Run the Numbers #18: Bitcoin Proof of Reserves

Bitcoin & Data Science

2021.01.02

Bitcoin proponents often debate whether or not Bitcoin banking is a good idea. In many ways, the ability to directly send value across the world instantly with a very low fee (at least for now) makes banking and many financial services as we know them obsolete. But before the rise of fiat currencies, banks served much simpler roles – to custody and to lend money. For most of recorded human history, gold was used as the final settlement layer for the world’s monetary system. Trade could be done with paper currencies which were easier to transport and verify the integrity of, but could always be redeemed for the gold backing it if desired. Typically this would be done between banks and governments to settle the balance sheets after having done commerce for some period of time.

In today’s financial system, there is no gold (or any hard assets) backing our money. Paper notes make up a small percentage of money in existence, but that amount is dwarfed by the digital money held by ultimately held by banks around the world. There is a high degree of trust involved in this kind of a system compared to a hard money system, where the assets can be verified and counted by anyone physically in their presence. One of the primary complaints from Bitcoin and Gold proponents about the fiat monetary system we live in is the effects of fractional reserve banking. The graph below shows how different rates of reserve banking expand a $100 deposit by lending out more than the deposit itself. The lower the reserve rate, the more they can lend in addition to the deposit.

Creating Money | Boundless Economics
Source: lumenlearning.com

In a Bitcoin financial system, the ease of verifying a bank’s reserves is shockingly easy. Bitcoin allows for the owner of a UTXO to sign a digital signature verifying they have control of the funds. without actually spending any of the funds. Over the last two years, an idea has been floating around that Bitcoin banks and financial service providers can in fact verify their entire set of UTXOs in one large digital signature in a so called Proof of Reserves.

In particular, this idea has been championed by Coinmetrics founder and Bitcoin journalist Nic Carter. He outlines one of his main arguments for Proof of Reserves here: “a banking system built atop Bitcoin is one in which federal depository insurance is impossible. Many believe this is a bug, but in my view it is a powerful feature. The FDIC is a lever of state control that has historically been used to weaponize the banking sector against lawful but disfavored industries. Additionally, guaranteeing bank deposits (and implicitly, the entire banking system) eliminates a market feedback mechanism and homogenizes the industry.” – Nic Carter

So far only a few Bitcoin exchanges have implemented a Proof of Reserves policy, most notably Kraken. But if more clients demand from exchanges and Bitcoin banks that they show they have the Bitcoin they are lending out, we will undoubtedly see it become more commonplace.