Traditional Finance and the Need for Crypto Regulation ~ Part 1

“Depression-era bank runs occurred in a number of ways, but the most common was a sharp drop in investor confidence — as we might see with today’s algorithmic stablecoins.”

Last month in May 2022, the crypto industry experienced a shocking event that wiped out nearly $30 billion from the ecosystem, the Terra UST de-peg event. This event is fundamentally similar to a bank run which has happened numerous times historically and it is important to understand why bank runs happen and why regulations were created.

In this blog post, we will take a deep dive into historical bank run events and how regulators were instrumental in addressing the problems.

On December 10, 1930, a Bronx businessman visited his local branch of Bank of United States, which sounds like a government entity, but was actually one of the country’s largest commercial banks at the time.

In need of cash, he wanted to sell his stock, but the bank manager refused, reportedly telling him it was a good investment. As he stormed out of the bank, the businessman warned all those waiting in the branch that the bank could not afford to make pay-outs as promised.

Depression-era bank runs occurred in a number of ways, but the most common was a sharp drop in investor confidence — as we might see with today’s algorithmic stablecoins.

Americans were understandably anxious about their money after the massive stock market crash of October 1929. The wealthy began shrinking their investments and consumer spending fell sharply. In 1929, some 650 US banks failed.

The next year the number doubled and confidence in US financial institutions collapsed. Finally, when a sizable number of depositors withdraw, or request to withdraw, their funds from the same bank around the same time, the financially devastating snowball has been kicked downhill.

Banks, let’s not forget, do not hold all of the deposits of all their clients in-house at any one time, but lend them out to borrowers or use them to build or buy assets. This brings to mind perhaps the best-known example of a bank run — which did not actually happen.

Photo by Etienne Martin on Unsplash

“You’re thinking of this place all wrong,” George Bailey pleads with a crowd of unruly depositors at the Bailey Brothers’ Building and Loan in Frank Capra’s classic It’s a Wonderful Life. “As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house, and in the Kennedy house, and Mrs. Macklin’s house — and a hundred others.”

After a few sizable withdrawals, a bank might have limited reserves on hand. If a word starts to spread about the bank’s limited ability to pay out, anxiety is sure to follow, spurring still more withdrawal requests. Bank officials might then quickly move to recall loans and liquidate assets at emergency prices, but often there’s just not enough time. Amid high financial anxiety, the mere appearance of being unwilling to pay out can tip the scales.

Whether or not the Bronx businessman’s accusation was true, word spread, and within a few hours, some 2,500 people were lined up outside Bank of United States looking to liquidate. By the end of the day, they had withdrawn some $2 million. This sparked a domino effect and bank runs hit other lenders in the Bronx and in Brooklyn. The next day’s New York Times announced that the Bank of United States — with over $260 million in deposits — had closed its doors and the state had taken control of its finances.

The bank’s downfall likely began two years prior, in 1928, when it started selling shares to depositors to raise funds. Possibly taken in by the bank’s name, which suggested powerful backers, immigrants and working-class locals were the bank’s primary clients. Today, we might call them “the unbanked,” as most found it difficult to access financial services in New York City on their meager incomes and savings. Immigrants likely viewed an account at Bank of United States, not to mention stock holdings, as a step toward financial stability and respectability.

The bank promised that the stock would hold its value and that it would be willing to buy back shares on demand. “For banks that hold illiquid assets,” finance professors from Brandeis and NYU wrote in 2020, “these promises of liquidity on demand are the key source of vulnerability.”

Even so, the bank’s clients likely felt confident that the Federal Reserve system would protect them in the event of collapse. “Few of these working-class depositors appreciated, however, the bold risks the bank had taken with their assets when it merged with other banks, bought and sold first and second mortgages and offered loans to anyone with an account,” Columbia University professor Rebecca Kobrin wrote in 2019.

The established member banks of New York’s Federal Reserve system, which had been created for just this sort of crisis had, in previous years, joined forces to bail out several troubled financial institutions. However, the ethnicity of this bank’s patrons and leadership — the president and vice president were Jewish — is widely thought to have played a role in the member banks’ decision to not step in and save Bank of United States.

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Few would view today’s crypto investors as akin to the immigrants and Jews of a century ago, who were among the more maligned minorities. Yet, it may not be much of a stretch to argue that the dominant traditional financial institutions of our era have a similar bias against crypto.

The up-and-comers not only pose a threat to their industry and status — a twist on replacement theory — but they tend to be seen as “new money” arrivistes, untrained in the ways of modern finance and undeserving of the riches so many of them flaunt. Thus, it would come as little surprise to learn that some of these institutions, hearing of their drowning crypto brethren, might have decided against throwing out a lifeline.

This may even apply to the greatest crypto collapse thus far. One of the leading theories for what happened to Luna centers around Anchor Protocol, a savings vehicle on the Terra ecosystem that promised ridiculous 20 percent annual returns for those who deposited their UST there. Anchor helped drive the rapid growth of UST, which became the third-largest stablecoin by market cap just 18 months after its September 2020 launch.

Some promotional sleight-of-hand may have played a role. “Terra used all the right language to imply low risk,” Peter Yang, product lead at Reddit and web3 advisor, tweeted after the collapse. “UST is a STABLEcoin. Anchor is a SAVINGS protocol. Anchor’s 20% APY was one of the most recommended DeFi entry points for beginners.”

But in early May, UST deposits in Anchor fell 20 percent in a single day, from $14 billion to $11.2 billion. Suddenly the criticisms that UST relied too heavily on Anchor seemed legitimate; it began to fall and soon lost its peg to the dollar. This in turn led to the collapse of Luna, which UST, an algorithmic stablecoin, relied on to maintain its peg.

Rumors have swirled that a top investment firm, leading market maker and crypto exchange worked to precipitate the collapse. All of them have denied the charge, and we may never know exactly what happened with Terra. But whether or not the collapse was intentionally engineered is largely immaterial. What’s clear is that a major pull-out from Anchor shook investor confidence, kicking off a domino effect.

“If a large number of a bank’s depositors simultaneously assign the same high probability of potential loss to the bank’s assets, the bank will experience large simultaneous requests for deposit withdrawals,” analyst George Kaufman wrote for the Cato Institute in 1988. “That is, the bank will experience a run.”

It’s largely about investor confidence, or the lack thereof, and regulatory support can provide a sturdy backbone. Without it, anxious investors might be left with nothing more than hopeful encouragement.

“We can get through this thing all right,” George Bailey urged the panicky crowd at the Building & Loan. “We’ve got to stick together, though. We’ve got to have faith in each other.”

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In the midst of the financial crisis, how did the government respond to end the bank runs and restore financial confidence? In Part 2 of this series, we will learn more about how this historical event brought the financial system into a new phase, and look into how the system has evolved through several major financial events in history. Stay tuned!

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Building Financial-Grade Digital Assets. The World’s First Regulated JPY-Pegged Stablecoin Issuer.