How to properly understand Bitcoin as a productive asset
TL;DR
Bitcoin is currently establishing itself as a new monetary asset on the global financial landscape. In the process of this, market participants are already coming up with different ways to use Bitcoin as a productive asset.
Because we think this is a natural process that cannot (should not) be avoided, we deem it all the more important to correctly understand how exactly Bitcoin is being made productive through different yield product approaches.
To do so, we propose three different angles that make up a trust spectrum every Bitcoin-based yield product is bound to. By introducing the consensus, asset and yield angles, we offer a mental framework that helps understand the risks and trade-offs different yield products have.
Last but not least and based on these three angles, we define what we consider the gold standard of a Bitcoin-based yield product to be and hint at a first implementation that we are building at Brick Towers.
Bitcoin, an Unprecedented Monetary Asset
What is Bitcoin? This question still seems to be up for debate. Some hope it to be a medium of exchange for everyday use. Others consider it digital gold that will serve as the 21st century’s prime store of value. Yet others see Bitcoin as a globally distributed storage layer, which trustlessly anchors and verifies off-chain computation of any kind.
All these viewpoints are somewhat true (and will become “truer” as time goes on). As of today, Bitcoin has morphed into a digital base money first and foremost. As a bearer asset like gold, a risk-free asset like Treasuries, and a currency denomination like the dollar, Bitcoin is becoming the new base money for the digital economy. Existing on top, there will be a multi-layered system of finance, supporting a new Bitcoin-based economy.
Bitcoin (BTC) is redefining the very concept of a monetary base asset. Guided by a transparent algorithm, the cryptocurrency operates under a non-discretionary monetary policy. Not only is there a supply limit (hard cap) of 21 million, but thanks to Bitcoin’s transparent supply schedule, we know exactly how many digital base money units there are at any given time. Bitcoin’s monetary policy is virtually unchangeable, while also being provably scarce.
Contrast this to today’s base money, the US dollar. Undoubtedly, USD is the world’s prime fiat currency and thus of great relevance. Nonetheless, the world has come to accept that the US dollar’s decision-making power over its supply lies in the hands of a small group of unelected technocrats. And it is this group that is tasked with constantly adjusting the US dollar’s base money supply to the vicissitudes of an ever-changing economy.
While this is considered a feature by many experts, it is also a fact that the US dollar’s future supply schedule cannot be known, as its rate of change might be erratic, and its supply cap is hypothetically unlimited. The central bank’s ability to anticipate the incredibly complex interactions of human action in assessing the “right” amount of base money was severely questioned by Nobel laureate Friedrich August von Hayek in his prize lecture “The Pretense of Knowledge”.
To Leverage, or Not to Leverage Bitcoin
For most Bitcoin proponents, the 21 million hard cap of Bitcoin is non-negotiable. As prominent Bitcoin writer Nic Carter summarized: “Bitcoin’s supply schedule cannot change, because Bitcoin IS the supply schedule”. As he and many believe, any alteration would produce something that is distinctly non-Bitcoin. Consequently, in the new world of Bitcoin, where an unchangeable monetary policy reigns supreme, the concept of credit and leverage is met with skepticism. Any type of leverage that creates more claims to Bitcoin is seen as a deviation from Bitcoin’s sacrosanct monetary supply limit.
Leveraging Bitcoin through financial means is considered outright monetary expansion by some Bitcoiners, which they believe is a very “fiat thing” to do. They reject any kind of credit or leverage whatsoever. More nuanced Bitcoiners don’t entirely disapprove of leverage, but still remain skeptical of most of it. They follow the great monetary economist Ludwig von Mises, a prominent figure of the Austrian School of Economics, who delineated two fundamental types of credit in his book “The Theory of Money and Credit”: Commodity credit and circulation credit.
According to von Mises, commodity credit is credit extended based on the tangible presence of real savings. Circulation credit, on the other hand, is credit that is not backed by any underlying real savings. In more technical terms, such credit claims are referred to as unbacked IOUs (from “I owe you”). It is these “paper Bitcoins” created through leverage that Bitcoiners consider economically unstable and thus problematic.
This sentiment echoes throughout the community, with figures prominent like Caitlin Long, former Wall Street veteran turned CEO of Custodia Bank, cautioning against the perils of leveraging Bitcoin. As she aptly puts it, “A fool and his leveraged Bitcoin are soon parted.” Her stance appears compelling, and for good reason. The events of 2022, marked by the downfall of leveraged-based Bitcoin lending companies like Celsius and BlockFi, underscored the validity of Long’s position and that of her peers.
Celsius and Co. Proved the Point
In a scenario reminiscent of the Lehman Brothers collapse, the wider crypto market spiraled into a credit crunch in 2022, impacting numerous players within the crypto lending sector. From crypto lenders and brokers to hedge funds and exchanges, a multitude of market participants either suspended operations or filed for bankruptcy altogether.
