It's interesting to watch Jeremy Allaire repeatedly say that only well-funded companies should be trusted to hold consumers' bitcoins.
Companies like, well, his.
Companies like, well, his.
To keep it simple, Banks hold reserves because they lend. Paypal, for instance, is not a bank.
If your tiny Bitcoin startup holds $1000 in bitcoin, and your obligations are $1000, I don't see the problem.
Paypal is a bank in Europe. A paypal account is legally a bank account here.
Ok, you're right, that's an oversimplified view.
And, if not, why do you need reserve capital?
Customer A deposits 2 BTC to Bank A
Bank A loans 1 BTC to Customer B
Bank A is now a fractional reserve bank, with 50% of its outstanding debts to Customer A actually on-hand.
Bitcoin would impose a 100% reserve requirement that is unheard of (as far as I can tell) in modern banking. I don't believe we can accurately predict the effects of this requirement. I also believe we can't state with any certainty that, given this requirement, a bitcoin banking system would behave at all alike to our current fractional reserve banking system.
Frankly, this appears to be another area where bitcoin doesn't seem suited to handle the economic needs of the modern world.
1. http://en.wikipedia.org/wiki/Reserve_requirement 2. http://www.federalreserve.gov/monetarypolicy/reservereq.htm
If memory serves, this is how banking works today (beware, there are gross simplifications in here):
1. Customer A deposits $1 in Bank A
2. Customer B asks Bank A for $9
3. Bank A now needs to borrow $9. It can legally do this because it can prove to the government that its reserves ($1) are greater than 10% of its outstanding liabilities ($9). It first tries other banks, but if all else fails it can borrow from the Fed.
4. Bank A gives $9 to Customer B.
I cannot see how step 3 happens in "bitcoin banking". The whole point is that there's no "central point of trust" and hence no lender of last resort.
Or to restate, one of fractional reserve banking's key purposes is to influence the money supply. But this is clearly impossible under a "pure bitcoin" system, where the money supply is fixed by fiat.
And step 4 should really read "Bank A marks Customer B as having $10". The vast majority of the money in our economy is numbers on ledger sheets. From there, Customer B uses it to pay off a debt of some kind with Customer C, who then pays Customer D, etc., until supposedly the money eventually gets back to Customer B in some way. Except Customer C deposited the money in Bank B, so Bank B can now lend out $100 to Customer E.
That's why pyramid schemes are illegal, the banks hate competition.
So yes, it especially doesn't work for bitcoins, because how do you make a blockchain for fractional bitcoins based on a mined bitcoin? The mined bitcoin is the one that has the blockchain. You can't make a bitcoin transaction without first checking the blockchain for double-spending, say nothing about 10x spending.
I haven't studied this subject in some time, so can't remember the exact mechanics. This summary sounds accurate. I would like to say that "it gets to make up the money on its own", while correct from one perspective, is another way of saying "other banks can respect its credit (how much money it says it has) if it plays by a certain set of rules".
I don't remember if this mechanically occurs via some kind of direct lending or via the Fed sanctioning "Bank A's" credit as satisfying reserve requirements for a "Bank B". The ultimate result is the same.
> That's why pyramid schemes are illegal, the banks hate competition.
I'm assuming that this is said tongue-in-cheek, but pyramid schemes are an example of perversion of credit and lending on a scale that separates them from banks. In particular, the core feature of pyramid schemes is a rate of return that is unsustainable, and thus requires rapid creation of new customers instead of gradual growth of new wealth.
If fractional reserve banking is indeed really terrible, what is the alternative? I think a massive body of research is required for someone to assert the superiority of such a system.
> So yes, it especially doesn't work for bitcoins, because how do you make a blockchain for fractional bitcoins based on a mined bitcoin? The mined bitcoin is the one that has the blockchain. You can't make a bitcoin transaction without first checking the blockchain for double-spending, say nothing about 10x spending.
