Is Fractional Reserve Banking a Ponzi Scheme? [BLOG POST]

[santaclause102]

Here is my feedback:

Insolvency is a very general word. I would suggest to either define it instrumentally (= saying "for this article I will assume that the word insolvency means ...") or always use more specific terms like "accounting insolvency" and "technical insolvency". See http://en.wikipedia.org/wiki/Insolvency

It is in this situation that we consider the bank to have fractional reserves.

Isn't it that fractional reserves equal liabilities > assets? It at least sounds intuitive to me. But you said "It is in this situation" and the situation you described in the sentence before involves another condition besides the "liabilities > assets" condition.

The bank will only be able to continue operation provided new depositors come in at a rate faster than withdraw requests, the classic characteristic of a Ponzi Scheme.

I would make extra clear here that this depends on BOTH conditions (liabilities > assets AND income < expenses). A reader that is convinced of the banking system would tend to oversee the necessary AND condition and then get the impression that you are wrong.

If the new creditors were not aware of the financial condition of the company then that constitutes fraud.

This is at least inconsistent with how the word "fraud" is used: "Fraud is a deception deliberately practiced in order to secure unfair or unlawful gain". (http://en.wikipedia.org/wiki/Fraud)
How could we know the intentions of the bankers and how can we generalize their intention?

In fact, I would argue that the easiest way to discover whether or not a system is a Ponzi Scheme is if all obligations can be met immediately when they are due.

Is "immediately" and "due" a contradiction here?
I would say that it is not true that "liabilities > assets" equals ponzi scheme. For it to be a "system determined to fail" it would in addition require that either expenses > income (net / over time) or that the system gives out "payable on demand IOUs". You described that above but reduced it here to just the "liabilities > assets" criterium. Here is an example: A company is also a system (if you don't agree I would suggest to define "system" more clearly) and it is not determined to fail just because its liabilities are greater than its assets.

In other words, is the system solvent.

...needs a "?" behind "solvent".

and a Ponzi Scheme is clearly fraud

fraud requires bad intent... Having the conclusion in mind that the banking system is determined to fail should not lead to using words like they normally are not used.

We all know how the warehouse receipt game goes. Moving the debt instrument accounting from the internal database of the bank to a public transaction ledger does not change the risk or prevent the fraud that the banking system has been unable to prevent for hundreds of years.

This one I probably just don't understand: Since we are talking about warehouse receipts (like Bitreserve etc.), how is it possible to show their actual USD/gold/whatever deposits on a blockchain or is this not what you are saying here?

There is another approach that technically avoids creating a Ponzi Scheme.

...added an "a".

The price information that is used to trigger these margin calls is provided by over 50 independent sources elected by the shareholders which are implicitly trusted to be fair judges of the price.

Wouldn't it be worth adding here that the median is making up the price feed? Otherwise "judges of the price" sounds more susceptible to collusion than it is.

It involves selling a crypto currency that you are not legally required to buy back at any price, but which you have established a proven history of doing so.

Shouldn't this say "buy back at a target price (for example 1 USD) per crypto currency unit at any time" also since in the next sentence you assume that the reader understands this mechanism?


My overall impression: Whether those articles (on general political, financial or economic issues) are a success with a wider audience, we will hopefully have later, hugely depends on whether it can be avoided that they are put in the same category of badly researched articles and videos that are just hating on the banking system and everything mainstream without making a concise argument. I think your article does make a concise argument and it nicely applies the arguments to crypto currencies. But there is the danger that many readers put it in the same category as described above because it suits their preexisting world view and the missing precision in many parts makes it easy for them to justify their perception of the article. This is especially true if it is regarded as more valuable to convince the unconvinced than confirm the world views of those that are critical of the banking system.

Even more general: Precision + implicitly making clear that one is aware of norms (in this context the norm to use words like they are normally used)  + conveying friendliness / goodwill + no over complication, makes it very hard to ignore an argument.

[aaaxn]

Banks have created very liquid secondary market for bonds, where they can instantly sell bonds to cover liquidity requirements. In fact much more liquid than bitassets are likely ever to be, because bonds are instruments with yield. BTS does not pay any yield as far as I know, so demand for it will always be smaller.
In any case there is far greater probability that you won't get your dollars back from bitusd than from well managed bank. If banks are ponzi then bitusd are even 'more ponzi' .

