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A comment on this answer pointed out that the total amount of bitcoins in circulation could appear to go above the limit of 21m if wallet services use a fractional reserve system. However, in that scenario you actually no longer have bitcoins - instead, you have some kind of bitcoin-credits that rely on a specific 3rd party to be used.

If my understanding is correct, it should be possible to determine through the blockchain whether a given e-wallet service:

  1. Definitely isn't using fractional reserves for a given account, or
  2. Might be using fractional reserves

How would this be done? Has anyone summarised this information for a selection of e-wallet services?

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There are two types of EWallets, hosted (shared) EWallets and hybrid EWallets.

With hosted EWallets, all the coins are shared (all customers funds are combined) in the host's EWallet. Examples of this are Paytunia.com, Instawallet.org, EasyWallet.org, WalletBit.com, as well as the online wallets with the exchanges, such as MtGox.com, Bitfloor, etc.

Hybrid EWallets are those that operate locally either from the browser (using Javascript) such as how Blockchain.info/wallet and StrongCoin.com operate or from a client like how Electrum (Windows, Mac, Linux, Android) or BitcoinSpinner (Android) operate.

With a hybrid EWallet, the private keys are kept locally but transactions route through the EWallet provider. To protect from loss, the browser-based hybrid wallets store an encrypted copy of the data from the wallet online with the EWallet provider. The provider doesn't have the password to decrypt the wallet stored with them and thus has no potential to spend your coins stored with them.

So your risk of fractional reserve exists only with the hosted EWallet providers.

One method these providers could prove they are not a fractional reserve would be to submit to sporadic financial audits. None do this today.

Another option would be for the EWallet provider to treat each account as if it were a standalone wallet. That way the blockchain would verify that the coins received have not been spent. No EWallets operate this way either.

When multisignature becomes functional, this will likely be a security feature available from one or more EWallet providers.

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    Also, the terms and conditions from the EWallet provider will specify what the service takes responsibility for. To protect themselves, most that do provide a terms and conditions will declare no liability from losses due to theft (hacking) either explicity or under a force majeure disclaimer. i.e.., you have bigger things to worry about than fractional reserve.
    – Stephen Gornick
    Commented Jul 12, 2012 at 21:27
  • In fact, with a fractional reserve, fewer of your Bitcoins are at risk of loss through electronic theft. The wallet service can also make money by loaning your Bitcoins out, allowing it to provide a better service, serve fewer ads, be less likely to feel the need to run off with your Bitcoins and disappear, and so on. It's the services that you can't possibly figure out how they manage to be profitable that you need to worry about -- there whole business model may be to disappear as soon as they hold maximum deposits.
    – David Schwartz
    Commented Jul 12, 2012 at 23:27
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    @DavidSchwartz: I would much rather have the eWallet 1. Be open about what they're doing, and 2. Give me a choice whether I want to pay a fee for his services or let him borrow out my money.
    – Meni Rosenfeld
    Commented Jul 13, 2012 at 2:27
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    @MeniRosenfeld: You may be the only one, and it's hard to build a business model around that. Most people will just go to the service that charges the least. But I definitely agree that these services should be open about what they're doing. Unfortunately, not a lot of people see to care about that either, which forces a race to the bottom.
    – David Schwartz
    Commented Jul 13, 2012 at 2:29
  • @DavidSchwartz: I'm the only one that wants a choice? Well, implicit in my comment is that I would also choose to pay a fee in most circumstances, and in that I may be a minority - but that's irrational, one should prefer to loan out his funds explicitly to someone who will give much better rates, more than the fees spared.
    – Meni Rosenfeld
    Commented Jul 13, 2012 at 2:36
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Verifying that an eWallet doesn't do fractional reserve requires collaboration on its part (and its users), and I hope in the future most will collaborate this way.

Every user will choose a unique identifier (which can be unrelated to any other identifying detail if they wish, or not if they want their ownership to be known publicly), and the eWallet will have a public list of the balance of each identifier, rounded to improve anonymity. From this the total amount deposited can be calculated, and each user can verify that his own record is on the list to make sure he's not underreporting. Once in a while the eWallet will move all coins in a single transaction to address(es) provably his own, this way he can show he has all deposited coins under his control.

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  • Isn't what you describe pretty much already available if the eWallet service gives you your own receiving address and leaves the coins against it? The balance against the address can be calculated from the blockchain (such as using blockexplorer).
    – Highly Irregular
    Commented Jul 13, 2012 at 5:01
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    @HighlyIrregular: Yes, but that requires the eWallet to keep the coins of each customer in the receiving address. This may be at odds with how the eWallet handles the coins, e.g. hot/cold wallet separation, green addresses etc.
    – Meni Rosenfeld
    Commented Jul 13, 2012 at 6:56
  • I don't think there is any need to check this, since there is no reason to pool the money if you do not want to do a fractional reserve in order yield interest.
    – Dr. Hans-Peter Störr
    Commented Jul 18, 2012 at 6:53
  • @hstoerr: No reason for the user or the eWallet? This is demonstrably false for both.
    – Meni Rosenfeld
    Commented Jul 18, 2012 at 9:08
  • @MeniRosenfeld Care to share those reasons here: bitcoin.stackexchange.com/q/4199/1595 ? I simply do not see another compelling reason for the e-Wallet provider.
    – Dr. Hans-Peter Störr
    Commented Jul 18, 2012 at 19:41
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Every eWallet that pools the users money will do a fractional reserve since there are only two compelling reasons to do so: either to re-lend the money at an interest, or to run away with it at some point.

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    In fact, I am amazed to learn that the users allow the eWallets to replicate traditional banking structures - in times when the more obvious problems with this are omnipresent in the media. I'd never give up control of my money like that.
    – Dr. Hans-Peter Störr
    Commented Jul 18, 2012 at 6:55

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