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Author Topic: Should the BTC protocol cater for a market driven fractional reserve world?  (Read 714 times)
bangers
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June 17, 2012, 06:33:38 PM
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Ok. I will firstly clearly state that I'm neither a techie nor an economist. What follows are probably just some ill conceived and flawed musings and I stand ready to be shot down by the obviously far wiser minds that linger in these parts. Never the less, I'm happy to put them out there in order to either open some debate or else be left a little more educated as to how this might all pan out.

I'm probably not alone in seeing what was a mild curiosity in this Bitcoin thing about a year ago turn into a mild obsession today coupled with an excitement as to where it might lead and what changes it might make to the world we live in.

So there I was, pleased to see another grey summer's day in London brightened a little by another decent overnight spike in the Bitcoin exchange rate and carried on with my usual review of the message boards. Onto one of the regular sites that maintains my interest I noticed their request of a 3BTC fee in exchange for a month's subscription. "Not unreasonable" I thought. But then I thought again and wondered why would I want to hand over any of my Bitcoins now when I'm quite sure that those 3 coins will be worth a whole lot more to me at some point in the future.

And if I'm thinking that, I'm sure many Bitcoin investors are thinking the same thing which doesn't surprise me at all as, all along, the most obvious benefit I could see in Bitcoin is in its capacity to store value. But where does that lead us in terms of a future thriving and functioning Bitcoin economy where said coins are readily used as an every day medium for the exchange of goods and services?

For anyone that subscribes to Elliott Wave Theory, it's kinda there in black and white that we humans have an incredible knack of both mirroring our previous mistakes and of eventually digging ourselves out of the holes we get ourselves into, marching on to our next phase of development albeit on ever grander scales. Inherent in this fractal process will be the claim that "this time it's different" but we all know that, so far, it never has been and most likely never will.

However Bitcoin evolves, I think that we can safely say that human nature will do what human nature does. Because of the nature of our current monetary system those of the Austrian persuasion (I guess that includes Bitcoin believers) will naturally shoot down those damn Keynesians at every opportunity. The inflation vs deflation debate will grind on for some time yet but shouldn't the limitations of a Full Reserve system of money also be considered and maybe look at the possibility that we need to find a middle ground in order to cater for the ups and downs of a healthy economy.

The reason that the money we are currently forced to use as an every-day means of exchange has been debased so much is that we have allowed its supply to be artificially manipulated by the powers that be. Ever since Tricky Dicky severed the final link to gold in 1971, and particularly since the dotcom crash, the central authorities and the banksters have consistently created an artificial demand for credit through the irresponsible setting of interest rates at levels way lower than the market would have set itself through the normal bargaining process of supply and demand. As such, humble savings continue to be destroyed by inflation and mal-investment continues to go unpunished leading to the massive imbalances and instability that we see all around us today. The issue of manipulated interest rates has been compounded by the inherent unchecked nature of our fractional reserve banking system.

If Bitcoin, or one of its future cousins, becomes a viable alternative to what we now have, shouldn't it be constructed in way that protects us from ourselves?

The idea of fractional reserve isn't necessarily a bad one as it can ease the flow and meet the demand of investment in innovation. If left to the laws of market forces, such credit would find its optimal price where risk and reward is reasonably balanced . It only becomes bad when it is left to the mercy of human greed without limitation or a reasonable and trusted system of control.

If there is to be a future world where Bitcoin is ubiquitous, unless there is an allowance for a variation in the money supply as and when the economy demands, human nature will do its thing and another unchecked fractional reserve system will eventually evolve, initially to help foster innovation and growth and eventually to satisfy human greed. We will then be finding ourselves exactly where we are today. Indeed, without any sort of flexibility in the money supply it is most likely that the deflationary attributes of Bitcoin will prevail and hoarding will kill velocity and stifle investment.

If this is to be the case, shouldn't the Bitcoin protocol consider this inevitability and be designed in a way that will allow for a market driven system of decentralised fractional reserve banking that is moderated by the market place and policed by the network? Rather, than allowing our future selves to revert to a system of trust that will eventually be abused, shouldn't Bitcoins have a feature that will accommodate a parallel "Digital Promissory Note" (DPN) protocol where such promissory notes (perhaps issued by Savings & Loans pools) are backed by actual Bitcoins at a multiplier that has been set by the market? Bitcoin owners (or, perhaps, the network) could define a multiplier to their coins and the market could then decide what the acceptable multiplier is for a DPN to be accepted as a means of exchange in the Bitcoin economy. 

