I don't think you're following me. This isn't some hypothetical scenario. It's common for people who own bitcoin to have their bitcoins deposited at some exchange. Since exchange customers are unlikely to withdraw all their bitcoins simultaneously, exchanges don't have to keep 100% reserves. For instance, they can lend out some of the reserves, or they can use them for whatever purposes they want. When this happens the quantity of bitcoins in circulation goes up. To all effects and purposes, new bitcoins have been created and put in circulation.

I hope that I'm not following, because what you just described is both crazy and illegal.

Cryptocurrencies are currently considered securities under US law. You can't just pop unrealized securities into existence when a prospective investor asks you for them: it's akin to naked shorting. That's why the stock market has "market makers," i.e. firms that provide low-latency settlement of securities in exchange for a small part of the spread.

I can't find any evidence online that any reputable exchange is using its underlying reserves to cover multiple in-kind balances. If you have links to exchanges actually doing this, both I and the SEC would love to see them.

Edit: I'm struggling to even find links to people discussing this hypothetically online. I found this one on a wiki[1], where it's discussed in the abstract. And I found another thought piece from the Atlanta Fed[2]. But no indicator that any current above-board reserve is currently doing this.

[1]: https://en.bitcoin.it/wiki/Fractional_Reserve_Banking_and_Bi...

[2]: https://www.atlantafed.org/cenfis/publications/notesfromthev...

It can be crazy, in your opinion, but the fact is fractional reserve banking has been a standard practice in banking since the invention of banking. I don't know of any country where it's illegal. Whether it would be legal for crypto-exchanges, which typically don't have a banking license, to engage in fractional reserve banking I don't know. Even if it was illegal in the US, it could be legal in Cayman Islands, or elsewhere, and the result would be the same—an inflated supply of bitcoins circulating around the world. Also a lot of exchanges don't seem to be regulated at all. The ones that are regulated could just get a banking license.

Fractional reserve banking isn't the crazy or illegal part. It's not crazy or illegal because it makes sense in the context of currency, where the purpose is denominational value and facilitating value transfers. The crazy and illegal part is the idea of "fractional reserves" in the context of a fixed-supply security. There's no such thing.

I used the US as an example; what you're describing is illegal on every single major international exchange[1]. And as far as banking licenses go: the FDIC won't touch Gemini's actual non-third-party-custodial depository products with a ten foot pole, and they're about as clean as a cryptocurrency firm can be.

If you want cryptocurrencies to "succeed" in some nebulous sense, it would be good to get a start on the "not just good for crime" part of the equation. This isn't it.

[1]: https://en.wikipedia.org/wiki/Naked_short_selling#Regulation...

Yeah, well that's your opinion. I don't think that you know what you're talking about. At any rate, my point isn't about whether crypto-currency deposits backed by fractional reserves are legal or illegal. My point is that the idea that there is a fixed supply of bitcoins is a lie, a marketing narrative to fool gullible idiots into thinking that the price of bitcoin can only go up. And my answer to that is to say that is 1) it's not true that a limited supply ensures that the price can only go up, and 2) it's not true that the supply of bitcoin is fixed, because financial institutions can create additional bitcoins via fractional reserves, and because as a consequence of international trade the supply of bitcoins in different economic areas would fluctuate (sometimes wildly) creating periods of inflation and deflation, just like it happened during the gold standard.