The Quickest Bank Run in History
U.S. equities got crushed last week. Regional bank stocks fell 3x as hard. Digital assets fell even harder. And it’s all because 3 regional banks went down. According to the Federal Reserve:
- Silvergate Bank was the #128th largest U.S. bank as of the end of 2022.
- Signature Bank was the #29th largest U.S. bank as of the end of 2022.
- Silicon Valley Bank was the #16th largest U.S. bank as of the end of 2022.
According to Morningstar, many others are still at risk. By now, plenty of great resources are available discussing why and how these banks failed so quickly. Everything written by Bob Elliott and this tweet from Jim Bianco are my favorites.
In short, the business of banking is riskier than most understand, just like the business of pseudo-crypto banks like BlockFi and pseudo-exchanges like FTX were riskier than most understood. They are risky because your assets are not your assets—they are the banks’ liabilities, and if the bank screws up its own assets, its liabilities (your assets) are not so safe.
But rather than focus on what happened, I will share my interpretation of what this means in the larger context going forward.
First, the U.S. government had no choice but to step in. And step in, they did. Before U.S. equity futures opened on Sunday night, they had to backstop depositors, or risk bank runs at every regional bank in the country. This should not have surprised anyone.
Why was this obvious? Because this banking mishap is nothing like that of 2008. In 2008, the assets that banks and insurance companies held were toxic—defaulted mortgages, IG and HY CDS, and other declining assets that had little to no chance of recovering without propping them up artificially. But the “toxic” assets that banks hold today are largely U.S. Treasuries and high-quality MBSs, which are almost certainly worth par but have declined in price simply due to rising rates. Poor risk and asset/liability management? Yes. Bad asset quality? No. This was a liquidity issue, not a solvency issue, and it would have made no sense to punish depositors over a liquidity issue.
Now, the word “bailout” has a very negative connotation. In 2008, many who deserved nothing were bailed out (bank executives, shareholders, debt holders). In 2020, many more undeserving parties received bailouts (airline executives and shareholders, real estate moguls, etc.) As a result, trust in government and banks has been declining for decades. But the latest bailout in 2023 shouldn’t be confused with past bailouts. Shareholders are not being bailed out. Unsecured creditors are not being bailed out. Executives at failed institutions are not being bailed out. Only depositors of cash in banks that were supposed to secure their assets were bailed out.
Now, you can argue that the FDIC insurance clearly states that only $250K per household is guaranteed at banks, and therefore depositors should have known this and not held more than that amount. And you’d be 100% right—in theory. But the spirit of U.S. banking is not to force every cash depositor who needs liquid working capital to open hundreds of checking accounts. But the online nature of banking, payroll, and bill paying today essentially forces small businesses and individuals to hold far more than the FDIC-insured amount in checking accounts. Could they have made a point by harming depositors? Sure. But that would have been the single dumbest, most expensive, and needless bank run in history to make a political point. In this case, the right people were bailed out.
Second, in the aftermath of these bank failures, like every asset manager and small business, Arca spent all of Friday and the weekend working to keep our assets “safe.” While some people might immediately jump many steps ahead—e.g., “Sell your stocks and crypto assets because the market will go down”—when you break that statement down to the actual workflows, it’s not really as safe as it sounds. For example:
- Sell your self-custodied XYZ tokens (MATIC, UNI, ETH, BTC, SOL, whatever)
- "Phew, I feel so much less at risk.”
- Receive a stablecoin (USDC, USDT, DAI)
- “Um, that’s a middleman with assets tied up in a bank.”
- Swap your stablecoin into U.S. dollars via an OTC broker
- “Hmm, that OTC desk has assets tied up in a bank—are you sure they can deliver?”
- Deposit your U.S. dollars into _______ (pick your bank—Silvergate, Signature?)
- “Can’t that bank default and lock my assets?”
- Swap your assets from the scary bad bank into a reputable good bank?
- “Umm, did we adequately go through all of the 10-Qs of said good bank to ensure they didn’t also load up on a ton of long-dated Treasuries when interest rates were at 1.5%?”
- Maybe we should keep our assets in self-custodied XYZ tokens after all. In fact, let’s sell our cash and stablecoins into more of these assets.
And that’s exactly the workflow that led to the risk-on rally this weekend, where BTC and ETH jumped 10%, and other high quality tokens jumped even more, while stablecoins traded down (USDC at one point hit $0.88, though it quickly recovered). As soon as bank “safety” is called into question, regardless of the explicit government backstop, every single asset manager and small business has to re-do their “safety rankings,” and it now looks something like this, from safest to least safe:
3. Bearer assets–BTC, ETH, and other high-quality tokens
4. Cash under your mattress
57.Cash in a regional, not strategically important bank
93. Stablecoins
Now, this is not the future. We can’t live in a society where every bill is paid online, but you have to be a top-tier hedge fund analyst to feel confident enough to keep your assets in a bank. Opening a checking account shouldn’t involve reading a 10-K. And that, in a nutshell, is why the government stepped in.
