What are cryptocurrency bank runs and how do they work?

The history of bank runs dates back to the advent of banking. The situation affects banking systems and other financial services that offer similar services. Cryptocurrency exchanges provide services similar to those provided by traditional banking systems, so they are not immune to the problem.

The widespread lack of regulation on exchanges makes it important to understand what cryptocurrency racing is and how to protect yourself from it. So what are bank runs and how can you protect yourself from their negative effects? You will know soon.

What is a bank run?

A bank run occurs when customers withdraw their money from a financial institution out of fear of losing it if the institution goes out of business. As more people withdraw their funds, the likelihood that the institution will be unable to continue processing withdrawals increases, especially if the financial institution’s reserve is not sufficient to cover withdrawal requests.

How do bank runs work?

Bank runs have occurred in different aspects of finance over time, but lately we rarely hear about them in mainstream finance because measures have been put in place to curb such instances. Banks typically also have insurance and reserves to safeguard against any adverse events that can cause them to lose client funds.

A bank run occurs when customers collectively withdraw their funds from banks in the belief that the bank is at risk of insolvency. It starts from a widespread fear that a system or financial institution is at risk of failure, usually triggered by a series of events. Customers then start withdrawing their money almost simultaneously, increasing the possibility of the financial institution going bankrupt.

Recent events in the cryptocurrency world have made bank runs slightly more pronounced. Many cryptocurrency investors have started withdrawing their money due to fear, uncertainty and doubts about cryptocurrency exchanges and cryptocurrencies, which were first triggered by the FTX crash.

After the collapse of FTX, many cryptocurrency investors started withdrawing their money from various exchanges out of fear that cryptocurrencies or other exchanges would crash and fall to the same fate as many FTX clients. Panic withdrawals have affected cryptocurrency prices.

The bank run hit many exchanges, causing a big name like BlockFi to stop processing withdrawal requests and eventually file for bankruptcy. Other exchanges have also seen an increase in withdrawal requests.

If cryptography is going to survive and gain more trust from its users, it needs to adopt practices that can ensure that its clients’ funds are safe even in the event of insolvency. One of the practices could be strict segregation of client funds from the general corporate fund or at least proof that there is a backup for each client’s deposits.

4 ways to protect yourself from the negative effects of bank runs

Below are steps you can take to ensure your funds are safe in the event of a future bank run.

1. Using exchanges that have proof of stock

Providing proof of reserve has become serious business since the FTX crash. Some big players, such as Binance and Bybit, have responded positively to the idea and have started showing evidence of reserve.

pile of coins

Proof of reserve shows users a picture of a cryptocurrency exchange’s assets and financial backing, enabling them to make better decisions when choosing an exchange to trade with.

As much as you would expect reputable exchanges to offer some form of trust and protection, the FTX bankruptcy case and subsequent trouble has made people discover that using a reputable broker is not enough to be safe during a problem. of failure. Rather, users now want to see that the exchange they are using is well audited and has measures in place to protect them in case of failure.

Providing proof of reserve is becoming necessary to increase clients’ confidence in an exchange as they want to be sure that their funds are backed by tangible assets.

2. Investment diversification

Diversifying your investment across different cryptocurrencies can be a good way to mitigate the negative impact of a cryptocurrency losing its value. You can also diversify your funds across several reputable exchanges to ensure you don’t lose your entire investment in the event of a bank run.

Investing in assets other than cryptocurrency is another way to diversify your holdings. The forex market, the stock market, real estate and many other sectors offer investment opportunities, although they are not as volatile as cryptocurrencies.

3. Using a cold wallet

Using a cold storage device to store your cryptocurrencies is one of the most reliable ways to protect yourself from bank runs. A cold wallet is an offline device on which bitcoin and other cryptocurrencies can be stored. The device is not connected to the internet and is not usually connected to an exchange. Thus, it protects you from unauthorized access, hacks and other vulnerabilities you may encounter with online exchanges, including bank runs.

bitcoin tokens and flash drives

When it comes to storing your cryptocurrencies, cold wallets offer better security than hot wallets or online wallets. Since the cryptocurrency industry is still undergoing a security reform and restructuring that would make it as secure as traditional financial institutions, saving your cryptocurrencies in a self-hosted or non-custodial offline wallet may be the best option.

4. Keep following the latest Crypto and Exchange news

Checking the news related to the cryptocurrency you are investing in and the platform you are investing in will keep you updated on the latest developments. It might help to be one of the first people to get information about an impending crisis or crisis at the cryptocurrency exchange, as you can withdraw your money faster before withdrawals are suspended.

Always take safety measures

You cannot control if or when a bank run will occur. However, you can largely protect yourself from its effects by using the measures we have explained in this article. A bank run can be so intense that an exchange can become worthless and be forced to close, causing users to lose their funds.

With the cryptocurrency industry still in its infancy, you should take practical steps to ensure your funds are safe and not completely dependent on your cryptocurrencies or online wallet.

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