Will the Bitcoin Standard Fractional Reserve Exist? – Bitcoin Magazine
This is a transcribed excerpt of the “Bitcoin Magazine Podcast”, hosted by P and Q. In this episode they are joined by Eric Yakes to talk about the seventh property of money that Bitcoin introduced, fractions on a bitcoin standard and what interesting Bitcoin projects are happening in space right now.
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Eric Yakes: I’ve spent a lot of time since the summer just reading news to know how I think Bitcoin “banking systems” will build out.
I actually published a research paper and there is a lot of discussion. It was back in July that I started digging into this research. A lot of people have put together “Here’s how Bitcoin works,” “Here’s title implications,” all that. There is a lot of information out there. How should this ecosystem actually be built? Bitcoin can do nothing.
Bitcoin can be a carrier for everything, but in terms of all that functionality, we need a whole financial system that is going to re-emerge in this area. I think it’s going to be very fundamentally different from what we’re familiar with historically.
I looked into the practical side of it and thought, “Okay, what company is this? How do they work? How does the Lightning Network work? How will it create different financial markets that exist on top of Bitcoin?” When I started it, and I looked around on Twitter and saw what people were saying, there was a lot of debate around just the general theory of what credit looks like on Bitcoin? Will it even exist? If it does exist, what will it look like look? Will there be partial reserves? All these different kinds of things, and I think there was a piece Nic Carter put out this summer, and then Stephan Livera had a response to that. They’re more higher-level discussions around credit than a lot of the public forum that was going on. People didn’t have a very complete understanding. What I released in September was a discussion of that and said, “Here’s what I think a full reserve system might look like, and here’s what I think a partial reserve system might look like can look.”
To make the caveat that when I say fractional reserve, there are ways that ultimately exist; it is within the banking model, which is something we historically have [few] examples of because governments control institutions, but this concept of free banking is something where we have observations and we have periods of history where we can say, “Okay, there was a system where the government didn’t rely heavily on currency issuance, and that actually just happened through banks. These banks decided how much gold they wanted to keep in reserve. Then they lent out over those amounts and some failed.
In my book I talk about systems where eventually we had a central bank and that creates this incentive for credit to continually expand until eventually the whole system crumbles. But when you look at free banking systems, instead of issuing gold to everyone, a major innovation was to issue paper receipts on top because they are much easier to trade. So they are much more suitable for transactions. So when you start issuing paper beyond the amount you have in reserves, that’s when you want to call it fiduciary media.
You are now expanding the money supply; you don’t just have one-to-one backing for every paper receipt you issue. It was interesting when you look at some of these systems that were generally free and weren’t heavily regulated, even though there wasn’t a central bank or anything. The USA is a good example of an overly regulated system. It was all these laws that still enforced all these perverse incentives within the American free banking system. So bond security laws were one of the big ones. We had all these banks that were in different states, and there was no central bank in the United States for about a century, maybe a little longer. Different states had separate rules and we had banks within them that all issued their own notes. These states heavily regulated it and forced these bond security laws on top of the banks where they said, “If you want to issue fiduciary media in this state, you have to use our bonds as collateral, and so the collateral was screwed up.”
There were problems that happened with wars going on and things like that, but that system didn’t work well and there were a ton of problems that came out of that system. What was largely overlooked – one of the systems that actually worked quite well – was a Scottish free banking system. It was in the 18th and 19th centuries; it was for a period of about a century. It wasn’t perfect and there were regulations that existed on top of that. We saw a fairly well-functioning system for almost a century. It was only during the Napoleonic Wars that it really had problems. When you’re in a banking system and there’s a war and all the governments around the world start printing and they start taking off their gold standards, it makes it very difficult for you to ultimately run a functioning banking system when you have to compete at an international level with something that freely prints currency.
The bottom line is that with this banking system things actually work pretty well. It was below a fractional reserve, and if you let it work in a market, there are natural limits imposed on the market on how much of these “believing media” (aka credit) is extended through these banks.
If you let the market say, if there are a hundred banks that exist in an economy and one of them goes too crazy and it eventually fails and there’s no bailout, then those systems work very differently than the danger that we have that exists within our current system. The banks will act under the assumption that they may fail. Without getting into all the nitty-gritty details, it’s the theory where people need to understand that fractional reserve, while a bad thing, isn’t necessarily the devil. There are situations where it has been left to free enterprise that has actually worked decently well.
So more of an ethical argument as to whether it should be allowed in the first place. Are you allowed to make a promise to people that they can redeem their notes one to one with you while you actually print more notes than the amount of reserves you have? Austrians will touch on ethics in the debate. It’s important to have those conversations, but what I focus more on is what we get to see. What we are seeing is that throughout history we have never had any kind of sustained full reserve that has ever emerged. We’ve had banks and large institutional groups that have been relegated to being like a full reserve, where they’re just a custodian that provides transaction services, but they don’t provide any banknote services. We have seen it in history, but there has never been a full reserve system in history. There is one: The expectation that will appear on Bitcoin is an exception to history. There have been two later, but there are many arguments as to why it will appear on Bitcoin.
I go into some of the trade-offs between how I see these things emerging and how eventually we’re likely to see both emerge. I’m still digging and researching it. When you look at the problems that Bitcoin solves and then the Lightning Network and Bitcoin enabled by issuing assets on the chain, I see the possibility of being economically viable, full reserve institutions emerging on a large scale to be a likely event. That doesn’t mean there won’t be some kind of fractional reserve, but when you look at all these different efficiencies in the system, how fast, how much information and transparency we now have that we’ve never had before in banking, there is the possibility of full reserves.
I’m digging in a lot of areas around that and the news relevant to that is Taro which was announced back in March of this year. They recently deployed their testnet. I think it will be a big step for asset issuance in Bitcoin.
