How a Bitcoin Web Service can Prove it is not Running on Fractional Reserves

[Michael_S]

I have written a 12-pages whitepaper with best practice examples on how Bitcoin related web services
holding user funds can implement a mechanism by which they can prove that they are not running
a fractional reserve system.

I am curious to see when the first service will implement this.

http://de.scribd.com/doc/137653644/Bitcoin-prove-not-fractional-v01-pdf
https://dl.dropboxusercontent.com/u/18219492/Bitcoin/Bitcoin_prove_not_fractional_v01.zip (incl. PGP-signature)

UPDATE: version 0.2b:
http://de.scribd.com/doc/143811117/Bitcoin-prove-not-fractional-v02b-pdf
https://dl.dropboxusercontent.com/u/18219492/Bitcoin/Bitcoin_prove_not_fractional_v02b.zip (incl. PGP-signature)


Abstract

Many Bitcoin related web services, like Bitcoin exchanges, online wallets and many others, allow
their users to open accounts and store Bitcoins with them. The question arises whether these web
services always have liquidity over all the funds that users have deposited, or whether they have
withdrawn (i.e. embezzled) some user funds for other purposes like investment, speculation or
straight fraud.

Such unauthorized withdrawal of a certain percentage of the user funds would remain undiscovered
as long as the users keep their funds with the web service. However, as soon as users start to
withdraw their funds at large scale, the fraud would become evident.

This paper suggests a mechanism by which a Bitcoin-based web service can publicly prove at
regular intervals that it is still in possession of all user funds (=Bitcoins) - a monthly interval is
recommended. Also between these "publication times" the web service can show in a plausible
manner that it does not lend/share its funds to/with other web services.

Thereby, such web services can create substantial trust and credibility with their clients and get a
significant competitive advantage over similar web services that do not implement this mechanism.

In the long run it is desired that the outlined mechanism becomes a quasi-standard amongst all
reputable Bitcoin web service providers that hold user accounts with Bitcoin funds.

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[Birdy]

Wow, if this works and is widely used it could solve a lot of problems.

[oakpacific]

A less accurate/transparent but easier method is for the service to move their holding to themselves once per month, and publicize the transaction for everyone to see.

[Etlase2]

Wow, if this works and is widely used it could solve a lot of problems.

Seems like it falls under the obvious category to me, the question is always whether or not services are willing to release this kind of information, especially when you take into account that not everyone has to believe that bitcoin's anonymity only applies to non-business entities. It isn't a slam dunk to say "if businesses reveal private data we will know if they're cheating!"

edit: I'm of the opinion that they should, while of course keeping account information private yet verifiable by the account holder. And I think the OP's assessment is correct in that businesses that go this route will find people seeing them more favorably than those that don't.

[Xendrios]

probably best to link useraccounts to an id

Use the id instead of the usernames to protect privacy some more...

[QuantPlus]

It's called segregation of Customer funds...
And only applies to specific industries like exchanges and brokers.

[agentbluescreen]

It's called segregation of Customer funds...
And only applies to specific industries like exchanges and brokers.

Well no, it is and always has been endemic to the operation of trading exchanges who by virtue of their business model are required to "pool" both cash and BTC in hopefully "segregated" accounts, but it's also a temptation any online "wallet" system would also be vulnerable to.

It's true that segregation is the best and lower risk, lower profit policy, but it often simply does not make "business sense" for them to do so. This has always been the "bankstering" case from the ancient coin banking-smiths of old to the paper banking-smiths that popularized the "Paper Receipt Notes" we all use as "mediums of labour-exchange currencies" today. If idiots are foolish enough to lend you their assets for free you have to be a fool not to make the best advantage out of holding them all!

Bankstering and money exchanging began long before the invention of worthless paper Receipt-Notes. In 48BC Julius Caesar was among the first to take notice of these frauds and implement a publicly owned for public profit mint and coinage system to both combat (private profiteering, usury and corruption) and return the profits from the operations of it's sorts of vital economic necessities to the public benefit. Indeed, he was subsequently assassinated, largely by them primarily because of his largess.

The war between public servants and corrupt private banksterers is as old as history itself.

[Michael_S]

A less accurate/transparent but easier method is for the service to move their holding to themselves once per month, and publicize the transaction for everyone to see.

Publicizing their holdings in Bitcoins is one part of the scheme, yes.
The other part is to publicize their users' holdings (in an anonymized yet user-assignable form).

Implementing only one of these two things is hardly of any value.

