Bitcoin and Fractional Reserve: An Off-Chain Possibility?

Off-chain community governance raises delicate questions about the invisible forces operating behind supposedly decentralized communities.

A rumor is circulating (or flanking) the blockchain: Coinbase might be issuing Bitcoin IOUs for BlackRock, which some believe could be manipulating the price off-chain. These theories raise concerns about how traditional actors can influence Bitcoin without directly relying on the blockchain, opening up the debate on the risks of manipulation in parallel markets and its impact on the crypto ecosystem.

But the focus shouldn’t be on the rumor itself, not because it may not be true, but because it opens the door to analyzing a subject with many layers and which has been one of the cornerstones of the much-criticized current fiat system: fractional reserve.

The controversy historically surrounding fractional reserve banking is reignited in the context of Bitcoin ETFs and the practices of major players like BlackRock and Coinbase. These contemporary institutions (or others) could be managing the rights to digital assets in ways that deeply affect market dynamics and Bitcoin’s real value.

Tyler Durden, a crypto analyst known for his critiques of financial institutions, has been one of the primary critics of this practice. Durden has argued that the issuance of these IOUs allows large players like BlackRock to borrow more Bitcoin than they actually hold, without providing proof of a 1:1 custody ratio. What does this mean for users and the crypto ecosystem in general?

The idea behind this practice is not new. In fact, the fractional reserve system has its roots in gold management centuries ago. Goldsmiths, who safeguarded their clients' precious metal, discovered that they could lend out a portion of that gold without fearing that all depositors would claim their assets at the same time. Under this same principle, some platforms today issue more rights to Bitcoin than they actually hold in reserves. This creation of "synthetic Bitcoin" inflates the perceived supply, generating artificial pressure on the price.

Durden argues that this mechanism could be suppressing the price of Bitcoin. By creating more "synthetic Bitcoin" through IOUs, the total BTC supply in the market is artificially inflated. This increased supply reduces demand pressure, and therefore lowers the price. The problem worsens when these institutions, like BlackRock, lack proof of holding the total amount of Bitcoin to back these promises.

As mentioned earlier, the practice of fractional reserve has its roots in gold management centuries ago. Back then, goldsmiths played the role of the first bankers, safeguarding their clients' gold in secure vaults in exchange for receipts representing that gold. Over time, goldsmiths realized that depositors rarely withdrew all their gold at once, as many began using the receipts instead of the physical gold for commercial transactions.

This led the goldsmiths to lend out a portion of the gold they were holding, trusting that there would always be enough gold in reserve to meet withdrawal requests. In this way, they lent out more money than they actually had in their vaults, and the interest generated by these loans provided them with an additional profit.

Ultimately, goldsmiths could lend out more gold than they had in their vaults, trusting that only a fraction of depositors would demand their gold at the same time. While this practice allowed for increased liquidity and facilitated economic growth, it also established the foundation of a system reliant on trust, which, if mishandled, could collapse during a bank run. Does this sound familiar in the context of today's monetary system?

Here’s where the debate around fractional reserve takes on new relevance. This debate, long-standing and controversial, remains alive, especially within the Austrian school of economics community, which is divided into two main stances: defenders of free banking with a gold standard and 100% reserves, and those who support free banking with a gold standard but with fractional reserves. The controversy lies in the ethical-legal nature of the fractional reserve system and its economic effects. The most heated points of the debate revolve around three types of contracts: the classic deposit contract, the loan contract, and the demand loan contract, with the latter generating the most disagreement.

The demand loan contract possesses characteristics of the deposit contract but with a key exception: under this contract, the bank acquires the availability of the deposited asset. This raises a fundamental question about its legal validity and the potential economic consequences if this type of contract is accepted as legitimate. This is a problem that also arises in the world of Bitcoin when platforms or exchanges operate under a scheme that resembles this type of fractional reserve, issuing more promises of Bitcoin than they can truly back.

Today, some crypto exchanges and platforms could (or may...) apply a similar logic by issuing rights to Bitcoin that exceed the actual reserves they hold. This "synthetic Bitcoin creation" inflates the perceived supply, exerting downward pressure on the price, just as goldsmiths inflated the gold supply by lending more than they had.

Returning to the rumor about Coinbase and BlackRock, Eric Balchunas, senior ETF analyst at Bloomberg, cited @bitcoinlfgo's post to counter the accusations attributing the currency's price drops to traditional investors. He explained that he understood the origin of such theories, as it is easier for some to “blame the ETFs” rather than accept that it could be native HODLers themselves who are selling.

At the same time, Brian Armstrong (CEO of Coinbase) responded to Durden's criticisms by explaining the issuance and burning process of ETFs and how they are settled on the blockchain. He assured that no wrongdoing had occurred, emphasizing that operations are audited and reports are available to the public. Moreover, Armstrong pointed out that they were not authorized to disclose the addresses of their institutional clients, including BlackRock.

In the crypto environment, transparency and trust are essential for market stability. Proof of Reserves (PoR) is presented as a crucial tool to ensure that exchanges and cryptocurrency platforms do not resort to fractional reserve practices with Bitcoin. This methodology allows independent audits to verify that the entities in question truly hold the amount of assets they claim to have in reserve. Implementing PoR not only strengthens market integrity but also protects users from potential fraud or manipulation arising from opaque financial practices.

Constant monitoring of Proof of Reserves is essential for maintaining investor and user confidence in the crypto ecosystem. By regularly auditing Bitcoin reserves, the misuse of funds can be detected and prevented, ensuring that custody and asset backing promises are fulfilled. Without a robust PoR system, platforms could be operating under fractional reserve-like schemes, risking market stability and investor security. Ultimately, the effective implementation of Proof of Reserves acts as a bulwark against financial corruption and promotes a safer and more reliable environment for all participants.

Conclusion

Fractional reserve in Bitcoin is a phenomenon that can reduce its price by increasing the artificial supply of BTC in the market. While it is a common practice in traditional markets, its introduction into the crypto ecosystem could endanger the scarcity and inherent value of Bitcoin. Just as with gold and silver in the past, the creation of unsupported claims can erode trust in the asset and distort its true price. Although current on-chain statistics suggest that miners have been selling BTC, the presence of traditional finance players in the ecosystem inevitably creates an environment of distrust and suspicion. This very lack of trust, along with other factors, led to the birth of Bitcoin. Therefore, the community and HODLers must remain vigilant of financial institutions' practices to protect the genuine value of their BTC.