Fractional Reserve Banking and Bitcoin - Bitcoin Wiki Bitcoin fractional reserve banking

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From Bitcoin Wiki

While Fractional Reserve Banking with Bitcoin is possible, there is disagreement over what it would entail. Much discussion occurred on the Myths Talk Page.

Keynesian Viewpoint

Fractional Reserve Banking with Bitcoin is possible and practical. It is already implemented with CoinLenders. There is no fundamental difference between classical currencies and Bitcoin as it applies to banking. Banks will still be free to take in bitcoins and present them to customers as "available for withdrawal" while still lending most of those bitcoins to a different customer for a profit. Some of those bitcoins will be held in reserves in case of a bank run. It will be up to the bank to hold a sufficient supply of reserves in order to prevent insolvency in the event of a bank run. Central banks were established to enforce reserve requirements and so, with Bitcoin lacking a central bank, some banks will almost surely collapse, taking their customers' deposits with them. A large bitcoin exchange could tomorrow lend out 10,000 bitcoins to an individual to start a business. The money supply would thus increase by 10,000 and we would instantly have Fractional Reserve Banking. The same amount of bitcoins would still exist in the Block Chain, but the body of people participating in the Bitcoin economy would have the perception that more bitcoins exist. If the value of a bitcoin is stable for a long period of time, then Fractional Reserve Banking is inevitable.

See Fractional reserve banking.

The Monetary Base of Bitcoin is limited to 21 million. But because Fractional Reserve Banking is possible, the money supply of bitcoins (which includes demand deposits) can exceed 21 million by a factor of x where x is the Money Multiplier.

Austrian Viewpoint

According to the Austrian viewpoint:

Fractional-reserve banking (or FRB) is the widespread banking practice in which only a fraction of a bank's demand deposits are kept in reserve and available for immediate withdrawal (as cash and other highly liquid assets), whilst the remaining cash is lent out to borrowers (and so is never actually available for immediate withdrawal to legitimate deposit-holders).

In order for fractional reserve banking to affect the money supply, the debt instruments issued by the bank (for example, bank notes or demand deposits) must be accepted as if they were money proper, in other words, they must be money-substitutes. This is explained for example by Rothbard in Austrian Definitions of the Supply of Money:

And so long as demand deposits are accepted as equivalent to standard money, they will function as part of the money supply. It is important to recognize that demand deposits are not automatically part of the money supply by virtue of their very existence; they continue as equivalent to money only so long as the subjective estimates of the sellers of goods on the market think that they are so equivalent and accept them as such in exchange.

In the historical cases of money based on gold or government issued fiat, the reason why money-substitutes are accepted as if they were money proper is that the money proper has in some circumstances high transaction costs (for example, gold might be too heavy to carry around, or the buyer and seller are not at the same location and want to perform the exchange electronically), or are not legally permitted (normal people are not allowed to obtain central bank reserves). This creates a demand for forms of money which have lower transaction costs. With gold/fiat, this requires the creation of debt instruments, which then, after being generally accepted in exchange, become money substitutes and a part of the money supply.

The situation with Bitcoin is different, because other forms can be created without debt instruments, for example Casascius physical bitcoins or Bitbills. Bitcoin in its "classical" form is similar in function of a bank account (allowing electronic transfers of balances) even though there is no debt instrument. Any object that can store 64 bytes of data (size of Bitcoin keypair) can, hypothetically, be used as a form of Bitcoin. In some cases, shorter forms than 64 bytes are possible too (for example, mini private key format used by Casascius physical bitcoins). Issuers of Bitcoin-based debt instruments, if they expect these instruments to be accepted in exchange, need to create demand for them as a method of payment outside of the Bitcoin network. This is difficult, because a transaction that occurs outside of the Bitcoin network is incompatible with it, so people equipped with software for handling only pure Bitcoin transactions cannot accept it. Furthermore, they also would need to compete against not only Bitcoin, but against other currencies, payment methods and services.

Currently, Bitcoin based debt instruments are restricted to a narrow field of uses. Exchanges allow these instruments to be traded against other currencies. E-wallets allow inter-wallet transfers. GLBSE allows the floating of shares or other contractual arrangements. However, these debt instruments are, in general, outside of these narrow fields, not accepted for exchange as if they were native Bitcoins. They rarely even circulate outside of the internal transactions of the providers of these services. There are very few exceptions, such as the redeemable Mt. Gox code. If the service provider attempted to conduct FRB by overissuing these instruments, they would be exposed at risk of having them redeemed too quickly. One possible way of mitigating this risk is to institute a suspension of specie payments (for example, Mt. Gox. having a default withdrawal limit).

If in the future, P2P exchanges and distributed wallets are available (both have been suggested already at forums), this would decrease the demand for Bitcoin-based debt instruments even further.

Historically, in all known situations where an overissue of Bitcoin-based debt instruments was produced, this resulted either in a voluntary elimination of the excess instruments (Mt. Gox hack from June 2011), bankruptcy (the demise of mybitcoin) or a new investor bailout (the demise of and subsequent takeover by Mt. Gox). Here we have empirical evidence that FRB with Bitcoin is possible.

Putting all this together, there are several steps that need to be addressed regarding Bitcoin-FRB and money supply:

  1. overissue of debt instruments (this would cause FRB)
  2. general acceptance of these instruments as a method of payment (this would mean the instruments need to be included in the money supply)
  3. market price of these instruments at a different rate than the reserve ratio of the issuer (this would cause inflation or deflation)

Even if we assume that an overissue is possible in long term, there are significant obstacles in phase 2 and 3, as elaborated above. It is therefore unlikely that even if Bitcoin-FRB became widespread, this would significantly affect the money supply of Bitcoins or inflation/deflation.