[bytemaster]

Banks have assets to cover all their liabilities. Banks assets are for example mortgages, which can be sold on open market when bank needs liquidity. There are regulatory requirements that bank have to maintain some level of reserves, so basically deposits are always covered in more than 100%. Not so different than bitshares.

Of course there are times when bank assets are temporary illiquid or permanently loose value, but same thing can happen to collateral in bitshares.

"Temporarily illiquid" is another word for "Temporarily insolvent".     

Everything can be sold at a "price" it just so happens that not everyone wants to "mark to market" and admit insolvency.   

If you owe someone $100,000 payable on demand and someone else owes you $100,000 payable over 30 years.    Then you are "insolvent" the moment they demand payment unless you can sell your 30 year bond for $100,000 to someone else "on demand". 

Now that $100,000 30 year bond might be backed by collateral, such as a house, that is worth $125,000.   Perhaps you have the right to seize collateral "on demand"... because of market conditions you cannot sell a house "on demand" even if you have clear title.  Thus you are insolvent.   

In any event, if there is a mismatch between the type of asset held and the type of liability then there must be a surplus of reserves sufficient to handle all price swings.  Thus if the value of a 30 year collateralized bond vs cash changes you can end up insolvent.   At this point in time the 30 year bond should be handed over to the person you owe "on demand" as part of bankruptcy settlement.

If you can find someone who is willing to lend you money then you are not "illiquid".  Your credit worthiness allows you to take on a 30 day "pay day loan" that allows you to meet your $100,000 payable on demand obligation.   

The key is this:  if a debtor is unable to pay when debts are due then they are insolvent period.    It doesn't matter that people owe him money or that he has property that could probably be sold.  If he cannot find someone to lend him the money he needs today based upon his property as collateral then he is insolvent. 

Lets take this a step further: if you use BTS as collateral for BitUSD then you are insolvent unless the collateral can actually be sold to realize the full value of the USD.   Hence, if I have $1000 BitUSD backed by $3000 worth of BTS then I can probably sell the BTS for $1000 without moving the market too much.   But if I have $1M worth of BitUSD I will probably need $3M or more worth of BTS at market price to realize $1M after all of the slippage.   

What this really means is that BitUSD is only worth a dollar in small quantities.   In large quantities BTS slippage will reduce the number of real dollars you can get for it unless you can cash out at a slow enough rate to minimize slippage.  As the market volume grows the situation gets better.

Bottom line, accountants like to offer "grace" when you are a high probability of being solvent "real soon", but the fact remains that you cannot pay your debts when they are due. 





 

 

[aaaxn]

Banks have assets to cover all their liabilities. Banks assets are for example mortgages, which can be sold on open market when bank needs liquidity. There are regulatory requirements that bank have to maintain some level of reserves, so basically deposits are always covered in more than 100%. Not so different than bitshares.

Of course there are times when bank assets are temporary illiquid or permanently loose value, but same thing can happen to collateral in bitshares.

[Empirical1.1]

I want all cryptos to uplift humanity and we are all walking this path together, learning and evolving in hopes of trying to make the Is it safe to say by this point that we could have a hangout with Jordan and Bytemaster to have a grown up, rational conversation about this?
world a better place overall for those here now and those in the future.  In light of this I think it would be valuable for all of us to consider having a hangout specifically on this topic where both viewpoints can be clearly and fairly represented. 

I would personally love to see this next hangout be one wherein Jordan visits our mumble server and brings any and all community members who would like to participate in an open discussion.  There is no reason why Nubits/NuShares couldn't find a way to fix these problems if in fact we come to a consensus that they are valid.

Please consider it.

NO!!! Absolutely not!

There is no point in BM arguing about a tone of nonsense every time some knucklehead comes around with his stupid ideas...

Hell, I can do a good enough job of arguing it Jordan... if you let me do so of course... I mean, if you decide that I am no longer the only person speaking on mumble worth cutting each time I open my mouth....

Saying that NuBits is like fractional reserve banking is a much better comparison than calling it a Ponzi.

I created a detailed post examining whether the notion of fractional reserve has any meaning within the Nu network eight hours ago. In short, because Nu is designed for zero counterparty risk and zero reserves, there can be no fractional reserve. There is, however, the related notion of a ratio of assets to liabilities:

https://discuss.nubits.com/t/regarding-reserves-and-fractional-reserve/1126

I hope you don't think it is inappropriate to post a link to our forum here, but where you are interested in fractional reserve in the context of NuBits right now, and where I just wrote about that, it seems appropriate to bring it to your attention.

