It is no secret that today, almost all modern banks operate on the basis of fractional reserves. To put in simpler terms: banks only has in their vaults a small percentage of the money that their customers gave them; if a large enough number of customers of a specific bank want to get their money back, the bank wouldn’t be able to meet the demand. Before there was modern central bank system, the bank could either have to borrow or file for bankruptcy. The central banks by design had infinite ability to lend, for they can legally conjure up money from thin air – there is a reason that modern currencies are called fiat money.
The Bitcoin world doesn’t have central banks, and this fact even appeal to some of its supporters with libertarian inclinations. Among these people, a widely-held belief is that bailing out insolvent banks is no different from highway robbing; if a bank screws up, the argument maintains, it should face the consequences alone, rather than letting all economy participants across the system to share the pain in the form of debased per unit currency value.
However, without a central bank system, a fractional reserve system can be risky. This is illustrated by the many failed banks in history and most recently, the spectacular fall of Mt. Gox. Before it became clear that the Bitcoin exchange was insolvent, users traded under the false assumption that they were trading their own bitcoins, when the reality is they were just trading in “Goxcoins”, which is just thin air. Later it is discovered that the exchange had lost tens of thousands of its customers’ coins; the cause remains a mystery to this day.
The collapse of Mt. Gox has great implications on the Bitcoin world. It shakes many people’s confidence in exchanges and security of the digital currency. Inevitably this has been factored into the price levels and employed by many Bitcoin critics – it is arguable that the psychological cost is even higher than the lost bitcoins.
In the aftermath, there was increasing demand for the exchanges to have 100% reserve ratio. In response, a cryptographic proof of reserve system was introduced to enable exchanges to prove that they can handle a Bitcoin version of run on the bank. Last week, OKCoin, a China-based Bitcoin exchange announced that they had passed a proof of reserve audit with its reserve ration of 104.86%. This means that the exchange has 4.86% in excess of the amount it owes its customers. While this is ensuring for OKCoin customers, it may not be a good thing for Bitcoin if you treat it as an economy system.
The benefit of fractional reserve banking is that it has positive effect on the economy by allowing banks to extend credit to people who are in need of it, provided the borrowers agree to pay back with an interest. In the Bitcoin world, such activities are rather discouraged. On one hand, the exchanges, which serve like banks in the sense that they are both custodians under obligation to safekeep customers’ assets, have to let all the coins sleeping in wallets in order to stay 100% solvent; on the other hand, market demand for coins in the market goes unmet.
A good solution for the problem at hand would be for the entire industry to agree to a certain reserve ratio, say 80%. This would cap the maximum risk, while giving the exchanges certain flexibility to engage in lending activity – one obvious benefit will be speeding up the circulation and increasing liquidity. Given that not all users have the same risk tolerance, they should be allowed to either opt for a zero-interest but full reserve account, or a fractional reserve but interest bearing one.