Crypto’s Most Critical Use Case (But It May Never Happen…)

In my recent articles, I decided to highlight examples of some significant real world use cases for Crypto, so that readers could appreciate why the Crypto sector has enjoyed such a phenomenal growth rate in recent years.

Today, I would like to explain how Crypto has the capacity to solve one of the biggest risks we as a society face: that of a cascading series of crises in the financial system. This is essentially because the traditional fractional reserve system that banks use is no longer fit for purpose. The need for a new solution is even more pressing now given the recent unprecedented rate of monetary tightening by the FED, which has materially weakened the financial position of all the banks. This year, we have already seen the unintended consequence of rapid monetary tightening in the form of a number of bank runs and failures. Without a new solution, I believe we face ongoing systemic risks and instability in the banking system, with all the economic damage that entails.

Bank Runs Galore…Are We Fine?

We are not even halfway through 2023 and already there has been a spate of bank runs, the speed of which is unprecedented in recent history. In just three days, we witnessed two of the largest bank failures in American history: Signature Bank, a New York-based regional bank, shuttered suddenly making it the third-biggest bank failure in U.S. history and just two days later, the country’s second biggest failure, Silicon Valley Bank. Concerns about liquidity issues soon spread to other regional US banks and, by mid March, the unthinkable happened with 167-year-old Swiss giant Credit Suisse also brought to its knees, culminating in a hastily arranged merger with rival UBS.

Given any bank failure typically causes widespread loss of confidence and consequent contagion risk to other banks, there is every incentive for the powers that be to proclaim that all is fine in banking. “Americans can have confidence that the banking system is safe”, said Biden. “There is no systemic risk to our financial system”, said Britain’s Chancellor, Jeremy Hunt.

These reassurances are understandable and necessary to help protect the whole financial system. However, as I will explain, we still need to examine the root cause of the immense strain on the financial system in order to assess whether these reassurances hold water. I believe that, given the banking system’s now outdated design, systemic risks are actually higher than ever.

Numbers Don’t Lie

What makes me think the banking crisis isn’t over? A cursory glance at the continuing loss of deposits elsewhere in the financial system to me signals that we are probably not out of the woods yet…..

They Reassured and Reassured….

History has also shown that some scepticism is warranted when we hear reassurances on the health of the financial system. In 2014, rural banks in China’s eastern city of Yancheng stacked piles of cash in plain view behind teller windows to calm depositors queueing at bank branches for a third straight day — following rumours that they had run out of cash. American banking tycoons Marriner and George Eccles did something similar during the Great Depression to fend off multiple bank runs.

More recently in the US, the Fed sought to reassure people just before the Global Financial Crisis (GFC) of 2008 — the worst banking crisis since the Great Depression: “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system,” declared Federal Reserve Chairman Ben Bernanke in May 2007 — just a year before the GFC.

The Intractable Problem: Structural Flaws in Fractional Reserve Banking Model

While we may not see a wave of bank collapses like in 2008, the speed and scale of the run on both Signature and Silicon Valley Bank reveal deep structural flaws with the very design of fractional reserve banking in the internet age. As information moves lightning fast and as deposits can be moved at the click of a mouse (or a touch on your mobile even), a bank run can ensue in literally days.

We are used to worrying about one bank and reassure ourselves that their ‘risk management clearly failed’. But the true story is that fractional reserve banking is fundamentally antiquated and doesn’t work as intended in the modern age.

Fractional Reserve Banking is just a Big Confidence Trick!

When you put money into your bank account, it looks like the money just ‘sits’ there safely until you need it. But the reality is that the balance on your bank account statement is an illusion — it isn’t actually there. The big mismatch at the heart of fractional reserve banking is this: deposits are liabilities of the bank that must be repaid on demand, but most of those deposits are being loaned out to earn an interest — and those loans have maturities that cannot be recalled on demand.