Buoyed by the resurgence of the bull market of 2020/21, institutions such as Voyager, Three Arrows Capital, Celsius, BlockFi, and FTX experienced substantial growth. Contrary to prevailing beliefs, most crypto lending activities were not peer-to-peer and came with significant counterparty risks. It was customers lending directly to the platform. The platforms then went on to deploy these funds into speculative strategies, aiming to generate superior yields without using an adequate level of risk management.
The DeFi summer of 2020 marked a surge in crypto activities. The rise of major DeFi protocols, including decentralized exchanges (DEXs) like UniSwap, and overcollateralized non-custodial lending and borrowing platforms like Aave, has facilitated economically viable and sustainable yield generation methods for liquidity providers and lenders in the on-chain markets.
Numerous large crypto players then capitalized on different versions of these emerging and highly innovative DeFi protocols to provide exceptionally competitive yields.
These yields were primarily fueled by protocol token inflation, artificially facilitating such attractive but unsustainable payouts.
However, because of a lack of a robust business model or properly designed tokenomics, there was no sustainable yield generated. Back then, these DeFi protocols remained disconnected from the traditional economy. This was exactly where a sustainable source of yield through real economic flow would have to come from. Yield is the generated flow above maintenance costs or depreciation of the carrying capacity of some stock of an economically productive asset. DeFi was lacking this, making the entire undertaking unsustainable. It was only later when protocols like Maker or Aave interacted more closely with businesses from the real world that this started to change.
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At its core, the main issues of the 2022 crypto credit crunch were
- Unsound portfolio decisions (Terra-Luna or stETH/ETH trade)
- Excessive leverage taking (3AC super-cycle bet)
- Hunting for unsustainable yields (Artificial Yields)
- Unprofessional risk management (Celsius’s collateral investing, Voyager’s highly concentrated uncollateralized lending)
- Unsecured lending to non-rated/unhealthy counterparties
- Misuse of customer funds (FTX, Alameda Research)
- Non-segregated collateral (Voyager, Celsius, Hodlnaut etc.)
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What the crypto credit crunch of 2022 brought to light was a myriad of issues surrounding centralized yield instruments. Ever since, concerns regarding transparency and trust have taken center stage, accompanied by a host of risks including liquidity, market, and counterparty risks.
At the same time, we learned that when new blockchain-based “banking services” are centralized and heavily rely on off-chain risk management processes, they do not really differentiate from traditional banking. And this is a problem. After all, the history of our traditional banking system is proof that an off-chain system without adequate risk management is riddled with continuous failures and fraud. This is mainly because necessary checks and balances cannot technically be implemented in a transparent and independently auditable manner, which tends to create the need to over-regulate.
Bitcoin-based Yield is not Optional
With all the bad memories from 2022, the inevitable question still stuck in many people’s heads is: Should the ecosystem embrace Bitcoin yield products, or do they pose too great a risk, resembling characteristics of the fiat system? While the reservations are indeed justified and the question seems reasonable, it is also naive to believe that bitcoin-based yield products will cease to exist.
In any well-functioning society, the need for credit and thus yield naturally arises. As a matter of fact, credit is a prerequisite for a wealthy society. It is in underdeveloped economies, where a web of credit facilities is lacking and the viability of long-term lending is severely constrained, that people are stuck in the clutches of a subsistence economy, mainly revolving around agriculture and direct consumption. It is only when credit is possible that a more roundabout, productive capital structure can emerge.
To build the Bitcoin-based economy many Bitcoiners are dreaming of, the Bitcoin protocol will need a system of credit and yield to emerge on top of it. While proponents may extol Bitcoin’s virtues as a new form of money ad infinitum, the reality remains: money requires a native economy, which turns it into a currency as well that people can actually use. This underscores the imperative for Bitcoin-based yield mechanisms to foster the development of a robust Bitcoin-centric economy. Such an ecosystem would pivot on Bitcoin as its digital base money, yet leverage Bitcoin-based yield products to facilitate widespread adoption and utilization.
It’s All a Trust Spectrum, Anon
Unlocking Bitcoin’s full potential as a productive asset involves navigating a delicate balance of trade-offs. When it comes to offering yield on Bitcoin, it is essential to understand that options can be built along a three-folded trust spectrum.
The primary aspects to look at are:
- Consensus
- Asset
- Yield
All of these aspects can be assessed according to their level of Bitcoin nativeness. The higher a Bitcoin yield product scores on that spectrum, the more aligned it is with Bitcoin and thus the more trust-minimized it generally is.
This reduces the exposure to counterparty risks, or rather, we move from a dependence on intermediaries to one on code. Code is much more transparent and thus more resilient than off-chain intermediaries. This is a progression worth exploring, and creating options for a native yield on Bitcoin should be the gold standard and the ultimate goal of the Bitcoin community.
