The collapse of Silicon Valley Bank perfectly exemplifies the dangers of digital finance. During the bank run in March – enabled by the increased speed and efficiency of digital finance – an unprecedented number of deposits were withdrawn at an unprecedented rate.
This spurred a liquidity crisis for SVB, which had to sell long-term bonds for losses to meet depositor demands. The result was a swift collapse, which sent tremors through a financial system that was already under pressure from central bank rate hikes. SVB customers withdrew $4.2bn each hour from their accounts, amounting to $42bn in a single day. The previous largest bank run came in 2008, when customers withdrew $16.7bn from Washington Mutual Bank over 10 days.
It is clear that the global regulatory and financial system is not prepared for the shift towards digital finance. Despite the clear benefits – most notably, increased efficiency and inclusion – the risks of volatility, violent swings in value and rapidly ensuing crashes are high.
Bank runs are nothing new. The problem is that digital finance enables bank runs to happen at a greater frequency, volume and speed. The young history of digitalisation in finance is replete with instances of new technologies spurring financial risk when they are poorly understood and regulated. The 2010 flash crash was owed in part to the impact of early high frequency trading, which played a role in spurring the 36-minute spiralling of key financial market indexes. Regulators subsequently introduced ‘circuit breaker’ regulations to prevent this sort of flash crash from occurring again.
The ability to withdraw funds instantly and remotely is something that depositors have already come to take for granted. However, it has yet to be tested across the full lifespan of an economic cycle.
Today, digital finance is similarly under-regulated. Once panic sets in and customers seek to withdraw or move deposits, bank runs become more likely. Social media allows information to be disseminated at incredible speed. And rumours of a run can take hold before regulators have time to react.
In such a scenario, even the most even-keeled traders could feel pressure to shift their capital if they were aware that others were trading in a panic. All of this could happen far more quickly than regulators may be able to respond, which was the case for SVB. The bank would likely have been able to post its bonds as collateral and borrow liquidity from the Federal Reserve to meet the deposit demand, staving off crisis. But the speed of withdrawals was so dramatic that it missed the deadline.
The implications of this capacity for rapidly ensuing panic are of particular concern with respect to digital currencies. In OMFIF’s 2022 future of payments survey, we found that over half of central banks are exploring the implementation of a central bank digital currency. And yet, we also observed that regulatory regimes around digital assets remain largely patchwork and not effectively tailored to the challenges and requirements of digital currencies. Instead, regulatory regimes tend to focus on research to better understand digital assets or on placing digital assets into existing regulatory buckets as either currencies or securities.
The shift to digital currencies may bring valuable benefits to the global financial system, improving efficiency in payments and opening up new business areas. Remittances cost about 7% on average, which is double the target established by the United Nations. Cross-border payments in general remain too slow, expensive and difficult to access. Moreover, 1.7bn people are ‘unbanked’. The move towards digital currencies and assets could help reduce the cost of remittances while simultaneously providing access to the financial system to individuals who have been traditionally outside of it.
And yet, with greater efficiency, ease and access comes risk. Inefficiencies can be a feature of safety – consider tellers counting out withdrawals by hand and being told to slow down by management. The nature of the risk that comes with greater efficiency was discovered by SVB during its bank run. Since digital finance enables swifter movement of currency and capital, it is possible that a domestic shock – for instance, macroeconomic trouble, unpopular policy or foreign conflict – may spur a panic and rapid currency substitution.
If a bank run dynamic emerged in foreign exchange markets, this could wreak havoc on national economics and the international economic order. Debts would suddenly become harder to pay off and governments would be hamstrung as the value of their currency collapsed.
Dollarisation is already a threat in some emerging markets (such as Turkey) and ease of access to digital dollars could represent a dangerous new vector for this threat.
Beyond this, greater use of digital finance to support easier cross-border payments may hamper developing economies and currencies. Individuals may flee to certain ‘trustworthy’ denominations, such as the dollar. In doing so, the concentration of global monetary control may be consolidated in the hands of a few large economies.
Regulators are not prepared to meet these challenges. The collapse of SVB provides an effective warning about the importance of setting sufficient protections for digital finance, before letting it run loose.
Julian Jacobs is Senior Economist at OMFIF.