Fragility is baked into the very nature of fractional reserve banking because it creates liquid claims against illiquid assets. Put simply, at any given time, banks do not have enough money to repay if all their depositors simply demanded to withdraw. And although we are largely content to forget this inconvenient truth as we go about our daily lives, it is only mere ’confidence in the system’ which is the essential cornerstone of how banking works today.

Recognising the risks in the way our financial system is constructed is nothing new. “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve”, explained Satoshi Nakamoto in a forum post announcing the Bitcoin White Paper in September 2009.

But it’s not just Bitcoin’s founder who could see this vulnerability: one of the first modern scholarly analyses of this fundamental contradiction was a paper titled, “Bank Runs, Deposit Insurance, and Liquidity,” written by Douglas W. Diamond and Philip H. Dybvig, published in the Journal of Political Economy in 1983.

“Under a fractional-reserve banking system (the system in operation virtually everywhere in modern developed economies), banks have to hold a fraction of their deposits (a liability for them) as deposits at the central bank (called reserves) (an asset for them), but they can “lend out” the remainder”, wrote Paul Sheard, Standard & Poor’s chief global economist.

Can You Rely on Confidence in the Internet Age?

In the past, rumours spread by radio, newspapers and television. To demand a withdrawal, depositors had to physically queue — and only during the opening hours of banks’ branches. In the internet age, rallies and crashes in financial markets are not only more extreme in magnitude, but also faster. The diffusion of information (reliable or not) spreads at the speed of a 140-character tweet. Furthermore, internet banking has also dramatically shortened the time it takes for depositors to demand withdrawals from troubled banks. It is perhaps then not a surprise that the fall of Silicon Valley Bank is being described as the fastest bank run in history.

March 10, 2023: SVB collapsed, shares were halted, and regulators shut down operations.

The internet means the banking environment has changed dramatically, and the current fractional reserve banking is no longer compatible with the rapidity of information dissemination in modern society.

The reserve ratio was a concept first introduced in American banking in 1863 to protect depositor funds from being used by banks in risky investments. Federal deposit insurance (FDIC) was pioneered in America in 1934, in an effort to stop the rampant issue of bank runs. Yet, with each passing decade, the use of these two tools appears increasingly inadequate to do their intended job — i.e. to prevent bank runs.

These concerns are not new. Industry observers were sounding alarm bells as early as 2019. “A digital bank run in a hypothetical future would be much more dangerous as it would happen in seconds and minutes when clients could simply use mobile banking apps to transfer money to another account,” said Susanne Chishti, chief executive of Fintech Circle, in an interview given to Raconteur magazine.

Former Canadian central banker Mark Zelmer’s independent review into the UK’s Co-operative Bank, noted that Open Banking “may come at the cost of less stable deposit-taking institutions”. In the report, Zelmer concluded, saying, “I would not be surprised if smaller institutions find their deposit bases become less sticky over time and more likely to run at the first hint of trouble”.

This remark by Zelmer has now become a shocking reality just 4 years later. SVB, the 16th largest bank in America that has operated for 40 years, collapsed in just a mere 48 hours, when the first hint of trouble around its $1.8B losses on securities spread like wildfire over social media and online spaces.

In comparison, the previous banking crises of Northern Rock (2007), Bear Stearns (2008), and Home Capital Group (2017) all took place over the course of several months. Northern Rock first sought emergency funding from the Bank of England in September 2007, but didn’t ultimately become nationalised until February of 2008. Bear Stearns started struggling in 2007 when the housing bubble burst, but the rumours around its decline and ultimate shutdown did not come until March 2008.

In just 15 years, the time it took for a bank to collapse went from a few months to just a few days. This unprecedented speed of collapse coming from a digital bank run will not be just an anomaly. It will become the new normal.

It is clear that our current model of fractional reserve banking is ill-suited to the networked digital age. Liquidity crises can very quickly become solvency crises — and it all hangs on the ‘confidence’ of depositors and investors.

Confidence, as we all know, is an incredibly fragile thing in the internet age. Yet, unbelievable as it may sound, it is in this increasingly frail house of cards that we are asked to store our entire life’s savings.

