Benefits of BitBank

Last time in Free Banking in Bitcoin, I introduced BitBank, a bank that only accepts deposits and makes loans in Bitcoin. I described how this bank would function, including a sliding scale of interest and a redemption schedule of 1% per year on deposits. This week, I continue my discussion of BitBank by illustrating the benefits of BitBank.

This simple schema has several immediate benefits. First, and most importantly, the bank cannot make up money on its own the way it can today with fiat currency. The only way BitBank could make a loan is if it were to receive a deposit in advance. No one can manufacture bitcoins out of thin air. Not you, not me, not the bank, not the government. This is the primary benefit of hard money: It will, by design, constrain lending. BitBank is therefore more like the original deposit lending banks, which required deposits before making loans, rather than the modern fiat banks today, which make loans first and create deposits later. This is by far the most important feature of BitBank: constraining bank lending, and in the long term, vastly limiting the inevitable credit bubbles that ensue from excess leverage.

Second, the lock-up of customer funds upfront prevents bank runs. There is no way for customers to make a run on the bank since their deposits would be unavailable by contract if they were locked up. Rather than restricting redemptions ex post, as banks historically have done during a run on the bank, BitBank instead restricts redemptions ex ante. Knowing this, depositors will not try to withdraw at once because they will know it is impossible. And even if all depositors were to exercise withdrawal in an emergency, BitBank would set its breakup fees high enough such that it would remain solvent. Because the lock-ups of deposits prevent bank runs by design, there is no need for a lender of last resort, the chief justification for the existence of a central bank. The Federal Reserve System in the US emerged after the banking panics of the 19th and early 20th centuries, all of which came from runs on banks, from individuals wanting to withdraw deposits in fear of their bank failing. If such bank runs were no longer possible, it would kill the need for a central bank acting as a lender of last resort.

Third, the redemption schedule from the depositors will govern the interest rates offered on loans, rather than the money supply determined through a central bank. If the deposit portfolio were to change, with some depositors wanting to lock up their funds at different horizons, so too would the loan portfolio change. In the example above, BitBank had an equal number of short- and long-term loans because Bob and Carol each deposited 100 bitcoins into BitBank. But if instead Bob were to deposit 50 bitcoins and Carol were to deposit 150 bitcoins, then BitBank would have three times as many funds for long-term loans as for short-term loans. If, instead, Carol were to not want to lock up her loans for a decade but only five years, then BitBank could offer medium-term loans of five years at rates of 10% to potential borrowers. Similarly, if Bob were to deposit not 100 but 200 bitcoins under his one-year lock-up, BitBank could offer twice as many short-term loans. And so, the redemption schedule and deposit portfolio will govern the loan quantities and rates, making the link between deposits and loans much tighter than fiat banks today.

Some of the major bitcoin exchanges today, like Coinbase and Gemini, offer customers the opportunity to lend out their bitcoin. Are these exchanges serving as banks? No. Banks do extensive underwriting and credit assessments for their loans, which are not present on the existing cryptocurrency exchanges. This may be why the exchanges have witnessed some spectacular failures, like FTX in November of 2022. Ultimately, an exchange that lends its digital assets out would go bankrupt if those loans were to default. The exchange would no longer be able to redeem its depositors, the customers who bought cryptocurrencies on the exchange. These exchanges are largely trading in non-bitcoin digital assets. Some host hundreds of coins, with bitcoin only one of many.

The failure of several cryptocurrency exchanges is surprisingly good news for capitalism, because it shows the market doing important work penalizing exchanges with poor risk management. Any exchange that lends digital assets without disclosing them or charging an appropriately high interest rate is either fraudulent or mismanaging its risk, and therefore should fail. A far worse outcome would have been the government bailing out the exchange. This would have created a massive moral hazard, leading to more gambling in the future, as it would be public knowledge that the government would provide a bailout.

The loans that banks make are long-term and illiquid, meaning they are difficult to convert into cash. When a bank makes a business loan to a company, that company uses it to make investments like buying equipment, hiring employees, or building a factory. So, it cannot easily pay back the loan on request. At the same time, deposits for the bank are short-term, with customers placing money that they need for immediate purposes on a shorter horizon than a loan. In this sense, the bank is matching illiquid assets to liquid liabilities. Some entity in the economy will need to provide this function in the economy, so some version of a bank will always exist, with or without a central bank.