We live in a weird world where Russia, China,
and the crypto market are all having the same problem at the same time.
And to make things weirder, none of the problems is causing another. They are all happening
separately. and are perhaps the biggest threat to any country’s—or cryptomarket’s—stability.
If China does not get it sorted out, the Chinese communist party will face a legitimacy crisis
and a wave of anti-government protests not seen since 1989.
If the crypto world does not get it sorted out,
the recent market plunge will look tame by comparison.
And if Russia does not get it sorted out, it means the end of Putin’s career
and a Ukrainian victory.
That thing is bank runs.
We’ve talked about bank runs a couple of times before on this channel,
but there have been a lot of developments since then.
To get us all on the same page,
here’s a quick explanation for what a “normal” bank run looks like.
When you deposit money in a bank, it does not just sit there.
They do not have a stack of cash in some back room waiting for you to reclaim it.
Banks need to make money. To do that,
they take your cash and invest in a place where it can accrue interest.
Only a fraction of it stays behind,
enough to cover the withdrawals it may encounter on a normal day.
This is a major problem if everyone comes to get their money back at the same time.
The bank literally cannot pay everyone. It becomes insolvent,
leaving its customers to pick up whatever pieces they can.
Bank runs are as old as banks themselves,
but are best-known because of financial crises that occurred
on both sides of the Atlantic during the Great Depression.
To make matters worse, bank runs are self-fulfilling prophecies.
Remember the beginning of the pandemic when toilet paper was basically impossible to find?
It was the same idea. Even if you had no need for toilet paper at the moment,
you had to worry about its medium-term availability.
That meant you’d go get some.
But everyone else realizes that all the others have the same incentive, so they too rush to buy.
The end result is that there is a shortage because of the expected shortage.
Game theorists call this type of a circular logic a stag hunt,
an idea dating back to philosopher Jean-Jacques Rousseau.
The idea is that successfully hunting a stag requires the coordination of many actors,
so everyone either will either hunt the stag or not,
depending on their expectations of others’ actions.
That’s true for banks as well.
If you anticipate everyone else is going to run to the bank,
you want to get there first so you don’t lose your money.
But so does everyone else.
Even if the original issue was a complete lie,
the bank still becomes insolvent because people thought it would become insolvent.
In 2022, Russia, China, and the crypto markets all faced their own versions of bank runs.
And each addressed the problem in its own way.
For Russia, trouble began in February 2022 with the invasion of Ukraine.
As I touch upon in my new book “What Caused the Russia-Ukraine War”,
western countries levied unprecedented sanctions against Moscow almost immediately.
This triggered bank runs within Russia for a variety of reasons.
For one, Russian citizens worried that the Ruble would soon become effectively worthless.
Those were fears well-founded.
At the start of the war, one hundred rubles bought one dollar and twenty-three cents.
Two weeks later, it bought just seventy-four cents.
Consequently, Russian citizens wanted to withdraw their foreign currencies.
The other big issue was uncertainty whether electronic payment systems would still work,
at which point rubles would be better than nothing.
Both of these concerns caused problems for the standard way countries protect against bank runs:
something known as deposit insurance.
In the United States, this is the FDIC
and the NCUA.
In the United Kingdom, it’s the Financial Services Compensation Scheme, which makes
it sound like they are up to something, but really they are just there to provide insurance.
And in Russia, it’s the Deposit Insurance Agency.
In general, deposit insurance promises to make customers whole if their bank experiences a run.
Under normal circumstances, that kills the psychological aspect of the problem. No one
needs to outrace the others to withdraw their money because the government will cover them.
But when the bank run is going after foreign currency,
government guarantees only work if the government has access to that money.
And right as the sanctions began, both the US and European Central Bank withheld Russia’s
foreign currency reserves. That kept the pressure on Russians looking for dollars.
But the ECB does not control rubles.
Russia, of course, can always print more of them.
But that still might not solve the problem for ruble-seeking Russians.
Their problem was more immediate. If government insurance takes a month to process,
that does little to allow ostensibly wealthy Russians from, say, eating in the meantime.
It seems Russia was able to address the liquidity problem without too much issue.
The central bank also raised interest rates to 20%
to incentivize citizens to willingly keep their money in the bank.
To address the systemic issues, Russia imposed foreign capital controls to prevent
non-Russian companies from taking foreign currencies out of Russia.
These measures were successful. The seventy-four cents 100 rubles used to buy
jumped to a dollar ninety-two by the end of June, higher than before the war.
