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Could Blockchain Technology Help End Fractional Reserve Banking?

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01/29/2022
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Fractional reserve banking has existed throughout history, long before the creation of government currencies or central banks. Once monetary custodians realized that not all depositors would demand repayment simultaneously, the practice of lending out deposits in excess of reserves became commonplace. This raises the question of how a system of full reserves would operate in practice. Although authors have laid out plans for establishing a full-reserve banking system using gold or fiat currencies, the decentralized and digital nature of blockchain technology provides some inherent advantages in implementing a full-reserve system.

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

Fractional reserve banking is easy to operate in a system of pure fiat money 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 been historically difficult to ensure full-reserve banking. Under a system in which gold functioned as money, most people preferred to hold their gold at a bank and transact using bank deposit notes. People chose to do this both for security and convenience. These notes represented an on-demand claim to the amount of gold deposited, meaning that as long as the banking institution was trusted to keep this promise, these notes could circulate as perfect money substitutes. The issue was that the perfect auditability of gold stored in banks was very difficult, and therefore it was tempting for banks to use some of the gold stored as deposits to create new loans, causing banks to possess less gold in their vaults than the collective amount their depositors had claims to. As time went on, gold became more centralized by banks and governments, which contributed further to the system of fractional reserves. Saifedean Ammous explains in his book The Fiat Standard that “[u]nder a gold standard, the cost and time required to move gold around are relatively high, so the economies of scale from centralization will provide existing banks a degree of leeway in extending unbacked credit without their depositors noticing or being able to do anything about it (p. 269).”

Additionally, because of 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 had the tendency to be centralized and seized, and convertibility of notes into gold has been suspended at numerous times throughout history. Transparently auditing gold has also often been an issue, making it difficult for a full reserve policy to be enforced. These flaws contributed to widespread fractional reserve banking existing even under the classical gold standard.

In contrast to this, blockchain-based networks such as bitcoin allow 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 which are used to identify and send tokens to it, and each address also has a private key which is required to send tokens from it. The public ledger of ownership is updated at regular intervals with the creation of a new “block.” Each block contains an updated record of which address owns every single token in that given moment. Each block builds on the record of the prior block, and this continuous linkage forms what we refer to as the “blockchain.” The existence of a shared ledger means that anyone can check when a specific token has been moved, and it can be verified that deposited funds are stored at a particular address.

The potential for trustless auditability means that consumers would have the power to demand transparency regarding a bank’s reserves. Banks would be able to give clients a code so that they could verify that their deposits are being stored in full 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 choose to forgo operating with a bank altogether, through self-custody of their own cryptocurrency. There are already numerous 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 far more difficult.

Moreover, using a natively digital currency removes many of the reasons for using money substitutes to begin with. Cryptocurrencies naturally integrate into today’s digital payment systems and allow for international settlement without the need for a centralized processor. The use of money substitutes was a primary reason that gold was able to be co-opted by banks and governments into the fractional reserve system present during 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 currency systems. Blockchain currencies such as bitcoin should be seriously considered as a potential solution to many of the problems plaguing the current monetary system.

Author:

Sammy Cartagena

Sammy Cartagena is an undergraduate student attending Rutgers Business School studying finance. He has a particular interest in monetary theory and financial markets. He is a Mises University 2021 alumnus.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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