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Fractional Reserve - iGolder

Last updated on October 13th, 2017 at 12:10 am


Bitcoin banking is likely on a very distant horizon, far from being implemented in any significant capacity in the mainstream economy. However, it is possible — and important — to use economics to create a rough vision of what Bitcoin banking may be like in the future, paying special attention to Bitcoin banking’s effects on business cycles.

The foundation of business cycles, the periodic phases of boom and bust that have plagued market economies since ancient times, lie in the practice of fractional reserve banking. In a market economy with Bitcoin banking, it becomes impossible to run fractional reserves, regardless of the legal status of the practice. Therefore, an economy that utilizes Bitcoin banking will very likely have a significant impact on the creation of business cycles.

This article serves as an introductory, first installation of a two part series on the theoretical economics of Bitcoin banking. In this installation, we will provide a basic overview of how fractional reserve banking produces business cycles, and how these cycles run their course in an equilibrium setting. In part two, we will discuss how Bitcoin banking could potentially resolve the issues of fractional reserve banking and business cycles.

 The Dangers of Fractional Reserve Banking

Past Economic Treatment of Fractional Reserve Banking

Friedrich A. Hayek

Many Austrian economists, while highly critical of central banking, have generally ignored or dismissed the dangers of fractional reserve banking. Ludwig von Mises — who laid the groundwork for Hayek’s in depth business cycle theory — argued that mandatory 100% reserve ratios were not necessary. Instead, market forces would eventually weed out any banks with artificially low interest rates, and the market would bring the interest rate to its natural level. Based on this argument, Mises focused his academic energy on exposing the threats of central banking.

Friedrich Hayek followed suit, and developed the Austrian business cycle theory based on the argument that central banks artificially lower interest rates.

Murray Rothbard, in contrast to Mises and Hayek, argued that fractional reserve banking was inherently fraudulent, and must be outlawed in a free society.

More recently, Jesus Huerta de Soto expounded on Rothbard’s argument and showed how fractional reserve banking is legally incompatible with private property rights. Additionally, de Soto explained the economic consequences of running fractional reserves, showing that business cycles actually originate from this practice, while central banks merely reinforce business cycles and protect banks from failure.

Of course, the mainstream of economic thought sees no inherent danger in fractional reserve banking. Mainstream economists believe that the money creation that comes from fractional reserve banking, when controlled and directed by a central bank, can spur aggregate growth. This belief likely comes from the fact that mainstream schools of thought lack a robust and detailed capital theory.

A Basic Overview of Interest Rates in a Purely Free Market

Before we examine how fractional reserve banking distorts the market and produces booms and busts, we must have a general understanding of how interest rates are determined in a free market, and how those rates are diluted by fractional reserve banking.

First, we must understand the difference between a time deposit and a demand deposit. Simply put, demand deposits are money put into a bank for the purposes of safekeeping and with the expectation of being able to withdraw the money at any time for consumption or hoarding purposes. Examples of demand deposits would be the familiar checking and savings accounts. Time deposits consist of money that is deposited for investment purposes. In a time deposit, the depositor gives his money to the bank with the intention of receiving a larger sum of money at a later date, with no expectation of being able to withdraw the money before the maturity date without paying a penalty fee.

Interest rates for bank loans in a free market are determined by the ratio between the amount of money in demand deposits and time deposits. In a free market, money can be lent out of time deposits, since the money in those accounts are meant for investment. Funds cannot be lent out of demand deposits, though, because the depositor placed his or her money in the bank with the expectation that he or she can withdraw part or all of the deposit at any time, and loaning that money out would make it unavailable to the depositor. Therefore, in a free market, only money in time deposits can be lent out; lending demand deposits while assuring the depositors that their money is fully available would be a fraudulent activity, with negative social and economic consequences.

Since free market interest rates are determined by the ratio between time and demand deposits, and only money in time deposits can be lent out, it follows that the actual quantity of money present in time deposits is a major factor in determining interest rates on bank loans. Other things equal, a larger amount of money would lower interest rates, and a smaller amount would increase interest rates.

A Basic Overview of Interest Rates Under Fractional Reserve Banking

Image courtesy of HowStuffWorks

Under fractional reserve banking, however, the time preference interest rate is diluted by the lending out of demand deposits. The dilution takes place because funds from demand deposits — which are allocated towards consumption or hoarding — are being given to investors as credit that they can use to take up projects which require resources to be shifted to higher levels in the capital structure. Thus, instead of granting loans strictly based on the amount available in time deposits, which is determined by time preferences, banks “artificially” lower interest rates by taking from demand deposits, thereby increasing the amount of funds available for loans and decreasing the interest rate for loans.

Since depositors expect their money to be available at any time, the bank does not subtract from the depositors balances after it loans out their funds. Instead, they keep the full balance available, and draw upon the deposits of other patrons when a withdrawal is demanded. This process leads to money creation. For example, a depositor places $100 in a savings account, the bank loans $50 of that deposit to an investor, and the bank assures the depositor that there is still $100 in his or her account, which he or she will use to purchase consumption goods. Thus, $150 has been created out of thin air!

Fractional Reserve Banking and Business Cycles

A graphical representation of a business cycle

The resulting shifts in the production structure that come from this process of money creation constitute the main cause of business cycles. When demand deposits are loaned out, the debtors use the money to invest in higher stages of production, while market demand remains constant — meaning that the goods produced by these more distant stages of production do not have enough demand to be profitable. Since market demand has not changed, prices for consumer goods rise, because resources are being shifted away from consumer goods production and into the production of higher order goods, thereby decreasing supply while demand remains constant. Simultaneously, prices for higher order goods increase due to the money created from fractional reserve banking enabling investors to exercise higher demand.

