The Future of Banking is Full Reserve Bitcoin

The inevitable failure of central banking will deal a fatal blow to fractional reserve banking. At the same time, cryptocurrencies — and particularly Bitcoin — are on the rise and could be given the occasion to replace the fiat currencies. The real question is whether the adoption rate will be high enough when the time comes. That’s where we can make a difference.

Now, as central bankers from Washington to Frankfurt are beginning to backpedal their plans to hike interest rates and are raising voices to cut the rates instead, the near-term once again looks like more easy money to the stock market and more sleepless nights for those who understand where all of this is heading.

There is serious talk between the central bankers and their advisers about “extending the business cycle”, which translates to even more aggressively piling on the already bloated central bank balance sheets in order to artificially maintain the economic boom in the fear of any significant downturn being a trigger for the grandest economic bust ever experienced.

Such fears are well justified. However, “extending the business cycle” is roughly the same as when an already heavily intoxicated person keeps drinking in the fear of the inevitable hangover. Drinking more will merely postpone the hangover — and makes it tremendously worse too. And in the real world you don’t get to sleep it off.

Thanks to these “business cycle extensions” the economic hangover will be all the more epic when the bills are finally due. As the problem is already globally systemic, the final showdown may very well include central bank obituaries which also spells the death of current monetary regimes — and possibly even the very idea of fractional reserve banking.

Enter Bitcoin

Traditionally when monetary regimes have failed, they have either been replaced by a new version of themselves or an entirely new monetary regime, sometimes even with some elements of sound money, such as the many historical revisions of the gold standard.

A very valid hypothesis for the successors of the current monetary regimes is to expect more of the same. The Euro is likely to dissolve and be replaced by national fiat currencies. The US dollar is likely to reinvent itself, perhaps with a significant nod towards the 79th element.

However, there is a new kid on the block. With Bitcoin (BTC) we can break the wheel and enter a new age of money. But like always when making history, the question of timing may once again be the most important one. Will Bitcoin (or some other crypto) be really ready for prime time when the occasion does arise?

To answer this question with any confidence, we must consider the technology itself and some of the main objections in the light of recent events and historical examples.

Why should we choose Bitcoin?

Let’s first cover the why before going too deep into the technicalities.

It’s perfectly okay to ask why on Earth should we take up something like Bitcoin — a relatively new technology, never actually used as legal tender — instead of yet another round of fiat currencies and central banks, which after all are centuries old, very familiar technologies.

Of course the answer is that fiat currencies and central banks are inherently flawed technologies. They are also in many ways inferior to some already tried and true alternatives, such as the gold standard and free banking as advocated by the Austrian school of economics, among others.

Fiat currencies — or currencies by government decree — are extremely useful to politicians, as they are the last resort of government financing. The gold standard is rather inconvenient for those oriented in spending other people’s money, as there is always only a physically limited amount of gold in the coffers of a given government and taxes can only be so high. Eventually your average politicians will always end up running out of it. They can always run a debt of course, but there are limits to that as well, as debtors will at some point grow suspicious about your ability and even willingness to repay.

Fiat currencies on the other hand can always be inflated — until hyperinflation takes over and the streets become littered with worthless bills with a lot of zeroes. But up to that point fiat currencies are very useful to politicians, as most of the time it’s likely that it’s the next politicians who have to deal with the consequences.

Central banks exist for one purpose only. You could think that it was the management of a fiat currency, but a government could do that literally just as well by itself. The real raison d’être for central banks is preventing the bank runs caused by banks losing the trust of their customers after engaging “too much” into fractional reserve banking.

You see, banks operating a fractional reserve can extend credit by loaning out more money than they have as deposits. If there is a free market in banking and fractional reserve banking is allowed, it always bestows a competitive advantage for a bank to run a fractional reserve. Other banks often have to follow suit in order to stay in business, even if their directors had hoped to run a more honest business as in full reserve banking.

However, fractional reserve banks run into problems if and when their depositors figure out that their deposits are not safe, because they have been lent out many times over. Discreet depositors will quickly withdraw their own deposits and then raise an alarm, prompting others to withdraw their respective deposits en masse. Obviously, the bank can’t pay all of it’s depositors and will be forced into bankruptcy. This is a bank run.

Central banks prevent bank runs by acting as the lender of last resort. If a bank faces mass withdrawals, it can borrow the money to pay its depositors from the central bank, thus avoiding the run.

Having banks that can never fail would be fine, but this creates a systemic moral hazard and is the source of the business cycle itself. It’s the very reason why we experience economic booms always followed by economic busts, especially pronounced on the stock market.

Essentially this is caused by incorrect non-market interest rates, which are artificially affected by both central bank and government policies, luring entrepreneurs, investors, politicians and households into making investment decisions based on flawed information and effectively committing to using resources that don’t actually exist. When this discrepancy is discovered in the market, an economic bust is sure to follow, entailing liquidation of many of the investments made on faulty premises and even of some that were made on sound premises.

Bitcoin solves these issues better than any of the previously existing alternatives ever could.

As the blockchain is a distributed public ledger, any attempt by a bank to get adventurous with the fractional reserve is certain to not remain unnoticed for long. This almost completely eliminates any competitive advantage gained from running a fractional reserve, rewarding those banks that want to operate a sound business. In turn this removes the need for central banks.