Fist off I screamed for 1/2 hour before starting to write this...

You and all the rest must realize that if 20% reserves is 80% Ponzi, your system with 0% reserves  is 100% Ponzi...
Nu is designed for zero counterparty risk - Yes, there is 0% counterparty risk  ...as the buyer has assumed 100% of the risk buying something backed by 0% value...
NuBits is not Ponzi...Nubits is a self appointed federal reserve that issues non-interest bearing bonds of a self appointed organization

In short if fractional reserve banking is 75-80-90% insolvent, the fed is 100% insolvent... but they at least have some power to claim themselves worth it... It is 'no-interest bearing bond/obligation of the government'...Nubits on the other hand is also 100% insolvent/100% no value backing it and only have the words of the totally lost and clueless  'JordanLee' to  collateralize Nubits value... And by definition:

' A NuBit is no obligation bearing instrument [no interest including], aka promise for nothing by nobody and/or [JordanLee???]'

[/end rant]

 

[theoretical]

I have an unrelated question about how Bitshares operates, if you will indulge my ignorance for a moment.  Let us suppose I purchase BitUSD, and then the value of BTS drops such that the party that went long BTS to create my BitUSD receives a margin call. The issuer does not meet the margin call, which I presume causes a liquidation. What happens to my BitUSD at that point?

TLDR:  Liquidation only happens if the collateral can be sold.  If no buyers want to buy the collateral right now, there will be no liquidation until buyers appear!

The margin call causes a "cover order" to be issued on the market, it attempts to buy back the BitUSD at the feed price.  This order is funded by the collateral.  The cover order is created automatically by the blockchain.  When the cover order is matched, the liquidation proceeds:  The BitUSD bought by the cover order is destroyed, and any leftover collateral will be returned to the short issuer, less a 5% fee taken by the blockchain (treated the same as other transaction fees).

In addition, shorts expire after 30 days [1].  The same cover process happens, but in that case there is no 5% fee.

From the long holder's point of view, what does this look like?

If you are just hanging on to your BitUSD, nothing happens. 

If you place a sell order, your sell order will be matched against cover orders.

We require $3 worth of collateral to create $1 worth of BitUSD, and force the cover when its value drops to $2.  So very extreme price movements would be required to break the peg, that no reasonable, legitimate cryptocurrency with decent market cap has ever experienced.

[1] This period was originally one year, but was changed later.  Existing shorts were "grandfathered," otherwise we would have been changing the terms of financial derivative products after people had already bought them!  Since BTS price has been rocky, most of these grandfathered shorts have been margin called, but a few still exist.

[zerosum]

I want all cryptos to uplift humanity and we are all walking this path together, learning and evolving in hopes of trying to make the Is it safe to say by this point that we could have a hangout with Jordan and Bytemaster to have a grown up, rational conversation about this?
world a better place overall for those here now and those in the future.  In light of this I think it would be valuable for all of us to consider having a hangout specifically on this topic where both viewpoints can be clearly and fairly represented. 

I would personally love to see this next hangout be one wherein Jordan visits our mumble server and brings any and all community members who would like to participate in an open discussion.  There is no reason why Nubits/NuShares couldn't find a way to fix these problems if in fact we come to a consensus that they are valid.

Please consider it.

NO!!! Absolutely not!

There is no point in BM arguing about a tone of nonsense every time some knucklehead comes around with his stupid ideas...

Hell, I can do a good enough job of arguing it Jordan... if you let me do so of course... I mean, if you decide that I am no longer the only person speaking on mumble worth cutting each time I open my mouth....

Saying that NuBits is like fractional reserve banking is a much better comparison than calling it a Ponzi.

I created a detailed post examining whether the notion of fractional reserve has any meaning within the Nu network eight hours ago. In short, because Nu is designed for zero counterparty risk and zero reserves, there can be no fractional reserve. There is, however, the related notion of a ratio of assets to liabilities:

https://discuss.nubits.com/t/regarding-reserves-and-fractional-reserve/1126

I hope you don't think it is inappropriate to post a link to our forum here, but where you are interested in fractional reserve in the context of NuBits right now, and where I just wrote about that, it seems appropriate to bring it to your attention.

