Though bitcoin and the blockchain technology that it bestowed unto the world have many practical uses, many of which we have only begun to scratch the surface of, there remains lot of confusion about its effect on the existing fractional reserve banking system (FRB). Having worked in the banking industry for over 12 years, I can say that it remains one of the few topics that most people do not have a good understanding of, and continues to be misunderstood even among many who work in finance. Indeed, there seems to be an air of ‘masonic knowledge’ that surrounds the details of how money is created, moves around and destroyed in our current monetary system, which is possibly due to historical reasons, and perpetuated by those who wish to keep the well guarded ‘secrets’ of the art to the selected few who are deemed high enough rank to be stewards of the information.
FRB is generally the act of a bank or institution creating money by lending out its deposits, without actually debiting the deposit account when it does so. There are no laws forbidding the activity*, nor are there any laws that enforce it’s use either. It is purely a voluntary act made by a bank, motivated by it’s desire for profit. This is an important point: there is nothing that forces a bank or a depository institution to engage in FRB. This is contrary to what most people believe, as many confuse the practice of FRB with the central bank’s practice of printing money, when in fact the two are completely different things. For example, FRB can occur in systems outside of the fiat money system, for instance, in gold. Most believe the US stores of physical gold held in custody for other countries are running an FRB system, as in recent years when Venezuela and Germany asked for their physical gold held in the US to be repatriated, the Fed hemmed and hawed and a multi-year repayment plan was drawn up. In the case of Germany, they reportedly will be able to have 50% of their gold delivered by 2020. I don’t know about you, but if I asked my bank if I could access the contents of my safety deposit box, and they told me to come back in 7 years, I would be a tad suspicious that they were running an FRB and had actually lent out or rehypothecated my deposits.
With bitcoin, FRB is still possible, as the act of creating an FRB only requires that a party lend out their deposits, without reducing the original deposit account when it is done. This is entirely possible with bitcoin, if the banking company keeps the addresses that they use to pool their depository assets private from the depositors who have banked with them. For example, if Adam banks 100 BTC with a coinbank, he sends 100 BTC to an address controlled by the coinbank. At this point, Adam’s money ceases to be his, and it is transformed to a number on a private ledger, essentially off the blockchain**. The coinbank could then decide to loan out 80 BTC to Eve, who runs a small bitcoin software development company. The bank sends 80 BTC to Eve’s address from its pool of assets. As Eve’s company pays its employees in bitcoin, she does not want to change the BTC to fiat, and instead wants to put it into safe storage and easy access for paying her employees. She happens to use the same coinbank as her bank, so she redeposits the 80 BTC into her account at coinbank. In this way, with an initial actual 100 BTC that was deposited with coinbank, there is now a total of 180 BTC on coinbanks accounts split between Adam (100) and Eve (80). The bank has just ‘created’ bitcoin on accounts, even though there is nothing that can actually back 180 BTC if both Adam and Eve decide to withdrawal all their accounts at the same time.
What would stop a bitcoin bank from doing this? Presumably, nothing. In fact, it is only the relative lack of cheap lenders of last resort in the bitcoin ecosystem that makes engaging in this activity a bit too risky for the current bitcoin banks. In the existing fiat system, banks can always borrow money from the Federal Reserve through the FedFunds window, if they fall short in their current accounts. (i.e. they lent out more than the sum of what they took in and what they actually have on account. ) If bitcoin became a mainstream currency, then it stands to reason that the large holders of bitcoin may start to lend out their bitcoin on an overnight basis, at interest, to bitcoin banks in need to fulfill their daily withdrawal requirements.
In conclusion, FRB is an artifact of humans lending to each other, and it is a result of our collective proclivity to extend credit to each other.
Bitcoin and the blockchain, while allowing us the ability to demand and ensure that banks maintain a 100% reserve requirement, does not enforce it. Therefore, it is up to each and everyone of us to evaluate the credit worthiness of the companies that we choose to act as custodians of our money, and to demand to know who they in turn extend credit to and by how much. Perhaps, if we find none worthy, we should be prepared to be our very own bankers. Indeed FRB is not only a future possibility for digital currencies, once bitcoin companies start to pay interest on deposits, it will be an inevitability.
Next article, I’ll talk a bit about banking and bitcoin, and how they can coexist.
* The Federal Reserve does require that member banks keep a minimum of 10% of their deposits on reserve. (as of writing)
** Some notable exceptions being bitcoin ‘banks’ that remain completely ‘on-chain’ which means that they never use their own bitcoin addresses to pool their deposits, and instead, they just manage a list of addresses which their clients have entrusted to them. The block chain does allow for the public audit-ability of banks who wish to maintain a 100% reserve.