Shermin Voshmgir, September 7 2025
Bitcoin is often idealized by its proponents for its “hard money” qualities. This term is frequently used to convey that Bitcoins supply is fixed and resistant to inflationary debasement, referring to the fact that Bitcoin issuance cannot be arbitrarily inflated in response to political or economic pressures. The core idea is that Bitcoin does not play the Quantitative Easing game because its issuance schedule is algorithmically pre-defined, capped at 21 million coins, and immune to manipulation by central authorities. However, this perceived strength is also a structural weakness. Since Bitcoin has no internal stability mechanism, its supply is entirely inelastic and unresponsive to fluctuations in demand, macroeconomic shocks, or liquidity shortages. As a result, its price is driven purely by demand-side dynamics and speculation, resulting in extreme volatility.
As a currency, Bitcoin behaves more like a rigid form of commodity money or representative money than a responsive monetary system which fiat-currencies set out to create. While it is true that its fixed supply protects Bitcoin the currency from discretionary abuse, it is also important to point out that this strips the network of any tools for stabilizing purchasing power or absorbing shocks. This makes Bitcoin “sound” in a mechanical sense, but arguably “stupid” in an economic one: it is inflexible, non-adaptive, and poorly equipped to engage with the real-world complexities that modern monetary systems must navigate. This is why stabecoins were eventually developed.
Bitcoin’s structural rigidity was supposed to be its strength. But ironically, the crypto ecosystem that grew around it has reproduced many of the very practices Bitcoin sought to escape—especially those linked to fractional-reserve banking, credit risk, and opaque leverage. While Bitcoin avoids central bank interventions and monetary discretion by design, its role as collateral in decentralized and centralized financial systems has enabled a new form of monetary expansion. Many DeFi applications use BTC (often in wrapped or synthetic form) to bootstrap lending and borrowing, sometimes in overcollateralized ways, but increasingly also via undercollateralized or opaque mechanisms. These resemble traditional banking dynamics: credit creation, layered risk, and speculative loops.
While Bitcoin itself avoids the mechanisms of Quantitative Easing and fractional-reserve banking by design, the wider crypto ecosystem using Bitcoin as collateral or building alternative cryptocurrencies or financial applications, has not. Many of the financial behaviors and risks that Bitcoin sought to eliminate, like the moral hazards of central banking and unsound banking practices, have reemerged in new forms, which only demonstrates that technological architecture alone cannot prevent the replication of old patterns, especially when driven by the same incentives of capital accumulation.
Particularly centralized financial applications (aka CeFi) and even in some corners of decentralized financial applications (aka DeFi), structures resembling fractional-reserve banking and quantitative easing have reemerged, albeit via different technical mechanisms. Numerous services, using Bitcoin as some form of collateral or reserve asset, have replicated the same overleveraging, synthetic claims, and monetary expansion that Bitcoin was originally meant to counter. Unfortunately, many investors and users often don't understand that difference.
To counter such tendencies, many decentralized financial protocols that emerged out of the Ethereum ecosystem and alternative blockchain ecosystems, were explicitly designed to avoid opaque financial practices and prioritize transparency, much like Bitcoin. When leverage or liquidity expansion does occur, these DeFi protocols, which are usually governed by open-source smart contracts, would provide on-chain accountability, enabling real-time, permissionless auditing by any participant. Yet despite this transparency and structural robustness, CeFi platforms have often outperformed DeFi protocols in user adoption, transaction volume, and fiat integration. The smoother onboarding process, centralized customer service, and integration with existing financial infrastructure seems to make CeFi more accessible, often at the cost of decentralization, transparency, and trust.
Fractional reserve dynamics are particularly evident in the case of centralized exchanges, which hold Bitcoins as custodians on behalf of their users, and often operate with opaque balance sheets and off-chain accounting. These entities often issue more withdrawal claims than they hold in actual reserves, as demonstrated by the collapses of FTX, Celsius, and others. Much like traditional banks, they rely on the assumption that not all users will request their assets at once.
In the DeFi space, overcollateralized lending protocols such as MakerDAO and Aave tried to avoid these risks, but newer undercollateralized or re-hypothecated models come closer to mimicking fractional reserve mechanics. This is a problem because during moments of systemic stress, even DeFi protocols have to turn to emergency minting or recapitalization schemes, such as MakerDAO’s 2020 issuance of MKR tokens to cover DAI shortfalls, which is very similar to central bank bailouts.
Synthetic and wrapped Bitcoin assets stretch similar boundaries. While tokens like wBTC or tBTC are nominally backed 1:1 with Bitcoin held in custody, they introduce custodial risk and depend on the solvency and operational integrity of third parties or bridge protocols. Some yield-bearing BTC products issued by centralized platforms or on Bitcoin L2s offer pseudo-staking mechanics, but often lock underlying BTC or engage in off-chain strategies that are not fully transparent. Under market stress, redemption guarantees can break down, and liquidity can vanish—exposing users to synthetic representations of BTC that may be temporarily or permanently inaccessible. Centralized BTC yield platforms can also act as liquidity engines, issuing BTC-denominated instruments against expected demand, thereby contributing to pro-cyclical risk buildup reminiscent of stablecoin overissuance in earlier cycles.
Fiat-collateralized stablecoins such as USDT and USDC claim full backing, but have faced skepticism around the transparency and quality of their reserves. Non-collateralized, purely algorithmic stablecoins like Terra/UST demonstrated how confidence-based systems without proper reserves can implode entirely.
What amplifies these effects further is the composability of DeFi, which enables recursive leverage loops. A user might deposit a stablecoin into a lending protocol and borrow BTC (typically in wrapped form) against it, convert that BTC into a synthetic or derivative token (such as wBTC or a BTC yield-bearing token), and reuse that token as collateral elsewhere. This chain of interactions multiplies exposure to the same underlying assets, much like the money multiplier in traditional banking. Even without a central bank, these dynamics produce similar systemic risks: feedback loops, liquidity mismatches, and leverage spirals reliant on continued confidence.
A similar dynamic plays out outside DeFi, most notably in the case of companies like MicroStrategy. The company has become a proxy Bitcoin leverage vehicle in traditional capital markets by repeatedly issuing debt or convertible notes to acquire more BTC. This effectively turns its balance sheet into a leveraged BTC position, amplifying both potential gains and losses. While not executed through smart contracts, the recursive nature of MicroStrategy’s accumulation mirrors leverage loops of TradFi: borrowing to buy more of the same asset and increasing systemic exposure to price volatility. As such, the Microstrategy and other companies that pursue similar paths, exemplify how financialization of BTC is not limited to crypto-native environments but spills into traditional finance, contributing to similar systemic and reflexive risks.
In a worst-case scenario, a sharp and sustained decline in Bitcoin’s price could force companies that overleverages their BTC holdings into a liquidity crisis, triggering margin calls on its debt or a collapse in market confidence. If these over-leveraged companies were unable to meet their obligations or chose to liquidate part of their BTC holdings to stay afloat, it could unleash a cascade of selling pressure, exacerbating Bitcoin’s decline. Such a fallout could ripple across markets—damaging investor sentiment, impacting related equities, and potentially triggering liquidations in BTC-backed DeFi protocols, even if they are not over-leveraged.
This text is an excerpt of The Bitcoin Book published in 2025 by Shermin Voshmgir