Bitcoin and cryptocurrencies have weathered the hype to become surprisingly durable analogues to real world currencies. But the ultimate goal of replacing the financial systems we have in place will remain elusive till they can emulate one critical aspect of modern monetary systems.
One of the lauded advantage of cryptocurrencies is that you can’t - other than by mining - create new coins. This means that, thanks to the blockchain, bad actors can’t just conjure money out of thin air. But ironically, the ability to do exactly this is how banks work that operate with traditional fiat currencies (i.e. non-cryptocurrencies like the dollar or pound).
How Banks Operate
The commonly held idea that people deposit money into banks and then banks lend that same money back out to people isn’t really accurate with modern banks. A closer analogy is that banks make a “promise” to pay out the “money” they loan out. When a bank makes a loan, those loans are considered “assets” - because everyone agrees whomever they’ve loaned the money too will pay it back with interest, eventually netting the bank more than it had to outlay in the promise.
But what happens if whoever the loan was offered to simply doesn’t pay it back? Then the loan has to be written off (as something that will never be repaid) and the bank will be devalued by what was outstanding from the loan. Though since a trustworthy bank makes loans only to people that it considers will pay the loan back, the bank will hopefully be profitable as long as it writes off less money than it gains from interest on the loans.
And what if a bank makes too many wrong calls on who will or will not pay the money back? This is why Professor Jim Scott, who was the Director of Boston University School of Law’s Banking and Financial Law program when I took my LLM, used to say that the most important thing in banking law is Capitalization. As long as a bank has sufficient capitalization (money from the initial investors, good loans on the books, etc) it can easily weather a certain number of loans being written off before the bank will “fail” (like Silicon Valley Bank famously did in 2023). Even a bank with some losses can be considered “trustworthy” as long as the regulations on capitalization are followed because it will be able to “weather the storm” of bad calls.
Because banks are considered trustworthy the financial system is designed to act as if the electronic promises banks are making during loans really are equivalent to money. Through the magic of the ACH system and other such agreements whenever a bank makes a loan to a person that person can then immediately transfer that “money” to another bank and that bank will treat it exactly the same as if someone had walked in off the street and deposited cash.
To all intents and purposes the bank making the loan has just “created” money backed by the assets it holds. This financial process is key to growth in our economy and is what fuels investment that is the lifeblood of modern business.
In Contrast, How Cryptocurrencies Operate
However, at it’s most basic, cryptocurrencies can’t be used this way. Pure cryptocurrency banks, who are limited to making transactions on the blockchains involved, are only able to loan out up to the exact amount of coin that was deposited and invested in them because they have no way to “create” the coin that represents their additional assets (i.e. the expected eventual return on the loans they’ve already loaned out). They’re severely hampered in a way that traditional banks - who can often loan out multiple times their funding.
Now, of course, cryptocurrency banks could - if they wished - operate with cryptocurrencies much like traditional banks do with fiat currencies. They could establish a system whereby the transfer of “promise to pay Etherium” from a loan could be treated between trusted banking partners as equivalent in value to an actual Etherium transfer on the blockchain itself. While customers could then withdraw limited Etherium in the same way that traditional bank’s customers could withdraw limited banknotes back out of a bank, the majority of the “money” would exist just as agreements between the cryptocurrency banks.
However, this would mean that cryptocurrency banks, in order to be trustworthy, would have to not only be capitalized by a certain amount of actual cryptocurrency but also regulated in the same way trusted banks are to prevent financial distress. At the very least, they would need to establish a network of trust between cryptocurrency banks about who was trusted for making good loans.
And this…this defeats the whole allure of a supposed decentralized currency. You suddenly have to have a whole infrastructure - unlike normal blockchain transactions - that cares about who is backing the money. Where most transactions are happening “off the chain” where they can’t be tracked (or, at least off the main chain). And you’ve gone a great length to essentially end up with the same issues of centralized infrastructure and power that the blockchain was trying to avoid.
Is there some solution to this problem? Yes and no…as always it’s complicated. Modern blockchain transactions aren’t as limited by ownership of coins. They have the concept of smart contracts that offer the possibility of enforcing contracts about money that could be used to ensure things like capitalization, repayment of interest, et cetera. This technology is being used to support DeFI (decentralized finance). This allows much more direct entity to entity lending that is more fitting to the decentralized ideals of the blockchain.
However, the vast majority of the “money” in the world is still represented by the trust relationships between traditional banks. This is a fundamental problem that cryptocurrencies must overcome if they want to supplant the existing financial networks: How do they effectively capture this existing wealth generated by traditional banks “creating” money through loans.
As time moves on I suspect we’ll see more hybrid solutions to problems with a mix of the old world of banking and the new world of the blockchain working in conjunction. What that will look like however…only time (and the market) will tell what we trust.
Last modified on 2025-06-28