The crypto industry is determined to learn all the lessons of traditional finance the hard way
Lesson summary
Hi everyone, I’m Jeff and this is Plain English lesson number 540. At Plain English, we talk about current events and trending topics. And by listening, you learn about the world, yes, but you also get exposure to new concepts in English, things you might not find in a textbook or in a classroom.
And I’ve been thinking about how to talk about the latest news in the crypto world. Before the holidays, we did two lessons on a real estate scam in the United States and I got a lot of good feedback on that. So I want to take the same approach.
Today I’m going to tell you about two ways a bank can find itself in trouble. The way I’ll explain it is an oversimplification, but it’s going to give you the vocabulary you need to understand what happened at FTX, a major crypto exchange. Then, next week, we’ll dive back into this topic with a discussion of what we know about FTX.
In the second half of today’s lesson, I’ll show you how to use the English phrasal verb “sour on.” And we have a quote of the week. Let’s get going.
How a bank works (and can fail)
This is basically how a bank works. A bank opens its doors to the public and takes deposits from customers. The customers give the bank their money for safekeeping. Maybe the customers get some low rate of interest on their deposits, but the real purpose of making a deposit is to safeguard money. The customers have the right to withdraw their money any time, but realistically, most customers just keep their money there. If they withdraw it, they take it out a little at a time .
The bank then decides to take the pile of money from depositors, and they lend it out to other people. Those people might be small business owners, real estate developers, or simply families looking to buy a home. They borrow money from the bank today and they pay it back over the long run, with a higher rate of interest.
The bank takes the interest payments from the borrowers and spends it on things like branches, vaults, expensive technology, and a lot of people to make the system run smoothly. The bank also keeps some of it as profit.
From the bank’s perspective, this is called borrowing short and lending long. They start by getting short-term money from depositors. The depositors can ask for their money back any day they like, on a moment’s notice—really short term. But banks lend long: they give money to others, but they, the banks, don’t get that money back for a long time.
A problem develops when, for some reason, or for no reason at all, some depositors lose confidence in the bank or in the system. When that happens, they rush to the bank, and ask for all their money back that same day. The first people who do this get their money back. But if enough depositors do this, then some of them don’t get their money back right away.
That’s because the bank doesn’t have all their money in the safe—remember, they lent it out to long-term borrowers—so only some depositors will get their money back on the day they ask for it. Other borrowers won’t get their money back that same day, even though they were promised access to it. Panic ensues and there is a crisis.
A banking crisis can take one of two forms. The crisis can be a liquidity crisis or a solvency crisis.
Liquidity is the word we use to describe the ability to turn assets into useable cash money. Let’s say you own a house free and clear that’s worth $100,000 and let’s say you also have $20,000 in the bank. Let’s say you have an emergency and you need to come up with $50,000 by the end of the week.
No problem, right? Your net worth is over $100,000, so spending $50,000 should be no problem. Actually, yes, it is a problem. Your biggest asset is a house, and you can’t sell a house for cash money by the end of the week. You have the value, but you don’t have the cash. You could get the money eventually, but you can’t get it right now. You have a liquidity problem.
Banks face liquidity problems when their depositors all ask for their money back at once. The bank can give them their money back, they just can’t do it today or tomorrow. They have to wait for their long-term borrowers to pay back their loans first.
That might take years, but the bank will get the money back. It’s just a question of timing. Depositors don’t want to hear that; they don’t want to wait. They, rightly, say the bank promised them immediate access to their money, so they would like their money now, please, and all of it.
In a liquidity crisis, a smart outside investor—or the government—might dispassionately analyze the situation and say, “Hey, this bank will get all the money back. They just need a little help in the short-term to pay their cranky depositors. I’ll lend money to the bank to help them through the crisis.” The bank says, “Thank you” and the bank is saved. It’s saved because all the money does come back from the borrowers over the long term. This is a simplification, but it’s basically what happens.
A solvency crisis is different. Solvency means, “Do you have enough assets to cover your liabilities?” In a solvency crisis, the bank has lent out all the depositors’ money, but they made reckless loans and for some reason, the borrowers are not going to pay the money back. In this case, the bank will not be able to pay back all the depositors. The money is not there now, and it never will be. In that case, we say the bank is insolvent.
In a solvency crisis, the bank collapses. No outside investor wants to touch it: the bank wasted the depositors’ money! It’s gone. Depositors are out of luck, and no one is coming to the rescue. The bank fails; it goes into bankruptcy and the creditors and depositors can fight over what little is left.
In most developed countries, there is government deposit insurance that protects depositors (ordinary citizens) from losing some—but not all—of their money, so not all hope is lost. But it’s still bad.
The good news is, this type of crisis is not common—neither a liquidity crisis nor a solvency crisis is common in developed economies. There are rules and regulations and supervision and tests and checks and software and systems and approvals and processes and allowances to prevent crises from happening in the first place .
This whole structure has evolved over centuries, as governments and banks have learned from past crises. Yes, this is all very annoying, boring, time-consuming, and expensive. But—with a few spectacular exceptions—it does generally work.
Now, I would like you to imagine an alternate universe. In this alternate universe, a bunch of people under the age of 30 decide they know better than the accumulated knowledge of decades—or centuries—of lessons of traditional finance.
They write lots of computer code, invent their own currencies, take deposits like a traditional bank, make promises like a hedge fund, and they don’t bother with all that boring stuff like—I don’t know—risk management, accounting, regulations. That stuff just puts me to sleep. Who needs it?
In this alternate universe , twenty-somethings convince people to invest their money in new currencies and on trading platforms that promise better investment returns. They, in their shorts, can do a better job than all those stuffy bankers with their suits—yuck—and Wall Street offices. Just give us your real money, they say, and we’ll make you rich with our invented money.
Ha, ha! Yeah, right, you might be saying. Who would do that?
But don’t laugh: this alternate universe exists, and it’s called cryptocurrency. And a lot of crypto depositors are asking for their money back…and they’re not getting it. Now, they’re trying to determine whether their particular crypto bank is having a liquidity crisis or a solvency crisis. And by the way, there’s no deposit insurance in crypto.
FTX, a popular crypto exchange, had a solvency crisis and lost $8 billion of customer money. Poof! And its collapse has precipitated a liquidity crisis at other exchanges. The irresponsibility of FTX is affecting even the crypto exchanges that acted responsibly, and customers around the world are souring on the whole crypto project.
That’s what we’ll talk about next Monday: what happened at FTX, the largest crypto exchange to collapse, and why its 30-year-old founder is facing over a hundred years in prison.
Not against crypto…
Bitcoin is like the stodgy old man of cryptocurrencies. Bitcoin can actually be used for things, unlike most cryptocurrencies. For example, you can buy a pupusa with Bitcoin in El Salvador . Anyway, Bitcoin’s price is down 75 percent from its peak. And this is the useful one!
I want you to know I’m not against cryptocurrencies. But if you are a true believer in crypto, you have to look at what some people in the industry are doing, and you have to admit that they are bringing the whole thing down.
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