On Bank Runs and the Future of Finance
The new transparent financial system will end our reliance on the good nature and competence of third-parties
I normally restrict these pieces to political questions, but it’s time for a little dose of reality about what’s happening in our banking system. A few critical observations:
Our regulators are mismanaging their oversight responsibility in an unprecedented fashion.
The internet has changed finance forever.
Cryptocurrency is the most misunderstood financial topic in history. By a lot.
We have all been amazed by the bank runs that took down Silvergate and Silicon Valley Banks, Seemingly in good health one day and gone the next. These failures bear no resemblance to the failures of the 2008 financial crisis, which were driven by declines in asset quality and poor management of credit risk by the rating agencies and the banks themselves. These new crises have been driven by the other side of the balance sheet - deposits. With a little poor duration management thrown in for good measure on the asset side.
There are several relevant regulatory angles. First, when you listen to people criticizing the crypto industry, the first thing you usually hear is that it’s dangerous because it isn’t regulated. So, now, the 16th largest bank in the US is permitted to run itself into the ground despite the heavy degree of oversight under which they were running? What was wrong with Silicon Valley Bank? Well, they managed two of their most critical risks very poorly. Their deposits were too concentrated in the venture industry, making them predictably susceptible to a deposit run in the event that the historic flood of cash into tech venture subsided. In addition, they ran too big of a duration mismatch between their short-term liabilities and their medium-term assets, getting crunched by the new realities of higher rates and an inverted yield curve. So, where were the vaunted regulators and regulations to restrict SVB’s ability to make two terrible and obvious mistakes that brought their institution’s viability into question?
The internet plays a critical role in this drama. First, it makes banks MUCH more exposed to runs in the future than they were in the past, as even a rumor of trouble sends depositors rightly running for the hills. A run on a bank is the most logical game theory exercise on earth. If a bank fails and you stay there, you might lose money. If a bank fails and you leave, you won’t lose money. What to do? SVB will not be the last institution to suffer from such a circumstance if we continue to maintain the same degree of leverage. The solution is to raise the FDIC limit to 25 million and make the banks pay for their “run-insurance,” rather than raising it to infinity for free in a non-systematic fashion.
The other internet-related point here is that the internet offers the comprehensive solution. A new, transparent financial system is being built today that will bring lower fees, higher yields and more safety to savers than they have in today’s system. The underpinning of that new system, what make it all possible is something called a stablecoin.
Most of the misconceptions that both sophisticated and unsophisticated people have about crypto come from the second part of the name - “currency”. Crypto is not currency. Currency is a means of exchange. Generally an effective means of exchange should be highly liquid, and stable in value. Bitcoin is not an effective means of exchange. It is too volatile. It does do a pretty good job of playing the role of a digital version of a gold bar - a safe, secure storehouse of value. But we discovered a long time ago, that gold bars are a pretty silly way to try to pay for things.
The rest of the crypto market - all of those so called currencies - are either 1) certificates of authenticity, 2) loyalty points or 3) equity-like participations in some business enterprise. Perhaps we can call them currency in the same way that we call Amazon shares currency when they pay their employees with stock options or use them to purchase a company, but we certainly don’t see anybody buying books or groceries on Amazon with their shares.
Many years ago Milton Friedman family said that the only key piece missing from the internet was digital money. Well, what do you think Zelle, Venmo and PayPal are? A large company, one that we trust, runs a secret ledger to keep track of transactions and we have faith the digital money they issue will not disappear and will be accepted by counterparties. Missing piece found? Not exactly.
The problem is those companies all rely on faith. Just like our current regulated banking system does. We don’t have transparency on what’s happening in real time, so we have to trust management and trust regulators to keep everything on the rails. Doesn’t seem to be working so well.
Ultimately, the missing piece that Friedman was seeking is the stablecoin. A stablecoin is a digital token that can be used as a means of exchange, instantly, without friction, anywhere in the world. Stablecoins are the real Currencies in crypto. They are the juice that will allow digital transaction volumes to accelerate, whether you want to buy a building, a bond, or virtual real estate in a metaverse.
Right now there is a lot of concern about the USDC stablecoin issued by Circle simply because they had cash in SVB. Seems like every “crypto” issue we face these days doesn’t emanate from the new tech, but from old world traditional finance issues. With USDC, the token isn’t the problem, it’s the old world bank.
A stablecoin’s transactions are recorded on a visible ledger. That transparency means that all of the market participants know exactly how many are outstanding at any time. What we can’t see with USDC and their peers is the old world part of the equation - the assets. We have to trust Circle (and their auditors) when they tell us how much they had on deposit at SVB or how many treasuries they hold. The solution is to tokenize the asset side. A variety of market participants have tokenized treasuries, money market funds, LP interests, corporate bonds and more. Once all stablecoins adopt digital assets to go with their transparent liabilities, the trust factor is eliminated. We can KNOW that our money is safe, not hope that’s the case. We don’t have to rely on anybody’s competence or good nature - not regulators, not management, not the good nature of depositors to stay loyal during a bank run.
In a stablecoin-fueled financial system, 24/7 global transfers of value will take place with no cost or delay. And ultimately, I believe stablecoins will pay dividends reflective of the yields of their underlying money-market assets. Now we just need the regulators to get out of the way and let it happen. And then the largest disintermediation in financial history will begin as depositors discover a better way to manage their cash than putting in the bank.