Bank-Runs, Insurance, & Historic Solutions?

FTX, Celsius and Repeating Patterns. There are Lessons to Learn. Urgently.

It may repeat. But varied just enough that we may not recognize it.

Celsius, Voyager, 3AC. Hacks. Volatility. Now FTX?

There is no lack of content on Twitter about the failure of FTX. There are “told you so” tweets; “Binance is evil”; “SBF Hero to Zero”; and all kinds of analyses of what happened and what’s to come.

Look past the Tom Brady memes and you’ll read real-world accounts of people who have lost everything. You’ll come across victims of this most recent crypto failure contemplating suicide. You’ll read about fear, depression, desperation. It is hard to face the reality of all the people hurt; to doom scroll Twitter and try to uncover the truth. The truth is that real people are being hurt. The truth is not as simple as “Crypto is the Mother of All Ponzi Schemes” as Nouriel Roubini suggests. We only have to look back 100 years [the equivalent of 10 crypto years we’re told] to see that this situation is not unique to crypto. The positive of this: there are solutions.

FTX used leverage without applying good risk management practices. Fine. We can agree to that. But, these types of leverage and insolvency issues aren’t siloed to Centralized Exchanges only. The solution isn’t simply a custody issue, or where your cryptocurrency is stored. Remember, there is a reason we call the mass withdrawal of crypto assets a “bank run”. The lessons learned within that definition — they are monumentally important today; critical to the crossroads at which we stand as a global economy.

Let’s put the term “bank run” in context of the Great Depression.

TLDR of the Great Depression: Wall Street investors traded around 16 million shares on the NYSE on October 29, 1929. Billions of dollars were lost, investors were cleaned out, and in the aftermath there was panic as the US and the rest of the world spiraled into the longer economic downturn in history.

Let’s also remember that banks can, and do, fail. Historically at greater numbers than they currently do. Prior to the Great Depression, the average number of bank failures was around 630 per year. After the Great Depression, bank failures climbed to 1,350 in 1930; 2,293 in 1931; 1,453 in 1932; and an overwhelming 4,000 in 1933. What caused this? Yes, it is overly simple to boil the dramatic increase in bank failures down to “the Great Depression” but ultimately that was the proximate cause [in insurance, this is the term we use to identify the event that is sufficiently related to damages; ultimately the determining factor in those damages].

Banks can fail for a number of reasons, but ultimately — not too dissimilar to the failures we have seen in crypto. To overly simplify a bank failure:

1,000 people deposit $1,000 in The National Bank. That is a total of $1,000,000. As cool as it is to imagine that $1,000,000 sitting in a vault in the back of a bank just waiting for Jason Statham to break in and steal it, that is not what happens. In most economies, banks use fractional reserves. This means that they keep a fraction of deposits as collateral and free up the rest for lending; creating a more robust economy. Let’s assume 30% collateral. $1,000,000 deposited. $300,000 held in “the vault”. $700,000 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, safe to say they won’t be getting that $700,000 back. Now, the original 1,000 people head to The National Bank to withdraw their funds. Um — yeah, they only have $300,000.

Back to bank failures, the Great Depression, and the current state of our globalized, decentralized economic future. Let’s pick up after 1929 and see what happened with banks after the Great Depression.

Bank Failures 1930:

• Economic pressure started a series of bank failures causing major distrust in the financial system.
• Depositors ran to the banks to withdraw their funds. This “bank run” caused 1,350 bank failures.
• The Federal Reserve didn’t do much to help with liquidity as most of the failures occurred with “non-member” banks.
• As a result, depositors lost $237,359,000 in total in 1930 alone.

CRYPTO COMPARISON: We are currently dealing with a regulatory environment that is often misled or undereducated on the new “banking system”. The overall feeling is that there are still other banking options and while regulators do feel investors should be protected, it isn’t fully in their wheelhouse, yet.

THE ECONOMICS: Apply inflation to depositor losses in 1930, and what do you get? About $4 Billion in lost deposits. For comparison, Celsius users lost about $4.7 Billion.

Bank Failures 1931–1932

• Continued economic downturn pressure.
• Great Britain abandoned the gold standard resulting in 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.

