Cypo Winter And The Future Of Banking Regulation

Crypto Winter didn't do much harm to "real economy", it is vulnerable to banking issues like runs on banks when operated as lending platforms, but since it wasn't heavily linked to the real economy, it didn't hurt it much. This could change as crypto partners with traditional banking institutions, requiring more regulation.

“Crypto Winter” refers to a systemic event that occurred in the cryptocurrency ecosystem—what we call “crypto space”—in 2022. Crypto space was wracked by plummeting crypto prices, the troubles of a large crypto hedge fund, and runs on many crypto lending platforms. Several large crypto firms went bankrupt, and households and firms lost billions of dollars. Crypto investors are still feeling the aftershocks. 

We begin with two observations. 

First, despite mass marketing campaigns to the contrary, crypto lending platforms recreated banking all over again. Crypto lending platforms were vulnerable to runs because, like all banks, they borrowed short and lent long. This is the essence of banking, so we label these lending platforms “crypto banks.” 

Second, crypto space was largely circular. Once crypto banks obtained deposits and investments, these firms borrowed, lent, and traded mostly with themselves. As a result, Crypto Winter did not cause the kind of financial turmoil that we witnessed in either 2008 or 2020, and it did not cause an economic recession.

We then pivot to a warning for regulators. The next generation of crypto firms are linking up with the financial sector, which means their failures will spill over into the real economy. To contain the inevitable growth of systemic risk, regulators should use banking laws to address a banking problem.

Gary B. Gorton, Jeffery Zhang, "Bank Runs During Crypto Winter" SSRN (May 15, 2023).