Bitcoin Banking Will Be Boring

By July 18, 2014Bitcoin Business
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Bitcoin Banking Will Be Boring

Matt Levine
Matt Levine

Here's my favorite part of New York Superintendent of Financial Services Ben Lawsky's proposed "BitLicense" regulations for companies that provide bitcoin services in New York:

Each Licensee shall maintain at all times such capital as the superintendent determines is sufficient to ensure the financial integrity of the Licensee and its ongoing operations. In determining the minimum amount of capital that must be maintained by a Licensee, the superintendent will consider a variety of factors, including but not limited to: ...

the amount of leverage employed by the Licensee;

Isn't that strange? Capital, in the usual financial sense,1 is just the inverse of leverage: Capital requirements determine how much leverage you can have. If you have an 8 percent capital requirement, then you can be 12.5 times levered. Saying "we'll decide how much capital you need based on how much leverage you have" is circular: How much capital you need determines how much leverage you can have.

This weird amateurism feels right at home, though, because these are bitcoin regulations, and there's a general flavor of weird finance amateurism running through bitcoin. Bitcoin is a self-conscious reinvention of every wheel in finance, and when you crowdsource your wheels some of them will be lumpy or ill-formed or oval. And some of them will be Reuleaux triangles because, and here let's just be brutally honest, bitcoin is largely for nerds.

My second favorite part of the proposal is this, from Lawsky's press release:2

Each firm must hold Virtual Currency of the same type and amount as any Virtual Currency owed or obligated to a third party. Companies are also prohibited from selling, transferring, assigning, lending, pledging, or otherwise encumbering assets, including Virtual Currency, it stores on behalf of another person. Each licensee must also maintain a bond or trust account in United States dollars for the benefit of its customers in such form and amount as is acceptable to DFS for the protection of the licensee’s customers.

What this means is that if you're in the business of bitcoinery -- "receiving Virtual Currency for transmission or transmitting the same; securing, storing, holding, or maintaining custody or control of Virtual Currency on behalf of others; buying and selling Virtual Currency as a customer business; performing retail conversion service ... or controlling, administering, or issuing a Virtual Currency" -- and you owe bitcoins to customers, then you need to have 100 percent of those bitcoins sitting in your bitcoin vault. And you can't borrow against them. And you need to have some extra cash in dollars, just in case (in case what?). And you need to have however much capital Ben Lawsky decides you should have.

So if you start Joe's Bank of Bitcoin, and you're holding 100 bitcoins for your customers, your balance sheet has to look sort of like this:

Where X is the larger of the capital requirement and the bond account requirement.3 What that means is, if someone comes in and asks you to hold another 100 bitcoins, you have to immediately come up with another $X of your own capital to do that. Where does that come from? Well, presumably from charging the customer a fee to hold on to its bitcoins. And the higher the capital/bond requirements, the higher the fee.4

So: That's a totally reasonable business model. Storage companies will take your stuff, hold onto it for you, and charge you a fee. They can't use your stuff while it's in their warehouses, so the fee is the only incentive they have to hold on to it for you. And they probably have some sort of insurance against the risk of losing your stuff,5 and your fee goes in part to covering their costs for that. There's no reason that bitcoin custodians -- and bitcoin converters and transferers and other infrastructure providers -- can't have precisely the same business model.

But, obviously, there is one sort of business that doesn't run on this model. Financial companies basically take your money and put it in places where it makes money for them while you're not looking. Banks, in particular, take deposits and lend or invest them back out. If I put $100 in the bank, the bank does not just put a crisp $100 bill in an envelope labeled "For Matt, whenever." The bank takes my $100 and buys credit derivatives or whatever with it, and relies on the well-understood magic of banking -- maturity transformation, diversification, deposit insurance, etc. -- to answer the question, "what happens if I want my $100 back?" That's why, instead of charging me a fee to hold on to my money, my bank can pay me a very teeny amount of interest.

Other financial intermediaries don't do exactly this, but there is a general theme of making money by using the customers' stuff when the customers aren't using it.6 This will not fly with Ben Lawsky, though, when it comes to bitcoin businesses. Bitcoin businesses, in New York, will have to be far more conservative than regular financial businesses.

In one sense this is ironic: Part of the bitcoin ethos is its libertarianism, and some of that raffish libertarian charm will be lost if bitcoin transactions are regulated much more strictly than dollar transactions.

But in another sense it's a perfect fit, because another part of the bitcoin ethos -- and one closely linked to its libertarianism -- is a fondness for hard money. Part of the attraction of bitcoin is that it's not a fiat currency: It can't be inflated or "manipulated" by central banks; it's like gold in its limited, exogenous supply and its deflationary effects.

