Reserve banking

Could Blockchain Technology Help End Fractional Reserve Banking? – OpEd – Eurasia Review

By Sammy Cartagena*

Fractional reserve banking has existed throughout history, long before the creation of government currencies or central banks. Once money depositories realized that not all depositors would demand repayment simultaneously, the practice of lending out deposits in excess of reserves became common. This raises the question of how a system of full reserves would work in practice. Although the authors have developed plans to establish a full-reserve banking system using gold or fiat currencies, the decentralized and digital nature of blockchain technology offers some inherent advantages of implementing a full-reserve system. complete.

When Nixon officially ended the convertibility of the US dollar into gold in October 1971, the dollar lost its last link to a commodity currency. This ushered in the power of the central bank to create a near unlimited amount of money, since the dollar no longer faced redeemability as a scarce commodity. The danger of bank runs thus became virtually non-existent, since more dollars could always be printed to meet ongoing withdrawals.

Fractional-reserve banking is easy to operate in a pure fiat money system with a lender of last resort in the form of a central bank, but fractional-reserve banking was also common in the days of commodity money.

Beyond the legal and economic debates regarding fractional reserves, it has historically been difficult to ensure full-reserve banking. In a system where gold functioned as money, most people preferred to hold their gold in a bank and transact using bank deposit notes. People have chosen to do this for both safety and convenience. These notes represented a demand claim on the amount of gold deposited, which meant that as long as the banking institution was trusted to fulfill this promise, these notes could circulate as perfect monetary substitutes. The problem was that the perfect verifiability of the gold stored in the banks was very difficult, and therefore it was tempting for the banks to use part of the gold stored as a deposit to create new loans, which forced the banks to have less gold in their coffers than the collective amount. their depositors had rights. Over time, gold became more centralized by banks and governments, which further contributed to the fractional reserve system. Saifedean Ammous explains in his book The Fiat standard this “[u]Under a gold standard, the cost and time required to move gold is relatively high, so the economies of scale resulting from centralization will give existing banks some leeway to extend unsecured credit without the their depositors do not notice it or cannot do anything about it ( p.269).

Additionally, due to this centralization, governments were able to control the majority of gold settlements, which allowed for high levels of manipulation in the gold market. Gold has historically tended to be centralized and seized, and the convertibility of banknotes into gold has been suspended many times throughout history. Transparent auditing of gold has also often been an issue, making it difficult to enforce a comprehensive reserve policy. These flaws contributed to the widespread use of fractional-reserve banking existing even under the classical gold standard.

In contrast to this, blockchain-based networks such as bitcoin allow for trustless auditability by anyone with an internet connection. On a traditional blockchain network, all tokens are stored at addresses. Each address has a set of public keys that are used to identify it and send tokens to it, and each address also has a private key that is needed to send tokens from it. The public property ledger is updated at regular intervals with the creation of a new “block”. Each block contains an updated record whose address owns each token at that given time. Each block builds on the record of the previous block, and this continuous link forms what we call the “chain of blocks”. The existence of a shared ledger means that anyone can check when a specific token was moved, and it can be verified that deposited funds are stored at a particular address.

The potential for auditability without trust means that consumers would have the power to demand transparency regarding a bank’s reserves. Banks could give customers a code so they can verify that their deposits are fully held by the bank. Venture capitalist Nic Carter is one person currently working to push for “proof of reserves” for cryptocurrency custodians.

Additionally, consumers could easily opt out of working with a bank altogether, thanks to self-custody of their own cryptocurrency. There are already many solutions available for secure storage of crypto without the need for a trusted third party. This would hopefully lead to a less centralized outcome than with gold, making government seizure or manipulation much more difficult.

Additionally, using a native digital currency removes many of the reasons to use currency substitutes to begin with. Cryptocurrencies fit naturally into today’s digital payment systems and allow international settlement without the need for a centralized processor. The use of monetary substitutes was one of the main reasons why gold was able to be co-opted by banks and governments into the fractional reserve system present in the era of gold standards.

Although it is difficult to determine which and how many cryptocurrencies will emerge as viable forms of money, blockchain technology has several significant advantages over traditional monetary systems. Blockchain currencies such as bitcoin should be seriously considered as a potential solution to many problems plaguing the current monetary system.

*About the Author: Sammy Cartagena is an undergraduate student studying Finance at Rutgers Business School. He is particularly interested in monetary theory and financial markets. He is a 2021 Mises University alumnus.

Source: This article was published by the MISES Institute