Why FDIC Insurance Doesn’t Work in Crypto
“No depositor has ever lost a penny of insured deposits since the FDIC was created in 1933.” - FDIC website.
Deposit insurance protects consumer cash held in banks and, since 1933, the Federal Deposit Insurance Corp (FDIC) has offered such insurance to every depositor at an FDIC-insured bank. Since 2008, that coverage has been up to $250k for every depositor.
No such protections exist for digital asset holders. As we’ve seen in the most recent crypto crash, popular crypto platforms Celsius and Voyager froze withdrawals to prevent bank runs and protect their own liquidity. That’s $12bn and $5bn of customer assets frozen, respectively.
But would deposit insurance work in the world of crypto? First, a quick refresher on how FDIC insurance works.
How Does FDIC Insurance Work?
The FDIC is a US agency that protects bank depositors against the loss of their deposits in the event of bank failure. The FDIC covers only deposit products such as checking and savings accounts, not investments like index funds or bonds.
In order to cover insured deposits in the event of bank failures, The FDIC maintains the Deposit Insurance Fund (DIF). The DIF balance was $123bn as of Q1 2022, or 1.23% of total insured deposits in the US banking system, notably below its minimum of 1.35% required by Dodd-Frank. Interestingly, Q1 saw the first decline in the DIF in over a decade, mostly due to unrealized losses on available-for-sale assets.
The FDIC is backed by the “full faith and credit” of the US government. This curious statement means that the resources of the US government stand behind FDIC-insured depositors, giving legitimacy to the institution. If all else fails, the US government & Treasury will step in to ensure consumer deposits are protected.
Would FDIC-like Insurance Work in Crypto?
On the surface, the answer appears to be categorically no.
The problem with crypto is that it is not backed by the “full faith and credit” of anything. No fail stops exist today to prevent cryptocurrencies from going bottoms-up. With recent examples of crypto platform failures, we see that no protection exists for consumer deposits in crypto land. Except perhaps for bailouts from SBF.
But maybe the DIF provides a model that can be copied in crypto without needing to be a public (i.e. government) solution. Interestingly, the DIF has proven to be surprisingly resilient in times of crisis. In the ‘08 financial crisis, the DIF remained liquid enough to cover the insured deposits of failed banks. It did not dip into the US Treasury, even though it could’ve with its “full faith and credit” backing.
The chart below shows the liquid assets held by the DIF throughout the financial crisis. Despite a negative net balance beginning Q3 2009, due to loss provisions for bank failures, the DIF maintained a positive balance of real liquid assets throughout the crisis. Their book balance was negative but they still had a positive number of assets.
So, if the FDIC has proven resilient in macroeconomic turmoil, perhaps it is possible for a crypto-native deposit insurance fund to back crypto assets on centralized platforms and exchanges.
We’ve heard the rallying cries of defi-natives shouting to get your coins off centralized exchanges and custodians. “Not your keys not your coins.” But what if you could have 100% certainty your assets were protected even on a centralized exchange? Deposit insurance would be a first step in that direction.
Unfortunately, our analysis of the DIF in 2008 is flawed because it ignores the $700bn bank bailouts conducted by the government, which spawned “too big to fail” discussions. But if we assume a deposit insurance fund model works at some reserve ratio, we can imagine a world where our crypto deposits are covered even when on centralized exchanges and custodians.
In Conclusion
Deposit insurance in crypto would put the minds of those with assets on centralized exchanges at ease and I think would be a major development for the broader adoption of digital assets.
However, in order for a deposit insurance model to work in crypto, many problems would need to be solved including the below:
Legitimacy: would centralized exchanges and custodians (and their end users) buy into a deposit insurance fund not sponsored by an institution like the US government?
Risk: Could we come up with institutional solvency and compliance thresholds that would mitigate risk enough for deposit insurance to work even in times of crisis?
Coverage: which digital assets should be covered by the deposit insurance?
Pay-outs: could we structure a deposit insurance fund to trustlessly pay out claims in the event of bank failures?
If these questions, and doubtless more, are addressed, we may see a deposit insurance product enter the crypto world.