Large Withdrawals by Crypto Whales Responsible for US Banking Crisis: Federal Reserve Bank of Chicago

The back-to-back downfalls of promising crypto projects last year has been blamed for causing the ongoing banking crisis in the US by the Federal Reserve Bank of Chicago (FRBC). In a fresh analysis, the FRBC has said large withdrawals by institutional crypto investors stirred a liquidity crisis so severe that it left the traditional banking system in the US gasping for breath. Last month itself, three banks in the US shut their businesses owing to the liquidity crunch.

The downfalls of BlockFi, Celsius, FTX, Genesis (in partnership with Gemini), and Voyager Digital have been named as the most impactful crisis creators in FRBC's report.

The collapse of Terra, that brought the crypto market to a standstill in May 2022, was the trigger point of severe turbulence for other players of the sector.

Terra's native stablecoin UST lost its equivalence to the US dollar that risked the finances of its holders. This had caused the crash of Terra. At the time Terra's LUNA and UST tokens reportedly lost around $45 billion (roughly Rs. 3,70,004 crore) within three days.

Several crypto firms resorted to laying off members of their staff just in order to keep their businesses afloat.

Eventually, crypto-related firms like Three Arrows Capital, Celsius, and Voyager ended up filing for bankruptcy after recording large outflows of funds.

“The number of customers each firm had as of its bankruptcy filing in figure 1 likely understates each one's peak customer count, since the popularity of crypto-asset platforms declined during the early months of 2022 and customers left during the runs described throughout this article,” the FRBC said in its report.

“To draw customers, these platforms offered and marketed high-yield investment products with the ability to withdraw funds on demand. They used customers' funds for illiquid and risky investments (e.g., in 3AC or the Anchor protocol) in attempts to generate the high returns promised to their customers. In response to negative shocks, customers had an incentive to run in order to avoid taking losses that would be borne by others,” the report added.

Within the first two weeks last month, the US witnessed three large crypto-friendly banks crumble under market pressure. Regulators who approved the closure of these banks said their unstable business status could have posed severe threat to the US economy.

To mitigate the financially damaging after-effect on the market, US authorities were quick to announce that all custodians linked to the collapsed banks would have access to their funds.

“Overall, while crypto-asset activities are sometimes described as unregulated, it may be more accurate to describe many crypto-asset firms as attempting to avoid the existing regulatory system—which would have required them to provide important disclosures about the financial risks of their products, including those that led the platforms to file for bankruptcy,” the FRBC study noted.

At present, the crypto market as well as the overall financial sector is undergoing a volatile run. In addition, the consecutive interest rate hikes from the Fed in the US have added to the prevailing pressure on the financial market, including the crypto sector.

The valuation of the crypto sector has dropped significantly from its highest point of $3 trillion (roughly Rs. 2,46,86,250 crore) to its current capitalisation of $1.14 trillion (roughly Rs. 93,54,177 crore), as per CoinMarketCap.