Consensus Angle
Here, we ask ourselves how close a yield product’s underlying security is based on the Bitcoin blockchain’s consensus. We can distinguish between four different categories. If there is no consensus at all, the base infrastructure remains off-chain and can thus be considered a centralized approach.
Within this category, we put centralized platforms. While examples like Celsius or BlockFi are defunct, there are still several so-called CeFi solutions on Bitcoin out there. Among the most popular are offerings by crypto exchanges (CEXs) like Coinbase, Binance, Kraken or Bitfinex (list not exhaustive).
As centralized platforms, their dominant model is custodial, having full custody over users’ assets. Because users relinquish control of their Bitcoin to third-party platforms, they are exposed to potential vulnerabilities stemming from counterparty risk and dependency on intermediaries. After all, these solutions “merely” use BTC, the monetary asset, while yield strategies are mostly enacted off-chain through the use of traditional finance mechanisms.
Although these solutions represent an inevitable step in the evolution towards Bitcoin adoption, these platforms remain highly centralized. Thus, they clearly resemble traditional financial institutions (many times, these platforms are even riskier because they lack the track-record, the necessary integrations and regulatory clarity compared to their traditional counterparts).
Another category we refer to is standalone consensus. The base infrastructure is decentralized, represented by a public blockchain with a distributed consensus. Distinctively though, the blockchain has its own consensus mechanism that is independent of that of Bitcoin, with no conscious intention to bind the former to the latter in any way. Examples of this category are public blockchains like Ethereum, BNB Chain, Solana, Polkadot, Dfinity and others.
A related but different category we define as inherited consensus. The base infrastructure is also decentralized, represented by what is commonly called a Bitcoin sidechain or Layer-2 with distributed consensus. Although a Bitcoin sidechain has its own consensus mechanism too, it aims to be more closely aligned with the Bitcoin blockchain.
Different Bitcoin sidechains have different degrees of incentive alignment with Bitcoin’s blockchain. Stacks can be considered a decentralized sidechain, while Rootstock and Liquid Network are categorized as federated sidechains.
The last category that we define along this trust spectrum of different consensus approaches is native consensus. The base infrastructure uses Bitcoin’s native consensus mechanism as the underlying security model. There is no blockchain or sidechain, but a decentralized network of off-chain payment channels cryptographically linked to the Bitcoin blockchain. As such, there is no additional consensus, but a full reliance on the Bitcoin blockchain’s consensus. Because of this, there is no additional consensus trust assumption in place for this to work.
The prime Bitcoin scaling solution that offers this type of native consensus is the Lightning Network. Several ongoing projects are attempting to develop yield solutions on top of Lightning, each with its specific setup in terms of assets and yield generation, which we’ll describe in more detail below.
The closer a Bitcoin yield product is to Bitcoin’s native consensus, the more aligned it is with Bitcoin. Generally speaking, we are also of the opinion that the closer the consensus layer to the Bitcoin blockchain, the more trust-minimized the Bitcoin yield product is. This is because we consider Bitcoin to be the most trust-minimized blockchain protocol there is. We are aware that this question is up for debate and things like consensus security or consensus decentralization need to be analyzed and juxtaposed to definitively answer it. However, in this article, we do not want to focus on this.
All we have to say is that we consider the no consensus category to score worst in terms of decentralization and thus trust dependency. There is the argument that a centralized base infrastructure that uses BTC to offer yield might be more trust minimized than a decentralized sidechain because of safety guarantees set in place through traditional regulations. Again, this boils down to a discussion that we cannot have here.
Native consensus on the other side, we believe, offers the highest level of trust-minimization. It gets trickier when we examine the standalone consensus as well as the inherited consensus categories. Different solutions within these categories can be assessed according to their level of decentralization. For one, there is the level of how decentralized the consensus of the underlying base infrastructure itself is. We can refer to it as consensus trust.
Public blockchains as well as Bitcoin sidechains vary in their level of decentralization and security, leading to different gradations in terms of consensus trust.
Asset Angle
When it comes to the asset part of the equation, we can ask a similar question: How closely aligned is the asset used by the Bitcoin yield product with Bitcoin (BTC) the asset? Here we can distinguish between three different categories.
The first one is non-BTC. Some solutions have a different asset apart from BTC altogether that is not even a tokenized version of it. If this is the case, the Bitcoin alignment level is rather low. When strictly looking at things from this perspective, Stack’s stacking option can be included in this category. In stacking, Stack’s native coin STX is used to generate a native Bitcoin yield in BTC. It is important to note that Stack’s offers other versions, mentioned below.