That said, while banking is and should still feel safe, this has all left a bad taste in Americans’ mouths today. While there will be no reason to withdraw your assets from a bank now that the government backstopped deposits, there certainly will be much more hesitation before making new deposits at a bank. Banking will likely become a transactional mechanism rather than a storage facility. At the very least, there will be more caution and reading of fine print.
As far as markets are concerned (and while this will likely publish long after markets open Monday, it was written on Sunday night), my expectations are as follows:
- Regional bank stocks will be down this week.
- No bailouts mean shareholders are on the hook.
- Broader equities will be higher.
- The government just backstopped the entire U.S. banking system, which is good for your other investments and likely means the end of the rate hike cycle.
- BTC and ETH will continue to go higher.
- USDC will see massive redemptions.
- Likely ¼ or ½ of USDC AUM will be redeemed ($10-20B). Even though USDC is itself backed by real assets, those assets are held by Circle, Coinbase, and a lazy susan of exploding banks.
- If USDC passes this stress test, it’ll likely grow assets again over time.
- A ton of assets will leave banks and find their way into higher-yielding money markets and Treasuries.
BTC and ETH outperforming on this news perfectly underscores the BTC objective. After the 2008 Global Financial Crisis left many with a distrust for banks, BTC was designed to be a non-fractionalized banking system to avoid exactly what has just transpired.
“If banks get shut out, a giant ball of money effectively gets trapped in this small ecosystem with really only one viable use case: buying more tokens. Roughly 15% of the total market cap of digital assets consists of USD-backed stablecoins (with USDT, USDC, BUSD, and DAI as the 4 largest). Stablecoins today act as 2-way assets—easy to get money into the digital asset ecosystem and an easy way to get money back out to the banking system. But if a "choke point" begins to restrict users’ ability to get their money back out of this ecosystem, there will be no reason to hold stablecoins anymore. Stablecoins offer a safety net from the price volatility of digital assets but have the same peer-to-peer transfer properties of other digital assets. Suppose that price volatility shield suddenly goes away because you can no longer get your dollars back immediately. In that case, stablecoins look a lot like other tokens in terms of spendability and transferability. The faster you swap your stables into BTC, ETH, or other assets, the more likely you'll be to preserve (and grow) that value since you can no longer take it out of the ecosystem and use that money to buy stocks, real estate, or other goods. These no longer relevant stablecoins won't be redeemed per se (meaning AUM won't necessarily fall) but will likely end up predominantly owned by market makers, exchanges, and the stablecoin issuers themselves.”
Long Telegram From ETH Denver
Written by: Michal Benedykcinski - Senior Vice President, Research
With the 6th edition of the longest-running Ethereum conference behind us, it’s an opportune time to take stock of what we saw on the ground in the Mile High City and share some key takeaways for our industry. This year’s event shattered the prior year’s records with over 16,000 in attendance at the main venue and an additional 4,000 participants in many of the side events. Additionally, the BUIDLathon week-long hackathon that preceded the main event attracted close to 10,000 attendees, including many participants, mentors, and judges from prior years’ editions, like notable alumni 1inch, Aragon, and Gitcoin.
Compared to the early 2018 event, which drew a fraction of the participants and presenters who all fit into a single venue, the sheer size and scope of this year’s ETH Denver made it impossible to experience it all. That’s how participants inadvertently chose their adventure, making each exchange, panel, workshop, and dinner memorable and heavily contributing to the cult following of this fully-fledged festival.
The event has also historically been a bellwether of major industry trends: the 2020 edition foreshadowed the summer of DeFi, the 2021 virtual edition was dominated by NFTs, and 2022 focused on DAOs. To the credit of SporkDAO organizers, ETH Denver has embraced the Big Tent narrative, opening itself up to a multichain future where Ethereum Virtual Machine (EVM) and non-EVM projects would go from sharing the main stage to co-hosting side events dedicated to interoperability and shared security.
While this year’s edition did not have a single dominant theme, we narrowed down the top 4 areas where we saw developer talent congregate.
1. Let Thousands of Roll-ups Bloom
Arriving at the main venue or any of the side events, you couldn’t escape the feeling that the proliferation of scalability solutions to increase transaction speed and throughput is showing no signs of slowing down. Roll-ups have been the dominant scaling strategy to cut costs and time when processing multiple transactions off-chain and then batching them into a single transaction on the Ethereum mainnet. Recently unveiled BASE was the talk of the town, and Jesse Pollak delivered several presentations outlining how Coinbase’s very own Layer 2 fits into the company’s aspirations to open the world of public networks to its 100M users and attract 1M developers while building it. Its current business model is heavily (90:10) skewed toward off-chain transactions. Still, Coinbase ultimately envisions a future where open networks can unlock much more accessible financial services that might not be beholden to the operating hours of the banks, eventually helping its user base migrate on-chain.