But that does not mean that the sanctions have failed.
Putin has just replaced a short-term problem with a long-term problem.
Both the capital controls and hire interest rates reduced investments in Russian businesses.
That means lower economic growth and a recession.
How bad it will be remains to be seen. But forecast range from a 3% to 20% contraction.
Meanwhile, the crypto crisis began in May 2022, three months after the invasion of Ukraine.
Here, the institutions in question produce something known as stablecoins.
Unlike standard cryptocurrencies, stablecoins—as their name suggests—trade at a fixed rate.
Minters of stablecoins will take one dollar from you and create one new stablecoin for the dollar.
This is useful because trading actual cryptocurrencies for dollars
is difficult. Stablecoins give a convenient way to do this implicitly.
They are a critical part of the crypto sphere, injecting liquidity into the marketplace and
representing four of the largest crypto eleven currencies by market capitalization.
Stablecoin creators benefit by investing the dollars received
into something that will bring a return.
In other words, stablecoin makers basically operate banks.
And like any other bank, they are susceptible to the standard bank run issues.
Worse, the lack of regulation allows stablecoin operators to invest in more aggressive assets
that imply a higher risk of insolvency.
A shady stablecoin operator could also mint
unbacked coins and use them to purchase regular cryptocurrency.
If stablecoin holders suspect that a producer is insolvent, then a bank run may begin.
At that point, it might not matter whether the producer was actually insolvent or not.
That takes us to TerraUSD. At the beginning of May,
it was a top 10 cryptocurrency in terms of market capitalization.
At that time, it appeared to be at a very stable $1 per coin.
But on May 9, it dropped by 21 percent.
By May 12, it dipped to four dimes.
Then three nickels the next day,
Less than a dime on May 18,
and under a penny by June 10.
Terra’s crash also caused instability in Tether,
the largest stablecoin and the third largest cryptocurrency more generally.
Its price briefly dropped as low as 95 cents on May 12.
The bright spot is that it recovered to the full dollar by the next day.
Its market capitalization, however, went from $83 billion
to $66 billion, meaning that the scare caused 20% stake to be cashed in.
To make matters worse, stablecoin failures can
trigger broader sell offs on traditional cryptocurrencies.
Unbacked stablecoins artificially inflate crypto prices.
When investors realize that worthless currency was used to buy crypto,
the crypto reveals itself to be less valuable than originally thought.
Prices crater, which perhaps helps explain why bitcoin fell from a May 2022
price of over $35,000 to under $20,000 by the middle of July.
The broader problem for the crypto market is that the standard solution to bank runs—regulation
and government-backed deposit insurance—is unavailable by its very nature.
Instead, some producers will try to promise
large reserves. But that does little to alleviate trust issues.
Like we saw earlier, governments do not have as deep of trust gap.
At the very least, everyone knows they can always print more money.
As a result, no one wonders whether the United States can cover FDIC insurance.
It’s problems like these which are why government agencies have shown increasing concern
and are working toward trying to change that.
And indeed, Secretary of the Treasury Janet Yellen has made it a particular focus.
China was the final piece in the bank run puzzle to hit the spotlight,
but their trouble began in April 2022.
Chinese law dictates that citizens are limited to using local banks for their savings.
However, it appears that some small banks in the Henan province broke these rules.
They began using online platforms to bring in
customers from outside their regional restrictions.
The Chinese government cracked down, freezing the assets of customers of four of these banks.
Protestors responded by congregating outside one of them on July 11,
which brought the issue into the international spotlight—such protests are rare in China.
Well, that’s one version of what happened. An alternative explanation
is that the banks made some risky investments and lost the ability to repay their creditors.
What actually happened is almost beside the point.
China’s economic growth is slowing, especially in the wake of its zero-covid policy.
If people think that their banks are insolvent,
that can be enough to trigger a run in China just as easily as it can in Russia.
Now China has deposit insurance, but initially they refused to honor it,
citing how the customers broke the regional banking rules.
That government policy could also cause a bank run at other banks that engaged in similar practices.
Ironically, the enforcement of China’s laws could cause greater economic instability for
the country as a whole. Following the protests,
China announced a change in course and said they would honor most of the deposits.
Whether that happens remains up in the air. Issues with bank runs might not be over.
And there you have it: three very different situations, all with the same underlying cause:
bank runs, which are a specific application of what game theorists call stag hunts.
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