Once it becomes evident that the projects — funded by interest rates that are lower than what would be determined pure time preference — are unprofitable and unsustainable, the debtors have to cease production and lay off all of their employees. Prices for higher order goods then decrease as a result of decreased demand, due to investors abandoning their unprofitable projects. Additionally, prices for consumer goods decrease as well; resources are reallocated to the production of consumer goods, restoring market equilibrium and lowering prices. However, prices are lowered even further since unemployment has increased, thereby lowering demand. After some time, labor and other factors of production will be fully restored to equilibrium, and the economy will return to the state that existed before the fractional reserve money creation began.

Now that we have a basic understanding of how fractional reserve banking can create a business cycle in an equilibrium setting, we can conclude this introductory installation of our two part series on how Bitcoin banking can affect the creation of business cycles. In the second installation, we will discuss demand deposits and time deposits under Bitcoin banking, whether or not a fractional reserve bank can successfully operate under Bitcoin banking, and the extent to which Bitcoin banking impacts the creation and severity of business cycles.  

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The Invisible Politics of Bitcoin: Governance Crisis of a .

Last updated on October 13th, 2017 at 12:03 am

This article is the second installation in our two part series on Bitcoin banking and its impact on business cycles. In the first part, we provided a very basic outline of how fractional reserve banking creates business cycles in an equilibrium setting. We concluded that business cycles mainly originate from the shifts caused in an economy’s capital structure when banks use funds from demand deposits to expand credit.

In this second installation, we will provide a basic vision of how Bitcoin banking would work in terms of preserving the pure time preference interest rate. From there, we will discuss how Bitcoin banking’s ability to preserve the pure time preference rate of interest would prevent banks from expanding credit and creating business cycles. Lastly, we will bring to light the fact that central banking very well may continue to exist in a Bitcoin banking system, and how a government’s requirement that taxes be paid in central bank notes leaves open the possibility of central banks retaining the ability to create business cycles.

Bitcoin Banking: The Limitations of Credit Expansion in a Bitcoin Economy

How can Banks Appropriate Demand Deposits Without Patrons Knowing About it?

In the previous article, we established the difference between a time deposit and a demand deposit. Additionally, we concluded that, in a free market, banks could not use funds from demand deposits to make loans, since that money has been allocated towards consumption and hoarding, and depositors are under the impression that they can withdraw the entirety of their funds at any time with no penalties or delays. Money, therefore, can only be lent out of time deposits in a free market, because the owners of these funds have relinquished all availability of their money for a certain period of time, expecting to receive a larger sum of money at the end of the term as compensation for granting a loan to the bank.

However, banks have always, throughout history, appropriated funds from demand deposits while keeping the full amount on the accounts’ balances available to the depositors. This practice essentially creates money out of thin air, the main consequence of which is the business cycle that we discussed in the previous article.

Banks have been able to make use of demand deposits while keeping the depositors’ account balances unchanged because there has been no way for individuals to audit their accounts and see if their deposits are still there. Essentially, bank patrons just have to trust that the bank has enough cash on hand to allow patrons to withdraw from their demand deposits to make every day purchases.

The Impossibility of Demand Deposit Appropriation Under Bitcoin Banking

Under Bitcoin banking, though, individual audits of accounts would be available. Given that the blockchain is a public ledger, accessible to everyone, bank patrons would be able to check and see if their money is available at any time. Additionally, banks would not be able to appropriate funds from a demand deposit, because the owner of those funds would be able to see the transaction take place immediately, and would be able to demand that his or her deposit be redeemed instantly.

It is highly possible — even likely — that individuals would not even put their bitcoins into a demand deposit bank account in the first place. Since there is virtually no storage cost for Bitcoin, and Bitcoin wallets can be made just as secure as a bank account, it is not too much of a stretch to say that most people, if not all, would consider it unnecessary to deposit their bitcoins into a bank account. They can use a hot wallet with an encrypted backup for their daily purchases, and keep their cash holdings in an encrypted offline or paper wallet. Thus, individuals in a Bitcoin banking system would be able to keep their money just as safe as if they had put it in a bank account, without having to trust a third party to ensure the full availability of their funds.

Therefore, since Bitcoin removes the need for individuals to keep funds that have been allocated towards consumption and hoarding in a bank account, it would be impossible to diverge the market interest rate from time preferences. If there are no demand deposits for bankers to appropriate in the first place, then interest rates cannot be artificially lowered, and production will not shift in a way that creates business cycles.

The Basic Premise of “Pure” Credit Under Bitcoin Banking

Without a need to place money in a bank for safe keeping and checking services, the only reason people would have to give their money to a bank would be for investment purposes. Thus, under a Bitcoin banking system, the main function of a bank would be to serve as an intermediary between those in search of an investment and those in need of a loan. In other words, virtually the only money that would flow into a Bitcoin bank would be time deposits.

Since most people would likely choose not to place their funds into a demand deposit with a bank — and since the ones that would open a demand deposit account would be protected from appropriation by the blockchain — a system of “pure” credit would arise under Bitcoin banking.

As we learned in the previous article, the free market interest rate would be based on time preferences, which are reflected in the ratio between time deposits and demand deposits. Additionally, since bankers would not be able to appropriate demand deposits in a free market, the quantity of money in time deposits would, ceteris paribus, be the major factor in determining interest rates for bank loans and bank-led investment projects.

Under Bitcoin banking, where demand deposits are largely nonexistent, and the ones that do exist are safe from appropriation, it is only logical to conclude that only money from time deposits could be allocated towards investment projects. Consequently, we get a de facto version of a 100% reserve banking system; even if there is no legal mandate that banks must keep 100% of their demand deposits on reserve, the nature of Bitcoin and the blockchain would make it impossible for banks to act otherwise.

