I often discussed a topic which is generally underrated:

BTC Exchanges: their functioning and their way of using a fractional-reserve

On a daily basis BTC exchanges make several operations: most of them are likely to be outside the BTC Blockchain.
If you don’t know, the majority of those operations happen on a private account book which will be never shown on the Blockchain.

Let’s take an example to see how a BTC exchange works.

Let’s say I deposited 10 BTC on the Lovely Exchange and my friend Charlie did the same: both the operations are official BTC transaction registered on the Blockchain.

Now, Charlie and I can start trading on the private account book and whatever will do is not registered on the Blockchain but it’s kept inside the exchange.

The Lovely exchange owns our 20 BTC that can theoretically be used on the real Blockchain: until we don’t withdraw those BTC they belong to the exchange unless we decide to take them out.

But, right now, those BTC can be used on the Blockchain  by the Lovely Exchange.

The value we see on the exchange is a virtual one: so long as Charlie and myself will keep those BTC on the exchange they’re not really ours. The real owner is The Lovely Exchange.
Now, if the Exchange is serious, wise and good enough will keep the 20 BTC there without using them: the day we will want them back we’ll do our withdraw and we’ll ask for them again.

But what if the exchange actually uses those BTC? What happens?

The exchange can start moving them on the Blockchain while Charlie and I keep trading them on the exchange itself.

This means that 40 BTC are moving: 20 real BTC and 20 virtual ones. What? The BTC can’t double! Can they?

Obviously, this will be the extreme situation but perhaps the Exchange will keep track of customers operations and it will understand that there will always be
a certain amount of BTC in its hands: this means that is very unlikely that customers BTC will be withdrawn all at the same time.
Therefore, the exchange will always keep a certain liquidity to honour small/medium sized withdrawals.

To be clear let’s say the exchange will keep the 50% of the BTC deposited.

Banks in the real world work the same way, they never keep all the liquidity in their belly but they have a small portion of the big cake.
Technically what they use is called Fractional-reserve banking. Laws require they keep at least the 2% of the total amount: again,
this means that the moment we would all take our money back the system will collapse since that money simply don’t exist in the real world. They are as virtual as our BTC.

What happens is that banks have a 98% of deposits in their hands: they can use that money for basically everything. Our money got multiplied with a magic trick.
This can happen due to the money multiplier, one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system.

With a fractional-reserve of 2% (like the one banks are using) the money multiplier is 50. This means that the amount of money will be multiplied by 50 compared to initial amount.
With a bigger fractional-reserve, let’s say for example of 50% we’ll get a money multiplier of 2 which is in any case the initial amount doubled.

So, let’s come back to BTC.

It is more than likely that exchanges have the power to decide what to do and how to use this money multiplier mechanism.
If they are savvy they’ll have a fractional-reserve of 100%, meaning that they’ll keep all the BTC deposited ready to give them to customers when they will want their BTC back.
But no one forbid them to use fractional-reserved based policies: if they use a value of 50% they’re going to double the amount of BTC they have because of what we saw before.

Therefore two things must be considered:

Since the majority of BTC transactions happen on a private account book which will be never shown on the Blockchain no one will notice (until a certain point)
whether or not an exchange is using some fractional-reserve based policies.

At present time there’s no regulation, no transparency whatsoever and in fact no exchange states this on their T&C and none of them admits if they use the money multiplier.

In the end just a practical example:

Let’s suppose that 20% (almost 3.000.000) of all present BTC are deposited on exchanges and that they’re actually using a fractional-reserve value of 50%.
These 3.000.000 BTC, considering what we explained regarding money multiplier, will become 6.000.000:

3.000.000 of real BTC as they appear in the Blockchain; 3.000.000 in exchanges’ private account books.

Yes, there are more BTC around since they’ve been doubled thanks to that mechanism.
All the value used were just useful to explain what can happen in the BTC exchanges world: we showed that having no regulation and no transparency it might be possible
that BTC exchanges are creating quite some inflation into the BTC ecosystem by using the means of the fractional-reserve banking.
This phenomenon probably increased BTC liquidity last year: it’s very likely that BTC exchanges started to use that power in order to profit from it.


Q&A


Q: Are you telling me that BTC Exchanges can do what they want with my BTC and also manipulate the price?