While Bitcoin is equally or even more limiting than the gold standard from a politician’s perspective, it’s all the more enticing from the citizens perspective. Whereas gold can always be debased — and always has been debased — there is no way to debase Bitcoin.

Currency debasement is a form of monetary inflation, not that very different from printing more bills with more zeroes in a fiat currency. Monetary inflation is always a transfer of wealth from the poor to the rich, as the rich tend to be the first recipients of the newly printed or debased currency, and the trickle-down to the poor tends to happen only after the price inflation has already kicked in.

And even without actual debasement, the politicians and the bankers could always lie about their holdings in specie, and historically often have. The effect of such lies is the same as with actual monetary inflation. The publicity of the blockchain fixes this one too.

It’s in everyone’s best interest that the money being used rewards for saving rather than punishes for it. This is also the cure to many social and even environmental ailments.

Encouraging saving helps the poor to rise out of poverty with their own choices and actions; it helps narrow down the income gap; it discourages running a consumer debt and drives down consumerism; and it promotes purchasing high quality durable products, recycling and other environmentally friendly decisions.

Unfortunately, most of the time politicians get to choose what kind of monetary regime is in place. When given that choice, they will always choose fiat over gold or Bitcoin, simply because fiat gives them more power, consequences be damned.

The golden opportunity

However, sometimes the politicians don’t get to choose. The window for such opportunities is rare and brief, only happening during or after failures of a grander scale.

An example of such an event is hyperinflation. Traditionally when a nation enters hyperinflation and new zeroes keep getting added to the bills (or even stamped, like in The Weimar Republic), the people will start using more stable foreign currencies (often the US dollar) as alternatives in the black market or even resort to barter.

Many Venezuelans have recently taken up Bitcoin as another alternative, with good results. For example, BTC is much easier to smuggle across borders and around authorities, because as a holding it’s not that susceptible to random searches and confiscations as paper (or any other physical) money, and transfers are obviously completely uncensored. Of course the publicity of the blockchain is a risk in this case, but that’s practically avoided with short-lived burner wallets and addresses.

When the opportunity to make the choice by ourselves instead of the politicians does present itself — maybe already at the end of the current business cycle — we need to be prepared to make the right choice. Is Bitcoin ready for becoming the world currency?

Technological readiness

As the Venezuelan example shows, the technology itself is ready enough. Bitcoin can be used as convenient enough means for transferring value, making payments and temporarily storing value.

A large variety of online and mobile wallets, many of them in various local languages, makes it possible for average non-technical people to become active users.

Lightning Network adds a new layer on top of Bitcoin, effectively taking away one of the old objections against Bitcoin not being scalable and transfers being too slow and expensive for daily usage. With Lightning Network in place, transfers become instant and nearly free. Lightning Network is still bit of a work in progress, but it’s ready enough and its adoption rate is climbing rapidly.

Price volatility is a common objection. However, it’s not relevant for the scenario we are considering, because at that point the chicken and the egg problem must have been solved and volatility is necessarily a thing of the past.

Volatility also hasn’t been an issue in the Venezuelan example, but in that case it has been enough for Bitcoin to act as temporary storage of value. Volatility would prevent the permanent storage of value in Bitcoin however, and then it couldn’t be used as money.

For this reason price volatility is one of the serious concerns for the adoption rate. If Bitcoin is to be ready for mass adoption when the current monetary regimes collapse, it has to be already adopted widely enough to reach the critical mass. The actual size of the critical mass is anyone’s guess, so let’s just say the adoption rate has to be as high as possible. If we fail even then, it’s not because we didn’t try.

The role of banks

The price volatility cannot be fixed directly. The problem will fix itself when the adoption rate is high enough and demand for Bitcoin is more constant over time, or when prices are quoted in BTC. However, volatility is only one of the factors impacting adoption rate (and partially it’s helping it too, with the influx of day traders). There are other things we can do to increase adoption.

Obvious steps are to even further improve the user experience, overall security and attractiveness of the various crypto services, wallets, apps and whatever relevant tools. They have already come a long way in the past ten years, but in these areas there is always room for improvement. However, that’s the easy part and can be trusted over to the competition between different players.

One of the key phrases repeated by the more or less ideological early adopters of Bitcoin was “Be your own bank” — and today it’s even a registered trademark of Blockchain Luxembourg S.A.. While that phrase is increasingly relevant in the modern banking environment, being your own bank is still not for everyone, and for most people it’s never going to be that way.

For example, storing your private key and its backups securely is a tall order, especially for the elderly, the technically illiterate and some other groups. Just consider the large amount of people whose password to every online service is 123456 —would you trust them to safely hold on to anyone’s private key, even if it’s their own?

While one could argue that the entire point of the blockchain is the trustlessness it creates, for many users too much trustlessness is a major inconvenience and trusting a third party is a better option in many ways. This is of course what custodial wallet services provide.

Banks and other similar institutions, on the other hand, provide a host of services other than just trusted custody of the customers’ funds. They include mortgages and investment loans, different kinds of saving and investment options, credit, even insurance and many other services that are crucial to the large masses.

Banks are where cryptos need to be when the opportunity for reform eventually arises, or at least the crypto community should have the capacity to quickly ramp up banking services or help the surviving traditional banks on-board crypto customers rapidly at that point.

When it’s time for fractional reserve banking (FRB) to go, it’s the perfect time for full reserve Bitcoin (FRB) to take over. In terms of acronyms the transition is easy, but nearly everything else will change. Are you ready for the challenge?