Fractional Reserve Bitcoin Banking

Once upon a time, a collective group of people declared the US Federal Reserve System a fraud. “During the time of the Great War, a loaf of bread cost a halfpenny! Now it costs $3.99 at Safeway!”

Such a scam. The government just keeps printing money*, causing runaway inflation! they cried.

These wise utopians decided to reject fiat money and invent their own monetary system called Shitcoin. Shitcoin was going to be a decentralized and trustless system, cuz dammit, we can’t trust central banks!

Every shitcoin** transaction would be authenticated by every node in the peer-to-peer network. Every node was equal. And the total number of shitcoins that could ever enter circulation would be capped at 21 million.

Everything was awesome. Shitcoin became a widely-adopted form of payment, and people used it to buy everything. The best part was that it was a distributed system, and everyone kept their shitcoins safely stored in their own personal wallets.

One day someone had an idea. Wow, there are so many people out there holding shitcoins in wallets stashed beneath their mattresses. We could really juice the shitcoin economy if we got more people actually spending their shitcoins!

And so this person announced to the collective community, Hey! If you put your shitcoins into MY wallet, I will pay you 5% interest on your deposit!

The shitcoin holders were intrigued. They had all these shitcoins just sitting in their wallets doing nothing, and here was an opportunity to earn 5% more shitcoin each year. And this guy seemed pretty trustworthy, because he went through Y-Combinator and all.

People began depositing their shitcoins into the new coinbank. Other people who didn’t have shitcoins went to the coinbank and asked to borrow some shitcoins. Sure, the coinbank said. We will loan you shitcoins at 8% interest.

It was a good business model. A few more shitcoin banks sprang up. Shitcoin still operated as a trustless peer-to-peer network, and every node was still equal, but some nodes were now a little more equal than others.

Years passed. The coinbanks loaned out shitcoins. People spent borrowed shitcoins. Sometimes people failed to pay back the shitcoins they borrowed.

Then the economy fell into a slump and people lost their jobs, because that sometimes happens in the world. People needed to withdraw their shitcoin deposits, and realized that some coinbanks couldn’t return their deposits, for they had loaned them all out.

Shitcoin got complicated. Maybe we need a central coinbank, some suggested. One that could insure all the other coinbanks, and loan money to the coinbanks to make sure we always get our deposits back no matter what.

And the people looked from Shitcoin to the Federal Reserve, and from the Federal Reserve to Shitcoin, and from Shitcoin to the Federal Reserve again; but already it was impossible to say which was which.

*Printing Money is a dumbed-down explanation for fractional reserve banking. What it really means is that a bank can lend out the money you deposit, maintaining only a fraction of the deposit on reserve. Your deposit + outstanding loan effectively creates more perceived value in the monetary system.

**Lowercase shitcoin denotes the currency. Capitalized Shitcoin refers to the monetary system.

See Also:
Bitcoin Banking Will Be Boring –BloombergView