Why it matters
Fractional reserves are incompatible with genuine custody. When a custodian lends out client bitcoin, clients hold claims rather than bitcoin. These claims work fine until they don't: during market stress or institutional failure, fractional reserve systems collapse as withdrawal demands exceed actual holdings.
How it works
A custodian receives bitcoin deposits and records them in their ledger. Instead of holding all deposits, they lend some out for yield or use them as collateral. The custodian bets they can meet withdrawals from remaining reserves plus incoming deposits. When withdrawals spike, the math fails.
Example
An exchange holds 5,000 BTC in deposits but only 3,000 BTC in actual reserves, having lent 2,000 BTC for yield. Normal withdrawals work fine. When prices drop and withdrawals spike, they cannot honor all requests. Withdrawals are paused. Depositors discover they held claims, not bitcoin.
Related terms
- Full-reserve custody
- Rehypothecation
- Proof of reserves
- Counterparty risk
- Exitability
- Segregated custody
