When writing ICOs for Infrastructure, I made a passing reference to Fractional Reserve. It seemed a big enough topic, so I decided to elaborate on it here instead.
Fractional Lending is Banks lending a multiple of their deposits in the form loans. Today, around twenty dollars is lent for every dollar you deposit. This down from highs of 33-to-1 in the Financial Crisis.
I first got my insight on this in a piece of history wrapped up as a parable. The loose history says Fractional Reserve Banking evolved from goldsmiths1.
The story goes that people deposited gold at goldsmiths as they had secure vaults. The goldsmith would issue a receipt as proof of deposit. It wasn't long before people realized they didn't need to shuffle gold around to transact. They could exchange the receipts. Now you have a form of banknote. It's a note backed up by a piece of gold. What we call the Gold Standard today.
If people wanted a loan, the goldsmith could lend them some gold and then issue them a receipt. The goldsmith could then charge interest. In turn, goldsmiths realized that people rarely come and collect the gold. Most of it sits in the vault.
So you can write more receipts than you have gold. If people leave gold in the vault for an extended period, this could be much more. This ratio between the amount held and amount loaned out is the leverage ratio.
There is one snag with leveraged loans. That's if people decide to collect, en masse. Today this is known as a Bank Run. If everyone shows up to withdraw, the money runs out. And if that seems like a possibility, it only encourages people to take their money out.
There are many arguments in favor of the Fractional Reserve system. A nutshell version is that a Fractional Reserve system rewards good loans. You create an investment environment with a strong incentive to put money to good work.
That said, do a quick Google search on the pros and cons of Fractional Reserve. You'll find yourself in a minefield of economic debate.
Does Fractional-Reserve work with Bitcoin?
Bitcoin has a lot in common with the Gold Standard as it can act as a commodity. In fact, some regulators classify it as exactly that2. This is interesting as the Gold Standard was eliminated for US Dollars in the 70s.
Bitcoin also has the property of distribution at its core. No single entity owns the ledger. At one level, this eliminates Fractional Reserve3. An institution cannot issue new bitcoins, the way the goldsmith or bank issues notes. Unless you're mining, you can't create coins.
However, it is possible with "off-chain" transactions. In these cases, the exchange holds an internal ledger. Movements between exchange members occur on this internal ledger rather than on the blockchain.
In the Factional Reserve case, transactions need to happen on that internal ledger. That single exchange. Alice deposits 10BTC. Bob takes a 9BTC loan and buys something off Carol, who deposits it. If those coins are ending up on the same ledger, there are still 10BTC. But the exchange is telling Alice she has 10BTC and Carol she has 9BTC.
It's not lending on a scale possible traditional money system, but it's a microcosm of that. It introduces centralization into a decentralized system. This centralization is antithetical to many Bitcoin principles. Yet, the temptation must be acute. Fractional reserve is near-literally printing money. It requires significant scale, and it revalues all Bitcoin. We'll see what eventuates on that front.
What if it was out in the open?
Another model would be a public "side-chain." An Ethereum-style contract where you could see the underlying chain that backs each lent token. It sounds strange to transact using "borrowed tokens," but we do it every day with our existing money system. The dynamics of such a model would be fascinating. Each token based on the lending of a token would be transparent. You could see exactly was backing the real transactions you're making.
In the meantime, still seems like most of your loans will come from a bank, leveraging the money system. However, the cryptocurrency economy is growing and so are investment needs.
There is a large amount of speculation sitting in the value of Bitcoin. If this value isn't put to work by loans, it needs to flow somewhere. This could will stress our existing loan systems. Or that value will flow into the emerging ICO market. It seems the latter at the moment.