Should fractional reserve banking be prohibited through the bitcoin protocol or otherwise, and how could such a change be implemented?

Question

There's a massive macroeconomic debate between Keynesians, who want central banks to control the money supply, and Austrians who want no central banks doing any such thing--or at least competing currencies which provide an alternative to central banks which do. Bitcoin, with its set mining schedule, takes a clear stand against the former and opts for what will in 2033 become a stable/deflationary currency.

A debate which has not been settled, even among hardcore Austrians, is whether fractional reserve banking is good or bad for economies. Similar to central banks, fractional reserve banking expands the money supply, but not at the fundamental level. The effect is often the same, however, and the result is booms and inevitable busts as growing loans and investment cycle with contractions and bank runs.

For bitcoin enthusiasts who are skeptical about inflation, fractional reserve banking poses a similar threat. As long as anyone except you are holding your bitcoins, there's no way to prove that your coins aren't being lent out at any possible reserve ratio. Gresham's law suggests that 'bad money drives out good', meaning people will first use unsecure, inflationary currencies and hoard better ones. Since bitcoin aims to be an optimal currency, it should explore avoiding the fate where it is bested by a regime which prevents fractional reserve banking.

My question is: Can fractional reserve banking be prohibited, technically, a) through a change the bitcoin client itself; b) in a customer-bank protocol; or c) in another cryptocurrency scheme.

I don't know enough about public key cryptography, but I have an inkling that it would involve limiting return addresses, so for example, I send 10 bitcoins to address A, but those bitcoins can ONLY be sent back to an address I provide, and nowhere else. Could that kind of scheme be implemented at any level, even just as an option?

Answer 1

No, you can't prevent fractional reserve banking technically. For example, IOUs can circulate just like Bitcoins and there's no technical means to stop it. Essentially, anything worth X Bitcoins (once risk and the like are factored in) can act just like X Bitcoins, even if it's not X Bitcoins. And since it's not Bitcoins, nothing Bitcoins can do can stop it.

Unless you foresee some massively powerful central coercive authority that prohibits it, you will always have fractional reserve banking. It just makes too much sense. It will happen absent the use of massive amounts of force.

There are trivial technical fixes to the "run on the banks" problem. However, there is still the very real "the bank is a crook" problem and the "the bank goes broke due to fundamentally unsound loans" problem.

Answer 2

I think there are a few problems with your assumptions.

1. If you are depositing bitcoins in a bank, you certainly can determine whether the coins are being lent out, if the bank wants to support this feature - it simply assigns a specific address to you, and whatever is in that address is your balance. As long as the coins stay there you know they are not being lent. And you could guarantee that the same address isn't used for multiple people by prefixing it with a hash of your account number using VanityGen.

2. In the future, I hope most deposits will not be in the form of giving the bank full control over the coins, but rather with a multi-signature scheme where the bank can't do anything without your consent.

3. In legacy currency, the reason people put up with fractional reserve is that a balance with a bank is generally more useful than cash, so people prefer a fractionally-backed balance to physical cash. Bitcoins are inherently digital and thus the advantage of depositing them in a bank are minor, so people will only deposit under good terms.

4. With legacy currency, what you give is what the other party gets. With Bitcoin, generally you can send bitcoins from a bank account while the recipient gets raw bitcoins (possibly the fees will be lower for intra-bank transfers, but fees for raw Bitcoin transfers should be low enough).

5. A suggestion as in your closing paragraph - an address which can only be spent to a address B - is isomorphic to simply sending to B. The bank will not let you transfer coins if he can't redeem what you deposited, and if address B is compromised you'll still lose your coins. But if you develop the idea a bit, you end up with multi-signature transactions, where spending address A requires both the bank's signature and your own signature.

Answer 3

If people would not use e-Wallets that pool the money, fractional banking would be impossible. Since it does not seem to be technically possible to prohibit this (see the other answers), the only way to do this is to make people acutely aware that they are needlessly giving up the possession of their own money, and thus create risks like the banker running away with the money, bad loans, and so forth.

Probably most users are not even aware that with bitcoins it is technically possible that the bank keeps your wallet but has no access to your money at all. That's fundamentally different from the old systems. If people don't know this, they will not search for alternatives.

Answer 4

Fractional reserve could be prohibited by contract - e.g., the bank and I agree that they will not loan out the funds, and if they breach that contract they're liable for damages.

Fractional reserve could be detected/discouraged by coordinating clients, who agree to coordinate a mass withdrawal of all or substantially all of their funds; if that fails, it suggests that the funds aren't really available. (And this might evolve into agreements among banks to cover each other in the event of a run, which might then evolve into agreements among customers of all banks to coordinate mass withdrawals. One could even imagine a national or international "withdrawal day", where everyone learns simultaneously who's been naughty and who's been nice.

Of course, this takes away a lot of the advantages of banking, and turns banks into, essentially, vaults - at which point I would expect that rather than paying interest, banks would charge for deposits/lodgements, since the more funds they hold, the greater their exposure is to liability, and the greater the incentive is for bad guys to break their security.

If that's the model, it would make a lot more sense to store one's BTC in a wallet under your own control - perhaps spread across several online storage providers, but they'll charge you minimally because they're only storing a little bit of data, and they'll provide in their contract that their liability if that data is lost is also minimal.

Answer 5

Many e-Wallets seem to run a single bitcoind server that only supports a single wallet. Thus, the default for such e-Wallets is to pool the money, and fractional banking is possible. If we could convince the bitcoind developers that it is a good thing to support many separate wallets for many users, more alternatives might appear, and sensibilizing the users to the issues might then help.