Crypto Corner: Banks Fail, What About Crypto?

It’s the first week of the month, payday… the bills are due, and you’ve gotten up early so you can take care of a few things before your family wakes up. Before making your bill payments online, you log into your bank to double-check your balance. You want to make sure your deposits have cleared and you’re adhering to your budget. Only… something is wrong. There’s a message from your bank posted on their site… something has happened to the bank; your funds are not available.

For a moment, you panic… then you remember that your deposits are insured, and you have money in your backup account for occasions just like this. This time, crisis was averted because of your thorough approach to planning, spreading out your funds, and doing business with reputable banks where your funds are insured. This is how this scenario might play out with a normal bank failure. But… what about those who are dabbling in crypto and moving funds with exchanges? Would this have been how the situation played out?

FDIC Insurance

First, let’s quickly review how fiat funds are insured with banks, and what happens if a bank fails and cannot distribute depositor’s money back to them. The first thing to know about is the FDIC, because what protects you is FDIC insurance. The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the US government that protects bank depositors against the loss of their insured deposits when an FDIC-insured bank or savings association fails.

FDIC insurance is automatic for deposit accounts opened with any FDIC-insured bank and are covered up to at least $250,000 per depositor, per FDIC-insured bank, per ownership category. What makes this insurance great, and helps keep our monetary system stable, is that depositors don’t need to purchase this insurance or worry about getting it separately. While there’s some complicated math, you know you can trust your money with an FDIC-insured bank, and feel pretty certain you’ll wake up tomorrow and it’ll still be there. If it’s not, no problem, you’ll get your funds reimbursed fairly quickly.

But… with crypto, it’s a different ballgame. Very different. Our little hypothetical scenario could have turned out very differently, very easily with today’s crypto landscape. In our hypothetical situation where fiat funds are unavailable due to a bank failure, we would be annoyed and inconvenienced, but it wouldn’t be catastrophic. However, in the still-young space of crypto, exchange failures and scams are often proving catastrophic for investors. So, let’s look at how crypto is different, and what we can do to protect ourselves.

To illustrate how different the crypto space is when it comes to recouping unavailable funds, we’ll look at a recent incident that happened at an exchange called OptiFi. Just recently, in what was supposed to be a routine program upgrade deployment, decentralized exchange OptiFi’s development team hit a “kill switch” by unintentionally executing a command that closed a software program key to its operation, locking 660,000 USDC stablecoins on-chain (which renders them unavailable). The result of this mistake is that the platform is now stopped indefinitely.

In a tweet to users, OptiFi had the following to say (paraphrased, of course): we messed up and shut down the OptiFi mainnet program and it’s unrecoverable, this is how much is locked away, and we’ll get your money back to you. A tweet… sounds completely reasonable. We mean, if this were your bank, and those were your funds, a tweet would suffice, yes? While it is more complicated than this, and official communications were made to investors, there still aren’t hard, fast rules and reliable insurances available on the vast majority of crypto funds.

Picture it… “Oh, hi there, Sir. Sorry about your funds. One of our engineers ran a bad line of code and we can’t give you any of your money. If you can send an email to our Customer Support team, we’ll get back to you as soon as possible.” While there are laws and regulations that steer the behavior of crypto exchanges, they are not mature or uniform. The key takeaway when it comes to exchanges is this: they should have policies that address hypothetical failure, but do not look for the same protections or conveniences afforded by banks.

You Have Only Yourself As Protection

Operating in the crypto space involves a lot of learning, so we must arm ourselves with knowledge. If we don’t know something as simple as if our holdings are insured, or how we’d be compensated for a loss, we’re walking into a field full of landmines thinking we’re going to be the next Daddy Warbucks from crypto investments. Luckily, there are fantastic tools available to us to help us learn what we need to interact with crypto as safely as possible. For instance, DHS guidance on pre-investment research.

According to DHS, when thinking about investing with crypto exchanges, always be sure to: research the platform, its protocols, and associated smart contracts; make sure the platform has conducted at least one code audit using independent auditors (this means to examine the code for errors, and using independent auditors helps eliminate bias); be weary of investment pools with extremely limited timeframes to join or rapid smart contract deployment; and look out for potential risks from open-source code repositories and crowdsourced solutions (these allow access to non-malicious actors and malicious actors equally).

To be extra safe, you could also check to see if you could find out if the platform has instituted real-time analytics and monitoring tools, as well as rigorous code testing practices. Also, while it may not cross the mind immediately, it’s not a bad idea to check with the platform to ensure that they have created and implemented an incident response plan that involves alerting investors of exploits, vulnerabilities, and other suspicious activities. In this, you want to work with institutions that practice open, transparent communications with investors.

Bottom line is… if an exchange is shy about your questions, you may want to be shy about investing in crypto with their platform, as you are not afforded the same protections as with a bank. Any exchange worth their salt is going to be happy to give you all the information you need to feel safe and confident… which is what we hope we help you feel all the time when you learn and invest with us. We hope you come back next week, we’ll be bringing you more great information and news from the crypto space.