Fractional reserve banking has been practiced almost since the beginning of banking. It is at the heart of all bank runs and is the reason the Federal Reserve was created. I have long believed fractional reserve lending to be an inherent evil leading to the inflation of the money supply and the boom/bust business cycle. I suspect that a most libertarians and crypto-currency enthusiasts have also developed a negative opinion about fractional reserves. In fact I have often referred to the system as fictional reserve banking.
Today I would like to explore the concept a little closer because there are many nuances that have a dramatic impact on whether or not the system is a fraud or even a Ponzi.
At the heart of all fractional reserve systems is a debt instrument, an IOU from the bank. When you put your oz of gold into the bank, the bank issues you an IOU. This IOU can take on many different forms and the form will indicate whether there is fraud or not.
One of the most basic forms for the IOU is a warehouse receipt. In this case you lend the bank your oz of gold for the sole purpose of storing in their vault. Obviously the bank has no financial incentive to borrow your gold unless you pay them for storage and insurance costs. Under this system there is no fraud so long as the bank does not do anything other than store the gold.
Banks realized that they could make more money if they could lend the gold to other people and collect interest. Under this system the depositors agree to lend their gold to the bank provided the bank pay them interest sufficient to cover the risk of default. In this case the bank is a mere broker that takes a cut of a transaction that pairs borrowers and lenders. There is no fraud under this system so long as the bank only lends the gold for the period the bank has a legal claim to the gold.
If a bank were to borrow the gold for 1 year, then they are free to do what they want with that gold as long as they can repay it by the end of their loan term. If a bank borrows the gold for 1 year and then lends it out for 30 years they have just lent gold they did not have title to. This is known as a maturity mismatch that can lead to bank runs if every depositor asks to be repaid in 1 year. This is the moral equivalent to the bank creating 1 uncollateralized IOU with a 29 year repayment schedule. If they sell the IOU as payable on demand then they have just committed fraud.
There is nothing wrong with a bank creating uncollateralized IOUs, after all everyone who carries a balance on their credit card does the same thing. The fraud occurs only when you sell your IOU as fully collateralized debt payable on demand. After all uncollateralized IOUs carry a much higher interest rate than fully collateralized IOUs. Look at the difference between credit card interest rates and mortgage rates for an example.
Fractional Reserves means Insolvency
We can conclude from this that a bank would be insolvent if at any moment in time its assets are less than its liabilities and its income is less than its interest expenses on uncollateralized debt. It is in this situation that we consider the bank to have fractional reserves. The bank will only be able to continue operation provided new depositors come in at a rate faster than withdraw requests, the classic characteristic of a Ponzi Scheme.
Insolvency without Liquidation is a Ponzi Scheme
From this we can conclude that any business can turn into a Ponzi Scheme provided it continues to operate after it becomes insolvent. The only way to escape the Ponzi Scheme is for the organization to return to solvency before it reaches 0% reserves and is forced to default on a payment.
Normally when a company reaches the point of insolvency it files for bankruptcy and all of the assets are divided among the creditors in a relatively fair and orderly manner. When a company opts to avoid bankruptcy it changes the game to one of musical chairs. Those depositing new funds are being robbed to pay off those exiting first. It has the potential to allow all of the original creditors to exit fully intact while leaving new creditors holding the bag. If the new creditors were not aware of the financial condition of the company then that constitutes fraud.
The question of whether or not a bank is committing fraud on its depositors depends entirely on the language of their deposit agreement. In most cases deposits are considered uncollateralized IOUs from the bank to the depositor. Often there is a clause that allows the bank the option to defer payment for a period of time. Without the right to defer payment all deposits would become warehouse receipts and the bank would have no opportunity to re-lend the funds.
While there is probably some fine print that you never remember signing or reading, the fact remains that most bank notes use to read “payable on demand” and thus mandate that the bank hold reserves that are also “payable on demand”. Based upon the language on the bank notes and the respective balance sheet of the banks and the practice of borrowing for a day and lending for 30 years we can conclude that the banking system is clearly fraudulent and a Ponzi Scheme.
In fact, I would argue that the easiest way to discover whether or not a system is a Ponzi Scheme is if all obligations can be met immediately when they are due. In other words, is the system solvent.