As a result of the de facto 100% reserve system that would arise under Bitcoin banking, interest rates would only be determined by time preferences, and the capital structure could not shift in a way that would produce macro-level inefficiencies. There would, of course, still be business failures due to shifting demands and entrepreneurial failure, but these kinds of business failures in no way create economy-wide slumps.

Bitcoin Banking Under a Central Bank

A Bitcoin banking system would not entirely put an end to the creation of business cycles as long as there are still central banks. If a government continues to require that taxes be paid in its own legal tender, which is solely issued by a legally created central bank, then the fiat currency in question would still play a major role in the economy. Wages would continue to at least partially be paid in fiat, merchants would still accept it, banks would still keep fiat reserves, and fiat loans would still be issued by banks. Essentially, everyone would still accept and use government fiat currency, because everyone must possess it in order to pay taxes.

The central bank could therefore create business cycles by injecting fiat liquidity into banks so that the banks have reserves in excess of 100%. These surplus reserves would allow banks to make loans and engage in investment projects without having to appropriate demand deposits, which we know would be an impossible task under Bitcoin banking. Thus, the same business cycle process that we outlined in the previous article would continue to occur; the central bank’s fiat injections would allow banks to decrease their interest rates below that which is determined by time preferences, leading to investment activities that alter the capital structure in a way that creates economy-wide booms and busts.

Therefore, to conclude, Bitcoin banking would have a serious potential to diminish the banking system’s ability to produce business cycles. However, central banks would still pose a major threat to economic stability, regardless of Bitcoin’s positive effects, as they would still retain the power of creating fiat money and giving banks excess reserves.

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How To Stop Bitcoin Banking; Give It A BitLicense In New York

From Bitcoin Wiki

Fractional Reserve Banking is the practice whereby a bank holds reserves that are a fraction of its on-demand liabilities. It contrasts with a Full Reserve Banking system in which banks must hold reserves for 100% of on-demand liabilities.

Holding only a fraction of on-demand liabilities means that in the event of a bank-run the bank is mathematically unable to meet its obligations.

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Bitcoin and Banking advocateofliberty

By Timothy W. Robinson and Tony Willenberg

Abstract: The relationship between monetary economics and cryptocurrency is as yet unclear. Since the Great Recession of 2008 the world order has been described as operating under a new Keynesian economics. This paper examines how central banks use fractional reserve banking (FRB) combined with market factors to stimulate or suppress aggregate demand through the money supply, a fundamental Keynesian tenet. The economic and operational functions of a central bank are, however, viewed through the lens of the Bitcoin crypto economy which has no such centralised structure or mechanisms. The closest artefact is Bitcoin’s consensus behaviour embodied in a shared algorithm. It is asked and answered would FRB organically emerge in the Bitcoin crypto economy if cryptocurrency exchanges were to act like fiat currency depository institutions.

1. The relationship between classical monetary economics and cryptocurrency is as yet unclear. The Bitcoin crypto economy whilst occasionally challenged in the court of public opinion, and despite setbacks, shows no sign of yielding since its advent in 2008. At the time of writing the Bitcoin crypto economy was worth $US16 billion or equivalent to the 153rd richest country, and growing. The currency is used in an estimated 275 thousand transactions per day [1]; a value which has been increasing progressively as the currency gains wider adoption.

2. The typical dynamics of fractional reserve banking (FRB) and the primary role of a central bank don’t fully apply to cryptocurrencies for three reasons. First, cryptocurrencies are decentralised and self-managed and so there is no need for a central banking institution per se to actually govern the cryptocurrencies. Second, there is no need for a banking institution to facilitate or intermediate transactions over great distances, or in large volume. Third, there is no need for a deposit. Personal crypto security measures are potentially sufficient to secure a small amount or a large amount of bitcoin, equally as well, making the security of a bank unnecessary.

3. Given that the function of cryptocurrency is to approximate fiat cash without the need for either deposit-taking banking institutions in the typical sense or a central bank, is FRB an obsolete mechanism within the context of crypto economies?

4. FRB is the intentional quarantine of a proportion of a commercial bank’s deposits into a reserve account, held by a central bank, or currency held at the bank; whilst using the remainder for commercial activity of the bank, to lend out make profit [2]. It is unclear where the practice first emerged, but would have existed prior to the establishment of central banks or even Government oversight or interest in the banking system. The central bank oversight mechanism likely began with the world’s first central bank, the Bank of Amsterdam established in 1609 [3].

5. FRB came about as banking institutions began to realise that they did not require actual cash to meet all withdrawals customers could potentially make at once. Further it ensures that fiat currency is not effectively taken out of circulation from an economy and can instead be put to work, by magnifying the base money originally created by the central bank. Banking institutions realized that they only need to maintain sufficient levels of reserves to mitigate the risk of simultaneous withdrawals, and that the rest of the funds on deposits could be put to work.

6. Banking institutions have a number of mechanisms under the current system to try to meet liquidity requirements including their reserves; the interbank market; lending windows from the central bank etc. The degree to which FRB leads to money supply creation then depends on the degree to which the banking institution feels it can lend out its reserves while still allowing people full access to their deposits.

7. The role of a central bank is the development and usually the implementation of monetary policy: which typically occurs through lending windows, open market operations, and potentially even auctions, base money management and the reserve requirement (albeit primarily in emerging markets [4]). Although the latter are typically less utilised [5]. Central banks have moved generally towards operational targets (i.e. something within their control day-to-day) of short-term interest rates and away from things like reserve requirements [6].

