Bitcoins, Fractional Reserve Banking, and Private Currencies

All of this started in an exchange I had with Steve Waldman a few weeks ago on twitter. Is fractional reserve banking possible with bitcoin?

Well the answer is “NO”, and “yes”. SqueekyWheel makes a great point:

“I think you misunderstand the bitcoin version of fractional reserve – it’s a bit more like gold standard fractional reserve.

Let’s take “BitBank” which has 20 bitcoins. I go and take a 10 bitcoin loan from ‘BitBank’. BitBank credits my BitBank account with 10 bitcoins – but does not use the Bitcoin system to transfer them. If I spend those bitcoins outside the bank, BitBank transfers *its* bitcoins to the recipient. Now BitBank holds 10 bitcoins in reserve and my account says 0. So it’s just like normal banks, but using bitcoins as the reserve. Nothing in here creates fake bitcoins.

However, just like normal banks, low fractional reserves requires either/both 1) many/most transfers are between accounts at the same bank, 2) deposits store value for long time periods. Number 1 requires a large bank (tough for bitcoin); number 2 assumes either that ppl need a place to put their money (not true for bitcoin) or the bank pays interest (possible for bitcoin, but who is borrowing?).

So yes, in theory Bitcoin can serve as a reserve currency in a fractional system. But in practice it would need to be a practical currency first and it’s not.” [Bold mine]

I contend the current structure of bitcoin will not allow fractional reserve banking. Bitcoin (and other P2P payment systems) take huge steps to prevent the spread of non-validated bitcoins. It is possible to use bitcoins like gold was used under gold standard systems. However, the current transaction network for bitcoins would not allow it. An entirely different transaction confirmation network would have to be developed.

Here is my reply:

“I don’t deny bitcoin “could” work as base money. I just deny that bitcoin is setup to do that right now.

And I fear you’ve fallen into my trap, SW. Because the way banks worked during the free banking period was…wait for it…with each issuing their own currency!

http://en.wikipedia.org/wiki/Free_banking

They could not use a common currency. They all used gold as their base money, but each of them had their own currency which was issued against their supply of gold. These currencies traded against each other at different and varying values, and the currencies had different values depending on how far the bank notes were geographically from the issuing bank.

This is exactly what I was talking about earlier. I totally agree – bitcoin COULD be used as base money. It’s just today, bitcoin cannot be used as base money because there is no transfer mechanism for the pretend bitcoins in the real world. The creation of a fractional reserve banking structure would require setting up a network that is independent of bitcoin. Every fractional reserve bank would need to have it’s own, independent network, so it could monitor and control the money issued against base bitcoins. You’d need a different wallet and transaction system for each bank. These different bitcoinzzz would trade at different levels to each other and to real bitcoins.

I think this is impossible in the modern world, and needlessly complex. If you need a manual, the product is poorly designed. And hell yeah, you would need a manual for this kind of payment system.

In the free banking era, the network was “dudes with banknotes in their pocket. ” With bitcoin like products, the adoption of these networks would be far, far more difficult.

I had a twitterstorm with Steve Waldman over this exact issue. I have not seen a single thing which shows me otherwise. Fractional reserve banking is impossible in todays bitcoin environment. Building up the networks which would allow fractional reserve banking requries a transmission system which is nearly impossible to develop for bitcoin-like products, because it relies on adoption.”

Every bank would need its own bitcoin like transaction confirmation system. In effect, this would create individual currencies, each issued by a bank using bitcoins as a reserve. Banks would not allow rival banks into their network, because they would not be able to control the money issuance by the other bank.

Each bank would create it’s own private currency, and hold commonly accepted bitcoins in reserve.

The problem with this the creation of the transaction network is not something you can program. A network is something which needs to be adopted by multiple counterparties to be effective. You can give someone the network protocols, and the programming around this, but you can’t make them use it. You can see that separating the network which validates bitcoins from the network which validates bank-currencies would need to be different. For a bank to propagate its own private currency transfer network would be a huge task.

This is a fantastic real world experiment, and we will see how it plays out.

 

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Expert in business development, product development, and direct marketing. Developed strategic sales plans, product innovations, and business plans for multiple companies. Conceived the patent pending Spot Equivalent Futures (SEF) mechanism, which allows true replication of spot and swap like products in the futures space.

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3 years 10 months ago

There is pseudo bitcoin that circulates. It’s called redeemable code and its issued by exchanges. No reason it couldn’t be (or currently isn’t) fractional.

But even more relevant is Ripple. It is a perfect system for building fractional reserve systems. [see my ripple posts]

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