Just imagine BullionVault.com would publish the amount of gold they are holding for their customers - like 5 tons, or 500 tons... just a number that would be meaningless, unless they also publish their users' holdings for comparison.

[QuantPlus]

It's called segregation of Customer funds...
And only applies to specific industries like exchanges and brokers.

Well no, it is and always has been endemic to the operation of trading exchanges who by virtue of their business model are required to "pool" both cash and BTC in hopefully "segregated" accounts...

This is not what is meant by "segregation".

If you give $100 to Amazon...
They can account for that money any way they like...
And use it any way they like, because they are not in the "investing" or "gambling" business.

On the other hand...
If you give $100 to Scottrade...
They must hold the funds in a special segregated account...
And it is illegal to use the funds to capitalize and grow their business.

The Securities Exchange Act of 1934 tightened up the rules...
After the abuses that led to the 1929 stock market crash.

The Bitcoin universe is not even aware of how the regulated Securities Industry works...
That's why BTC exchanges will get shut down one by one (including Gox).

These regulations are in place to protect ordinary people from ruthless predators...
To safeguard things like retirement accounts for granny...
It's not some wild-eyed bankster conspiracy.

http://en.wikipedia.org/wiki/Securities_Exchange_Act_of_1934

[kjj]

Just out of curiosity, is your scheme better, or at least different, from the several other schemes that have been posted over the years to "solve" this "problem" ?

[Michael_S]

Just out of curiosity, is your scheme better, or at least different, from the several other schemes that have been posted over the years to "solve" this "problem" ?

Hello kjj,

this scheme is the result of taking what is practiced at BullionVault.com in the context of physical gold, and mapping this principle to the Bitcoin use case, plus adding some own thoughts.

So the whitepaper represents the best scheme that I could think of today.
Of course, any comments, criticism, suggestions for improvement are welcome.

I made a first suggestion along these lines on 11 Aug 2011 in this forum, in the "flexcoin.com" thread (this company is essentially a bitcoin wallet provider, but the first one that calls itself a "bitcoin bank"), and I suggested them to prove that they do not run a fractional reserve system - but they did not seem to (want to) understand the benefit of it.

You can find my postings from that thread here:

• My initial posting on this
• further posting
• further posting (including a good posting of kjj)
• Another posting giving a concrete best practice example

kjj, I am realizing that you have been thinking along the same lines as me in that thread nearly two years ago, and have well explained in your words what I was intending to say.

Now I have revived this topic because I thought it is a good idea to put the complete concept into a single, self-contained whitepaper.

All my ideas of that previous thread are included in this whitepaper. Concerning terminology, my whitepaper calls "secret user name" what I called "secret ID" in the other thread - in fact it is exactly the same thing. Maybe "secret nick name" is even better, I think I will use that term in the next revision, to avoid confusion with the (public) "user name" or with the "login name".

In addition, I have added in the whitepaper a way how the web service provider can not only prove that he is (still) in possession of the Bitcoins, but also that the Bitcoin addresses that he is publishing as his own addresses, are indeed owned exclusively by him, and not shared with another, similar, web service provider.

If there are any further descriptions of schemes that have been posted over the years (I don't know of any), I would be interested to get some links. Without having seen them yet, I am guessing that one advantage of "my" scheme might be that it is given not only in the form of some (incomplete?) ideas posted in some forum possibly spread over several posts, but that a complete description exists in the form of a single self-contained whitepaper with best practice guidelines.

It would be great to collect comments, ideas, suggestions from the community, such that there will be a consolidated whitepaper v1.0 in the end.

[kjj]

Awesome!

To be honest, I didn't look up the old posts, and so I didn't recognize your name.  A bunch of people have posted similar things over the years, none of which seemed to be aware of the work you'd already done.  Very happy to see that this is from you, and not from yet another noob that was unwilling to search.

[agentbluescreen]

It's called segregation of Customer funds...
And only applies to specific industries like exchanges and brokers.

Well no, it is and always has been endemic to the operation of trading exchanges who by virtue of their business model are required to "pool" both cash and BTC in hopefully "segregated" accounts...

This is not what is meant by "segregation".

If you give $100 to Amazon...
They can account for that money any way they like...
And use it any way they like, because they are not in the "investing" or "gambling" business.

<<<clip>>>

The Bitcoin universe is not even aware of how the regulated Securities Industry works...
That's why BTC exchanges will get shut down one by one (including Gox).