At the point in the business cycle where credit is most in demand, market forces will adjust both the multiplier and the cost of credit. This will allow for an organic and flexible expansion and contraction of the money supply where mal-investors are punished when they should be whilst protecting investors from the over dilution of their base currency.

If Bitcoin allowed for a DPN connection, the network could keep track of the total fraction of actual Bitcoins that are backing any DPN at any given time keeping a real time-time record of the money supply. Future Savings & Loans pools could issue valid DPN's with a fixed multiplier as interest bearing loans backed by deposited reserves which would become acceptable tender in the wider economy. By all means, Bitcoin owners could choose to set a high multiplier to their coins but, in doing so, would run a higher risk of capital loss should an "event" cause a sudden demand for deposits. This factor would in turn allow the market to cap the multiplier as excessively fractionalised DPN's would not be accepted as a medium of exchange.

Those that are completely risk averse could opt for the pure warehouse banking that already exists and maintain the safety net of 100% demand on their deposits whilst others can opt for fixed term deposits, defining their own level of risk and reward. At the end of the term on their deposits, should they choose to do so, depositors could adjust the multiplier on their Bitcoins to match the prevailing market rate. The market will then define the upper and lower bounds of risk in the economy without inhibiting risk per se.

Any Bitcoins that have been assigned to back DPN's would perhaps be rejected by the network as a pure medium of exchange themselves. They would only be released as and when a replacement deposit has been found in order to maintain the required level of reserves. Perhaps the DPN protocol would give the DPN's issuer the first option to provide a replacement reserve deposit. If the issuer can't provide a replacement then the protocol would search the network to find a willing replacement from an alternative Savings & Loans pool.

The additional convenience of such a system is that DPN's would be fungible between Savings & Loans pools as long as they carried the same multiplier. Maybe, in times where the money supply is contracting, DPN's that carry a higher multiplier than is currently acceptable in the economy would incur a pro-rata capital loss upon redemption thus punishing the holder for taking excessive risk.

Well, that's kind of what I wanted to put out there. Very flawed, I'm sure, but maybe something to build on. Feel free to poo-poo the idea or develop it as you see fit. IMHO, if Bitcoin is to grease the wheels of a flexible and functioning economy it will probably need a certain degree of elasticity added at some point. Just wanted to open some debate on how that might eventually work.
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June 18, 2012, 12:03:06 AM
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Fractional reserve banking with Bitcoin doesn't need "Digital Promissory Notes" or any other kind of protocol change. It is already possible as it is. Any of the larger hosted wallet services or exchanges could become a fractional reserve bank right now if they wanted to by just loaning out depositor's bitcoins and hoping the depositors don't try to withdraw their bitcoins until the loan is repayed. That's how fractional reserve banking works with real money, and there's no reason it won't work with Bitcoin. The only difference is that with Bitcoin there's no government to bail the banks out in the event of a bank run.

Will pretend to do unverifiable things (while actually eating an enchilada-style burrito) for bitcoins: 1K6d1EviQKX3SVKjPYmJGyWBb1avbmCFM4
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June 18, 2012, 06:25:12 AM
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Fractional reserve banking with Bitcoin doesn't need "Digital Promissory Notes" or any other kind of protocol change. It is already possible as it is. Any of the larger hosted wallet services or exchanges could become a fractional reserve bank right now if they wanted to by just loaning out depositor's bitcoins and hoping the depositors don't try to withdraw their bitcoins until the loan is repayed. That's how fractional reserve banking works with real money, and there's no reason it won't work with Bitcoin. The only difference is that with Bitcoin there's no government to bail the banks out in the event of a bank run.


Yes. Agreed. That is how it works now on a system of trust, which is not something we're too good at. And I'm rather sure that nobody would trust an exchange or hosted wallet service to do a better job.

My point is that if some sort of Digital Note was issued and backed by an investor's actual Bitcoin that couldn't then itself be exchanged over the network unless it had been replaced by a new investor's Bitcoin to do the job then it would remove the requirement of trust and, instead, the network would ensure that there are real Bitcoins somewhere on the network backing up any Digital Notes that were in circulation. The network would then always know what the current multiplier is based on fact, not on trust. If a note was withdrawn from circulation as money supply contracted then an appropriate number of Bitcoins could be released from their role of backing that note.

