This is how they print bitcoins on-chain. Centralised payment platforms can do the same thing, except they would credit an internal account, instead of a BTC address. Hopefully now it's clear.
Got it, yeah that's clear. Centralized platforms can certainly credit accounts for BTC that don't exist, on a technical level. Will this happen in practice? Will it be legal? Will it be possible to transfer these fake BTC to other platforms? I don't think so.
In the case of USD, the answer is yes. Banks are incentivized to accept fractional reserve dollars from other banks, because in practice they are exactly the same. Why is that the case? Because the issuer of those dollars, the government, has specifically deemed it to be a legitimate practice. There's no risk in accepting fractional reserve dollars. Fractional reserve dollars can be withdrawn as cash, used to pay taxes, used to pay debts etc.
Let's think about Bitcoin now. Fractional reserve BTC cannot be used to pay on-chain transaction fees. It cannot be used on the lightnight network. It cannot be used to participate in smart contracts. Would Coinbase accept fractional reserve BTC from Gemini? There would be no way for Coinbase to redeem them for on chain BTC, without trusting Coinbase to fulfill it. There's no government that can print extra BTC to fulfill Gemini's debts..so it would be surprising if Coinbase accepted these IOUs from Gemini. The issue with fractional reserve BTC is that they are completely unportable. Usable within the issuers ecosystem, sure, but not beyond that.
The thing is that these fractional reserve BTC are indistinguishable from normal BTC. If you receive a payment to your BTC address, you have no way of telling whether these BTC have been created by an exchange. So, to answer your question, yes, Coinbase would accept fractional reserve BTC from Gemini, because they wouldn't know, they would just receive BTC. As long as Gemini has enough BTC reserves to remain solvent, nobody would notice that they have been creating BTC out of thin air.
Wait no, if you receive a payment to your actual Bitcoin address it’s real BTC..I thought we agreed payments to an address can only happen on chain, and on chain BTC cannot be inflated via fractional reserve?
Of course, it's real BTC. The exchange debits the internal account and then uses its BTC reserves to make a payment to the BTC address. The supply of BTC is the sum of BTC balances and this includes balances held in BTC addresses as well as balances held in exchange accounts, just like the supply of dollars includes cash and central bank reserves as well as USD balances held in bank accounts. BTC balances in exchange accounts can be spent just like BTC held in BTC addresses, and are therefore as "real" as BTC held in BTC addresses. To think otherwise is an exercise in wishful thinking on your part, or not really understanding how money works.
> To think otherwise is an exercise in wishful thinking on your part, or not really understanding how money works.
I think you are missing that, with USD, there's actually no distinction between a dollar and a dollar created by fractional reserve banking. They can be used for exactly the same things. With BTC, it's fundamentally impossible for that to be true.
You are comparing fractional reserve dollars generated by a bank to a fractional reserve BTC created by an exchange but it's not an apt analogy. The bank has a charter from the government to essentially create real dollars.
I'm certainly not claiming that it's impossible for a BTC exchange to be insolvent, but doing so is likely illegal and, although it may appear to, does not add net new BTC into the system. Fractional reserve banking adds net new dollars into the system which can be redeposited into a different bank (or the same bank) to once again generate new dollars. Won't work with Bitcoin.
Let's take existing exchanges and brokerages: Coinbase, Robinhood, and PayPal all keep full reserves or lie about it.
To be clear, this is not an analogy. I was describing the process by which commercial banks create money out of thin air. And the same exact process can be used by exchanges to create bitcoins out of thin air. There's nothing special about bitcoin that prevents this money-creation process from working. It works with any asset. It works with commodity-backed money as well. And you don't know that this isn't happening right now, because not all Bitcoin exchanges are audited. It might very well be the case that bitcoins are being created out of thin air right now by some exchanges, thus inflating the global supply of bitcoins. You have no way of telling. Also you don't know whether this is illegal. These exchanges could be in a jurisdiction where it is legal, and it would still affect the global supply of bitcoins.
I understand that an exchange can show you a UI, saying you have BTC that the exchange does not own..