These regulations are in place to protect ordinary people from ruthless predators...
To safeguard things like retirement accounts for granny...
It's not some wild-eyed bankster conspiracy.

http://en.wikipedia.org/wiki/Securities_Exchange_Act_of_1934

Oh, yes, indeed it is!  ROTFLMAO

FYI a bitcoin is technically classified as an "over the counter (OTC) derivative" it is NOT a "common nor preferred share" in a business "security" (since it is pure-fiat, unbacked and representative of nothing but itself), nor is it token of a "Future Quantity Buying Contract" for any quantity of commodity, material product or produce. It only "represents" the right to an externally derived future exchange-value of itself accepted between it's counter-parties.

A Bitcoin is a commercial "over the counter (OTC) derivative" of the future possible values of itself and it's network, which are only (at best) commercial resources, and not "commodities".

Bitcoins and those who trade or exchange it are totally, completely and invincibly "DEREGULATED" in ALL REGARDS save for so called general “safety and soundness” standards (nobody bitches). Bitcoins (a straight-up "confidence gamble")  fall under the blanket gaming "bucket shop" exemptions to the CFMA that were placed there to exempt State casinos and back door "funded credit default swap" (fCDS) instruments (largely used to bid-rig market prices) from any and all regulation, and therefore, what is good for the private bankster goose is great for the public currency gander.

http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

You see almost every other day either Morgan or Goldman go nearly bankrupt dumping (so-called "naked" shorting) massive gold and silver futures contracts to depress their prices and make practically income-less Bonds and counterfeited FRNs look more attractive. In fact they are never "naked", they just ping-pong the (thus -"funded") "counter-party losses" back and forth (keeping any profits of their own) out their back doors effectively sharing known, prearranged, totally "deregulated" fCDS swapfunds to sustain each of their maximum daily losses.

A Bitcoin functions exactly in exactly the same way as a CDS. You fund it's former owner's "loss" (costs) on it, and the next owner funds yours.

Somewhere here I came across somebody wanting to know why none of the BTC Markets did not also trade Investments, Indexes or Funds etc...  Obviously here is your reason.

next answer please....

[Anon136]

A less accurate/transparent but easier method is for the service to move their holding to themselves once per month, and publicize the transaction for everyone to see.

yea i thought about that right away but the problem is they could hire someone who does actually have a lot of btc to do it for them.

[Walter Rothbard]

One great tried and true method for keeping money deposit holders honest:

A Run On The Bank!

Bank runs are wonderful for flushing out this kind of thing.

[agentbluescreen]

One great tried and true method for keeping money deposit holders honest:

A Run On The Bank!

Bank runs are wonderful for flushing out this kind of thing.

Indeed, the rather more vulgar term for "stress tests"  LOL

[Michael_S]

I just submitted an update (2nd version) - I think it is quite complete now - see updated original post for the links.

There doesn't seem to be too much interest yet. Probably most people do not understand what a fractional reserve system is - otherwise our today's financial system would not be where it is today.

Anyway, as more and more bitcoin web services evolve and new cases of user funds' losses and frauds show up, I think the interest into this may increase, and then it is good to have a reference where to point at - the bitcoin web service provider just needs to be asked to implement what is described in this whitepaper.

[roy7]

Hope this isn't too offtopic, but couldn't a web service / exchange / pool allow the user to supply their own public/private key for their account (a separate wallet than they normally use, only used for this web service). Then they can always see what is on deposit by checking the wallet for that account, can withdraw/deposit any time by simply doing a transfer in their own wallet.

Since bitcoin is unique, I think, in the sense your "funds" are simply stored on the blockchain and thus multiple copies of the wallet could exist simultaneously (with user and web service).

[Michael_S]

Hope this isn't too offtopic, but couldn't a web service / exchange / pool allow the user to supply their own public/private key for their account (a separate wallet than they normally use, only used for this web service). Then they can always see what is on deposit by checking the wallet for that account, can withdraw/deposit any time by simply doing a transfer in their own wallet.

Since bitcoin is unique, I think, in the sense your "funds" are simply stored on the blockchain and thus multiple copies of the wallet could exist simultaneously (with user and web service).

In principle possible, but the web service does not want to go via the blockchain for every action that the user does in the local environment of the web service. Hence the web service's local ledger is different from the blockchain.

This becomes increasingly relevant in the future when tx fees increase due to competition in the blockchain, which will make off-blockchain services for various purposes increasingly attractive (and due to the possible abuse of "fractional banking", the need for proving that a web service is not running fractional will become increasingly relevant).

So theoretically yes, practically no.