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FDIC Insurance
The Federal Deposit Insurance Corporation (FDIC) is one of the pillars of American banking.
In 1929, the Great Depression decimated the United States banking system, and the public began losing faith in these institutions. Banks participated in fractional reserve lending, a system where banks hold onto a fraction of your deposit while lending the rest to someone else. This practice is dangerous and led to more than ⅓ of all banks failing during this time period, prompting the creation of FDIC insurance in 1933.
FDIC-insured bank accounts provide deposit insurance to American commercial and savings bank accounts. As of 2011, FDIC-insured accounts are backed by the full faith and credit of the US government for up to $250,000.
Every FDIC-insured deposit has been properly paid out at the time of writing. No one has lost a dime using these accounts. It only took one year after its introduction until Lydia Lobsiger received the first federal deposit insurance disbursement, following the failure of the Fond Du Lac State Bank in Peoria, Illinois.
Fractional Reserve Lending
Fractional reserve lending is a system where banking deposits are not backed by cash on hand. Instead, a fraction of the money remains within the bank, while the rest is used for loans.
Theoretically, this practice stimulates the economy by injecting capital into it, but there are tradeoffs. It all sounds well and good until everyone wants to withdraw their money simultaneously, which is commonly known as a bank run.
There were a handful of bank runs before the 20th century, and there were many during the Great Depression. Up until 1933, all bank deposits were backed only by the full faith and credit of the bank itself. If the bank overstretched its lending division and failed to attract new depositors, the previously deposited funds would be gravely at risk.
This situation is harrowing when there is a sudden mistrust of banks, and many people attempt to withdraw simultaneously. At some point, the bank simply runs out of money.
When this happened to the IndyMac Bank during the 2008 Financial Crisis, uninsured depositors lost an estimated $270 million while insured depositors cost the FDIC over $9 billion.
DeFi
Lending and borrowing are a big deal. The way an economy goes about it can have drastic consequences, as detailed above. The Crypto industry has seen the fragility of traditional finance and is building an alternative.
Decentralized Finance (DeFi) has been taking off over the past two years and is projected to expand tenfold over the next decade. Rather than rely on trusting banks or the federal government to bail out users, DeFi attempts to implement technology and principles that avoid users needing a bailout altogether.
The crux of DeFi is self custody & composability. You may have heard the phrase, ‘not your keys, not your coins.’ That is true. If you have funds on a centralized exchange like Coinbase, you trust Coinbase to hold onto your funds. You also trust Coinbase to give you access to your capital because they are in custody of it.
When you create a digital wallet like Metamask or Math, you generate both a public and a private key. The public key encrypts data while the private key decrypts it, ensuring the security of any transaction. If you don’t have access to both, you are not in custody of your capital. If you lose your keys, you lose your capital. This is why it is imperative to physically write down your public and private keys and store them in a safe place.
Composability refers to the nature of different DeFi protocols seamlessly integrating with one another. All the dApps on Ethereum share the same fundamental settlement layer – the Ethereum blockchain. All the dApps on Solana share the same fundamental settlement layer – the Solana blockchain. This consistent foundation and settlement layer enables developers to build ‘money legos‘ on top of it, which are simply different decentralized financial products and services.
Conclusion
Many argue that our society would not be as well off as it is without fractional reserve lending and banking. Fractional reserve lending not only increases the number of times that money changes hands, otherwise known as the velocity of money, but it also exponentially increases risk as more money is involved.
The FDIC has made a valiant attempt at backstopping this risk with guaranteed insurance, but the maximum amount of coverage you can obtain is $1,500,000. If you open any further FDIC insured account after that, your funds won’t be covered. While that won’t affect most Americans, it is vital to consider the billions of bank accounts that are not FDIC insured.
Most countries do not offer anything remotely close to FDIC insurance, and the public is forced to subject themselves to unnecessary banking risk. Some banks even require you to pay them to hold your money. That should be criminal.
Thankfully, crypto and DeFi enable the self custody of funds and the composability of financial services. This new alternative may take over the existing banking industry, or it may exist alongside it, but it is definitely not going away.