Fist off I screamed for 1/2 hour before starting to write this...

You and all the rest must realize that if 20% reserves is 80% Ponzi, your system with 0% reserves  is 100% Ponzi...
Nu is designed for zero counterparty risk - Yes, there is 0% counterparty risk  ...as the buyer has assumed 100% of the risk buying something backed by 0% value...
NuBits is not Ponzi...Nubits is a self appointed federal reserve that issues non-interest bearing bonds of a self appointed organization

In short if fractional reserve banking is 75-80-90% insolvent, the fed is 100% insolvent... but they at least have some power to claim themselves worth it... It is 'no-interest bearing bond/obligation of the government'...Nubits on the other hand is also 100% insolvent/100% no value backing it and only have the words of the totally lost and clueless  'JordanLee' to  collateralize Nubits value... And by definition:

' A NuBit is no obligation bearing instrument [no interest including], aka promise for nothing by nobody and/or [JordanLee???]'

[/end rant]

[starspirit]

I do like this blog post, nice one.

[btswildpig]

Obviously you cannot use the market cap of NuShares as a basis of solvency because it is based on the spot price where there is relatively little depth.

As I understand it, Nu and Bitshares are quite similar in this regard. In Bitshares, if a margin call is not met, it causes a liquidation, I presume, which due to limited liquidity would reduce the value of all collateral.

I would be very interested to know how many NuBits are held by parties other than your market making custodians or NuShare insiders ready to support the peg?

We are developing automated reporting to make this figure publicly available in real time. While I don't have access to real time figures, there are almost certainly between 500,000 and 1,000,000 NuBits out in the wild right now.

So while technically you say there are no "reserves" that is only true legally but not true practically.

There are some reserves right now. My point is that because reserves equate to counterparty risk and are not necessarily useful in backing NuBits, we are aiming for 0% reserves,  not 100%.

I have an unrelated question about how Bitshares operates, if you will indulge my ignorance for a moment.  Let us suppose I purchase BitUSD, and then the value of BTS drops such that the party that went long BTS to create my BitUSD receives a margin call. The issuer does not meet the margin call, which I presume causes a liquidation. What happens to my BitUSD at that point?

Your BitUSD stays intact .
The market will force the short order to cover , sell the BTS in exchange for BitUSD from other players on the sell order  .
So , all this time , ordinary people who purchased BitUSD , will not even know there is a cover (no matter force or not) happened on the short order that created the BitUSD he bought in the first place .

[bytemaster]

Obviously you cannot use the market cap of NuShares as a basis of solvency because it is based on the spot price where there is relatively little depth.

As I understand it, Nu and Bitshares are quite similar in this regard. In Bitshares, if a margin call is not met, it causes a liquidation, I presume, which due to limited liquidity would reduce the value of all collateral.

I would be very interested to know how many NuBits are held by parties other than your market making custodians or NuShare insiders ready to support the peg?

We are developing automated reporting to make this figure publicly available in real time. While I don't have access to real time figures, there are almost certainly between 500,000 and 1,000,000 NuBits out in the wild right now.

So while technically you say there are no "reserves" that is only true legally but not true practically.

There are some reserves right now. My point is that because reserves equate to counterparty risk and are not necessarily useful in backing NuBits, we are aiming for 0% reserves,  not 100%.

I have an unrelated question about how Bitshares operates, if you will indulge my ignorance for a moment.  Let us suppose I purchase BitUSD, and then the value of BTS drops such that the party that went long BTS to create my BitUSD receives a margin call. The issuer does not meet the margin call, which I presume causes a liquidation. What happens to my BitUSD at that point?

Your bitusd is untouched.  It is fully liquid and fungible.    In fact chances are you bought your usd from some else and not a short.   The collateral just has to buy any bit usd.  Could be bit usd from a new short or someone else looking to sell. 

It looks like we both have about the same real circulation.   

[JordanLee]

Obviously you cannot use the market cap of NuShares as a basis of solvency because it is based on the spot price where there is relatively little depth.

As I understand it, Nu and Bitshares are quite similar in this regard. In Bitshares, if a margin call is not met, it causes a liquidation, I presume, which due to limited liquidity would reduce the value of all collateral.

