Exchange Run – explained

My thoughts on recent events in crypto...

What’s a ‘bank run’?

When you log on to your bank account, you see you have $100 in cash. Does this mean the bank actually has $100 sitting in its vault waiting for you? No, of course not. The bank executives have used your money to make loans, invest in stocks and bonds, invest in class action lawsuit receivables, invest in insurance claims, and whatever else struck their fancy. They only keep enough cash sitting around to cover the daily needs of account holders like you to pay bills and other general uses, which they know is way less than what you actually have deposited with them.

Now, if word gets out that the bank made a bunch of stupid investments and lost all the money you might say “I’ve gotta get my money out of that bank!”…and all the other account holders do the same. Everyone “runs” to the bank to get their money out, and of course the bank doesn’t have that much money sitting in their vault because they used your money to make a bunch of investments that went bad. So they shut the doors and stop permitting withdrawals.

In steps the banking commissioner and the FDIC. They take over the bank and over a period of a few days, they ensure that everyone gets their money back (up to $250,000 per person).

What’s a ‘crypto exchange run’?

When you log onto your crypto exchange account, you see you have $100 in cash or crypto. Does this mean the crypto exchange actually has $100 in cash or crypto sitting in its vault waiting for you? No, of course not, as FTX and others have shown. The crypto exchange executives have used your money and crypto to make loans, prop up coin prices, and other investments. They only keep enough cash and crypto sitting around to cover the daily needs of account holders like you, which they know is way less than you actually have deposited with them.

Now, if word gets out that there are problems with the exchange and you…and others…say “I’ve gotta get my cash and crypto out of there!” then everyone “runs” to the exchange to get their cash and crypto out. And of course the crypto exchange doesn’t have that much money or crypto sitting in their vault because they have used your cash and crypto to make a bunch of investments that went bad. So they shut their doors and stop permitting withdrawals.

In steps the…um…wait…well, in steps the bankruptcy trustee. They take over and in a period of months or years ensure that whatever assets are left in the vault get distributed to creditors, lawyers, and maybe even you and other account holders. Maybe you’ll get something, more likely you’ll have lost everything.

What about “stock broker runs” or “trust company runs”?

That never happens as those firms are not permitted to hold your cash, stocks, bonds, crypto or other assets on their balance sheets. They can’t make investments or use your cash or assets for anything. They can only hold them in their vault, exactly as you deposited them, and only for you. Thus there is never a situation where a trust company or a broker dealer doesn’t have your cash or assets available for you, and so a ‘run’ is never a risk.

How do you protect yourself?

Easy, don’t keep cash or assets at any place that can do stupid things with them. Don’t keep them somewhere that, when you log on, displays “$100” in cash/crypto but in reality doesn’t have that sitting in their vault. And if you do, then don’t be upset when you get out of bed one morning and learn that the exchange has frozen withdrawals and all your cash and crypto are gone.

How do you know if your crypto exchange is doing this?

You don’t. But if they have the capability to do this then you should probably assume that they are doing it. And due to a lack of regulation, every single one of them has the ability to do this unless they are holding 100% of assets at a trust company. The list of exchanges who have said on Monday “no risk here, all assets are backed 1:1 in our vault…trust us…really…we pinky promise” and then on Tuesday said “we are halting withdrawals as we don’t have enough assets in our vault to cover account holders” is a frequent occurrence.

Why aren’t regulators stopping this? Why isn’t Congress doing something?

It’s been a learning process for them (even if at the expense of consumers needlessly losing tens of billions of dollars), and government is typically slow to act when new technologies emerge. That was trust in the Industrial Revolution in the 1800’s, it was true of the public stock markets in the 1920’s, it was true of the Internet in the late 1990’s, it was true of mortgage lending in the early 2000’s, and it’s true of crypto now.

Our legislators, regulatory agencies, and law enforcement agencies are working on this. Obviously not quickly enough to prevent the fraud and losses thus far. But we also don’t want another Dodd Frank-type Act that stymies the very real, very positive transformative effect that the blockchain will have on society and the economy as concert tickets, estate documents, insurance receivables, inventory control systems, anti-counterfeiting tools, music, healthcare records, real estate, and so much more becomes “tokenized.”

Conclusion:

This will get cleaned up. Crypto exchanges will, I believe, be prevented from holding cash or crypto on their balance sheets (just as securities exchanges don’t hold assets on their balance sheets). The exchanges facilitating securities transactions will have to register under Reg ATS or under the Exchange Act. The exchanges facilitating lending will have to get licensed accordingly. The exchanges selling tokenized goods including Amazon, Ebay, Stubhub, Etsy, CraigsList, etc will be held to consumer protections just as they’ve always been.

Until then…don’t keep any of your cash or crypto at any exchange that even remotely has the ability to hold your assets on their balance sheet. Period.

Disclaimer: as always, these are just my musings...my thoughts and observations as someone who is deeply involved in both crypto and banking. That said, I am in no way making a recommendation that anyone invest or divest in anything, ever. Only rely on the advice of your licensed investment, legal, and accounting professionals. These matters are extremely complex and something as short as my blog is just to reflect my opinions, not a complete analysis of any of the events or situations I discuss. So only make decisions after consulting with the professionals you employ.