Are we in an era of fractional reserve crypto banking?

Allegations in the wake of the recent Tether hack bring up a fascinating topic about the very nature of "money" and what we believe to have value.

In theory, Tether (or a competitor with a similar asset pegged business model) has a certain allocation of fiat currency it can exchange one-to-one with a crypto token worth the same amount of fiat equivalent.

With Tether, one USDT is always supposed to be worth one US dollar. This provides a gateway to exchange value between fiat and digital currencies as long as people trust one Tether can be exchanged for one dollar (less ever present fees of course).

But what if Tether's are stolen?

In rudimentary form, when physical dollar bills are stolen and the serial numbers are known, the currency can be flagged and made invalid. The same is true for stolen Tether tokens that can be declared invalid and thus not accepted by regulated merchants.

Thus, the Tether fiasco is a distillation of how the entire fiat currency system works. Because value is fictitious, central control can declare any and all currency invalid and simply issue new ones.  If managed well the system works fine, but mismanagement by centralized power structures can easily lead to hyperinflation and debasement of currency. 

If an equivalent amount of physical gold bullion was stolen, it might be possible to put out warnings to gold dealers about accepting large gold transfers, but the underlying asset could not be declared invalid and worthless as gold has an intrinsic value that cannot be destroyed.

"Real" cryptocurrency where the user controls the private keys behaves just like physical gold. No central authority can declare the currency invalid, though stolen funds can still be tracked through the blockchain (unless laundered through an anonymous protocol like ZK-SNARKS)

But what if the number of Tethers in circulation do not equal audited reserves?

As of November 22nd the market capitalization of USDT hovers around 676 million which can be seen here broken down by exchange.

The last semi audited reserves of Tether took place on September 15th with the total value of US dollars under Tether control estimated at $442,481,760, which exceeds the Coinmarketcap estimated value of $420,283,000.

Less than two months later the market cap of Tether has risen to over 675 million US dollars. As the auditing is not real time transparent, either Tether acquired 200 million US dollars of new currency in the last 2 months, or they have invented the first crypto fractional banking system. 

Are centralized exchanges massive derivatives markets?

Even if Tether provides perfect one-to-one dollar-to-Tether matching (again less fees ), does every exchange behave with perfect balances of user funds to actual funds?

Each exchange has a certain number of requests for withdrawals each day. As long as the daily withdrawal requirement can be maintained, in theory less actual tokens could exist than are traded.

Fortunately the blockchain itself exists to help with this problem. 

Every exchange operates two types of wallets:

  • A  "hot wallet" with a small amount of tokens accessible for everyday withdrawals connected to the internet.  
  • A "cold wallet" away from internet access that stores the bulk of the reserves users have with the exchange. 

Example audit

To illustrate this example, the exchange Poloniex has one of the largest balances of the cryptocurrency NEM in the entire blockchain.

It's interesting that an exchange representing 25% of all transaction volume only represents 3.3% of outstanding NEM in circulation. This could very well be innocent as most NEM is still in the hands of it's original investors verified by searching the block explorer rich list. 

Takeaways

The lessons learned in the wake of the Tether hack illustrate the dangers of fractional reserve banking. By printing money out of thin air rather than tied to an audit-able record of account, belief in the system can be severely undermined. 

This is not to disparage the history of fiat fractional reserve banking. In a time before cryptocurrency, the low tech creation of massive liquidity and debt helped fuel the modern world at a pace full reserve banking would never allow for.

As we step into the next monetary era, we should remember lessons from the previous era to not make the same mistakes again.