I would be very interested to know how many NuBits are held by parties other than your market making custodians or NuShare insiders ready to support the peg?

We are developing automated reporting to make this figure publicly available in real time. While I don't have access to real time figures, there are almost certainly between 500,000 and 1,000,000 NuBits out in the wild right now.

So while technically you say there are no "reserves" that is only true legally but not true practically.

There are some reserves right now. My point is that because reserves equate to counterparty risk and are not necessarily useful in backing NuBits, we are aiming for 0% reserves,  not 100%.

I have an unrelated question about how Bitshares operates, if you will indulge my ignorance for a moment.  Let us suppose I purchase BitUSD, and then the value of BTS drops such that the party that went long BTS to create my BitUSD receives a margin call. The issuer does not meet the margin call, which I presume causes a liquidation. What happens to my BitUSD at that point?

[Stan]

I tried to start a similar new discussion on this article over at bitcointalk.

https://bitcointalk.org/index.php?topic=913075.msg10171481#msg10171481

If you visit, please do so with the intention of making friends.

 

[fuzzy]

Is it safe to say by this point that we could have a hangout with Jordan and Bytemaster to have a grown up, rational conversation about this?

I want all cryptos to uplift humanity and we are all walking this path together, learning and evolving in hopes of trying to make the world a better place overall for those here now and those in the future.  In light of this I think it would be valuable for all of us to consider having a hangout specifically on this topic where both viewpoints can be clearly and fairly represented. 

I would personally love to see this next hangout be one wherein Jordan visits our mumble server and brings any and all community members who would like to participate in an open discussion.  There is no reason why Nubits/NuShares couldn't find a way to fix these problems if in fact we come to a consensus that they are valid.

Please consider it.

[bytemaster]

Saying that NuBits is like fractional reserve banking is a much better comparison than calling it a Ponzi.

I created a detailed post examining whether the notion of fractional reserve has any meaning within the Nu network eight hours ago. In short, because Nu is designed for zero counterparty risk and zero reserves, there can be no fractional reserve. There is, however, the related notion of a ratio of assets to liabilities:

https://discuss.nubits.com/t/regarding-reserves-and-fractional-reserve/1126

I hope you don't think it is inappropriate to post a link to our forum here, but where you are interested in fractional reserve in the context of NuBits right now, and where I just wrote about that, it seems appropriate to bring it to your attention.

Thank you for posting your thoughts and for engaging in discussion.  I think it will be beneficial for all.

I understand the principle that technically NuBits are not a liability of any single individual, but to remain valued at $1 means that there must be someone, somewhere, with $1 worth of assets ready to accept an ask of $0.999 for every NuBit in circulation.   If those assets do not exist then the system as a whole is insolvent. 

There are two ways to get those assets:  NuShareholders and their elected custodians can be *TRUSTED* to bring the bids  AND general market participants that believe in the system.   
The general market participants cannot be relied upon "long term" because their trust may waiver. 

This means that the only thing that matters is Assets at the disposal of NuShareholders.   These assets are BTC, USD, etc held by individuals that could be confiscated or stolen  AND the NuShares themselves which may be diluted as necessary.     

Obviously you cannot use the market cap of NuShares as a basis of solvency because it is based on the spot price where there is relatively little depth.   If you attempted to dump $2 million worth of NuShares to buy back the NuBits in circulation I suspect you would be hard pressed to find buyers.  Obviously your system as a whole has a range of assets and probably holds a large number of NuBits itself and thus the total liability of your system is likely much less than the 2 million stated on coin market cap. 

I would be very interested to know how many NuBits are held by parties other than your market making custodians or NuShare insiders ready to support the peg?

So while technically you say there are no "reserves" that is only true legally but not true practically. 

[JordanLee]

Saying that NuBits is like fractional reserve banking is a much better comparison than calling it a Ponzi.

I created a detailed post examining whether the notion of fractional reserve has any meaning within the Nu network eight hours ago. In short, because Nu is designed for zero counterparty risk and zero reserves, there can be no fractional reserve. There is, however, the related notion of a ratio of assets to liabilities:

https://discuss.nubits.com/t/regarding-reserves-and-fractional-reserve/1126

I hope you don't think it is inappropriate to post a link to our forum here, but where you are interested in fractional reserve in the context of NuBits right now, and where I just wrote about that, it seems appropriate to bring it to your attention.