Fractional Reserve Bitcoining

Scaling solutions, banking in bitcoin, and institutions

 

“Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the blockchain. There needs to be a secondary level of payment systems which is lighter weight and more efficient.”

Hal Finney Bitcointalk Forum December 30th, 2010

 

Key Takeaways:

• An old idea of institutions reserving bitcoin has been reignited after analyst Nic Carter published a detailed blog post which covers some of the intricacies of how the idea would work in practice
• The vision was initially laid out by Hal Finney in 2010

 

There has been much debate over what the best use case of Bitcoin is. Some see it as a censorship-resistant currency ideal for countries with sovereign currencies that have inflation spiraling out of control.

Likely the most popular use case seen is as a digital store of value. It offers an alternative to storing value in fiat currency which will lose its value to inflation over time.

 

One of the original use cases is as a widely used peer-to-peer currency. However, the scalability limitations Bitcoin stands directly opposed to this use case.

 

We have seen all kinds of propositions to tackle these scalability limitations which we covered in detail here. One approach has been to increase the block size which has led to the controversial hard fork of Bitcoin Cash.

 

A  blog post by renowned crypto analyst Nic Carter revisited an old idea which has been around since the beginning years of Bitcoin. The idea was originally proposed by Hal Finney and is based on a full reserve or fractional reserve system developing whereby institutions hold bitcoin and issue receipts to their customers.

 

Such a system would allow payments to be made free and almost instantaneously. It would apply a more efficient use of the blockchain network as a settlement layer.

 

However, the idea has much opposition and has received intense backlash from some who feel the vision vastly deviates from Bitcoin’s true value proposition. We explore the idea of institutions reserving bitcoin on a wide scale and explore both the potential benefits and drawbacks.

 

The Mainstream Scaling Solutions

Before delving deeper into the idea of institutions reserving bitcoin, let’s explore the leading scaling solutions currently being implemented. Already mentioned is the controversial decision of implementing protocol upgrades to increase the block space.

 

Many analysts including Nic Carter are convinced that this model simply does not work. The issue is that the value proposition of the Bitcoin network requires network users to easily be able to obtain a full version of the ledger and larger block sizes result in fewer entities being capable of doing this.

 

Bitcoin Cash ABC and Bitcoin Cash SV are the most salient examples of protocols that have emphasized block size increases. The chances of the Bitcoin Cash SV protocol continuing to survive has recently been brought into question amid significant drops in hash power and widespread exchange delistings.

 

Another method being experimented with to tackle scalability is building on top of the protocol as opposed to upgrading the protocol itself. The most popular implementation built on top of the Bitcoin protocol is the Lightning network.

The Lightning network facilitates bi-directional payment channels to be created which use Bitcoin’s blockchain as a settlement layer for opening and closing the transaction. The commonality with all solutions to scale Bitcoin is that they involve tradeoffs with what the Bitcoin protocol offers by itself.

 

For example, increasing the block size results in a more centralized group of entities procuring the network. The Lightning network brings some caveats such as deferring settlement.

Institutional Fractional Reserve

 

The idea of institutions reserving bitcoin and issuing receipts to customers, effectively bitcoin banks, has a number of interesting upsides. Bitcoin receipts could be used for payment almost instantaneously and effectively at no cost.

 

It would also result in more efficient use of the blockchain as a settlement layer. There is evidence that the criss-cross of transactions between major institutions operating with bitcoin is highly inefficient.

 

But what about the elephant in the room 🐘? What if the institutions do not hold the bitcoin that they claim they do?

 

Carter (@nic__carter) has demonstrated in the article a number of technological approaches institutions can apply to communicate to their customers that they hold their funds. Such practices have already been implemented by top cryptocurrency exchanges in the past.

 

While not fool-proof, they serve to provide strong assurances as to whether an institution holds or does not hold the funds that it claims. But it does not necessarily mean that bitcoin cannot be used in a fractional reserve system with these bitcoins.

 

It would be likely that different institutions would hold different degrees of reserves. Some institutions would be full-reserve while others would be fractional reserve and facilitate the development of credit markets.

 

“A free market for reserve/capital ratios could even develop, as depositors would be able to select banks with varying levels of reserves to suit their risk preference.”

Nic Carter

 

The natural evolution of businesses is expected to apply whereby weaker, undercapitalized, and negligent businesses are pushed out of the market.

 

“Bitcoin backed banks will solve these problems. They can work like banks did before nationalization of currency. Different banks can have different policies, some more aggressive, some more conservative. Some would be fractional reserve while others may be 100% Bitcoin backed. Interest rates may vary. Cash from some banks may trade at a discount to that from others.”

Hal Finney

 

Conclusion

 

As with any scaling solution, key trade-offs are made. A wide-scale system whereby institutions reserve bitcoin is definitely a future possibility that may be mutually exclusive with a future whereby individual user transactions represent a large proportion of overall transactions.

 

This particular vision for the future of Bitcoin is especially divisive. While some are strongly opposed to any system which would introduce fractional reserves into Bitcoin, others view it as inevitable.