8. Reserve requirements set by central banks have often been thought of as the binding constraint that determines the amount of money on-lent (see Figure 2); however, in mature and sophisticated banking systems the amount of money on-lent is, to a larger degree, a function of banks determining lending opportunities available to them in the market at sufficient interest in order to earn a profit relative to (a) the risk of the lending opportunities; (b) the rate of interest, if any, they could earn on reserves, and (c) the need for liquidity to meet customer needs and cost of acquiring emergency liquidity (through any of the options described in paragraph 6), although this latter component of (c) plays a limited role given the degree to which the central bank can now act as completely as a lender of last resort [7]. Given this three-way dynamic one could ask how important then is the role a central bank’s regulation of reserves?

9. Decisions by banks on investments are also heavily influenced by international and country-wide regulatory requirements, for example, under the Basel III banking supervision framework, capital adequacy ratios (CAR) are well-defined. CARs determine the proportion of loans a bank can make relative to its risk-weighted assets. The need to maintain CARs determines the degree of profitable lending opportunities for the banks, and thus the “opportunity cost” of reserves. Therefore, even regulatory ratios on asset composition can determine the degree to which funds are on-lent in a monetary system.

10. Let us explore what Bitcoin is and how it works. It is important to know this before we can consider how FRB might work and arise in a crypto economy and more importantly whether FRB is needed for improved economic outcomes in a crypto economy.

11. Bitcoin is the world’s first decentralised digital currency, built on cryptographic techniques to control the generation of units of the currency, to verify the transfer of funds from one person to another, and to operate independently of a central bank. Bitcoin is virtual currency in that it is not represented by a physical token*, and is not backed by or pegged to the value of another underlying physical asset like gold or a unit of an existing fiat currency.

(* There have been a number of attempts to provide a physical representation of bitcoins but these are not the predominant representation of the cryptocurrency held by participants in the Bitcoin crypto economy. See: Casascius, Alitin Mint, Cryptmint Coins, and Titan Bitcoin.)

12. The Bitcoin cryptocurrency is implemented through a globally shared and distributed ledger of transactions representing Bitcoin events in its economy stored on a data structure called the blockchain [8]. Events recorded on the blockchain are either: (a) new bitcoin minted into supply (referred to as “mined”), or (b) bitcoin traded between parties (“transacted”). The blockchain contains the history of every single bitcoin from when it was mined to whom it is presently owned by, and the blockchain data structure exists in hundreds of thousands of computers simultaneously, each copy synchronising itself with other “full nodes” (the name given to computers the Bitcoin Core open source software, are connected to the Internet, and hold a complete copy of the global blockchain).

13. The total supply of bitcoins in the Bitcoin economy (what we have termed ‘C0’), by design, is set to never exceed 21 million bitcoins and the number of bitcoins in circulation increases gradually according to an algorithm. At the time of writing there were just over 16.2 million bitcoins in circulation out of the possible 21 million [9]. The limit of bitcoins mined into existed is expected to be reached sometime in the year 2140 [10]. A bitcoin is also presently divisible into 2 x 10–8 smaller units, known as “satoshis”, which means that at the upper limit there would be 2 x 10-14 units of money, or 2.1 quadrillion units.

14. Bitcoins are brought into existence by an algorithm embodied in the Bitcoin Core open source software running on “full nodes” and the process is referred to as “mining”. Each computer in the Bitcoin ecosystem must run either: (a) a basic wallet application (to receive and send bitcoin) or (b) run a “full node” (that mines blocks and validates transactions).

15. Mining bitcoin means solving a mathematical puzzle, one that can only be solved using brute computer force [11]. Once a full node solves such a puzzle two things occur: (i) the computer has generated an empty block (think of it as a blank page in an accounting ledger) and for which it earns a mining reward (at the time of writing, 12.5 bitcoins or roughly US$13,000), and (ii) it has earned the status of an ‘honest node’, through its proof-of-work. The proof-of-work (solving the puzzle) represents a vesting of interest in the network remaining honest. An ‘honest node’ then gets to examine queued transactions in the network and earn further transaction fees from each transaction on the ledger page (block) they validate. Validating transactions means checking that the transactions parties own the bitcoins they are transacting and that the cryptographic integrity of the transaction is intact.

16. Once these transactions are validated, they are encoded onto the block and chained to the global blockchain and the new state of the blockchain is then propagated throughout the Bitcoin network. There are a number of other rules and behaviours for resolving conflict, rejecting invalid transactions, and arriving at a consensus, but the above describes in broad terms the process that drives the Bitcoin ecosystem.

17. Wallet software is used to generate the “addresses” used to receive inbound bitcoin from a sender. One or more addresses are created for receiving Bitcoin and these addresses are (the “hash” of) the public key side of a public-private key pair. The private key is known only to the receiver and is also cryptographically linked to the public key. A recipient of bitcoin can prove they own the bitcoin sent to their address (effectively the public key) because they know the private key linked to that public key. Lose the private key and one loses the bitcoin associated with the public key.

18. Addresses are meant to be used only once, to preserve the anonymity of the receiver by preventing patterns from appearing on the blockchain associated with duplicate public keys, Reuse of an address is considered a cardinal breach of personal crypto security in blockchain applications. A sender’s address is never recorded on a transaction on the Bitcoin blockchain. The premise is if a valid transaction makes it to the blockchain then the sender had bitcoin to send because the sender had access to the private key associated with the public key where bitcoins were located (having arrived there from earlier validated transactions).

19. Bitcoin is acquired by someone in one of two ways: (i) either they themselves have mined the bitcoin (solving puzzles and then earning transaction fees for validating transactions), or (ii) they received it through trade (presumably for something of equivalent value). By trade it means that someone can trade another fiat currency or even another cryptocurrency for a sum of Bitcoin. Like any currency exchange point, reserves of one currency can be exchanged for a sum of Bitcoin. At the time of writing, a single bitcoin was worth US$1,173 on the third largest cryptocurrency exchange, Kraken [12].

