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November 9, 2022

What are Fractional Reserves in Crypto and the Pros and Cons?

You may have heard the term "fractional reserve" in relation to traditional banking, but what does it mean in cryptocurrency? In short, a fractional reserve is when a crypto exchange holds less than 100% of customer deposits in cold storage. While this practice isn't unique to crypto, it does come with some risks that are worth considering. This blog post will take a closer look at what fractional reserves are and some of the pros and cons associated with this practice.

What is a Fractional Reserve?

A fractional reserve is when a financial institution holds less than 100% of customer deposits in reserve (i.e. not loaned out). This practice isn't unique to cryptocurrency; banks have been using fractional reserves for centuries. The most common reserve ratio is 10%, which means that for every $100 deposited, the bank can lend out $90.

The advantage of fractional reserves is that it allows banks to loan out money and earn interest on those loans. This extra income can be used to cover operational costs or used to grow the business. The downside is that if too many people try to withdraw their money at the same time (a run on the bank), the bank may not have enough cash on hand to cover all of the withdrawals. This could lead to insolvency or even collapse.

In cryptocurrency, exchanges also use fractional reserves to loan out customer coins and earn interest on those loans. However, because crypto exchanges are not regulated in the same way that banks are, there is an increased risk of fraud and abuse. For example, if an exchange says it holds 100% of customer funds in cold storage but only actually holds 50%, then the other 50% is at risk of being stolen or lost.

Another downside of fractional reserves is that they can contribute to market volatility. For example, if people start withdrawing their money from an exchange because they think the price of Bitcoin is going to crash, then the exchange may not have enough cash on hand to cover all of the withdrawals. This could cause a panic sell-off and further drive down the price of Bitcoin.

Fractional reserves can be a valuable tool for exchanges to earn interest on customer deposits while still allowing customers to trade freely. However, there are some risks associated with this practice, including fraud and abuse by exchanges, as well as market volatility caused by runs on the bank. These risks should be considered before doing business with any exchange that uses fractional reserves.

Jacques Potts - Sr. Marketing Manager at Ledgible and experienced financial author, marketer, and crypto expert. His work has been featured on The Street, Project Serum, FirstTrade, and Invstr.
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