I recently listened to the What Bitcoin Did podcast with George Gammon and Jeff Booth. George Gammon argues that if we move to a Bitcoin money system, then there will be more than 21m bitcoins as paper bitcoin is created in a fractional reserve banking system and this will lead to inflation. George is right in that Bitcoin on it's own, does not stop fractional reserve banking. There is already a lot of paper bitcoin in the system, but he is wrong about a future bitcoin system inevitably being fractional reserve. There is a way that we can stop it and I will explain that later. Firstly, let’s look at the current situation.

FTX were operating a fractional reserve bank, they were selling people numbers on the screen that they thought were bitcoin, but there was not sufficient on-chain Bitcoin to back them. The exchanges and the custodial wallets are where paper bitcoin currently exists. When you give your bitcoin to one of these entities it is no longer yours. You have an IOU from them and you are a creditor to that company. A Bitcoin custodian can issue as many IOUs as they like as long as they have some bitcoin to make good on withdrawals and maintain confidence. The problem comes, if they sell the bitcoin that they have been given and gamble with it or use it to fund an expansion of their business, then run the risk that they can’t make good on withdrawal requests. If a lot of customers try to exchange the IOUs for bitcoin at the same time, then the fraud will be exposed.

The paper Bitcoin that exists on exchanges and custodial wallets can’t be transacted on the Bitcoin blockchain, it can only be transferred on the internal ledger of that service. If you and I have the same brand of custodial wallet and I send you Bitcoin, then no Bitcoin transaction will take place, the company will simply update its internal database to move the value from my account to your account. A Bitcoin transaction will only take place if I send you Bitcoin to another brand of wallet.

There is currently fractional reserve banking and paper bitcoin in the bitcoin system, but the image of the future that George paints, where bitcoin adoption would lead to the same old fractional reserve banking system is not likely to come true. This is because a real use case of Bitcoin is self custody and an ever larger number of people are learning to self custody their bitcoin. It is estimated that only 1.7m bitcoin are currently on exchanges, that is about 10% of the bitcoin currently mined and that is down from approximately 20% a couple of years ago. As increasingly more people lose money with corrupt custodial wallets and exchanges, more and more people will move to self custody. The remaining float of 10% that is held by exchanges will get withdrawn into self custody wallets. As Warren Buffet once said, ‘when the tide goes out, we are going to be able to see who has been swimming naked’.

It is estimated that only 25% of people that buy Bitcoin withdraw it into a self custody wallet. That means that 75% of bitcoiners think that they own the 10% that exists on exchanges. There is a lot of paper Bitcoin out there right now and the custodians that are creating that paper Bitcoin are effectivley shorting the bitcoin price. As the 10% on exchanges slowly gets withdrawn by the hodlers who are dollar cost averaging their savings and as more people get their money off the exchanges and into self custody, there is going to be an almighty short squeeze. Those that are in self custody are going to get very rich and the people that didn’t do the work to learn how to be self sovereign are going to be very disappointed.

Exchanges that have been operating honestly and keeping customer assets on a 1 for 1 basis will be able to allow all their customers to withdraw if they want to. The operators that have been borrowing customer Bitcoin and using it to fund advertising campaigns to grow their business more quickly will be caught out. This event will be a form of singularity in the Bitcoin space, from that time forward, everyone will know that they can’t trust custodians and that Bitcoin must be verifiably on-chain to be real. This is very different future from the one that George Gammon suggests. The people will not tolerate fractional reserve banking, paper bitcoin or inflation. As each of us exercises our right to own our own money, we will be contributing to the integrity of a system that is better for all.

The Irony of what George suggests in the podcast is that, if Bitcoin stays a niche thing for P2P transfers, then it could avoid the fractional reserve printing of paper bitcoin. In reality, fractional reserve and paper bitcoin are already here at this stage of niche adoption. Wider adoption will in fact lead to more self custody that will squeeze out the counterfeiters at the custodial level.

Not your keys, not your Ponzi scheme!