How to push back on a bank run

SVB and then Circle got pushed into a difficult situation: A bank run. Depositors wanted their money back. The problem is that these vendors are set up to always redeem their liabilities at $1.00, until they run out of money. So, they are left with two choices:

1) Continue to redeem at $1.00 (or nothing) and leave the shortage for the last redeemers. This incentivizes a run. Depositors have an incentive to be the first out and not the last out.

2) Shut down redemptions until they can allocate a haircut to everyone equally. This incentivizes a run. Depositors want to get money out before a shutdown.

The Sweep savings coin that we designed for DeFi has a floating price. If everyone wants their money back quickly, the price will decline. If people want their money out immediately (economists call this a “high liquidity preference”) they take a loss. I sold USDC at a loss over the weekend because I had so little cash outside of USDC. It was worth it to me. This puts the loss onto the people that are willing to pay the price.

Then, borrowers can buy back those discounted coins, paying off liabilities cheaply. This leaves more assets per coin for the remainers. It might even end up above peg. The system works to incentivize people to wait, not run.

This is considered cheating in TradFi. That is why Circle is stuck redeeming at $1.00 or nothing, instead of buying back discounted USDC and smoothly repegging it. It’s cheating because the bank can create an imbalance of information. They can say that the situation is bad, drive down the price of their liabilities, and buy them back at a profit.

However, in a fully transparent DeFi system, it is a great mechanism. Everyone has the same information. Borrowers have an incentive to buy back liabilities when they are cheap, and accelerate repayment of their loans. Depositors can choose to accept the cost of getting out quickly, or hold and participate in a repeg process.

These dynamics become important even in the TradFi system, because in reality, any decent-sized pool of liabilities has a floating price. Over the weekend, hedge funds offered to buy SVB deposits at a 70% discount.

Banks like JP Morgan are agitating to offer “deposit coins”. These are like stablecoins, but they don’t have stablecoin reserves. Instead, they are general liabilities of the bank. This has some economic advantages. Stablecoin reserves go into low velocity pools like Fed accounts. They get subtracted from the main street economy. This can amplify economic problems in a run for safety. Banks (claim to) lend money back into the real economy. That’s also a goal of Sweep.

It also has some disadvantages. The deposits are traded and in a liquidity crunch they may not be worth a dollar. JP Morgan is not a very transparent system. If they buy back their liabilities to smooth out a repeg, they will be accused of cheating. A transparent DeFi approach may be necessary in the modern world.