Investors Are Becoming More Cautious After Seeing The Impact A Run Can Have On Crypto Market

When it comes to investments, it’s easy to become emotional or fearful. When bad news or rumors begin to circulate, it can easily lead to a financial crisis. Bank runs, in which depositors withdraw large amounts of cash very quickly, still occur today. For cryptocurrency exchanges with no insurance or proper support, this can be a big problem that leads to people losing their investments.

There are several ways to prevent bank runs and protect your investments. Even if you aren’t concerned about a crypto exchange you’re using or an asset you’re invested in, use this guide to learn more about how bank runs affect the financial system and everyone involved.

What Is a Bank Run?

A bank run occurs when large numbers of depositors withdraw their money simultaneously from a bank, typically due to fear that the bank will run out of money.

For cryptocurrency exchanges like FTX and Terra, large numbers of users withdrawing the same asset within a short period led to significant price drops in the asset’s values.

How Does a Bank Run Work?

When a large number of depositors withdraw funds within the same short period of time, financial institutions can run out of the funds they have on hand. During a bank run, the problem usually arises from the unexpected amount of withdrawals. The financial institution doesn’t necessarily lack the funds to fulfill their obligations; they just don’t have them on hand.

Unfortunately, whether the bank run occurs at commercial banks or popular cryptocurrency exchanges, the answer isn’t as easy as collecting the funds from another location. For physical banks, the U.S. Federal Reserve sets cash limits on how much money can be stored at each location. This amount is based on typical demand, and is put in place to limit risks.

Banks also lend customer deposits to other customers, or use them to make investments. To help protect consumers, a fractional banking system was introduced which allows banks to lend or invest a large portion of deposits, but they must keep some funds on hand to cover any withdrawals.

During a bank run, banks need to quickly increase the amount of cash they have on hand to cover all of the withdrawals taking place. This can lead to the bank quickly selling off assets to avoid insolvency. While central banks can lend money to commercial banks as a last resort, it isn’t always enough to keep the commercial bank afloat.

For cryptocurrency exchanges, bank runs can be devastating to investors. Some exchanges handle billions of dollars in transactions. While the Securities and Exchange Commission (SEC) does enforce a Customer Protection Rule that separates broker and customer assets, many brokers use custodians to handle transactions. Some assets may not have the same requirements, depending on how those assets are transferred and used. This can lead to more potential issues when investors attempt to withdraw all their funds within a short period of time.

What Causes a Bank Run?

There are several reasons why a bank run could start. Historically, bank runs didn’t occur just because a few people thought an investment was too risky, and decided to pull their funds all at once. In many cases, bank runs were responses to external political or economic factors. For example, the 1929 stock market crash caused a great deal of panic, prompting many Americans to want to hold physical cash. Rumors of banks running out of cash reserves spurred some of the first bank runs.

Today, the majority of bank runs are silent. People don’t form long lines outside of the local bank to withdraw funds; they do it digitally. If the bank is in danger of failing, there are strict procedures in place to prevent it from doing so, such as receiving money from central banks, or allowing another bank to promptly and silently take over.

Bank runs, whether they’re silent or not, tend to be very swift and unexpected. Runs on crypto exchanges, on the other hand, often have a few warning signs that signify the exchange is in trouble.

Bad Publicity

A little publicity can go a long way, especially with cryptocurrency. Because a lot of cryptocurrency assets are speculative investments, it doesn’t take much effort to cause fear and shake a community. A few bad tweets can cause large investors to reconsider where they hold their assets, which in turn can cause significant decreases in asset prices if there’s a lack of buyers.

Asset Mismanagement

Proof of reserves is crucial for cryptocurrency exchanges. Verification will always be done by a third party, and could reveal if funds are being mismanaged. Even if an exchange is practicing fractional reserve banking activities, they should be able to easily track and access assets. Because regulations are different for cryptocurrency exchanges, there are several different factors that could lead to accounting errors or the mismanagement of funds.

Effects of a Bank Run

There are several short- and long-term effects of a bank run. In addition to affecting financial institutions and customers, bank runs can also spark changes in Federal Reserve policies. Here are just some of the ways bank runs make an impact.

Effects on Companies and Crypto Exchanges

If a bank run occurs and a company or crypto exchange doesn’t have enough cash on hand to properly handle it, it can lead to distrust in the brand. Even if another institution or central banks bail out the company or exchange, holding customer funds — even for a short period — may result in fewer customers.

In addition to public relations issues, banks and cryptocurrency exchanges can suffer from “liquidity crunches.” These occur when a bank can’t find a bailout, and must quickly liquidate assets — often at a loss — to generate cash in order to avoid collapsing. If the amount the bank owes is greater than the amount of cash the bank generates, this can lead to its failure.

