Reserve Currency Fallacy

There is a theory that Bitcoin will eventually be held by states as a reserve currency and that individuals will transact using state money "backed" by Bitcoin. The theory asserts that transaction volume is insufficient for its use as a consumer currency, but the ability to prevent monetary inflation makes Bitcoin an ideal reserve asset. Central banks and their authorized functionaries would issue negotiable promissory notes while holding Bitcoin in reserve. Given that Bitcoin cannot be inflated, the litany of problems produced by state control of money would be resolved, ushering in a new era of prosperity. Transaction fees would be low while transaction volume would be limitless.

Let us consider the scenario as it unfolds. Bitcoin becomes a fairly widely utilized currency but struggles with low transaction volume, high fees and long confirmation times. In order to obtain a reserve of bitcoin (BTC) the state issues negotiable Bitcoin Certificates (BC) in exchange for bitcoin. This may be accomplished by seizing centralized accounts (compelling conversion) or by market trading, both of which have been done to build gold reserves. An auditing process is set up whereby people can verify that the issued BC never exceeds BTC reserves. Legal tender laws are created, requiring people to accept BC as payment for settlement of debts unless otherwise explicitly agreed. People purchase BC with BTC so that they can pay taxes and buy stuff from white market retailers. Eventually most BTC is held as state reserves.

This scenario should sound familiar, as it is how states ended up with gold and people ended up with paper. The theory is invalid on multiple levels.

The ratio of issued BC to BTC in reserve cannot ever be effectively audited. Even if Bitcoin consensus rules somehow remain, there is no way to know how much BC has been issued, and there is no recourse if debasement is suspected. The central bank must be trusted to account for BC issuance, and ultimately this means everyone trusts the state to not engage in easing. History demonstrates that this is unlikely, and nevertheless it is no improvement over current state monies.

So why is it that a person cannot ever effectively audit (validate) BC, as is possible with the BTC that it replaced? Because that would make BC indistinguishable from the BTC held in reserve. In other words the reason there is a difference between legal tender and reserve currency is to enable inflation of the currency in use (taxation) while holding a better money in reserve (hoard).

Furthermore, for Bitcoin to exist there must be an actual decentralized Bitcoin economy. Without individuals validating BTC received in trade, there is nobody to refuse invalid BTC as it comes to be redefined by the state. In this case censorship and inflation can easily be introduced, invalidating the theory. Only black market Bitcoin transaction and mining can resist this transition. This provides little economic pressure on the state to maintain consistency with Bitcoin consensus rules.

Layering preserves the cryptodynamic principles of decentralization, while "backing" is full abandonment of them. Bitcoin cannot be sustained as predominantly a backing money for central bank notes. People must trade with it for it to be secure. It is certainly possible for Bitcoin to be held by state treasuries, but this offers no transaction scaling or other advantage to people.