Fractional Reserve Banking Comes to Crypto

source: defipulse.com

Actually, that title is a lie. It was always here, and is a natural tendency of crypto’s purported role as money. I love the passion and open-mindedness of the hardcore “cryptocurrency is better money” crowd, but sometimes they are so open minded that they convince themselves of things demonstrably untrue. One of those things is the false belief that fractional reserve banking only happens with fiat currency like the U.S. Dollar. In truth, the activity long predates fiat currency, and is in some ways as old as money itself.

This post was inspired by recent developments within the Decentralized Finance sector on Ethereum, where there has been a surge of users depositing and borrowing a stablecoin called Dai from a decentralized money market called Compound, as can be seen here:

source: compound.finance

The actual lending and borrowing and lending of Dai is not that interesting, and not that different from what goes on at your corner bank. Savers hoping to earn yield have deposited $518m dollars worth of Dai, $476m of which has been borrowed by those in need of capital. What is interesting is the fact that the amount of Dai currently sitting in Compound is far greater than the amount of Dai ever generated by its own decentralized protocol in the first place.

source: makerburn.com

Upon first glance, this seems impossible. How could Compound users deposit more Dai tokens than exist? The numbers aren’t wrong, because unlike with your corner bank, everything that happens on the blockchain is transparent and independently verifiable. There are no mistakes here, just magic, the same kind of magic that exists in the traditional banking system. To wit, consider the latest stats from the Federal Reserve:

source: Federal Reserve

The top number is the total amount of dollars created by the Fed, as represented by physical coins and bills, and the reserves commercial banks have to keep at the Fed. These dollars — known as the monetary base — happen to be the highest quality dollars in the world, because the Fed is unlikely to fail.

The bottom number represents the amount of dollars currently deposited with commercial banks. Here too we have a large discrepancy. Somehow, banks such as Wells Fargo and Chase and have far more dollars deposited with them than was ever created by the Fed. This is not an illusion, nor is it some kind of fraud. In fact it’s what we expect to see in any economy where there is borrowing and lending, because credit creation always increases money supply.

To see how, let’s walk through a simple example. Let’s say that you have a $100 bill, and decide to deposit it at a bank. The bank would like to earn a profit, so it lends $20 of your money to somebody else. You as the depositor are mostly oblivious to this loan, and still consider yourself as having $100. But a total stranger now has $20 that she didn’t have before, so the total supply of money has grown.

To be fair, not all of the dollars in question here are created equal, and the magic is aided by the conversion of one kind of money into another. The $100 bill that you started out with is a claim against the Fed (if you look closely, it will say “Federal Reserve Note” at the top). That makes it central bank money, also known as public money. Depositing that $100 bill at the bank converts it to commercial bank money, also known as private money. Commercial bank money is always riskier than central bank money because commercial banks are more likely to fail than an arm of the government granted the right to print more money. But people who have savings accounts don’t think this way, they just think “I have $100, and it’s at the bank.”

(As a side note, the current debate on whether central banks should issue their own digital currencies is in part driven by the fact that the digitization of payments as currently only offered by private entities is slowly diminishing public access to central bank money).

Note that the inflationary impact of credit creation on the total money supply applies to every kind of money, not just the fiat variety. If you have five gold bars and lend one to a friend, you have technically swapped a portion of your base money for a liability against your friend. But you expect to get that gold back, so you still think of yourself as having five bars. Your friend on the other hand has one bar that he didn’t before, so the synthetic gold supply is now 6. Money supply isn’t how much money people physically posses — it’s how much money they think they have.

Note further that the same thing could happen, and in fact already does, with Bitcoin. There are services such as BlockFi that let you deposit your cryptocurrency to earn interest. They do this because they turn around and lend some of those coins to exchanges who need liquidity or traders who want to short Bitcoin. The second you send your coins to BlockFi, you are technically not in possession of them anymore, and instead own a claim against BlockFi. But in your mind, you probably don’t think “I don’t own any Bitcoin, I only own a claim against BlockFi.” You just think “I own 5 Bitcoins, when moon?”

This brings us to the central fallacy of Bitcoin and any other type of hard money such as gold, that there is truly limited supply. Yes, physical or algorithmic scarcity can limit the monetary base (and that is indeed distinct from fiat currency, where the Fed just created a cool 2 trillion worth of new dollars). But there is never a limit on how much additional supply can be generated from credit creation

Your favorite blockchain explorer might tell you that there are currently 18.42m Bitcoins in existence, but the actual number is greater, thanks to services like BlockFi and the wBTC money market on Compound (not to mention individuals who may occasionally lend a coin to a friend). This phenomenon can also go in the opposite direction, as credit destruction reduces the total money supply. The fear of that happening, and its consequences on the broader economy, is the main reason why central banks love to pump during a crisis.

source: Federal Reserve

Going back to Dai, what’s happening now is that in order to earn free COMP tokens (the DeFi equivalent of the free toaster) people are depositing as much Dai as they can get their hands on into Compound. Some of those users are using their deposits as collateral to borrow even more Dai, effectively lending and borrowing the same asset from the same bank. As strange as this may sound, it’s not that unusual, and is not that different from someone who already has a savings account taking out a loan and depositing the borrowed money at their bank. This is why the money multiplier is such a potent force.

As with anything else in the economy, there is no free lunch here. Regardless of whether it happens at Wells Fargo or on DeFi, and whether it’s denominated in dollars or Dai, all of this synthetic money creation via lending comes with credit risk. The interesting question that DeFi poses is whether users are taking more or less risk when they interact with a decentralized bank.

On the one hand, transparency, automation, censorship resistance and trustlessness should reduce risk. As I’ve said many times before, one of the appeals of projects such as Compound is that the general public knows more about them than your typical CEO does about his own bank. On the other hand, smart contracts can be hacked and blockchains can fail, especially when they are relatively young. So let’s call it a wash— although I suspect that DeFi will gain in the years to come, particularly once central bank digital currencies enter the mix.

In the meantime, critics of fractional reserve banking, many of whom tend to be closed-minded Bitcoin maximalists, should take note that all of this adoption is happening on a single platform, and it’s not their favorite.

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