The sort of change to the protocol that I would envisage to cater for this would just be a simple counter of Digital Promissory Note connections. Too many connections applied to a single coin would denigrate the value of the notes attached to it.
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June 18, 2012, 08:10:33 AM
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I don't understand how this is supposed to work. If you have multiple Digital Promissory Notes backed by the same bitcoins, what happens when someone redeems one of the Digital Promissory Notes for its bitcoins? Then the others aren't backed anything anymore, so you've got the same problem. Fractional reserve banking always relies on trust: the depositors have to trust that the bank won't make unnecessarily risky loans with their money, and the bank has to trust its debtors to pay back their loans on time. There is fundamentally no way to create debt-based money without trust.

Will pretend to do unverifiable things (while actually eating an enchilada-style burrito) for bitcoins: 1K6d1EviQKX3SVKjPYmJGyWBb1avbmCFM4
bangers
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June 18, 2012, 09:21:04 AM
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I don't understand how this is supposed to work. If you have multiple Digital Promissory Notes backed by the same bitcoins, what happens when someone redeems one of the Digital Promissory Notes for its bitcoins? Then the others aren't backed anything anymore, so you've got the same problem. Fractional reserve banking always relies on trust: the depositors have to trust that the bank won't make unnecessarily risky loans with their money, and the bank has to trust its debtors to pay back their loans on time. There is fundamentally no way to create debt-based money without trust.


On a 50% reserve ratio there will 50% of the deposited bitcoins available as "demand money" on a day to day basis. As with the current system, if everyone demands all of their notes to be redeemed at once then you have a problem but the supposition in an fractional reserve system is that not everyone will do that at once. If the issuer of the note over extended itself or made bad investment decisions then depositors lose faith and you get a bank run whereby investors will lose some or all of their deposits. DPN's would be fungible with other Savings & Loans pools as long as the notes have the same reserve ratio as that pool would also have, in this case, 50% of their deposits as reserves available as "demand money".

In the past an old school goldsmith could just get greedy and issue more and more notes against his deposits. It has been that inability to trust lenders not to do so in the past that has lead to the extremes of economic expansion and contraction. If a paper bank note could notify you that its issuer is being a bit sneaky and issuing loads more notes against the same gold deposits you'd be alerted to the fact that and go and demand your gold deposit back asap. But it can't.

A network managed system would help prevent this. You'd still have risk in the system - but risk is either rewarded with interest payments on your loans or punished by too many defaults on your loan pool. However, the issuance of notes would not be abused as any holder of a note would know what is is backed by in real time. The community would decide en mass what is a safe level reserve to be held against the notes that they are willing to use as a means of exchange at any given time rather than an centralised authority.

This would allow for economic expansion but only up to a point that the whole Bitcoin community decides is safe. Real market forces would drive expansion and contraction rather than relying on the manipulated centrally controlled system that we have today which has proven itself to be so damaging.

If over time  the economy starts to contract, either loans will be repaid and notes removed from circulation as the money supply decreases or else loans will default and investors will wear losses as they should in a free capital market economy. Rewarded for sensible risk with interest payments in good times. Punished for excessive and poorly managed risk in bad times.



bangers
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June 18, 2012, 09:47:30 AM
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I don't understand how this is supposed to work. If you have multiple Digital Promissory Notes backed by the same bitcoins, what happens when someone redeems one of the Digital Promissory Notes for its bitcoins? Then the others aren't backed anything anymore, so you've got the same problem. Fractional reserve banking always relies on trust: the depositors have to trust that the bank won't make unnecessarily risky loans with their money, and the bank has to trust its debtors to pay back their loans on time. There is fundamentally no way to create debt-based money without trust.


Forgot to add that the DPN protocol would obviously need to work in a way that, if demand money was handed out, it would need to find a new depositor on the network in order to maintain the reserve ratio.



bangers
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June 18, 2012, 10:11:43 PM
 #7

ah. I've just found "Open Transactions".'

It would seem that it's already in hand. cool.


https://en.bitcoin.it/wiki/Open_Transactions

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