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Explained: Bank runs and why they spell trouble for crypto exchanges

Explained: Bank runs and why they spell trouble for crypto exchanges

Explained: Bank runs and why they spell trouble for crypto exchanges
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By CNBCTV18.com Nov 24, 2022 11:27:09 AM IST (Published)

Banks and crypto exchanges can both face bank runs, but they’re quite different. Banks have regulatory bodies, and the government overlooks them and comes to their aid when something goes wrong.

Crypto exchanges seemed like the untouchable epitome of the crypto world until a few weeks ago. And then one collapsed, followed by the big one, FTX, last week. Now, everything in the cryptoverse seems fragile, and investors are walking on eggshells about the future.

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If we look at the patterns of the fall, every crypto exchange falls similarly — with a bank run creating chaos. In this article, we learn what a bank run is, how they’ve affected banks in the past and how they’re doing the same to crypto exchanges.
What is a Bank Run?
A bank run refers to a situation when most of the customers of a bank simultaneously withdraw all their money saved with it due to concerns about its insolvency. Every bank has the capacity for a limited amount of cash withdrawals a day. But when for some reason, justified or otherwise, most of the customers run for withdrawals, the bank may be unable to do so. This creates more chaos and puts the bank at risk of failure.
The banking system almost entirely runs on trust. You deposit all your hard-earned money in a bank because you are assured about its safety and availability when you need it. The bank keeps some of the capital available for withdrawals and loans out the rest to earn interest income on it. Naturally, it may not have adequate cash reserves available if everyone wants to withdraw at the same time.
Historically, we have seen some instances of a bank run, and then banks go broke. Governments and other central banks have taken measures to ensure that this isn’t a regular occurrence. For instance, central banks ensure that a minimum percentage of reserves is always available physically at a bank to accommodate any surge in withdrawals. Additionally, we have insurance to cover a bank’s inability to accommodate a withdrawal. We also have maximum daily withdrawal limits and other such measures to ensure that there is never an instance where the bank is unable to pay.
Why Bank Runs Spell Trouble For Crypto Exchanges
When FTX collapsed, of course, it was because of the malpractice and misuse of funds, but the kill shot was a bank run. Everyone who got the news wanted to withdraw their funds from FTX all at once, and the exchange could barely accommodate that, so it stopped withdrawals. It caused further panic that left no other choice for FTX but to file for bankruptcy.
Banks and crypto exchanges can both face bank runs, but they’re quite different. Banks have regulatory bodies, and the government overlooks them and comes to their aid when something goes wrong. This happens because if one bank collapses, it might have larger repercussions across the financial system and cause other bank runs.
The crypto market is unregulated, and the government’s care with crypto is limited to taxing it today — there isn’t any help offered to exchanges in the form of bailouts. As a result, crypto exchanges need to have all of their reserves readily available instead of a percentage of them in the case of banks. When exchanges fail to uphold this proposition, things get troublesome.
Moreover, as per reports, the crypto exchanges do not have sufficient liquidity to cater to a huge surge in withdrawals. The liquid cash available with them is minimal compared to the assumed value of cryptocurrencies held by them in their digital wallets on behalf of investors.
Conclusion
Binance has recently come up with a solution in the form of proof of reserves for crypto exchanges to tackle the problem of bank runs. Their CEO also acknowledged that crypto exchanges do not have the liberty to keep partial reserves or use client funds for anything but safekeeping, and hopefully, that’s an example set for the rest of the industry.
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