Fractional Reserve Banking onchain
Stablecoins are, in essence, the first large-scale experiment in narrow banking. Every USDC or USDT is (or supposed to be) fully backed by reserves - cash or short-term Treasuries - sitting safely off-chain. This architecture is what makes these tokens stable, but it also sterilizes capital: every dollar deposited creates no new credit, no new economic activity.
In contrast, the traditional banking system is predominantly built on fractional reserve banking: a mechanism through which deposits become the raw material for credit creation. For every $1 held in reserves, banks can extend several dollars in loans, multiplying money supply and stimulating growth.
And even though narrow banking has some undeniable stability advantages, they come at a cost: much higher cost of money, tighter credit conditions and a much less dynamic economy overall.
The goal of this post is to explore what fractional reserve banking could look like onchain: why it matters, what early experiments exist, and what’s missing to make it truly work.
Fractional reserve banking vs narrow banking
Fractional reserve banking is the operating backbone of the modern financial system, a structure in which banks keep only a fraction of deposits as reserves while lending out the rest. This system enables credit creation: when a bank issues a loan, it simultaneously creates a matching deposit in the borrower’s account, effectively expanding the money supply. In practice, most of the “money” circulating in the economy does not come from central banks issuing it and distributing it downstream but from commercial banks creating deposits through lending.
This mechanism also introduces maturity transformation: deposits are short-term and redeemable on demand, while loans are long-term and illiquid. The system is powerful, enabling liquidity, investment, and economic growth, but also structurally fragile because it relies on confidence that deposits can be redeemed even though the underlying assets are not fully liquid.
Narrow banking adopts the opposite philosophy: deposits are backed 1:1 by safe, liquid assets such as cash or short-term government securities. There is no credit creation, no maturity transformation, and no expansion of the money supply beyond the base assets. Narrow banking is exceptionally stable, but that stability comes at a clear macroeconomic cost: higher cost of money, constrained credit availability, and a more sluggish economic engine.
The stablecoin world sits squarely on the narrow-banking side of the spectrum. Tokens like USDC, USDT, or PYUSD are fully backed (or meant to be) by cash and short-term Treasuries held off-chain. They do not fund credit, they do not lend against deposits, and they do not create new money. Every token in circulation corresponds to a dollar of reserves sitting in a custodian account. Stablecoins therefore replicate narrow banking almost perfectly: zero credit creation, zero maturity transformation, full reserve backing. This makes them safe and predictable, ideal for settlement and payments, but it also means the onchain economy lacks an endogenous credit engine. Without fractional reserve dynamics, stablecoins can store and transfer value, but they cannot expand it.
How to implement it onchain?
Building fractional reserve banking onchain starts with one key ingredient: tokenised credit. Credit instruments - like loans, mortgages, invoices, receivables - are the essential yield-bearing assets that could serve as collateral of a fractional reserve stablecoin. Various experiments onchain have tried different approaches but none of them has actually closed the loop between deposits and credit creation.
Maker Dao <> Centrifuge
MakerDAO was the first major stablecoin to integrate tokenised credit into DeFi through its partnership with Centrifuge, but the integration also exposed the structural inefficiencies of tokenized credit markets.
In this model, asset originators (Centrifuge) tokenized pools of loans - typically SME or trade finance receivables - and deposited them into Tinlake vaults, which issued two tranches: DROP (senior, stable-yield) and TIN (junior, risk-bearing). Maker accepted DROP as collateral to mint DAI, enabling offchain loans to back an onchain stablecoin.
However, while borrowers often paid interest rates above 10%, investors in these pools typically earned only 3-8%. The spread was absorbed by intermediaries - SPV costs, legal structuring, offchain servicing, and Centrifuge’s own fees - revealing how dependent the model remained on legacy financial infrastructure. The result was a complex, high-friction system that fragmented returns and severely limited scalability.
Indeed, after these initial integrations, no significant expansion followed. The model proved too cumbersome to evolve into a broader, liquid, and composable framework for credit creation onchain - a pioneering attempt that ultimately highlighted the limits of bridging DeFi with traditional credit through legal wrappers alone.
Onchain private credit platforms (Figure, Tradable)
A second wave of platforms has focused on directly tokenizing credit rather than integrating it with stablecoin protocols. Figure operates a vertically integrated system on the Provenance blockchain, tokenizing mainly home equity lines. Tradable structures short-term private credit pools designed for institutional DeFi participation. These platforms typically offer yields in the 8-15% range, depending on borrower risk, currency, and tranche composition. Lenders are primarily institutional investors and accredited DeFi participants seeking exposure to real-world yield.
However, there is no connection between deposits and credit: these platforms act as originators issuing tokenized claims, but they are not banks. They do not transform deposits into loans; they do not engage in maturity transformation; nor do they create money from thin air: credit is funded directly by investors, not created through a stable, money-like liability. As a result, they generate yield, but not money creation.
A new model
In both models described above, the primitives for onchain credit already exist but what’s missing is the liability side of the equation (or a scalable one). Fractional reserve banking cannot emerge without the issuance of deposit-like tokens that are only partially backed by reserves, with the remaining portion backed by credit. That’s the true bridge from today’s DeFi yield markets to genuine onchain money creation.
The real leap will come when stablecoins evolve into tokenized deposits: instruments that function like stablecoins but derive part of their backing from yield-generating credit assets. In such a model, each deposit token would represent a claim on a diversified pool of liquid reserves and longer-dated credit, introducing a controlled form of maturity transformation within the protocol. The system would not promise infinite immediate redeemability; instead, it would algorithmically manage liquidity ratios (akin to reserve requirements in traditional finance) using oracles, onchain accounting, and verifiable proofs of both reserves and loans.
This is where composability becomes transformative: stable deposits, credit creation, and collateral reuse could all coexist within the same ecosystem, operating continuously and transparently onchain. The result would be a living, self-sustaining credit system, one capable of not just allocating existing capital, but creating new money directly within DeFi.
Conclusions
Today’s stablecoin ecosystem is built on a narrow-banking foundation: safe, liquid, fully reserved, and economically inert. This design has enabled extraordinary growth in payments and settlement, but it has also created a structural ceiling: an onchain economy that can move money, but cannot create it. As long as stablecoins remain strictly 1:1 backed by Treasuries and cash, DeFi will continue to depend on external capital inflows. Value can circulate, but it cannot multiply. Credit can be allocated, but not originated. In short, the onchain economy will remain a payment layer piggybacking on the credit engine of traditional finance.
Fractional reserve banking onchain would fundamentally change this equation. By allowing deposit-like tokens to be backed partly by liquid reserves and partly by tokenised credit, DeFi could develop its own endogenous supply of money. Maturity transformation, liquidity management, and credit creation could all become natively programmable behaviours. The result would not simply be “higher yields” but a true financial system: one capable of expanding economic activity, supporting productive credit, and sustaining growth without relying on the balance sheets of US commercial banks and money market funds.
The stablecoin world began as an experiment in narrow banking. The next frontier is the opposite: building the first open, transparent, and composable version of fractional reserve banking. If successful, it would transform DeFi from a settlement layer into a true economic engine one that doesn’t just mirror onchain value created elsewhere, but that actually creates it.