Cryptocurrency has received praise for the ability to privately provide economic actors with a stable money stock. This accomplishment is laudable. The full potential of cryptocurrency to act as money, however, is incomplete. The quantity of most cryptocurrencies does not coincide with demand for them. This contrasts with other market-generated monies, like gold, where supply expands and contracts with changes in demand.
A partial solution to the problem of a relatively or perfectly inelastic cryptocurrency supply would be to allow the development of tradeable securities. Partly because of regulation and partly because of cryptocurrency protocol, cryptocurrencies like Bitcoin are not well-suited for lending by traditional banks and other financial firms. The beauty of blockchain technology is that these old intermediaries are not necessary. Intermediation of cryptocurrency can be performed on the blockchain and therefore does not require a third party.
The Bitcoin blockchain provides a fitting example. The ledger does not allow for lending of cryptocurrency. Bitcoins are transferred from one party to another with no place for recognizing an offsetting asset on the blockchain. For the Bitcoin blockchain to facilitate lending, it would need to generate securities for parties lending their goods.
If the new securities are to serve as money, ownership of these assets would need to be transferable. If this was possible, we could imagine users paying for securities in bitcoins at a discount to the expected return of the asset. This change in the ledger would also facilitate swapping of debt, such that holders of short-term bitcoin securities could trade these for long-term bitcoin securities at some rate determined in exchanges with other users.
Confusion Over Meaning of Terms in the Bitcoin Community
Any cryptocurrency could accomplish this feat given the correct protocol. Surely this represents a profit opportunity even if it violates a belief common within the community of cryptocurrency advocates that both fractional-reserve banking and the use of money substitutes that are claims to debt are immoral, inefficient, or just plain unnecessary. While the use of cryptocurrency-denominated claims to debt is precisely what this post argues for, the use of fractional-reserve banking is not necessary. If the claims to assets in the future are not demand deposits, but securities whose values move up and down according to expected inflation, risk, and rate of return, then many of the problems associated with fractional-reserve banking are ameliorated.
The article “Fractional Reserve Banking and Bitcoin” at the Bitcoin Wiki exemplifies the problem of failing to distinguish clearly between fractional-reserve banking and the use of debt instruments as money. But, and this is important, the trading of debt instruments at a discount is categorically not the same thing as traditional fractional-reserve banking, in which depositors expect they can exchange banknotes at par even though all reserves are not on hand for exchange. Holders of any given debt instrument bear the risk that the instrument will not be repaid. Investors are aware of this fact, and these instruments are priced accordingly.
This confusion is bound up in narratives of past events involving cryptocurrency. The article’s description, and that of many others online, accuses the defunct bitcoin exchange Mt. Gox of having operated with fractional reserves:
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 bitomat.pl and subsequent takeover by Mt. Gox). Here we have empirical evidence that FRB with Bitcoin is possible.
Mt. Gox apparently suffered from a bug in its system and a compromised computer within the company. Mt. Gox did not advertise itself as a bank that lends out its reserves, and the lack of consensus concerning whether this represents fractional-reserve banking suggests that this description is the result of a misconception. Having bitcoins stolen by hackers and not being forthcoming about the problem is different from operating with fractional reserves.
The confusion over fractional-reserve banking is a symptom of misunderstanding monetary arrangements and theory more generally. Andreas Antonopoulos, who is author of many books and respected in the cryptocurrency community, acknowledges this problem as concerns the general population:
The average person on the street doesn’t understand how money or banking or fractional reserve or Central Banks work. They don’t. if you talk to the average person, they have this constructed mythology about money that is about as factually accurate as Santa Claus.
Even among those with a more sophisticated understanding of money and credit, there exists misunderstanding. In a video published within the last year, Andreas describes fractional-reserve banking as individual banks creating money out of nothing. This may seem true at a glance, but the details deserve consideration. A bank lends a fraction of reserves from every deposit it receives. Claims to deposits, which today exist as access to money in an account via debit cards and checks, act as money. The currency itself is transferred to another borrower, who may place these funds at another institution. The process repeats.
I suspect Antonopoulos would not disagree with this presentation. However, shorthand descriptions matter. Banks do not create money out of nothing. Banks create money substitutes denominated in base money. Individuals are happy to treat these as money. Thus, they become money. There are limits to this process of expansion as overissue of credit by a bank will lead depositors to move their funds to a different bank. Short-run fluctuations do occur, but the worst of these, like the Great Depression and the Great Recession, are a consequence of intervention in markets by the state.
An increase in demand for credit — that is, the willingness of borrowers to pay a relatively higher interest rate and the faith of lenders that the borrowers can and will repay — or an increase in the supply of deposits makes possible an expansion of the credit stock at the system level. But this is true whether the debt is generated by fractional-reserve banking or other means of lending. Debt instruments, especially those for short-term debts, generated through lending are positively valued and highly liquid.
If the creation of tradable debt instruments denominated in cryptocurrency and recognized on the blockchain is to become possible, money, financial markets, credit, and their regulation by market processes must be better understood by those who use and innovate in cryptocurrency markets.