Bitcoin Forum

This topic just get hot recently

After several Chinese exchanges opened the option to do leveraged trading, many doubted that they can essentially create many bitcoins out of thin air based on fractional reserve principal, then they could use those coins to short the market and squeeze out many traders to get real coins in their hand

Of course, they can also create fictional fiat money to push up the price by many folds using the same practice, most possibly MTGOX has already done that and that is the main reason the exchange rate fluctuated so dramatically before

So what is your opinion about this? Even if you auditing an exchange and make sure their cold storage contains 50K coins, it does not stop them from creating 500K coins sell pressure using a fractional reserve ratio of 10%

I wouldn't touch these exchanges even with a ten foot pole. Too many manipulation can occur in these.

I don't like the idea.

As long as the exchange is not large enough to move the market, and bitcoins and fiat can flow freely in and out of the exchange, would it be profitable for the exchange to create imaginary buy/sell pressure?

leverage and margin trading is destroying the Bitcoin price ...

Yes, when the price is high, the exchange sells leveraged coins to the market. When the price is low, they buy back or still sell leveraged coins. They makes lot of profit from trading in terms of fiat.

only if fully disclosed to site users.  otherwise it could mean insolvency.

I think it's a terrible idea. If I wanted fractional reserve instability than I'd just buy USD, not bitcoin.

The exchanges are free to do whatever though, and people should vote with their wallets. But they must be responsible enough to at least tell everyone how they operate. 

Of course not, but the question is what you can do to prevent them from creating too much volatility in market?

If one of the large Chinese exchanges are taking a market share of 15%, they can essentially sell millions of bitcoins on the whole market and push the price into single digits and crash people's confidence in bitcoin, and people can not do anything about it: The only thing you can do is to withdraw coins from the platform thus they will have a bitcoin bank run, but as most of the people on Chinese exchanges are speculators, I doubt they even want their bitcoin back if the price dropped to that low  ::) Besides, many people still don't want to withdraw bitcoin since it is too easy for them to lose it without proper IT knowledge, they regard the exchanges like a stock exchange, they trade there but never touch a bitcoin/stock

The main problem is that currently there is no regulation for bitcoin exchanges anywhere, and maybe there will never be


On further thoughts, another exchange might use the same trick to create fictional fiat money to buy lots of coins on their platform, and let the arbitrager to drain the bitcoins from the other exchange to make a bitcoin bank run for them... We need more exchanges

buyers and sellers create the volatility not the exchange in and of itself.  FWIW why is no regulation a problem - regulation doesn't solve the faults of fraud and incompetency that we see in the existing banking systems  - we need decentralized exchanges with a mechanism to use them in a centralized "liquid" manner - the ability to take 5000 usd and use it efficiently across X number of exchanges with just one account to be able to either buy 5000 worth of BTC or sell 5000 worth of BTC across them all.

It's a criminal enterprise.

Same as you claim banks are criminal enterprise, it does not stop them from using FRB and creating financial crisis

Actually I don't really know how stock exchanges are regulated. For example, could a stock exchange create fictive stocks and short them to crash the market? I think they can not, there might be some kind of third party auditor holding all their stocks so that they could not create stocks out of thin air by using FRB, they can only request deposit or withdraw of equities from that auditor upon customer request

In bitcoin's case, the exchange are holding both fiat money and bitcoin, no one knows how much fiat/coins they indeed have, unless there is a panic withdraw, which is very seldom

An exchange going for transparency could perform and display real time btc holdings data to its users.  Or at least a daily audit of crypto holdings.  This wouldn't stop other exchanges from practicing fractional reserve but it would give us a choice when we are choosing which exchange to use.

+1

Fractional reserve banking is a scam, all financial exchanges or places of businesses should operate purely on a 1:1 ratio of whatever they hold and what is represented digitally.