20. The most infamous of cryptocurrency exchanges was Mt. Gox, an exchange based in Japan which began as a web site for game card trading and was then re-purposed for trading bitcoin in 2010. The exchange was plagued by problems (primarily related to poor corporate governance) but its trade volumes rose to a peak that accounted for almost 70% of all bitcoin transactions by 2013. By February 2014, however, the exchange suspended trading and filed for bankruptcy. It announced in the filings that around 850,000 bitcoins had gone missing or had been stolen from the exchange. Since the fiasco, some 200,000 bitcoins have been recovered, but to this day, a number of people remain who lost all of the bitcoin that was being held on their behalf by Mt. Gox.

21. Mt Gox provided a hosted wallet service. These wallets held bitcoin on behalf of the customers. The company was also a miner of bitcoin, deploying large numbers of applications-specific integrated circuits (ASIC) to the mining problem and then accruing the bitcoin rewards from the mining process. Finally, Mt Gox was also an exchange, providing a point where fiat currency could be exchanged for bitcoin and vice-versa. When it failed all three repositories of bitcoin were affected: those held for customers in web wallets, those it owned itself as a result of its mining operations, and the reserve of bitcoins held to enable interchange.

22. Today, cryptocurrency exchanges are better managed and although they are not specifically regulated, it is increasingly common for exchanges to be attached to commercial banks, which are heavily regulated in most jurisdictions around the word. The three largest exchanges: Quoine (Singapore), Bitfinex (China) and Kraken (US); all abide by international Know Your Customer (KYC) and Anti-Money Laundering (AML) practices just as a commercial banking institution would.

23. There are two specific questions asked herein: (i) would FRB emerge naturally in a crypto economy; and (ii) is there a role for a central bank in a crypto economy whether FRB were to emerge?

24. Let’s first think about FRB and central banks with our well established fiat monetary systems. As discussed above, many decisions in modern banking are influenced by monetary policy and based on central bank-controlled interest rates, rather than as a function of “hard” limits (like reserve limits) set by a central bank. The interest rate the central bank pays out on reserves, for example, acts to incentivise bank behaviour. Banks themselves will make decisions on lending based on the lending opportunities in the economy, and the profit they will generate when compared to the rate earned holding reserves, or the potential cost of acquiring liquidity.

25. This does not imply that if a central bank were to pay a zero rate or even negative interest rates on reserves, that banks would have no incentive to hold reserves: banks hold reserves not just for the returns, but also for safety and to meet customer needs. Contrary to the simplified description in economic textbooks, the money multiplier cannot be thought of as just 1/RR (1 divided by the Reserve Requirement) as discussed above. Other factors must be included in the calculation, including an assessment by the banks on the need to hold liquid reserves to meet withdrawal obligations; and the available returns on other investment options (which in part is also determined by rules on capital assets and risk).

26. From this we can see that it is not necessary for the existence of a central bank for fractional reserve banking to occur in a crypto economy [11]. Banks have limited profit incentive to lend out all reserves, and certainly no incentive to hold 100 percent reserve coverage, unless they are paid an explicit fee for the service. It’s a balance between being able to lend in the market a proportion of your cash and earn income, and being able to secure the other portion holding it in reserve.

27. In a hypothetical scenario where Bitcoin was used as the primary, or sole means of exchange, we could have a money supply which relied neither on a banking system (to process payments and secure funds) nor a central bank (to act as a clearing system). These two functions is what we will refer to as the operational functions of the banking system, as opposed to the economic functions of the banking system. Economic functions relate to their role in the stimulation or suppression of economic activity, a fairly established role [12], and the provision of individual economic benefits (investment opportunity, creation of credit, etc.) [13].

28. Examining the process of money creation by looking at the transactions that occur on a set of banks’ balance sheets, the settlement of a loan for the purchase of a house, in the below diagram, shows the creation of a loan, and the corresponding deposit to the account of the borrower. If the bank does not have sufficient reserves to cover likely withdrawals or new loans they will both seek to retain deposits, and secure new deposits to maintain capital adequacy.

Figure 1: Modern money creation.

Source: Adapted from “Money Creation in the Modern Economy”, Bank of England.

29. Bitcoin removes, in part, some of the need for the operational role because the clearing and settlements system can happen automatically and across large distance, in much the same way it would for a fiat currency over short distances (i.e. with cash transactions). When one transacts in a shop and parts with physical cash the “accounts” of both parties are settled immediately. In Bitcoin this same mechanism occurs, but over any distance and for any scale of transaction. This would be the case for simple wallet-to-wallet transactions.

30. The security over Bitcoin wallets, however, still poses a major obstacle to Bitcoin going mainstream. Personal crypto security practices are just not sufficiently mainstreamed in the general population at this time, and may never be. One could ask if this is a similar juncture in economic history to the time when credit cards were not well understood on main street and even today credit card companies bear the burden of the cost of protecting consumers with credit card charges and insurance schemes. With Bitcoin, the loss of a private key (by forgetting a passphrase, say) means loss of the bitcoin assigned to the counterpart public key.

31. The wallet however remains, despite perception, still potentially more secure than a physical wallet. Therefore, the need for the physical security of funds is reduced, albeit not entirely — it is likely significant quantities of bitcoin stored in a single wallet, regardless of how safe, would never be completely trusted. It is also worth noting that not only individual wallets, but also wallets left with other institutions (e.g. Coinjar, Bitcoinica,, etc.) and even insured wallets are at risk. The system, as currently in place, requires individuals to make either their own security arrangements, or invest significant time determining the reliability of entities that secure or insure their bitcoins. Personal crypto security is critical. Lose your private key and one loses their bitcoins. Personal crypto security is a significant new area of consumer literacy and companies like Circle Internet Financial and Xapo are addressing these issues to mainstream them [8].

