Recent events have exposed that cryptocurrency exchanges do not provide the same level of protection as more regulated financial institutions. When you log into your crypto exchange account, you may assume that the money or assets you see displayed are physically held in a vault, ready for you to access at any time. However, as we've seen with recent events at exchanges like FTX, this is not always the case. These platforms may use your deposited funds for loans, investments or other purposes, leaving only a fraction of it available for daily use by account holders.
In the event of financial trouble or fraud, this can lead to a "run" on the exchange, with many account holders attempting to withdraw their funds all at once. While traditional banks and trust companies have measures in place to prevent and mitigate runs, cryptocurrency exchanges are not as regulated and do not have the same level of protection for users. Let's explore the concept of "crypto exchange runs" and how you can protect yourself.
What is a 'bank run'?When you log on to your bank account, you see you have $100 in cash. Does this mean the bank actually has $100 sitting in its vault waiting for you? No, of course not. Bank executives have used your money to make loans, invest in stocks and bonds, invest in class action lawsuit receivables, in insurance claims, and whatever else struck their fancy. They only keep enough cash sitting around to cover the daily needs of account holders like you to pay bills and other general uses, which they know is way less than what you actually have deposited with them.
Now, if word gets out that the bank made a bunch of stupid investments and lost all the money, you might say, "I've gotta get my money out of that bank!"… And all the other account holders do the same. Everyone "runs" to the bank to get their money out, and of course, the bank doesn't have that much money sitting in their vault because they used your money to make a bunch of investments that went bad. So they shut the doors and stop permitting withdrawals.
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In steps the banking commissioner and the FDIC. They take over the bank and, over a few days, they ensure that everyone gets their money back (up to US$250,000 per person).
What is a 'crypto exchange run'?When you log onto your crypto exchange account, you see you have $100 in cash or crypto. Does this mean the crypto exchange actually has $100 in cash or crypto sitting in its vault waiting for you? No, of course not, as FTX and others have shown. Crypto exchange executives have used your money and crypto to make loans, prop up coin prices, and make other investments. They only keep enough cash and crypto sitting around to cover the daily needs of account holders like you, which they know is way less than you actually have deposited with them.
Now, if word gets out that there are problems with the exchange and you — and others — say, "I've gotta get my cash and crypto out of there!" then everyone "runs" to the exchange to get their cash and crypto out. And, of course, the crypto exchange doesn't have that much money or crypto sitting in their vault because they have used your cash and crypto to make a bunch of investments that went bad. So they shut their doors and stop permitting withdrawals.
In steps the bankruptcy trustee. They take over and, over months or years, ensure that whatever assets are left in the vault get distributed to creditors, lawyers, and maybe even you and other account holders. Maybe you'll get something, but more likely, you'll have lost everything.
What about 'stock broker runs' or 'trust company runs'?That never happens, as those firms are not permitted to hold your cash, stocks, bonds, crypto or other assets on their balance sheets. They can't make investments or use your cash or assets for anything. They can only hold them in their vault, exactly as you deposited them, and only for you. Thus there is never a situation where a trust company or a broker-dealer doesn't have your cash or assets available for you, so a "run" is never a risk.
How do you protect yourself?Easy. Don't keep cash or assets at any place that can do stupid things with them. Don't keep them somewhere that, when you log on, displays "$100" in cash/crypto but, in reality, doesn't have that sitting in their vault. And if you do, don't be upset when you get out of bed one morning and learn that the exchange has frozen withdrawals and all your cash and crypto are gone.
How do you know if your crypto exchange is up to no good?You don't. But if they have the capability to do this, then you should probably assume that they are doing it. And due to a lack of regulation, every single one of them has the ability to do this unless they are holding 100% of assets at a trust company. The list of exchanges that said on Monday, "No risk here, all assets are backed 1:1 in our vault… Trust us… Really… We pinky promise," and then on Tuesday said, "We are halting withdrawals as we don't have enough assets in our vault to cover account holders" is a frequent occurrence.
Why aren't regulators or Congress stopping this?It's been a learning process for them (even if at the expense of consumers needlessly losing tens of billions of dollars), and the government is typically slow to act when new technologies emerge. That was trust in the Industrial Revolution in the 1800s, it was true of the public stock markets in the 1920s, it was true of the internet in the late 1990s, it was true of mortgage lending in the early 2000s, and it's true of crypto now.
Our legislators, regulatory agencies and law enforcement agencies are working on this. Obviously, not quickly enough to prevent the fraud and losses thus far. But we also don't want another Dodd-Frank-type Act that stymies the very real, very positive transformative effect that the blockchain will have on society and the economy.
ConclusionCrypto exchanges will, I believe, eventually be prevented from holding cash or crypto on their balance sheets (just as securities exchanges don't hold assets on their balance sheets). The exchanges facilitating securities transactions will have to register under Reg ATS or under the Exchange Act. The exchanges facilitating lending will have to get licensed accordingly.
Until then… Don't keep any of your cash or crypto at any exchange that even remotely has the ability to hold your assets on its balance sheet. Period.
Disclaimer: The views expressed in this article are my personal musings and should not be taken as investment advice. It is important to consult with licensed professionals before making financial decisions. This article is intended to reflect my opinions and is not a comprehensive analysis of the topics discussed.