Yes that can be done, but it does not stop even this specific exchange from practicing FRB

For example, an exchange through third party auditor shows that they have a daily holding of 50K+ coins in their cold wallet address. Customers can be sure that their coins are safe

However, on exchange's platform, everyone's account balance is just a number, only when you withdraw, they need to take bitcoins out from that cold storage, in the daily audit, they always have 50K+ coins in their cold wallet (suppose the amount of  customer deposit and withdraw are almost equal)

Now since all these 50K+ coins are just sitting there collecting dust, the exchange could loan out 80% of those coins to themselves (they can not loan out to other exchanges, that will affect their cold storage balance). That is just an accounting record on their own book. Now suddenly they have 40K coins at hand ... to sell

So they start to dump all these coins on the exchange and drive the price much lower, and will cause more panic sell and they collect real coins during the process. The interesting thing is, customers can see that the amount of coins in their cold storage even increased, but most of the customer won't withdraw bitcoin, they might even want to sell the coins and withdraw fiat money, this will create a liquid squeeze of fiat money and very quickly the fiat money on exchange will run out, and the price crash hard

Of course then smart money will run into this exchange to buy coins and withdraw, the withdraw will directly affect exchange's cold storage thus they have to buy back coins to reduce the size of their loan, but if the price were so low and many people's confidence of bitcoin get hurt, it will take a long time to recover

The best solution from a user perspective is to withdraw bitcoins as soon as you bought it, never leave a satoshi on the exchange, but I think many of them just left their coins/money on the exchange due to old habit in stock/commodity trading

I'm no expert, but I will disagree this time. 

They should have third party software performing the Merkle construction once a day lets say.  A second "third party program" could verify individuals account holdings (crypto only mind you) by checking hash values.  This program would be encrypted and stored on exchange servers by a third party.  Then individuals could be assigned personal private keys to decrypt and run the verification software as they please.  The private keys could be stored locally on customer devices.

Encrypting and MACing the verification software would ensure the exchange themselves could not alter this software.  As long as enough users verified their holdings periodically they might be able to prove the exchange was not holding less coins than that declared by the daily merkle tree.

This is not an audit of course, more like an inventory check.  I am I missing something?

Agreed completely.  What is concerning is that it is very easy to implement a proof of reserves feature; why aren't all exchanges doing this?

It's big trouble. It's just a matter of time before the exchange owner blows the money on alcohol and girls. This is a real problem with high rollers in china. I try not to use an exchange and when I do I try to avoid china but when I can't I get my money back as soon as possible.

I think that is real. Look at the fiats market, USA's credit, and other economics global credits with fictional fiats. After that btc fictional credit story look like a joke.

I would disagree that traditional fractional reserve banking is a scam.

What happens in a traditional fractional reserve system is that someone deposits $100 in a bank, so the bank would have $100 in assets (the $100 bill) and $100 in liabilities (the deposit to the account holder). What the bank will do with part of the $100 is they will lend it to a borrower. So now they will still have $100 in assets (now a $10 and $90 that is owed to them from the borrower) and $100 in liabilities (the same $100 deposit).

What is potentially happening with Chinese exchanges is they are taking a 1 BTC deposit, and spending some amount of it, say .1 BTC. In this example they have only .9 BTC in assets (they spend the .1 on themselves) but 1 BTC is liabilities. Hopefully you can see how different these two scenarios are.

They could do what you describe in your OP without leveraged trading.
Leverage is a tool for investors *cough* to lose their money faster *cough* and not a way for exchanges to rig the system.

If an exchange is untrustworthy can just run away with your money. They don't need to introduce more trading options for that to happen.

When you deposit 10 bitcoins into an exchange, they move those coins into their cold storage, and they publish that address, so that you can check that they indeed have your bitcoin in a secure place, this is all fine

And then you open the trading platform, place an order of selling 10 coins and receive 5K dollar. On your account, you will see that you now have 0 bitcoin and $5K, but if you look at that address they provided you, you will see that those bitcoins are still there

So what you see on the trading platform is exactly like what you see in your bank account, those are just numbers in a database, they changes upon your trading activity, but the real fiat/bitcoin never moves until you do a deposit/withdraw

Actually the trading activity on platform always carry out in a database, never touch the real money. Suppose that the exchange added an account into the database, which has 30K bitcoins, then this account could immediately start to sell those coins on the exchange, without physically have 30K coins at all

The key for auditing is this database. By manipulating this database, an exchange who has only a little coin could create huge amount of  coin transaction volume by creating fictional coins in their database. That is the reason some of the Chinese exchanges suddenly had that huge volume during last year

I saw BTC china just provided open letter to let third party to audit that database, that is a great step forward, but all the other exchanges provide no such transparency so far

I've been saying this and no1 listened.

Most of the westerners dont understand crap about Chinese culture. I'm not discriminating but its the fact that when it comes to money, Chinese are all about cheating.