While solvency is the key to identifying a Ponzi Scheme and a Ponzi Scheme is clearly fraud, it is still possible to be technically solvent and commit fraud. If you are tricked or deceived as to the nature of the debt contract between yourself and the bank then that is also a fraud. In this case the fraud is the same as selling someone watered down milk at full price. The amount stolen is proportional to the difference in value between the milk and water. In the case of a bank, the amount stolen is the difference between the interest rate you would have demanded had you been fully aware of the loan terms.
Fractional Reserves, Crypto Currencies, and Ponzi Schemes
One of the challenges faced by attempts to create trust-free crypto-currencies pegged to real world assets is how to manage the reserves. A blockchain cannot store an oz of gold or silver so we are left with two options: ask someone to store it for us and issue a warehouse receipt as a crypto debt instrument or hold something else in reserve of equal or greater value.
We all know how the warehouse receipt game goes. Moving the debt instrument accounting from the internal database of the bank to a public transaction ledger does not change the risk or prevent the fraud that the banking system has been unable to prevent for hundreds of years.
This means that the only option available to create a trust-free crypto-currency pegged to an oz of gold is to use a trust-free crypto-currency as the reserve asset. The problem with using a different asset for reserves than what is owed is that prices are constantly changing. If you start out with 100% reserves and the value of the reserves fall by even 1% then the system has become insolvent and the Ponzi Scheme begins.
The best way to minimize the risk of turning into a Ponzi Scheme is to hold excess reserves that are sufficiently liquid that they can be sold to cover all debts. The amount of excess reserves that is prudent depends upon the expected volatility of the price ratio between the two assets.
Regardless of how much excess reserves are held, there is always the black swan event that results in excess volatility. You cannot sell a crypto-currency as being fully pegged to a real world asset under all market conditions. This would be a misrepresentation of the risks involved and the terms of the contract. That said, it is perfectly reasonable to sell a gold-bond backed by excess reserves in a crypto-currency with terms that include settling the debt with all the available reserves in the event of insolvency. This would be the moral equivalent of an insolvent bank dividing its assets equally among its creditors at the instant of insolvency. So long as everyone voluntarily agreed to these terms the system is free from fraud and never becomes a Ponzi scheme.
There is another approach that technically avoids creating Ponzi Scheme. It involves selling a crypto currency that you are not legally required to buy back at any price, but which you have established a proven history of doing so. Under this system people buy the asset because they believe it will be worth a dollar in the future. They are effectively betting you will continue to buy the asset even though you are not obligated to.
Such a system is borderline fraud if the individual creating and selling the crypto currency is not transparent regarding their ability to buy back in the future. If the market knew that the entity that has been habitually buying the asset at a dollar lacked the resources to buy back all of the assets at a dollar then the market would adopt the behavior of a Ponzi. Without the promise of a high return everyone would run for the exits. The only way to avoid a run for the exits is to promise and deliver a high return for staying in the game. This would turn the system into a clear Ponzi scheme complete with contractual obligation to pay.
BitShares and BitUSD, BitGold, and BitSilver
The BitShares network can be thought of as a company ledger that tracks the equity of the owners. These owners allow each other to create collateralized debts denominated in USD, Gold, and Silver with the terms that the debt is immediately covered anytime the collateral falls to less than 2x that value of the debt. The price information that is used to trigger these margin calls is provided by over 50 independent sources elected by the shareholders which are implicitly trusted to be fair judges of the price. The collateral used is shares in the network (BTS). In the event that the collateral falls in value relative to the bond, then the bond may be settled for the underlying collateral and all parties are made whole under the terms of the ‘contract’. The interest rate paid on the bonds is established by an auction and paid by the borrowers to the creditors.
What BitShares has created is a system with guaranteed mathematical solvency with predefined and fully transparent rules that guarantee all parties get what they signed up for and nothing less. When you buy BitUSD you accept the risk of extreme volatility but are freed from the risk of almost all reasonable volatility. To compensate you for the risk that does remain the network pays a small variable yield.
Because of this setup it is my opinion that BitUSD is the most trust-free crypto-currency pegged to the dollar. The limited trust that is necessary is that the delegates elected by the stakeholders are not going to collude to produce a false price feed. Even if they did produce a false feed they cannot force you to sell for less than a dollar unless the collateral was really less than a dollar.
Those exposed to the most risk of delegates manipulating the price feed are those that borrowed the dollars and provided the excess collateral. These individuals made a calculated bet on the value of the network growing and implicit in that bet is that the price feeds would continue to be honest.
From this we can conclude that BitUSD is entirely “trust free”, and relatively low risk within the limits of the volatility of the reserve asset and the total reserves.