Why Fractional Reserve Can't Work in Bitcoin

The Short Answer: Acceptable Counterparties do not exist to issue debt instruments backed by bitcoin which would be as fungible as actual Bitcoins held. There is also a long answer too.

We begin from a fundamental assumption inherent in Bitcoin that was brought up briefly in the third part of my discussion on Gliph, that

By definition the rightful owner of any coins is "he who can send them". If you take issue with that, please stick to fiat. You are not ready for Bitcoin yet.

Thusly, any arrangement in which you place Bitcoins on deposit with a third party are for the duration of their stay, no longer your Bitcoins. On possibly the dumest wiki page in history, a string of failures to implement fungible debt instruments denominated in bitcoin are held up as "evidence it is possible" contrary to the actual string of failures presented as evidence of the possibility. Someone else posted a hypothetical case for using fractional reserve banking to "expand the money supply" and suggest positive effects might arise. These cases miss a fundamental feature of Bitcoin provided not through some vague social contract, but by the mathematics that establish Bitcoin's parameters.

Bitcoins are the the balance assigned to some address which is the hash of a public key, and the corresponding private key gets to spend the coins. If you don't have the private key, you have something other than the Bitcoins. Maybe you have go so far as to establish a formal debt instrument of some sort you hold in exchange, preferably backed by a GPG contract.1 A debt instrument backed by the best formed GPG contracts though still lack fungibility, because everybody values, or at least should value potential counterparties differently.

What this doesn't mean is that Bitcoins are Bitcoins and nothing but Bitcoins can be denominated in Bitcoin. Mircea Popescu has had success with creating Bitcoin denominated financial instruments, but most of those are equities and options contracts. The lone debt instrument I know of is the MPOE Bond2which backs the options trading robot, in a manner similar to but predating Just-Dice's investment option. Though they have depreciated substantially in value in recent months ASICMiner's shares served a similar purpose, though they traded without an exchange. ASICMiner and S.MPOE shares in the past have served as collateral for Bitcoin denominated loans with some success, but this is a rather different beast than trading debit instruments in that ASICMiner and S.MPOE shares are equity instruments backed by their ventures. Holding these equities may be preferable to holding Bitcoin, if you think that they will appreciate against bitcoin and trust the operator of the venture to continue operating reliably. Because of continued counterparty risks, these equity backed securities still aren't fungible with Bitcoin.

What equity backed securities denominated in Bitcoin do accomplish though is that they themselves can be monetized. Effectively this arrangement seems to practically expand the monetary base demoninated in Bitcoin while not requiring the compromises and failures3 that have come from past efforts to instead bring poor implementations of the old fractional reserve model of banking into Bitcoin.

Now for any newcomers to Bitcoin that might be under the impression that I'm endorsing the trade in Bitcoin demoninated equities as an alternative to holding Bitcoin read here first: The Most Important Word in Bitcoin (hint: the word is Counterparty). Cultivating a rich Web of Trust so you can evaluate who might present an acceptable counterparty takes time, and you shouldn't rush into accepting counterparty risks merely because I say someone would make a good counterparty. Read independently and come to your own conclusions. Look at the track records of people you are considering accepting risk from. This part is your homework.

  1. Even a GPG contract can't provide absolute security, but a well written contract can definitevely show if you have been scammed by a counterparty who fails to uphold the conditions of the contract.  

  2. Update: it took time to dig this up, but thea fuller explanation of the MPOE Bond exists here  

  3. Mt Gox, MyBitcoin, Bitomat.pl, RIPple, and CoinLenders/Inputs.io most recently but others exist  

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