Cryptocurrency and the Modern-Day Bank Run

A gold bitcoin which is a symbol of cryptocurrency.

Following the 2008 banking crisis, cryptocurrency emerged offering anonymous, decentralized financial services organized on a peer-to-peer network called a blockchain. Since that time, the cryptocurrency economy has blossomed into a multi-trillion-dollar sector and millions of investors have poured their hard-earned funds into cryptocurrency markets – hoping to make exceptional profits. Unfortunately, many of them incurred exceptional losses instead.

In 2022, the cryptocurrency craze stalled, and some investors lost everything. The turmoil in cryptocurrency markets brought the risks of these investments to the forefront and reminded investors why asset protection is critical.

The 2022 Cryptocurrency Selloff

The total value of cryptocurrencies reached an all-time high in November 2021, around $2.8 trillion. In 2022, prices plummeted and by August, market capitalization had fallen by more than 60% to $1.1 trillion. Many factors contributed to the 2022 selloff including a diminishing fascination with the cryptocurrency markets, slower economic growth, widespread inflation, and investor pessimism.

During the crash, even the most well-established cryptocurrencies experienced steep declines. Bitcoin, the oldest and largest cryptocurrency by market capitalization, fell nearly 75% from November to June. Likewise, Ethereum lost more than 80% during the same timeframe. Many investors lost their savings during the crash, but individuals were not the only ones to suffer. Cryptocurrency based companies like Three Arrows Capital [3AC] failed during the selloff creating additional turmoil in the cryptocurrency markets. This Singapore based hedge fund managed more than $10 billion in assets before succumbing to the crash and many of its investors suffered significant losses.

The Cryptocurrency Selloff Led to Trouble for Some Exchanges

As cryptocurrency prices tumbled, investors rushed to withdraw their funds, putting pressure on cryptocurrency exchanges to meet their requests. The failure of 3AC and similar companies further strained cryptocurrency exchanges. In response, several cryptocurrency companies were forced to make tenuous decisions.

In June, cryptocurrency lending platform Celsius froze all withdrawals, swaps, and transfers, then filed for bankruptcy a few weeks later. In July, Voyager Digital followed suit – suspending withdrawals and eventually filing for bankruptcy. Other cryptocurrency exchanges like CoinFLEX, Babel Finance, and Finblox froze or limited withdrawals during this time. The turmoil continued into August when Hodlnaut froze all withdrawals.

A similar pattern has occurred many times in the past. An inciting event causes investors to panic and withdraw their funds but custodians with poor management or excessive leverage are unable to meet the heightened withdrawal requests. As a result, some custodians fail, and investors are left holding the bag. This pattern is reminiscent of the investor ‘panics’ that were followed by bank runs in the 1800s and early 1900s.

Parallels Between the 2022 Cryptocurrency Panic and Early American Bank Runs

Bank runs crippled the U.S. economy several times prior to the Great Depression. One example is the Panic of 1873 when rampant speculation in the railroad industry finally reached a pinnacle. Jay Cooke & Company, a banking firm heavily invested in railroads, collapsed. This led to widespread panic and bank runs in the Northwest, South, and Midwest. During the Panic of 1873, there were few protections in place for depositors and when more than 100 banks failed, many consumers lost everything.

Bank runs were a fairly common occurrence during the first few centuries of American history. Like the cryptocurrency turmoil in 2022, many consumers and businesses became unable to access their assets during a banking panic. Additionally, many lost their savings when banks failed, as they did when cryptocurrency exchanges crumbled. Because bank runs were so devastating for American consumers and businesses, protections were put into place to prevent failures and ensure that deposits are safe.

Consumers Are Protected When Banks Fail, Not Cryptocurrency Exchanges

After the Great Depression, several protections were put into place to prevent turmoil resulting from bank failures. Now, banks are required to keep a certain amount of assets on hand to meet withdrawal requests. These rules aim to ensure banks remain afloat in the case of a bank run. In addition, the Federal Deposit Insurance Corporation [FDIC] was created to insure deposits against bank failure.

Reserve requirements have helped to keep banks solvent and the FDIC has been overwhelmingly successful in preventing consumer losses when banks do fail. In fact, from 2001-2021, 561 banks failed, but the FDIC ensured that no depositor lost a penny of insured funds.

The FDIC covers assets like savings accounts, checking accounts, money market accounts, and certificates of deposit. When businesses invest in these assets, they know that their funds are safe – up to the limits established by the FDIC – if the institution holding them fails. On the other hand, cryptocurrency custodians are not held to the same standards as banks. Cryptocurrency exchanges do not adhere to the same federally mandated reserve requirements as banks and cryptocurrency assets are not backed by the FDIC. This means that investors are not protected from losses if a cryptocurrency exchange fails – as many unfortunate investors learned in early 2022.

Without a program like the FDIC, cryptocurrency could continue to be a risky asset that moves more like an equity than a currency. As such, cryptocurrency cannot be an effective safe-haven investment until there are protections in place to prevent investor losses. For now, businesses and individual investors who need to ensure that their investments are safe should turn to FDIC insured investments.

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