Firstly, I know that the equation for the escape velocity is $$v_{\text{escape}}=\sqrt{\frac{2\,GM}{r}}\tag{1}$$ and understand it's derivation.
The following is such a simple derivation; for a test body of mass $m$ in orbit with a massive body (assumed to be spherical) with mass $M$ and separation $r$ between the two body's centres. Equating the centripetal force to the gravitational force yields;
$$\frac{mv^2}{r}=\frac{GMm}{r^2}\tag{2}$$ which on simplificaton, gives $$v=\sqrt{\frac{GM}{r}}\tag{3}$$
What I would like to know is why eqn $(3)$ is not a valid escape velocity equation?
Or, put in another way, mathematically, the derivation in $(2)$ seems sound; yet it is out by a factor of $\sqrt{2}$. What is 'missing' from the derivation $(2)$?
EDIT:
As I mentioned in the comment below, just to be clear, I understand that equation $(3)$ will give the velocity required for a bound circular orbit. But to escape it should follow that the test mass has to move at any speed that is infinitesimally larger than $\sqrt{\frac{GM}{r}}$ such that $$v_{\text{escape from orbit}}\gt\sqrt{\frac{\,GM}{r}}$$
So in other words eqn $(3)$ gives the smallest possible speed for a bound circular orbit. I referred to this as the 'escape speed'; since speeds larger than this will lead to a non-circular orbit, and larger still will lead to an escape from the elliptical orbit.
So my final question is; do the formulas $(1)$ and $(3)$ actually give the highest possible speed not to escape orbit rather than the 'escape speed' itself?
Thank you to all those that contributed these answers.