This was ultimately my point. The principles behind fractional reserve banking and bitcoin seem fundamentally incompatible. Given that fractional reserve banking has worked for many centuries, any alternatives that are radically different should be approached with caution.
The amount of money a bank can lend out is a multiple of the bank's capital, because when a loan defaults, the corresponding amount is subtracted from the bank's capital, i.e. from the net value of the bank (assets minus non-capital liabilities).
We as society want to limit the amount of loans that a bank can make to such an extent that its bank capital won't go negative. Because if bank capital were to go negative, the bank would be in default and would effectively have given money out "for free".
And banks are limited exactly in this way: Loans are limited in terms of the amount of capital that banks owe their owners. You may argue that the capital requirements are too low (and they are...), but qualitatively, the system makes sense.
It actually makes much more sense than this foggy picture of reserve banking that most people have in their heads.
http://en.wikipedia.org/wiki/Fractional_reserve_banking#Exam...
No. There were experiments with trying to influence the money supply in the past, but it doesn't work. Today, the money supply develops endogenously, that is, it is determined by potential borrowers' willingness to borrow and by banks' determination of the credit-worthiness of said potential borrowers.
The central bank is tasked with making sure that the interbank clearing system works smoothly and with setting the short-term interest rate.
Also, your story about how banking works today is a bit muddled. Whether Bank A can borrow those 9$ has nothing to do with how many reserves they have, but with quality of the bank's assets relative to its capital.
The volume of reserves really does not have a noticeable effect on the behaviour of the banking system, mostly because, as I wrote above, it is endogenous anyway.
This is very different than how banking works today. Banks (in the US) can lend up to 1000% of their current deposits. This is a core feature of the fractional reserve system, and is clearly impossible under a pure bitcoin alternative.
I guess you are saying they do accounting shenanigans with the Federal Reserve to make the deposits larger than they really are?
(I will admit, I am more interested in aggregate practice here than I am in what the more extreme banks are doing)
If I recall correctly, "demand deposits" are the subject of reserve requirements, not total deposits. The vast majority of deposits are subject to strict regulation and can't be withdrawn on demand (hence the "demand deposit" distinction). They are, in essence, another form of credit. Not a cash equivalent.
If we compare demand deposits (1.1T) to securities and net loans and leases (9.63T), we get pretty close to the 10x money multiplier.
Because demand deposits are the only things that need to be backed by cash, the rest of the money is essentially re-invested from another institution in the system. Someone didn't come in to the bank and put cash on the table for those deposits. Instead, they told their bank to exchange their credit with another bank.
In other words, it's just a change in the ledger sheet between two parties. Simplistically referred to as "created money". The Fed lets banks "create" this money as long as they meet certain rules. The most important being reserve requirements.
Getting back to comparison with bitcoin, my original statement ("1000% of deposits") was perhaps an oversimplification. But it's hard to say exactly where bitcoin fits in to a "new banking order". Would it be considered money, e.g. cash equivalent? What then is used as the medium for credit exchange e.g. the other 90% of financial activity?
Or is it the unit of account for EVERYTHING, including credit exchange? If so, then how do parties loan money? Won't 90% of bitcoin sit idle for very long periods of time? And does it really make sense to use a deflationary unit of account for an inherently inflationary activity (lending)?
Maybe try working from the assumption that what I am saying is (more in the direction of) correct. The banking system may be set up to work in favor of the establishment and bankers, but it isn't a giant fantasy.
What? I'm not ignoring those deposits, just pointing out that those deposits are "created money". They are made by banks, not issued by the Fed. The only restriction on their creation is the Fed interest rate on one side and the reserve requirements on the other.
In technical terms, they are part of M2, not M0 or M1 [1]. And banks are definitely allowed create M2, though obviously not M0 and M1.
> Maybe try working from the assumption that what I am saying is (more in the direction of) correct. The banking system may be set up to work in favor of the establishment and bankers, but it isn't a giant fantasy.