A: First of all, as we said, they have a huge power which is the possibility of using the money multiplier.
We don’t know whether or not they’re using it but it’s likely that some of them are taking advantage of it.
The good thing for you is that you have a great power as well: NEVER store your BTC into an exchange.
Use the exchange only when you really need to change your BTC for something else.
This is the only way to avoid that exchanges will use the money multiplier to double, triple etc. your (our) BTC.
Of course there are traders out there who will keep their BTC on the exchanges a little longer but for the average
Joe there’s no need to use an Exchange as a wallet.
This is the reason why we decided to write this guide since we believe that more and more people need to be aware of this very little known phenomenon.
As we see it there’s just a simple rule to follow:

DO NOT HOLD YOUR BTC ON THIRD PARTY EXCHANGES – BE YOUR OWN BANK

BTC technology grant you the right to be the only responsible for you money, you can really be your own bank. Never use any third party service unless it is really necessary.
This is the way you’ll contribute the lower the power of these powerful exchanges.
Don’t let them taking your own rights and don’t let them getting rich with your money.


Q: So is it possible to have an open-source exchange?

A: Yes, it is but it’s more important that this exchange will decentralized as well, therefore it needs to be p2p as the BTC protocol itself since the most important thing
 is that it doesn’t have to make someone else’s interest.
There are some projects out there, have a look
https://bitsquare.io/
but these projects require time and in the meanwhile we must learn how to live with traditional exchanges.


Q: What about exchanges which give interests on BTC deposits? Do they use a fractional reserve system?

A: That might be the case. They’re buying at a cheap rate the power to use the money multiplier. This is why we must spread this awareness regarding how the exhanges work.
Being in the BTC world since 2 years and not having heard about this before it’s really a problem. This could be a ticking time bomb for the whole BTC system.
Everyone believes that we have only 13.700.000 BTC available but if what we said it’s true maybe we have way more than that out there.
This also means that exchanges can “create” BTC at a dirty cheap rate that, on the long run, might kill the BTC mining industry.


Q: Why do you think this is already happening?

A: We do not have any proof so far, we can just guess.
We can notice that objective indexes like total addresses, number of active addresses, number of transactions etc. are growing exponentially.
For example, at the beginning of 2014 there were about 2.400.000 active addresses e now there are more than 4.000.000 (an increase of 70%).

There’s a need of a huge inflation to balance and surpass in a negative way a phenomenon like this one.
On the other hand, the market is getting more and more liquid. Here on BTCTALK you have a great deal of explanations such as:
a)miners get their liquidity very soon and therefore they create inflation: but miners can generate no more than a 10% inflation rate per annum (and this is already diminishing);
b) Historical big holders that dump their belongings in a very masochistically way: why they didn’t do that when BTC value was above 1000$?
c)more and more merchants accept BTC payments (like dell, overstock, Microsoft) and get fresh fiat money straightforward but they don’t produce inflation;
   it’s true that they raise the circulation speed but that’s not very relevant anyway.

None of the above convince us if tested with data.

The number of BTC exchanges is growing day by day and so it goes for total transaction volumes. The more they are, the more volume the move the greater
will be their power to use the money multiplier at very low prices and risks. No transparency evidence comes from the BTC exchanges regarding this matter.
All these proofs lead us to suspect the this phenomenon is real and it is already happening. Anyway, even if these proofs were not sufficient,
no one should leave the power of using the money multiplier to exchanges. Granted that they’re not using it, nothing blocks them to use it at a certain point.

DO NOT HOLD YOUR BTC ON THIRD PARTY EXCHANGES – BE YOUR OWN BANK


Q: You convinced me that this problem is a real one. What can I do to help?

A: AS we said this is a real problem indeed which is giving already its inflation related problems. But, I’m sorry, right now we don’t know any technical solutions for it.
The only thing you can do is helping proposing/creating a technical solution to compel exchanges to be more transparent and asking for the creation of p2p exchanges.
In the meanwhile, please spread the word about this problem and use this signature if you wish

DO NOT HOLD YOUR BTC ON THIRD PARTY EXCHANGES – BE YOUR OWN BANK

If you are a normal user, like us, it’s good for you and for our community at least to be aware of this problem and its effects.
If you are a miner, an honest exchange or a honest BTC investor then you have a great deal of interest in avoiding this phenomenon to happen.


Q: I don’t believe you, I don’t understand the problem and I don’t really mind. Are you just another conspiracy theorist?

A: We’re not conspiracy theorist and whether or not you don’t get our point it’s in your best interest not to store your BTC in any third party exchanges for too long.
Do you want to be the next Mintpal, Mt.Gox, Bitstamp etc. sad customer?

So, even more if you think we said a bunch of bullshits just bear in mind our golden rule

DO NOT HOLD YOUR BTC ON THIRD PARTY EXCHANGES – BE YOUR OWN BANK


gbianchi  bitcointalk.org Donations: 17ykWbCHG6eMfLt42zCJVw5bZE1YxRMihL

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