32. The economic functions of a banking system can be thought of as being separated into their role in the provision of investment opportunities to investors (as both an investment opportunity themselves — i.e. through the payment of interest on deposits; and in their role as a facilitator for investment — i.e. in helping people invest in equities, bonds, etc. Primarily they function to aggregate deposits providing the “missing link” between firms wishing to borrowing large sums and lenders wishing to invest small [14]). This latter role would be consistent with a Bitcoin system which would operate without FRB — the only role the bank would play would be effectively a “matching function” — helping an investor connect with an investment option for a fee. This would not suffice to create additional money, since the entire value of the funds a person wishes to lend is passed along to the borrower immediately and directly (that is the very nature of a bitcoin transaction), and the lender loses access to it. The lender acquires an asset, in the form of either shares or a loan, and the borrower acquires funds. No deposit is retained. In the former role, the bank acts as a mechanism to gather together often smaller volumes of money, into a more efficient investment, and also absorbs the liquidity risk from individuals. This former mechanism however would require some form of FRB.

33. We see then two conclusions: (1) the power of the banking system to create money is an extension of its role in taking and creating deposits, and (2) the reason for the taking of deposits has functions and incentives beyond just the purely operational benefits. Therefore, even in a circumstance where the need for the operational role is removed or reduced by the use of Bitcoin, there is still a need for them to play a role in finding the most efficient investments, and providing a simple investment opportunity for individuals; which is potentially sufficient for the creation of deposit taking institutions, so FRB would naturally emerge.

34. In order for Bitcoin to operate with a fractional reserve banking model we would need to postulate: (i) depository institutions (beyond the model used for organisations like Mt. Gox which take possession of a bitcoin wallet), and (ii) bitcoin denominated borrowing. The former would not likely materialise for operational reasons, in a system in which Bitcoin is the primary means of transaction, but for economic ones.

35. Simply put, should one wish to extend bitcoins from their personally held wallet to another individual, one would need to: (a) incur a cost to determine whom to lend to; (b) incur administrative costs in joining with other lenders to pool to then have sufficient funds to provide the loan; and (c) take on the liquidity and loan risk oneself.

36. The lending operation itself would then require one to transfer bitcoin from their wallet to the borrower’s and using the smart contracting mechanism of the Bitcoin protocol, albeit rudimentary, to create the repayment transactions according to the agreed terms, while simultaneously linking in a ‘sidechain’ representing the details of outstanding debt value (what the borrower owes the lender at any given point in time). This can be thought of as analogous to lending in cash; without any banking institution.

37. It must be remembered at this point that the Bitcoin protocol does not hold a shared ledger of balances. The balances of an individual are simply the aggregation of bitcoin addresses to which they hold a private key. Those bitcoin addresses they possess, are to where bitcoins are sent by other bitcoin holders. The “repayment ledger”, i.e. what is owed back from the borrow to the lender, would like need to be stored in a sidechain or what is referred to as an off-chain mechanism or in automated rules that run on the blockchain (in what is referred to as the virtual machine component of the blockchain ecosystem).

38. It should also be noted that the very nature of the Bitcoin protocol is that it solved the difficult double-spend problem. In the same spirit, the value of bitcoin loaned from one person to another would need a mechanism to signal that although this address received bitcoin, that the bitcoin was consideration granted under a loan and the nature and terms of the loan would need to be potentially side chained to the address that received the proceeds of the loan. Sidechaining is the process of linking additional transactional data to a bitcoin transaction using the same cryptographic relationship as those in the blockchain data structure underlying the Bitcoin protocol itself. In our example here, the related information would signal that this a loan repayment schedule or loan agreement and the encompassing terms and conditions of the loan would need to be attached. In this sense some of the other operational roles of the banking sector (i.e. recording amounts due; loan terms, etc.) can be undertaken through bitcoin with either a sidechain mechanism or an Ethereum like virtual machine contract (another way of saying a loan contract that lives on the blockchain as part of the original transaction).

39. The creation of a bitcoin depository institution would create, as it does with fiat currency, economies of scale to lending. While some of the above search and matching costs can be reduced through aggregation via a fee-taking institution for bitcoin (or smart contract on the blockchain), the liquidity risk management functions, and even some lending risk management functions cannot be so easily implemented. Which again reiterates — there are benefits to deposit-taking institutions in a Bitcoin universe, even beyond the operational.

40. Handing over the Bitcoin wallet for protection or aggregation (in the manner of Coinjar) would be similar to, under current banking systems, placing funds in a safety deposit box instead of a deposit account. Bitcoin exchanges earn their income from fees. If the former has advantages however, then the latter must — given the former only provides security and no economic benefit. Anything lent out from the wallet (or safety deposit) would therefore reduce access. Put simply: if one lends out funds from their safety deposit box one can no longer access those funds until they were repaid, vastly different from a bank that lends out funds (sourced from an aggregation of funds from numerous deposit holders’ accounts).

41. Theoretically, then, there is no difference between fractional reserve banking for a fiat currency and that for a cryptocurrency. If the Bitcoin acts as the base currency, and there is still incentive for the existence of deposits in circumstances where people receive a deposit in exchange for Bitcoin — as in paragraph above (i.e. banks would need to hold a portion of the bitcoin to meet likely withdrawal demands). Bitcoin merely acts as a more useful form of base money because of the in-built security, span of distance for transactions, and rapid settlement times (relatively to fiat currency transactions intermediated by today’s global banking system).