If you like hard money, you probably don't like fractional reserve banking.7 That basic business activity that banks get up to, where they take in deposits and then lend most of them out, so that both the depositor and the borrower think they have "money" (mine in a bank account, yours in the currency that you borrowed from the bank), is viewed with great suspicion by those who want to keep a close eye on the money supply. And Ben Lawsky, for all that he's a government official meddling in bitcoin, is also doing his part to prevent private bitcoin actors from inventing fractional reserve banking. No one will be lending out bitcoin deposits on his watch.

Or, almost no one: "The license is not required for merchants or consumers that utilize Virtual Currency solely for the purchase or sale of goods or services; or those firms chartered under the New York Banking Law to conduct exchange services and are approved by DFS to engage in Virtual Currency business activity." If you want to be a bitcoin bank in New York, your best bet is to be a regular bank first.

1 Does Lawsky mean something else? There's a colloquial usage of "capital" to mean just, like, "money you've got in the bank" -- liquidity, sort of -- so maybe he means that? But the factors also include "the liquidity position of the Licensee." I don't know.

2 And here I am cheating, because the actual proposal is less drastic. The press release says, "any Virtual Currency owed or obligated to a third party," but the proposal says only:

To the extent a Licensee secures, stores, holds, or maintains custody or control of Virtual Currency on behalf of another Person, such Licensee shall hold Virtual Currency of the same type and amount as that which is owed or obligated to such other Person.

Each Licensee is prohibited from selling, transferring, assigning, lending, hypothecating, pledging, or otherwise using or encumbering assets, including Virtual Currency, held, stored, or maintained by, or under thecustody or control of, such Licensee on behalf of another Person.

So there's a conflict between the "owed or obligated" language in the press release, which would prohibit basically any bitcoin leverage, and the "custody or control of Virtual Currency on behalf of another Person," which would allow leverage -- but still not fractional-reserve deposit banking, etc. Like if I wrote you a bitcoin swap ("you pay me $6,500 in a year, I pay you 10 bitcoins in a year"), I (probably?) don't need to sit on 10 bitcoins under the language of the regulation, but I (probably?) do under the language of the press release.

3 The bond seems to have to be invested in a segregated bank account. If your capital exceeds that, then you can do what you want with it. Oh wait no you can't. From the proposed regulations:

Each Licensee shall be permitted to invest its retained earnings and profits in only the following high-quality, investment-grade permissible investments with maturities of up to one year and denominated in United States dollars:

(1) certificates of deposit issued by financial institutions that are regulated by a United States federal or state regulatory agency;

(2) money market funds;

(3) state or municipal bonds;

(4) United States government securities; or

(5) United States government agency securities.

Man! You have to invest your profits in short-term government guaranteed debt! Imagine if JPMorgan was subject to that requirement.

4 Linearly, though I guess the fee isn't $X. Technically the fee is enough to attract capital of $X. So if X is $100 -- if you need to hold one U.S. dollar for every bitcoin that you hold for customers -- and the expected return on capital is 20 percent, the fee for holding 100 bitcoins would be $20 a year.

5 Maybe it's even required by New York law. That seems like the sort of thing that New York law would require. I have not checked.

6 The obvious parallel for the BitLicense rules is to customer segregation requirements at brokers, but those requirements are not nearly as absolute as the BitLicense rules seem to be. (As MF Global customers found out.) So for instance stock brokers can make use of securities and cash in margin accounts, for stock-lending and other purposes. And all sorts of money-transfer and intermediary activities make similar uses of float to earn some money.

The Austrian obsession with intrinsic worth leads me to another observation about the crypto currency faithful. Not sure if this is an Austrian theory per se (in fact I don’t think it is at all) but it’s certainly something I keep hearing about in the crypto forums and at crypto debates.

What they ultimately desire is a no-debt society.

I find this strange since it runs contrary to the intended evolution of bitcoin that you read about on the bitcoin wiki. This very much envisages a lending market in bitcoin once the supply cap is reached. The only difference with conventional lending is that it prohibits dreaded fractional reserve lending. Only what exists can be lent.

(Related thoughts here, etc., just read her whole blog.) Here is the bitcoin wiki on fractional reserve banking. Here is John Carney arguing that "There's nothing about Bitcoin that means you can't have fractional reserve banking," which is entirely correct but bear in mind that he's arguing against libertarian bitcoin supporters who view the absence of fractional reserve banking as a desirable feature of bitcoin. Here is a post from Libertarian News that begins, "I recently got into an argument over on the Reddit Bitcoin boards where I held the position that fractional reserve banking with Bitcoins was not possible," which sounds fun; he recants that view but does make what I think is a very valid point:

The one thing that would NOT be possible under Bitcoin banking would be the creation of a central bank or FDIC type “insurance” scheme to backstop bank reserves. This is because there is no way for new Bitcoins to be created other than the mining process and because people directly conduct transactions using Bitcoins themselves.

Fractional reserve banking is possible without a lender of last resort who can print money. But it's not, like, a great idea.

To contact the writer of this article: Matt Levine at

To contact the editor responsible for this article: Tobin Harshaw at

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