Admittedly there are several challenges along the way, from the centralized nature of sequencers that execute the transactions and pack multiple transactions into a roll-up block to privacy concerns over the confidentiality of asset transfers. Even so, the early signs of developer activity and major applications embracing BASE are promising. Other projects at the frontier of scalability design that caught our attention were Eigenlayer which enables users to re-stake their ether (ETH) and extend crypto security to additional applications, and Celestia, which proposes a much more modular build for blockchains by ordering and publishing transactions without having to execute them. Both projects will be launching later this year, and we will cover them in great detail.
2. Zero-knowledge Craze
Unlike last year when most crypto conferences had a shadow track dedicated to Zero-knowledge proofs (ZKPs), ETH Denver felt like a coming-out party that prominently featured many of the projects implementing ZKPs for enhanced security and privacy. As a method for validating a statement without revealing anything about the statement itself, ZKPs have been one of the core primitives of modern cryptography for over 3 decades. Only recently, they started finding early signs of product-market fit in crypto with a rising interest in privacy-enabled use cases that zero-knowledge Ethereum Virtual Machines (zkEVMs) could enable. However, it took several years of deep R&D and close to $1B in venture funding to make ZKPs compatible with smart contracts on Ethereum and a wide range of potential use cases like identity, payments, and gaming.
Many projects that have raised staggering capital in the last 18 months were quick to cool down the high expectations, with investors outnumbering founders 2:1 at the zkDay. While everyone we spoke to agreed that ZKPs are an important building block for a more decentralized web, most had divergent opinions on how to express this as an investment and on what timeframe. With a seemingly infinite number of potential software applications for ZKPs today, there is a finite supply of hardware that can accelerate secure and private computation. Projects like Fabric Cryptography, which initially was building liquid-cooled bitcoin mining rigs, are pivoting to custom chips design that will be able to execute ZKP algorithms in milliseconds compared to the minutes-to-hours possible with existing hardware.
3. Account Abstraction to the Rescue
A welcome change to years prior was the laser focus on user experience, which has coincided with account abstraction ERC-4337 standard going live after close to 9 years of R&D. Many of the potential benefits—like flexible key management and social recovery, ability to add multiple addresses associated with the same private key, transaction batching, and ability to pay for gas in any token of choice—are yet to be fully implemented by the majority of the wallets. The implications were hotly debated during the WalletCon, with many popular decentralized applications unveiling their wallet aspirations and some, like Uniswap, even unlocking early access for the attendees. This year, instead of crypto conference swag, participants could actually experience the magic of decentralized internet first-hand. From the conference MEWwallet where you could redeem your $BUIDLBux for food truck lunch or conference merch, to an Arbitrum Shake Shack airdrop redeemable at point of sale, the conference was a great opportunity to show technology at work.
The core idea of account abstraction is to introduce programmable logic that will allow users to set certain parameters without requiring their signature each time. This, in turn, opens new design paths. For example, mobile Web3 game developers demoed a seamless gameplay experience that did not take you out of the flow every time you had to sign a transaction. The account abstraction will turn every account into a smart contract with a predefined set of rules, transaction batching, and gas fee optimization, as well as improvements in security and recovery features. The real challenge for the industry will be implementing standards that minimize click-through and maximize familiar, seamless Web 2.0 mobile experiences like hailing a ride to the airport.
4. RWAs and the Quest for Real YieldWhile DeFi’s presence felt largely subdued, many projects were very open about their plans for sustainable yield generation from real-world assets (RWAs). RWAs have been loosely defined as tangible and financial assets with the potential to serve as collateral to many DeFi primitives. Some popular examples include credit notes, corporate debt, real estate, royalties, and invoices, which are already a linchpin of yield generation in traditional finance. Some of the veteran projects in the space, like Centrifuge, have built a nascent ecosystem for on-chain credit, where smart contracts are used to represent RWAs on-chain with an off-chain guarantee for the redemption of the underlying instrument.
With the demise of the recursive yields tied to the on-chain activity of borrowers and traders on decentralized exchanges (DEXs) or over-collateralized lending platforms, the stable nature of cold hard RWAs has been particularly appealing. As a result, stablecoin issuers and asset managers are taking note, as we have recently seen in the $220M fund announcement where MakerDAO provided $150M of senior capital and BlockTower provided $70M of junior capital in the largest on-chain investment in RWAs to date.
Private credit is a particularly interesting area where RWA is picking up some steam—it has grown to $1.4T in non-government-issued debt. When we examine the composition of loan books of the most popular projects on the RWA.xyz tracker, the vast majority are tied to fintech and emerging markets. While the supporting infrastructure and liquidity are in their infancy, the space continues to attract talent, embracing RWAs’ potential to diversify returns profiles and insulate DeFi from crypto volatility.
Spring Is in the Air
With 2023 off to a choppy start following a flurry of regulatory actions and recent bank runs posing existential threats, ETH Denver stands out as a beacon of hope for the industry at a crossroads. Attracting builders, investors, and enthusiasts from all corners of the world, one could not help but feel optimistic about the future. We see the continued developments in the 4 areas outlined as critical for the arrival of the long-awaited crypto spring.