The second category in the asset angle is tokenized BTC. Here the level of Bitcoin alignment is higher when compared to the first category. In this category, we find tokenized versions of BTC on public blockchains with a standalone consensus like Ethereum (WBTC, renBTC, tBTC), BNB chain (wBTC), Solana (tBTC), Polkadot (Interlay BTC), Dfinity (ckBTC) and others.
Also part of this category is a suite of tokenized BTC-hosted Bitcoin sidechains with inherited consensus. There is XBTC, aBTC (and soon sBTC on Stacks), L-BTC on the Liquid Network as well as RBTC on Rootstock. There are many more versions of tokenized BTC in the pipelines, as projects like Merlin Chain (M-BTC) are about to be launched over the next several months.
When it comes to tokenized BTC, decentralization matters as well. More specifically, there is a level of decentralization regarding the so-called pegging mechanism. Given there is a consensus network that is different from the Bitcoin blockchain, assets have to be transferred between them. This is where a certain level of trust through bridging (as in the example of tokenized versions of Bitcoin, e.g., WBTC) or pegging (L-BTC, RBTC, etc.) comes in, and it differs for different public blockchains from the standalone consensus category, as well as for different Bitcoin sidechains that are part of the inherited consensus category.
The third category is native BTC. This means that the asset used is on-chain Bitcoin (BTC) and there is no tokenized version of any kind involved. For this category, Bitcoin alignment is the highest as there is perfect alignment since BTC is used. Interestingly, CEX solutions use Bitcoin’s native asset BTC. Also, there is a project called Babylon that is focused on Bitcoin staking. It is an attempt at “reusing” the staking mechanism from Proof-of-Stake blockchains for Bitcoin. Babylon’s Bitcoin staking protocol allows PoS systems such as PoS chains, L2s, data availability (DA) layers, oracles, and others to acquire staking capital from Bitcoin. The asset that is used is BTC and in doing so, the goal is to scale Bitcoin to secure a decentralized world of finance.
One of the first projects making use of the “Lightning Network” to power Liquid Staking is Stroom Network. There is a DAO that functions as a financial protocol connecting the Bitcoin Lightning Network to EVM-based blockchains, like Ethereum, for example. This way, users can earn Lightning Network revenue from payment channels Stroom manages by depositing their BTC with the Stroom Treasury. Against BTC, wrapped tokens called stBTC and bstBTC can be minted on EVM-based blockchains and used in the wider DeFi ecosystem.
Yield Angle
Again, on the yield side, the question of Bitcoin alignment arises as well. We can apply the same categories we did for the asset part, which are non-BTC, tokenized BTC and native BTC.
On the non-BTC side, we have Babylon. The yield paid comes in the native asset of the PoS blockchain, whose security is increased through Babylon’s staking mechanism.
In terms of tokenized BTC, with Stroom, a user receives yield in the form of a lnBTC token. Sovryn, running on Rootstock, enables lending and borrowing on Bitcoin using the tokenized BTC version RBTC that is also generated as yield. On the Liquid Network, there exists the Blockstream Mining Note (BMN), which is an EU-compliant security token in USDT that provides qualified investors access to Bitcoin hashrate. At maturity, the mined bitcoin is delivered to the respective BMN token holders in BTC or L-BTC.
When it comes to Stacks, different options are available. Yield applications that will be using sBTC are paying out yield using tokenized BTC. Regarding Stacks’ stacking option, it is important to note that the yield generated is accruing in native BTC. This also goes for centralized yield products provided by several CEXs, where native BTC is delivered as a yield for users.
What We are Building at Brick Towers
Contemplating the ideal Bitcoin-based yield product, the gold standard product would combine the following three attributes: Native Bitcoin consensus, native Bitcoin asset and native Bitcoin yield. Such a product would mimic near-perfect Bitcoin alignment.
At Brick Towers, we believe in Bitcoin as a long-term savings solution and want to make it a productive asset following this trust-minimized and native approach. We want to enable our customers to participate and let them productively use Bitcoin without effort and, just as important, without ever having to worry about the security of their Bitcoin.
Our solution targets to generate a native yield in Bitcoin, which will depend on the success of Brick Towers to bootstrap and gain a reputation as a valuable routing node for other participants in the Lightning Network.
Our sophisticated algorithm deploys capital where other network participants demand liquidity and are willing to pay for it while optimizing for capital efficiency. It is based on quantitative analysis with hands-on experience built up during the last three years and captures deep insights into the fundamentals and economics of the Lightning Network.
This setup is a win-win-win for the growth of the Lightning Network, Bitcoin as an asset, and our customers. There is no wrapped coin involved while we are aiming to minimize any counterparty risks by our approach.
© Brick Towers 2024 (inc. ₿ Block 791008)
Co-Author: Pascal Hügli — a dedicated Bitcoin analyst and researcher, deeply immersed in all facets of the Bitcoin ecosystem. He has been studying the development of a proper and robust Bitcoin-based financial system for years.