Effects on Users

Depending on the speed of the bank run, customers may not have a lot of time to react. On a cryptocurrency exchange, panic can spread very quickly, especially if the exchange’s native token starts plummeting in value. This can create a snowball effect, causing the platform or its asset to become worthless in a matter of hours or days. Should the exchange shut down or an asset become virtually worthless, customers can lose their entire investment.

The biggest difference between a run at a commercial bank and a run on a crypto exchange is in the FDIC regulations and deposit insurance. These factors help to prevent financial system collapses and bank failures, but they’re typically nonexistent for exchanges.

How to Stop a Bank Run

The government has taken several measures to prevent bank runs. In 1933, the FDIC was founded to maintain stability and regulate the industry. Bank runs can be slowed down or prevented in several ways. 

Slow It Down

Bank runs are typically driven by panic and fear, rather than actual issues with financial institutions misusing funds. Slowing the process down doesn’t just help to protect the bank or exchange’s assets — it provides a cooldown period. If faced with the threat of a run, a commercial bank or exchange may shut down for a short period of time. Inspectors may also actively work to gather proof of reserves to give the public peace of mind.

Borrow Money

After slowing down the run as much as possible, banks and exchanges need to raise funds to cover all of the withdrawals. For commercial banks, this typically means borrowing from other institutions or central banks to cover large loans and boost their cash reserves.

Some cryptocurrency exchanges may offer an industry recovery fund. For example, Binance offered recovery funds of $1 billion following FTX’s collapse to help the crypto industry recover.

Insure Deposits

Deposit insurance guarantees that investors and consumers will get their money back, should there be a bank or exchange failure, or another issue with the financial system. Part of the reason why runs are devastating in the crypto community is that the FDIC doesn’t insure investors’ assets as it would for central banks. Should a bank collapse, the FDIC allows other banks to purchase the bank having issues, and customers can typically access their funds with little to no interruption.

Set Term Deposits

One prevention method is to actively encourage investors to leave their assets on an exchange or in a bank. This is typically done by offering a percentage of interest. Sometimes, deposits are arranged for a set period. The user makes the deposit, and at the end of the predetermined term, they can make the withdrawal.

How to Protect Yourself During a Bank Run

Investors are becoming more cautious after seeing the impact a run can have on crypto exchanges. Observing crypto exchanges’ actions during previous runs can give an idea of what to expect should history repeat itself. Following the November 2022 FTX collapse, some exchanges like Bybit established funds to support institutional traders’ access to liquidity. This move not only demonstrates Bybit’s willingness to support traders during a difficult time, but it helps to show the exchange’s reliability.

Only Use Reputable Cryptocurrency Exchanges

While there are several steps financial systems can take to prevent runs, one of the biggest things you can do to protect yourself is to conduct extensive due diligence before using an exchange. While runs can happen on any crypto exchange, working with a trustworthy platform that’s been successfully operating for several years can decrease the odds of being affected by a run.

Ensure Your Crypto Exchange Has Proof of Reserves

Carefully research any exchange platform you plan to use. It should have publicly shown proof of reserves. Since the FDIC doesn’t offer deposit insurance on crypto exchanges, you need to be cautious when choosing whom to trust with your money. Some exchanges may practice fractional reserve banking, a system where they only keep a percentage of funds on hand.

Rather than offering deposit insurance, a reliable exchange will be able to show proof of reserves. This independent audit shows what assets the exchange has, confirms that the exchange is financially stable, and indicates if any fractional reserve banking practices are being implemented. Proof of reserves should show that the exchange has more assets available than the balance of their users’ accounts, much like the reserves at traditional commercial banks.

Store Your Funds in Your Own Wallet

Even if you’ve selected a reliable exchange like Bybit to handle your crypto transactions, you need to ensure you always have access to your funds. Never leave your assets on a third-party exchange. This helps to protect you in the event of a run, or any other issues an exchange may run into, such as downtime. Investing in a cold storage wallet for your assets will also add an additional layer of protection against hackers and scammers.

Diversify Investments

It’s tempting to specialize in one or two cryptocurrencies, especially if you have a lot of faith that a particular asset will increase in value. Unfortunately, various events can affect the value of an asset. One of the easiest ways to avoid a financial crisis is to diversify your portfolio with multiple investments. Some investors also work with multiple exchanges so that they’re always ready to trade if necessary.

Keep Up With the News

It’s no secret that the world of cryptocurrency moves quickly. Following multiple news sites who report on the assets you’re investing in, as well as the platforms you’re using, can save you some heartache later on. Whether there’s a run or another financial crisis, being one of the first people to know gives you an advantage. For example, during the collapse of FTX, depositors who withdrew their funds early were able to recover some of their investments. Those who waited to withdraw may not have been able to recover any of theirs.

The Bottom Line

Bank runs can cause a financial crisis at any time. While the U.S. financial system doesn’t have as many federal reserve regulations for cryptocurrency exchanges, there are still several ways you can protect your digital investments. By understanding the causes of a run and taking precautions, you can protect your assets during an unforeseen financial crisis.