Fractional Reserve Bitcoin Would Be Devastating

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  • Reminiscences over the ‘Nixon Shock’ of 1971 brought back discussions over Bitcoin fractional banking
  • MasterCard filed a patent in 2018 that could end up undermining Bitcoin’s scarcity
  • Fractional reserve banking encourages the kind of chains of loans that brought down the banking system in 2008

The concept of fractional reserve banking was raised again last week as the U.S. marked 50 years since the ‘Nixon Shock’ that took the U.S. dollar off the gold standard for good. This is a concept that many in the crypto space may feel divorced from, but banking giant MasterCard is still working on a patent filed in June 2018 that would allow them to set up a fractional reserve Bitcoin bank. The move caused consternation within the cryptocurrency community at the time, with suggestions that it would undermine one of Bitcoin’s key tenets and would force on Bitcoin a tool it was created to oppose.

Show Me the Money

Fractional reserve banking stipulates that banks need only hold a portion of their stated assets in actual cash, allowing them to loan out the rest and increase liquidity in the financial system. MasterCard’s patent would allow them to do this with Bitcoin, which would mean they could trade 10 times more Bitcoin than they own, potentially making a mockery of the self-imposed 21 million limit.

This issue has in fact been a point of discussion for Bitcoin enthusiasts since 2014, but to date the discussion has been merely theoretical. It may, however, soon become a reality. The fact that MasterCard is the one working on the patent is particularly galling for Bitcoin fans, seeing as the CEO labeled the cryptocurrency “junk” weeks before the patent was filed.

Bitcoin Could Become Victim of Hypothecation

Bitcoin fan and Wall Street veteran of 22 years, Caitlin Long, said at the time in a debate about Wall Street’s intentions for Bitcoin that, “Wall Street wants to ‘solve’ what it sees as BTC’s ‘problem’-scarcity-by rehypothecating it.” Rehypothecation involves a bank receiving an asset, in this case Bitcoin, as collateral for a loan it has given out.

It then uses this asset as collateral to obtain a loan itself, passing the Bitcoin on and on down the chain so that if one counterparty defaults, or the holder of the asset is hacked, the entire chain collapses. Needless to say, this was not what Bitcoin was designed for, and exposes it to a whole raft of new risk, completely unassociated with itself.

Keep Your Friends Close

Bad debt is what brought the financial system crashing down in 2008, and fractional reserve banking is a system founded on debt. Should Bitcoin and the US dollar become too interlinked through this kind of banking, a collapse of the dollar, which some predict isn’t too far away, could ironically bring Bitcoin down with it, at least temporarily.

Given Bitcoin’s decentralized nature, it seems that only the US Patent Office can stand in the way of Bitcoin being used to promote the very system it was created to fight.