Designing Better Banking Models

The pursuit of more resilient alternatives to fractional reserve banking has been going on for decades. As early as 1933, a group of economists hatched an idea known as the “Chicago Plan”. They hoped to identify the causes of the Great Depression. Among the culprits they identified was fractional reserve banking.

Their solution? A 1:1 ratio of loans to reserves. The Chicago Plan would not only have subjected checking deposits to 100% reserves, but banks could no longer make loans out of savings deposits. To obtain the capital to make loans, they would have to raise money by equity-financed investment trusts.

Despite generating a lot of interest at the time, the plan fell into obscurity. It resurfaced briefly several years later, following the US recession of 1937–1938, and once more in the wake of the 2008 subprime mortgage crisis.

In March 2015, Iceland published the results of an intensive study that explored the viability of ending fractional reserve banking. The report, commissioned by the prime minister, explored alternatives to the fractional reserve system, including a revival of the Chicago Plan.

It proposed the separation of bank deposits into two types of accounts: (i) interest-free Transaction Accounts kept at the Central Bank, which are not available for banks to invest, and redeemable on demand, and (ii) yield-bearing Investment Accounts which are invested by the bank, and only redeemable at maturity, ranging from 45 days to a few years.

Funds can be transferred from a Transaction Account to an Investment Account. Banks can offer Investment Accounts with different risk profiles, maturity and interest rates, catering to different types of savers. This was another proposed solution which wasn’t taken seriously.

Overall, it’s easy to see why these solutions were ultimately unpalatable to the banking sector: while they may help avert crisis, they would effectively significantly diminish banking profitability and return on capital.

Crypto’s Smart Contract Solution

Anyone who bothers to understand can clearly see that fractional reserve banking is honestly just a walking contradiction propped up by mere confidence. That confidence is increasingly fragile in an internet age where both the circulation of information, and the ability to act happens 24/7, at the speed of a click. Deposit insurance, and reserve ratios — the two primary tools developed to shore up confidence in fractional reserve banking are in practice proving to be increasingly inadequate.

I believe SVB and Signature certainly won’t be the last to fall in an internet-fuelled bank run. Standing back, in every crisis from the Great Depression to the 2008 subprime mortgage crisis, to Silicon Valley Bank — robust alternatives to fractional reserve banking have been proposed, but not implemented. Perhaps the inertia and the wholesale change required is just too great for large institutions to stomach.

There are two perhaps less drastic solutions than wholesale system change: (i) restrict deposit withdrawals in crises, (ii) restrict lending to prevent crises. The problem is that these two options are still highly unpalatable to depositors and banks respectively.

So the financial welfare of ordinary banking customers is totally reliant on a system which looks vulnerable. It is here that Crypto provides a workable alternative: one key advantage that Crypto gives private individuals is the tools to build alternatives to commercial banks, or central banks for that matter. These tools in effect allow us to build an on-chain alternative to fractional reserve banking. And although tiny compared to traditional finance, a decentralised financial system built using Crypto is already a reality which has been stress tested and shown to function smoothly and seamlessly even through the harsh conditions we have recently witnessed (full of falling prices and crises and high profile failures).

This is one example of how a decentralised banking reserve design might work:

The elegance in this design would be that it would basically eliminate the creation of liquid liability claims against illiquid assets and thereby prevent bank runs — but importantly without the need to eliminate the banks’ ability to make loans or impose deposit withdrawal limits in times of crisis.

By separating liquid funds (e.g., “checking account”) that people use for transactions from funds people are willing to risk more for investments, this design provides transparency and assurance that people’s funds are actually not only safe but as liquid as they imagine them to be (i.e. no longer commingled and used for investment purposes). In addition, because liquid assets are being held in self-custody solutions like wallets, there is no need to have trust in the risk management etc of another third party, like a bank.

All of these features can be automated and enforced via smart contracts which means no one — for nefarious reasons or otherwise — can change them. It removes the need for attestation or independent audits and minimises the difficulties of banking supervision and oversight.