42. It is however worth noting that this has two additional effects. First, the benefits are now largely economic, not operational, to having deposits that can be accessed at any point, although the operational ones exist. Second, institutions unlike the current set of “depository” institutions for bitcoin would have to arise and would likely do so organically in the current system.

43. A central bank provides a similar split of operation and economic roles [15]. Its operation functions include, although they vary country to country: its role in the clearing and payments system; a printer of currency; lender of last resort; banking supervisor and regulator, and providing government banking services. Its economic role extends to monetary stability; controlling inflation and influencing growth (and sometimes an economic development role, too). Some of this role can be taken on through the Bitcoin protocol; although with amendments and additions. The transfer of funds, for example, could be made from one bank to another bank immediately through their wallets, without the need for a central clearing and settling of the transaction (like The Federal Reserve in the United States operating a clearing system called the Federal Automated Clearing House (FedACH)).

44. It is worth noting that the banks are likely to see a greater potential risk with no access to any central bank lending facilities meaning they are likely to want to maintain greater reserves given that the cost of acquiring shorter term liquidity will be higher. As a result both (a) deposit interest rates are likely to increase, and (b) lending is likely to be lower and at higher cost than that of a fiat currency system.

45. Practically, there is a big difference. Without regulation and an authorised central actor in the Bitcoin economy monetary policy is effectively controlled by an algorithm — the controlled supply of bitcoin by mining. In which case, what then does monetary policy mean in a crypto economy? Is there such a construct in a decentralised crypto economy?

46. Today’s cryptocurrency institutions (what are referred to as the cryptocurrency exchanges) could, in theory, immediately begin lending out the majority of the bitcoin they hold on deposit with the remainder being the fractional reserve amount. However, without a central bank or similar for the Bitcoin cryptocurrency, the cryptocurrency focused on in this paper, there would be neither a lender of last resort to provide emergency liquidity to the system, nor a centralised oversight and regulatory body. This lack of any centralised system of assurance would likely make any deposit taking institutions arising out of Bitcoin of higher risk — in much the same way as the current bitcoin institutions are seen.

47. One could say that to even suggest the introduction of such a centralised authority in the crypto-economy is likely to be met with intense resistance from the Bitcoin movement, who view the cryptocurrency as an expression of libertarian principles, satisfying a need for a currency free from the control of the state and other third parties, such as commercial banks [8, 9].

48. So, one could think of the cryptocurrency held in exchanges as, effectively, base money held out of circulation and the Bitcoin crypto economy as operating without the multiplier effect of FRB at work, operating with only base money. Further, the economy operates without the monetary policy control mechanisms to adjust and target base and higher monetary aggregates that fiat currency possesses, instead relying on a single algorithm.

Figure 2: Expansion of the monetary base at different reserve ratios.

Source: Adapted from, accessed: 9th April 2017.

49. There is an historical analogy for these circumstances: in the period starting the late-1830s and ending around the 1860s the US saw the creation of multiple “free banks” — banks issuing their own currencies, backed by gold or other metals and providing demand deposits. Increasing utilisation of the banking system led, during this period, to the creation of the New York City Clearinghouse, to allow banks to settle accounts and exchange funds [16].

50. It was not until 1913 that the US created the Federal Reserve system, following a series of banking crises [17]. With the signing of the Federal Reserve Act by Woodrow Wilson, a new decentralised system of central banking was created. The system was created from 12 Reserve Banks (splitting the country into 12 zones), and a single Federal Reserve Board, and Federal Open Market Committee. While the creation of these structures was in part necessitated by the existence of fractional reserve banking it did not pre-date it. Fractional reserve banking necessitated the creation of these structures to stabilise the system, as well as other aims.

51. If we have sufficiently demonstrated therefore that even under a Bitcoin-based economy we would still likely see the formation of deposit taking, in the traditional sense of a deposit slip, institutions who would lend out deposits while maintain depositor access to them because of the individual economic benefits, then it is not a significant step to state that such a system would eventually likely need a support and regulatory infrastructure, which could be institutional or algorithmic (the latter being more likely).

52. In their current form digital currencies may be better thought of as digital commodities; and the current institutions of “deposit” for bitcoin are more akin to a Fort Knox, albeit with less of a track record on security. Instead of approaching Bitcoin from the point of view of how it resembles a currency and whether or not it meets the three primary criteria to function as a one (store of value; medium of exchange; unit of account), we have instead adopted the premise that Bitcoin is a currency and then asked now what?

53. The discussion set out here adopts a simplified assumption that Bitcoin is a currency and is the primary (or only) medium and then considers whether it is likely that FRB (and expansion of the crypto-monetary base or a C0) and therefore a central banking system would organically follow, whether physically or embodied in algorithm.

54. Our conclusion is that the same elements of a central banking and monetary system would emerge, in the case where Bitcoin was used as the primary means of exchange, deposit and loans, but that these same elements potentially make it less likely that Bitcoin would become a primary means of exchange: despite the benefits of both transactions of any size over any distance, these same benefits exist in the current system, and the current system has the added benefit of allowing economic returns without significant search costs.

55. While Bitcoin would likely generate some of these benefits as the structures we examine emerge over time, it is likely that while taxes remain paid in fiat currencies and volatility of Bitcoin remains high, there would not be a significant switch over; quite aside from the difficulties with using a token instrument that requires high degrees of personal crypto security. Also, the very features needed for FRB to occur with Bitcoin, i.e. exchange of the contents of a Bitcoin wallet for a deposit slip, and its existence within some form of structured banking system, are antithetical to those who currently use the system [18].

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