Look at Chinese stock market and all the scandals from "investment brokers"

Regulation in China  means " corruption". Most Chinese stock traders are actually low income citizens (factory workers, minimum wage labourer), they treat stocks as gambling.


I'm shocked and disappointed to see NO ONE asked Houbi , OKcoin at whatever conferences they participated about proof of transparency. Its safe to assume they're all thieves. In China, thats 90% the case.

Well, bitstamp and btc-e also don't provide such transparency, and MTGOX used to be the worst

It is a fact, since trading data and real money are separated on the exchange, there is a lot of room to play around, just like a bank do, you never know what is going on behind the scene until one day that bank suddenly claim a liquidity crisis -- their vault has been emptied since long ago, all the numbers on their customers account are just virtual

Fractional reserve is almost necessary for exchanges to run without having massive amounts of principal.

I would disagree that traditional fractional reserve banking is a scam.

What happens in a traditional fractional reserve system is that someone deposits $100 in a bank, so the bank would have $100 in assets (the $100 bill) and $100 in liabilities (the deposit to the account holder). What the bank will do with part of the $100 is they will lend it to a borrower. So now they will still have $100 in assets (now a $10 and $90 that is owed to them from the borrower) and $100 in liabilities (the same $100 deposit).

What is potentially happening with Chinese exchanges is they are taking a 1 BTC deposit, and spending some amount of it, say .1 BTC. In this example they have only .9 BTC in assets (they spend the .1 on themselves) but 1 BTC is liabilities. Hopefully you can see how different these two scenarios are.
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Right. Trouble can occur if a bank has bad loans, which is what caused the last financial crisis. But there were real loans, and real houses behind them. What happened was that the value of those houses declined, and the people owning them stopped making payments.

Also, banks are heavily regulated, and in many countries backed up by deposit insurance. No US depositor lost money because the bank in which they had a deposit made bad loans. (Many bank depositors in Iceland did lose money. Look up "Icesave".)

Fractional reserve banking does not mean the bank gets to skim off most of the money.

Well, duh. If you want to run a financial institution, you have to have some money.

Fractional reserve is ok if they are willing to cough up any loss due to taking risk on directional bet or even lending.

Have you ever heard of MT. Gox?  If not why don't you take a google they tried fractional reserves..  Did not go too well.  This is why we the gov should keep the F out.. alas they are pigs and will attempt to countrol everything to give the other pigs at the top an advantage.  Lucky for us most of them cannot create a txt file.

I 100% disagree.  It is criminal our entire monteary system is criminal.

What do you mean? By historical standards the price has been remarkably stable lately.

Educate people to avoid exchanges without proven reserves.

As long as people are aware that these exchanges are doing fractional reserve, the selling of fractional reserve bitcoins should not affect the bitcoin price. Real bitcoins will trade at a higher price than bitcoin IOUs.

As long as they are very clear about what they are doing I don't have a problem with fractional reserve in principle, but if exchange owners are doing this to trade on their own exchange to the detriment of other users then surely people would just move to a different exchange?

If a business wants to engage in fractional reserve practices then they need to offer something to their users in return for taking the risk of allowing the business to do this, like interest payments or something. That way people can choose - play it safe by using a service with no fractional reserve or take a risk on trusting a business with their coins in the hope of getting a share of the profits.

Those companies need to change their names. The idea of exchange cannot get along with the idea of fractional reserve, and this is just another reason not to leave any money at an exchange. Exchanges are made to trade, nothing else. I guess some people haven't learned anything from the MtGox fiasco.

What most exchanges that are likely operating on a fractional reserve are likely doing are spending their customer money. What a "real" fractional reserve exchange should do is use a portion of customer deposits to lend money to borrowers with the hope that, after interest payments and customer defaults, they will have a net profit on their loans.

Exchanges could lend these coins to themselves to short the market and trigger speculator's stop-loss. Since they have all the customer's coins on exchange, based on FRB principle they could borrow 90% of the coins, they could greatly crash the price to wipe out everyone, because no single big whale have the amount of capital to deal with all the coins on that exchange (Whale's money is only part of that pool)

For example, an exchange have 50k coins, and the amount of fiat money on exchange is 25 million, which maintains an exchange rate of $500. Then exchange borrow 45K coins to themselves and short the market, so all the fiat money on that exchange will be quickly drained, and the exchange rate could cut by half or more

