel investors should be protected, but like then, it isn’t fully in their wheelhouse…yet.

Bank failures 1931-1932

  • Continued economic pressure
  • Great Britain abandoned the gold standard; mass conversion of deposits to gold
  • More depositors ran to the bank to withdraw their funds
  • The result: 3,643 bank failures. $558,778,000 in depositor losses

People were still waiting on sound regulation and guidance in these years. We hear those same sentiments echoed now. Others are waiting for crypto to ”crash.” In the past and currently, the financial hurt falls on the people.

The economics here go deeper than the total amount of deposit lost. The volatility resulted in exponentially larger implications for the overall global markets.

Likewise, the implications of a crypto crash ripple across socioeconomics and global markets and cause reputational harm to this emergent technology. The immediate financial toll of a crypto failure is serious, and scares away users and investors that would otherwise benefit from a decentralized and inclusive financial system

1933 and beyond

Fiveyears after “Black Friday,” the day the markets crashed causing the depression, bank failures continued to cause spiraling confidence in the financial system, which led to even more bank failures. The largest of which was the Bank of the United States, an institution with over $200 million ($4 billion in today’s dollars) in deposits.

The future of the U.S. dollar? Not looking so good (sound familiar?). In March 1933 EVERY STATE IN THE U.S. declared a bank holiday. No, not just a day off for bank employees, but instead a nationwide closure of all bank transactions. No more withdrawals.

A key presidential adviser at the time is quoted as saying:

“We knew how much of banking depended upon make-believe or, stated more conservatively, the vital part that public confidence had in assuring solvency.”

Make believe? The same U.S. dollar that is touted as the be all end all today – the physical paper in our physical wallets or in our bank accounts – that U.S. dollar? Isn’t “make-believe” the term used to describe cryptocurrency?

The bank “holiday”* lasted from Mar. 6 to Mar. 14, 1933. 4,000 banks were unable to reopen.

Depositors lost $550,000,000 – almost $12 billion today. It had to stop. And it did. How?

Insurance to the rescue?

Skipping over the full politics of the situation, there was an obvious sentiment that confidence had to be restored in the financial system. In 1933 the Federal Deposit Insurance Corporation was signed into law. It wasn’t simple: Big banks hated it, lobbyists fought against it, politicians clashed, but ultimately it was signed into law.

The implementation of a robust and industry-wide insurance system bolstered confidence in the banks and squashed increases in bank failures. This new secure and insured system of storing currency raised confidence by protecting depositor assets. Depositors didn’t have to opt-in for this coverage; banks were required to pay for this protection.

There is plenty of research you can do on the economic impacts of the FDIC. I believe, however, there is only one statistic necessary to focus on: In 1934, nine banks failed. Pre-FDIC 9,000+ banks failed. That’s it. Hard stop.

The question is whether something like the FDIC could be applied to crypto – giving investors the peace of mind that there is some protection in the event of a bank failure and promoting a more inclusive system. Sam Bankman-Fried had the industry’s trust, and yet everything evaporated in the blink of an eye once pulling your funds from the exchange became the most reasonable choice.

(It turns out that FTX was actually overleveraged, but before that information was released, the rational calculation would have been to keep your money on the exchange, because if everyone did that, by definition no bank run would happen.)

Current FDIC rates are 1.5 to 30 basis points per $100 of deposit. Apply this math to a bit of the crypto market:

  • TVL [total value locked] in CeFi exchanges and DEXes: $260 billion
  • 2.5 basis points = $6 billion; less than 25% of total exchange revenue

In other words, that’s $6 billion used to provide user protection. Does this seem like a reasonable price to pay for a more stable system? Would this type of security increase user adoption of blockchain tech?

The numbers above don’t consider the revenue generated by other players in the blockchain economy – so it is safe to say that 25% is a high estimate, if there are other protocols or players that could help fund an insurance product.

Crypto technology can also support an FDIC-like system leveraging the permissionless nature of blockchain to create a system that protects not only the currently bankable (or those that have the privilege of using an insured bank) but anyone who enters into this ecosystem.

I left the traditional insurance world after 22 years to build a more equitable insurance system that works not only across blockchain, but for the world. Crypto is transparent, immutable, fast, efficient and scalable.

Crypto is a technology that, with increased adoption, will lead to a more equitable and inclusive financial system. But not if we continue to expect new users and veteran users left shouldering the risk alone.


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Adam Hofmann

Adam Hofmann is CEO and founder of Nimble, a decentralized insurance protocol.

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