We collectively place our faith in institutions that have failed time and time again.
Bank runs are an example of failings in the world of traditional finance that leave all of us vulnerable. In 2023 alone, we have seen multiple bank runs threaten to create widespread economic instability.
While similar crises can happen in crypto, trustless, overcollateralized, and decentralized protocols like Liquid Loans are immune to this threat. Here’s why a bank run can never happen with Liquid Loans.
Bank runs occur when a large group of people withdraw their money from a bank at the same time. When the bank does not have enough liquidity to fully return their customers' money, it creates panic—further increasing the consequences of the bank run.
As a result, bank runs can be a devastating panic cycle, both for financial institutions and everyday customers.
We recently saw this play out when one of the largest banks in the US collapsed in just 48 hours as the consequence of a bank run.
In March of this year, Silicon Valley Bank’s customers withdrew $42 billion USD in a single day. This left SVB with a negative balance, as the bank did not have enough liquidity to pay out all of its customers at once. As a result, federal regulators shut down Silicon Valley Bank the following day.
This sudden and catastrophic bank run soon spread to other banks. Most notable of these was Signature Bank, which federal regulators ended up closing as well.
Silicon Valley Bank was one of the world’s largest banks. Having been around since 1983, it was also a major institution in the world of traditional finance. But all it took to take it down was enough people withdrawing their money at the same time.
Many stablecoins claim to be backed by money held in reserves, claiming that their holders will be able to redeem their coins at a 1:1 rate in exchange for fiat currencies like the US dollar.
The crypto movement was designed to be decentralized and remove the need for intermediaries like banks. However, the fact of the matter is that centralized exchanges currently fill a similar role.
Like banks, these exchanges hold their users’ funds on their behalf. Worse still, they can be just as reckless.
In the past, we have seen numerous cryptocurrency exchanges fail to have sufficient liquidity to pay out their holders.
In practice, this can play out similarly to a bank run. A crypto exchange being unable to fulfill all of its withdrawal requests due to liquidity issues creates panic for people who have accounts with the exchange. As a result, they rush to withdraw their funds as well, further amplifying the crisis.
One of the most notorious examples of this in the crypto space was when FTX, a massive cryptocurrency exchange once valued at $40 billion USD, experienced a bank run of its own.
Last year, FTX saw roughly $6 billion USD withdrawals in just 72 hours. While the exchange tried to solve what it called a “liquidity crunch”, it ultimately failed to return its customers’ holdings back to them in a timely fashion.
FTX’s native token, FTT, was trading at between $26-$22 USD per coin price to the bank run. Today, FTT is valued at less than $1 USD. The platform's co-founder, Sam Bankman-Fried, was recently jailed ahead of his upcoming trial.
The crypto landscape has witnessed several notable examples of major stablecoins failing to survive their own versions of a bank run.
However, many projects are far from transparent when it comes to proving that these reserves can easily be liquidated or even exist in the first place.
While some stablecoins are audited to prove that their claimed reserves actually exist, other projects fail to disclose the results of their audits altogether.
The most obvious example of a stablecoin that fell victim to a “bank run” of its own is TerraUSD (UST)—which was once valued at more than $40 billion USD.
While once one of the largest crypto currencies by market cap and valued at $100 USD per coin, UST’s partner coin, LUNA, is now worth only a fraction of a cent.
The failings of UST and other stablecoins as a whole serves as a stark reminder of why it is important for stablecoins to actually adhere to a specific range of criteria.
For more about this important topic, check out our article on the 7 Tenets of a Decentralized Stablecoin.
Unlike the bank runs that we have seen in both the world of traditional finance and the crypto landscape, Liquid Loans and the USDL stablecoin are safe from this kind of panic-induced economic disaster.
For the most part, bank runs are caused by issues regarding access to liquidity. Banks, centralized exchanges, and even stablecoins are often designed around promising to hold enough capital in reserve to allow their customers to liquidate their holdings.
In actuality, they often fail to do this.
This is where USDL is different, as it does not rely on claiming to be supported by dollars in a bank account.
Rather, USDL is an algorithmic stablecoin that is fundamentally designed to be overcollateralized at all times.
This means that there is always more than enough liquidity available to allow all USDL holders to redeem their USDL for PulseChain (PLS) whenever they decide to.
As a result, USDL is immune from the panic cycle that we have seen taken down major banks and centralized exchanges.
This is furthered by Liquid Loans’ transparent algorithmic redemption mechanism, which creates a hard price floor for USDL. This ensures that the stablecoin’s market price stays at (or near to) $1 USD worth of PLS.
Liquid Loans has also designed USDL for the community in a way that allows the stablecoin to fully exist in the community’s control. The Liquid Loans team does not have any ownership of USDL, and it was created with no admin keys.
Finally, it is important to consider that bank runs always have one thing in common: panic.
Panic occurs when people become rightfully concerned about whether or not the institution that holds their money has the intention—let alone the ability—to return their funds.
This is why it is especially important for financial projects to be noncustodial and transparent. When projects like Liquid Loans are fully and transparently audited, and make use of transparent protocols and smart contracts, holders are given no reason to panic.
Instead, they are fully aware that they can redeem their holdings whenever they decide.
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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.
WaLLrus is the Global Head of Growth and Partnerships at Liquid Loans, and host of The Weigh In With Wallrus podcast series. He has been in the crypto space since 2015, and is widely recognized as a DeFi thought leader and strategist.
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