Oct 28
2013

A Case for Fractional Reserve Banking with Bitcoin

It is quite surprising to find that the overall feeling toward Fractional Reserve Banking among bitcoiners is so hostile. In my own mind, the major problem with bitcoin is that there are few things to do with your bitcoins that have a better return than leaving it in your wallet. In fact, it’s become quite the meme that the best and most trustworthy investments will simply offer to pay back the full amount of your investment at a later date. It is my opinion that governmental regulation (I know I just lost a lot you there, but bear with me.) and fractional reserve banking could actually do a lot of good for the bitcoin economy.

The primary arguments that I’ve heard against this have been that promissory notes for bitcoins are simply not as valuable as having actual bitcoins and that banks cannot be trusted with our digital money. I can appreciate the fact that some people have gravitated toward a peer to peer currency system to avoid banks. I respect that, and propose a bitcoin banking system that does not require participation. After all, choice and freedom are what bitcoins are all about.

For the uninitiated, the Fractional Reserve Banking system is what the world of fiat currencies operates on. It is based on the idea that, since all depositors don’t generally demand their funds from a bank at once, the bank can invest some amount of the deposits to generate income and pay interest to its depositors. It actually predates modern banking and started when goldsmiths began issuing notes to keep their customers’ gold safe for them. Eventually, they stopped charging fees for this service and started paying interest to convince more people to trust them with their gold.

From an economic standpoint, the effect that Fractional Reserve Banking has is that it increases the money supply. This happens, because when you deposit money in the bank, you still act as if you have the same amount of money, even if the bank is using half of it to fund a new business. You could go to that bank any time, and receive the full amount back, so you haven’t lost any money, but the new business owner can also spend that money at the same time.

Going one step further, an expanded money supply would lower the price of bitcoin. This may sound bad, but much of the loss in price would probably be offset by increased demand stemming from the new resulting investment possibilities that would be available in the market. Once the banks are able to lend, new entrants could enter the market, posting fiat currency or securities as collateral. By the nature of investing in a volatile currency, the possible borrowers would almost certainly be limited to those who plan to invest in BTC-yielding opportunities to limit exchange risk.

What is currently holding us back from this system? The main problem is that it is hard to trust any entity with our bitcoins, for fear of them running off into the wind with our coins. Additionally, even an honest banker would have to contend with unreasonably high delinquency rates.

One possible answer to these problems would be measured regulation (I know, the ‘R word” again…) from a central bank. The most useful thing that they could do is insure deposits into the system. Since it is probably unreasonable to ask a central bank to hold appropriate reserves of BTC, I would propose that they insure them at a nominal rate of fiat to bitcoin which is at least a substantial fraction of the market value. Such a rate would have to be adjusted periodically or preprogrammed to scale with the exchange rates.

In any case, I for one, would be more than happy to deposit my bitcoins with a regulated and insured bank if I could earn interest on those funds. I think that monetary supply expansion could also become important in the future with a capped currency.

4 comments

  1. Mixles says:

    Promises are useful for gold, because gold is cumbersome to securely move and verify. Promises are useful for fiat, because if everyone does it, you know they’ll print more to make good on otherwise unpayable promises.

    But why oh why do you want to create unpayable promises, when the underlying thing can be transacted as easily as the promise itself?

    This is one of the stupidest ideas and has been beaten to death already. If you want to do some fraud on the side, go right ahead.

    • admin says:

      The point is to use it, not as a secure holding place for money, but as a secure and regulated form of investment. I hope that I was clear that I want regulators to prevent fraud.

  2. Jack Larkin says:

    “”"In my own mind, the major problem with bitcoin is that there are few things to do with your bitcoins that have a better return than leaving it in your wallet.”"”

    Considering the change in value bitcoin has had in the last year, combined with the still speculative nature of the currency, I’d say that’s a problem you WANT to have… not a problem needing to be solved.

  3. Clifford Monnington says:

    In a fractional-reserve system, those depositing their bitcoins (for a deposit note) should expect to earn interest — which should offset the credit risk they are running against that bank. Otherwise, why bother depositing ?

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