What is striking is that esteemed US traditional finance research powerhouse Bernstein has also come to the same conclusion:

“The future of banking has no banks. Welcome to ‘hyper-bitcoinization’” Bernstein

The current environment is the perfect setting for the decentralised-financial system currently being built on the major Crypto networks to stand out as an alternative to traditional banking, a report from the firm said.

Interestingly, rather than seeing Crypto as the solution, many in the traditional financial world see Crypto as the problem! In fact, initial mainstream media reactions to the collapse of Silvergate Bank, Silicon Valley Bank and Signature Bank were that those banks held deposits from the Crypto world and therefore their problems were idiosyncratic. But Bernstein’s in-depth report counters that First Republic Bank’s (FRC) deposit rescue package by multiple institutions should make it obvious that this is a “generic banking problem” and Crypto isn’t to blame.

“This is the perfect setting for bitcoin, ethereum and the rest of the decentralized-financial system to stand out as an alternative system, delinked from the traditional centralized banking system,” analysts Gautam Chhugani and Manas Agrawal wrote.

Banks are dealing with a new risk, Chhugani said, which they “never fathomed previously.”

The Risk of Doing Nothing

And if nothing is done, things are about to get much worse! Even faster outflows will soon be enabled by instant payment systems like the FedNow platform. Launching later this year by the Federal Reserve, FedNow will provide real-time, 24/7 access to payments for financial institutions of any size.

The new era of hyper-speed deposit outflows brings unknown counterparty risks for customers, and again it is Crypto that might actually help alleviate some of those risks, Bernstein said.

The one important counterargument to the use of Crypto as an alternative is its sky-high volatility. Bitcoin for example might not appeal to customers who view stability in U.S. dollar terms right now, but not only could that change but also the “killer application” growing exponentially in Crypto is stablecoins, designed to offer minimal volatility relative to fiat currency.

“The simplicity of Crypto as digital bearer assets solves for the immediate counterparty risks that bank customers are dealing with, but customers also require stability of value,” Chhugani wrote.

Old meets new

The benefits of smart contract-based decentralised financial systems would suddenly appear as “built for this world,” the investment bank argued. DeFi, in Bernstein’s view, could facilitate a sort of new-age do-it-yourself banking system.

“Instant liquidation of positions without any lag, do-it-yourself risk vaults on the blockchain, deposit stablecoins for revenue-based yields from financial protocols” is what the bank’s analysts envision.

Banking would be more customised, intelligent and work in real-time — leading to more financial independence for the users of tomorrow, they said.

“The future of banking has no banks, we might make this our meme!” Chhugani and his colleagues wrote.

Final Thoughts

Rationally what has occurred this year with Signature and SVB over just one week should spur a re-examination of our current banking system at a foundational level.

While on-chain finance and DeFi are still in their nascent stages in economic design and adoption, they have enormous potential to solve the deep structural issues of our banking system and create a new one, more compatible with our modern digital society. This would go far in helping prevent the financial and economic chaos and misery we otherwise seem destined to experience as the current banking fractional reserve model proves time and again that it is now unfit for purpose in the digital age.

But Do I Think It’ll Happen?…in a word, No!

Perhaps because it is too radical to contemplate, maybe because it would be using new tech but worst of all….it may very well not happen just because it would more or less remove the control from the hands of wealthy middlemen (banks) and central authorities (central banks)!

What I am convinced will happen however is that DeFi continues to take share at pace — albeit from a very low base — as people seek to diversify their exposure — at least at the margin for now — away from the existing financial system. This trend would be boosted every time we see a new banking crisis going forward.

The upshot is that the prospects for DeFi — and Crypto as a whole for that matter — are very bright and we therefore fully expect the sector’s exponential growth (currently twice the rate of growth seen in the early internet days) to continue. Not only does the sector stand to benefit from the myriad of real world use cases I have explained in my earlier articles, but it actually provides a solution to this critical banking reserve issue.

PTLIB is CIO of Dragonfly Asset Management.

DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.