Bank Pulse: Breaking Down Crypto Banking | Article

A crypto-run textbook bank

The crypto company that had to halt redemptions earlier this week — and in doing so sparked another wave of panic — is different: It’s neither a stablecoin nor a regulated bank, but for its core product offering it used bank-like language such as “savings” and “deposit”. It has also distinguished itself by offering double-digit returns not found in traditional banking. The company had several run-ins with US supervisors, who felt it was offering a securities product without proper registration.

Faced with a rush, any establishment that is a priori solvent can become illiquid

The crypto company vaguely resembled traditional banks in that its assets tended to be riskier than its liabilities tended to be perceived. Moreover, some of its assets appear to be locked in for a longer period, while its liabilities were immediately redeemable. Finally, the liquidity of some of its assets has rapidly deteriorated in current markets. These transformations of risk, maturity and liquidity are central functions of a traditional bank. They also make a bank vulnerable to runs. Faced with a run, any institution that is a priori solvent (its assets are worth at least as much as its liabilities), can become illiquid (it cannot immediately liquidate its assets at the right price to honor repayments). For this reason, banking regulation can be the most elaborate type of regulation, including liquidity buffers to manage redemptions, capital buffers to absorb losses, detailed risk management and transparency requirements. If, despite all this, a bank runs into difficulties, the central bank can act as a lender of last resort (against appropriate collateral), and if the bank fails, deposit guarantee schemes (usually industry-funded -even) ensure that depositors don’t end up with a loss.

Mutual funds have the important difference that they do not issue liabilities at par, which means that unlike banks, they transfer credit risk to their investors. To the extent that their assets are tied up for a longer period, they can impose periods of unavailability on investors wishing to redeem themselves.