Then the bargain hunters will rush in to deposit and buy coins to withdraw, money arrives after several days, exchanges will soon find out that they are facing a much larger withdraw than 5K coins (the rate under normal market condition), that will dramatically reduce their reserve and they have to buy back coins to reduce the withdraw pressure, then the price will recover quickly

Bitcoin world is wild west, no regulation on exchanges for what they can do

Great observation, as long as the banks/exchanges take their own loss, they can do whatever they want. But in reality, since customer's money is kidnapped by them, you have little option if they incur a huge loss and have nothing for you to withdraw

I think this would be very risky. First of all if people started to withdraw their coins before the exchange can have an impact on the market then the exchange would be forced to repurchase the BTC at a potentially higher price. Also if the exchange were to crash the market in the way you described then their average price per BTC that they get from their borrowed BTC would likely be less then where the price would be once the market recovers as buyers would likely stop buying when the market is in a free-fall.

Right. A big problem with Bitcoin exchanges is that they act as broker, custodian of assets, transfer agent, and exchange. In the real world, those functions are separated.
The NYSE does not itself handle money or stocks. It's just an order-matching service.

Fractional reserve exchanges are a terrible idea.  I think all of them should be required to have audits showing they have 100% of everybody's coins.  Leveraged trading is okay if everything is transparent like Bitfinex, but not just making BTC out of thin air.

The only way that bitfinex can lend bitcoin is by borrowing bitcoin from it's other users (it would be too expensive to lend out their own bitcoin).

Bitfinex is essentially working on a two tier system. One - 100% reserves for people who simply have their bitcoin on deposit there. Two - fractional reserve for people who have invested in swaps, these people receive some amount of interest in return for being on the fractional side.

Banks use fractional reserves because they invest and borrow money, so they gain money with the customer's money.


But how an exchange can earn money with customer's funds? They don't borrow money, also they don't have the same level of protection from the State as banks.

Can't see it not ending as Gox.

They don't need customer funds to earn money, they just need to create their own virtual funds

A simple example: I'm an exchange and I create an account with 1 million bitcoins, then I dump those coins to drive the price down from $500 range to $50 range, then I buy back all of those coins and drive the price back to $500 range. This account still have 1 million bitcoins but also have 1 million x $100 = $100 million dollars (Suppose the average profit is $100 during the sell-off). This is a very profitable business, I don't see the reason why exchanges don't want to do it?

From exchange's perspective, the only risk is: When they sell the coins, there might be large buyers absorbed all their coins thus force them to buy back at a higher price. But exchanges see all the clients' data, as soon as they see the large amount of customer deposit is arriving, they could always abort the operation before those fiat money are credited to the customer's account. They could even delay the deposit process to make more room for themselves

This is known as "speculating with customer funds". It's a form of theft. The US SEC (http://www.sec.gov/litigation/complaints/2014/comp23058.pdf) routinely has people prosecuted for this.

We can do much, much better than that.

Exchanges can work together form m-of-n multisig pool in which to store customer deposits, then audit each other continually in real time, provided that they can provide cryptographically secure proof of liabilities.

This arrangement is called a voting pool (http://otblog.net/2014/05/voting-pools-stop-plague-bitcoin-heists-thefts-hacks-scams-losses/).

Proof of solvency alone is pretty much pointless, since a fraudulent exchange can prove solvency right up until they decide to take the bitcoins and run.

The voting pool arrangement means that no exchange can unilaterally refuse to honor withdrawal requests - they have to convince a majority of the exchanges simultaneously.

So once they are deployed we should see a substantial reduction in the amount of exchange fraud, at least on the Bitcoin side (there's no such thing as multisig for USD).

This is one thing that the NY regulations are going to try to prevent via audits of balances in customer accounts and audits of bitcoin balances. It would increase costs a little bit however it would result in more security for the customer

I think this would essentially make it impossible to create new customer deposit addresses more then once per day (or would be limited as to how many they would be able to create). This would potentially create negative customer experiences across all bitcoin exchanges.

I think it would also create a false sense of security for keeping bitcoin at exchanges as multiple exchanges could potentially work together to be able to run away with their customer deposits.

No, it wouldn't. Why would you think it would?

Right now, exchange operators need to cooperate with nobody in order to run off with customer deposits. This would be an improvement.

It will lead to the bust of many more exchanges and the theft of many BTC.
Our job is when it happens to teach people this is the correct way of how things operate and the gov should NOT be there to bail out bad players that have been raping you.