What exactly are you asserting? Nowhere did I state that the banking establishment is some kind of giant fantasy. I just made the fairly uncontroversial assertion that banks are allowed to issue more credit than they have cash on hand. In a sense, when they do so they are "creating" money (though this "created" money is technically referred to as M2).
However, when that effect is multiplied throughout the entire banking system [1], the system as a whole amplifies the base amount of money in the system. A 10% Required Reserve Ratio equates to a maximum potential money multiplier of 10, meaning the system as a whole can turn a $10 deposit into up to $100 in circulation.
[1]: http://en.wikipedia.org/wiki/Fractional_reserve_banking#Exam...
Not that I personally think there is anything wrong with a reserve currency, but they tend to significantly curtail the power of governments to wage war, so it's extremely unlikely we'll ever go back to such a system.
It is far easier to create "virtual currency" than you seem to think.
How would you fraction a bitcoin, thereby allowing 10x spending? You can't just invent new bitcoin hashes, because the creation of valid bitcoin hashes is the mining process itself, and is designed to be time-consuming.
When you transfer USD into Mt. Gox, you can then buy some "virtual" BTC. The BTC that is in your Mt. Gox account is purely virtual. Until you manually transfer it out of Mt. Gox, you don't even know if those BTC exist yet.
I'm not necessarily saying that Mt. Gox is lying to anyone (although they don't strike much confidence in me...). I'm simply stating that the job of lying to the customers is a lot easier than you might think.
Take GPL for instance. It "virtually" held BTC for its customers, and one day... they decided to disappear off the face of the internet. Unless those BTC are exactly in a private, offline wallet, you have NO guarantee that you are actually in full possession of those BTC.
That is why BTC regulation as a currency is a necessary step forward. If institutions are forced to offer guarantees on the promised value of your BTC Accounts, then life will be a lot easier for the BTC consumers.
Slightly tangential to the main topic, but this is a common misunderstanding and incorrect. Bank lending is not constrained by the amount of reserves a bank has, because banks can and do lend each other reserves (or sell each other reserves in exchange for other assets).
So banks just make loans regardless of how many reserves they have. Afterwards, a separate department checks whether they satisfy the reserve requirements. If they do and they have too many reserves, they will try to lend those reserves to other banks. If they don't, they will try to borrow reserves from other banks or from the central bank.
Note that banks still cannot make loans willy-nilly. It's just that they're constrained by capital requirements instead, as opposed to what people commonly believe.
Edit: If you are interested in the low-level workings of the system, I recommend reading the corresponding writeups of Modern Monetary Theory economists. A good starting point (though somewhat lengthy) is here: http://neweconomicperspectives.org/p/modern-monetary-theory-...
In theory, we can design a banking system that accepts deposits in bitcoins and gives out loans in the fiat currency.
Also, such a system mutes a key feature of current "money multiplier" based systems, which is recursion. Under the current system, when you deposit $100 in a bank, that bank can then lend $10 to nine other people. Who can then each take that $10 and deposit it nine other banks, which can each lend $1 to nine other people...
Without this effect, the money multiplier would probably need to be tweaked pretty drastically.
There's a school of thought that the expansionary fractional reserve system we've had for the last 100+ years has worked OK because more and more fossil fuel energy was available over that time. It's possible we're in a new era where total energy usage will be essentially static, and the current monetary and banking system won't work.
I'm not necessarily saying I buy the argument.
For one, a few billion people are currently moving from an annual income of less than $10,000 to closer to $30,000. That's a huge, unprecedented global shift that will lead to a big increase in worldwide energy demand.
Second, I think ingenuity will solve our future energy supply issues. A geologist once said "oil is found in the minds of men" and I think that claim holds true for all sources of energy. Look at shale gas: this is a huge energy source that wasn't even in anyone's radar thirty years ago. Moreover, effeciency increases over the next two decades, both in MPG standards, industry and electronics, could yield a savings equivalent to 13 million barrels of oil per day. That's like adding a new Norway and Russia to world energy supplies.
Daniel Yergin's book The Quest coveres these future challenges quite well, I highly recommend it.