CRYPTO COMPARISON: We can all do the math on this one. We continue to wait for sound regulation and industry best practices. Some continue to wait for crypto to “collapse”. In the meantime, people are continuing to be hurt financially.

THE ECONOMICS: The economics here go deeper than the total amount of deposit lost. There are impacts from the volatility created which results in overall global markets implications. The ripple is exponential.

1933 and Beyond

We can see how, rightfully so, people panicked and withdrew their funds from banks. There was an overall loss in confidence. This led to bank failures across the board. The largest of which was the Bank of US. An institution with over $200M [$4B today] deposits.

All of this created fear of the future of the US dollar. [sound familiar?].

Now — this is where we can learn lessons from history. And pause long enough to reThink a solution to our current situation.

In March 1933 EVERY STATE IN THE US declared a bank holiday. No, not just a day off for bank employees. Instead, every bank in every state was closed to any and all bank transactions. No withdrawals.

Sound familiar?

A key presidential advisor at that 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”

A presidential advisor actually used the phrase “make-believe” as it related to the security of the US dollar. The same US dollar that we believe to be the be all, end all of currency because it is physical paper in our physical wallet or in our physical bank [kind of: remember it isn’t really in our bank]. Isn’t “make-believe” the term used to describe crypto currency? Ultimately:

• The bank “holiday”* lasted from March 6 to March 14th.
• 4000 banks were unable to reopen.
• $550,000,000 lost to depositors — almost $12B today.

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.

All too familiar, yes?

There is plenty of research you can do on the economics impacts of the FDIC. I believe, in this case, there is only one question to ask to get a full view of how this helped.

What was the result of the FDIC? In 1934, 9 banks failed. That’s it. Hard stop. Compare that to 9000+ bank failures pre-FDIC.

Here’s the simple beauty of this solution. The FDIC created a system that prevented bank failures. That’s good for banks, sure, but the real focus here is on the depositors. The implementation of a robust and industry-wide insurance system installed confidence into the banking system. It did this [and continues to do this] by creating a secure and insured system of storing currency. When you deposit money into a bank that is FDIC insured, you have peace of mind knowing there is some protection in the event of a bank failure.

That peace of mind is not something you have to choose or opt-in for; it is peace of mind that is subsidized by the bank. When enacted into law, all member banks were required to participate in the fund — to the tune of 0.5% to 1% of insurable deposits. Banks stayed in business and continued to make money. Depositors were protected and weren’t at risk of losing millions of dollars in funds.

CRYPTO MATH: Let’s do a quick and fun math exercise using the current FDIC rates of 1.5 to 30 basis points:

• TVL in Crypto Spot Exchanges: $240B
• TVL in DEX: $20B
• Total $260B
• 2.5 Basis Points = $6B assessed to provide user protection
• Global Crypto Exchange revenue is around $25B.

Does this seem like a reasonable price to pay for a more stable system?

A reasonable price to pay to protect depositors and investors?

What role do Blockchain Protocol Foundations have in this?

Would this type of security increase user adoption of blockchain tech? And, what are the benefits of that adoption to our overall global economy?

I believe that increased adoption of blockchain technology leads to a more equitable and inclusive financial system. But not if people are completely at-risk to try it. That’s why I left the traditional insurance world after 22 years; to build an insurance system that works not only across blockchain, but also for the real world.

Sure, blockchain is transparent and immutable and fast and efficient and scalable. But, if we keep resting on those laurels without building a system of financial protection and security we are going to continue to rub up against the confidence paradox. As FDR said:

“After all, there is an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people.”

I firmly believe most of us are on the same page that the current traditional financial systems could use a reThink and rebuild; that protection for consumers is imperative. Building safely and inclusively isn’t mutually exclusive to sustainability and profit.

Insurance undoubtedly plays a role here. It may not always be in indemnification or making people whole and it certainly isn’t as sexy as the NFT market — but real, risk based, insurance solutions will be a huge step towards instilling confidence.

So, what are we going to do about it? How can we include this in the regulation-conversation? I know one thing, the amazing team we’ve built at Nimble will continue to work towards an insurance system that can achieve greater overall stability and security.